Step 9 to Reviewing a Business Valuation Report – Reasonableness Testing

Does the valuation report provide sufficient reasoning and rationale to support its findings?  This is a key question to ask when reviewing a business valuation report given that business valuations are somewhat subjective in nature.

Step 9 to reviewing a business valuation report involves assessing the reasonableness of the value conclusions, including the implied intangible value, and/or identifying what reasonableness testing the valuator used to support his/her findings.  Here are 6 reasonableness tests to consider when reviewing a valuation report:

1.  Nature of intangible value

The value of a business can be segregated into 2 components: net tangible asset value (including redundant assets and net of debt); and intangible asset value.  To assess the reasonableness of the value conclusion, you must determine the implied intangible asset value and consider whether this value is justified in light of the specific factors regarding the company’s history and operations.

Factors to consider can include: a recurring revenue stream; customer contracts and/or long-standing relationships; a competitive advantage; a recognized brand name; an established workforce; an effective sales team; an experienced and effective management team; past and future growth; proprietary software or technology; copyrights, trademarks, patents, etc.

2.  Alternate valuation approach

A business valuator will typically select a primary valuation approach to value a company. You should consider whether it is reasonable to consider a secondary valuation approach and, if so, what the value would be under this secondary approach.

Does the secondary valuation approach corroborate the findings under the primary valuation approach?  Examples might include: using the market approach as a secondary approach to an income approach; using the Capitalized Cash Flow ("CCF") approach as a secondary approach to a Discounted Cash flow ("DCF") approach; and using the Capitalized Earnings ("CE") approach as a secondary approach to a CCF approach.

3.  Implied valuation metrics

Certain implied valuation metrics should be calculated when reviewing a business valuation report.  Some common ones to determine include: payback period (i.e. number of years to recover intangible value), EBITDA multiples, Seller’s Discretionary Earnings ("SDE") multiples, sales multiples and intangible value as % of enterprise value ("EV").

Do these valuation metrics make sense given the company’s operations, specific risk factors and when compared to implied multiples from comparable public companies, industry transactions and rules of thumb?

4.  Public company valuation multiples

The implied valuation multiples from comparable public companies can be compared to the implied valuation multiples of the target business (i.e. calculated under #3 above).

Although there are issues with relying on public company valuation multiples to value a privately held company (e.g. due to differences in operations, size, liquidity, growth, etc.), if properly selected and adjusted, they can be useful as an effective reasonableness test.

5. Industry transactions

The implied valuation multiples from actual industry transactions can be compared to the implied valuation multiples calculated under #3 above.

Although there are issues with relying on valuation multiples from actual industry transactions to value a target company (e.g. lack of information, negotiating strengths, emotions, form of consideration, etc.), if sufficient information is available and multiples are appropriately adjusted, they can be useful as an effective reasonableness test.

6.  Industry rules of thumb

Industry rules of thumb can be compared to the implied valuation multiples calculated under #3 above.  Although rules of thumb should never be used in isolation or as a primary valuation approach, they can be useful as an effective reasonableness test.

 

Assessing the reasonableness of the value conclusions is critical to an effective review of a business valuation report.  Depending upon the scope of review, depth of inquiries and experience level, this is an area where business valuators can differ significantly.

If you have any questions with respect to valuation reasonableness testing or if you would like an independent business valuator to assist in your review of a business valuation report, contact us at www.vspltd.ca.