Business valuation is a complex discipline. Much of its lingo, logic and underlying mathematics can be incomprehensible to those outside the profession, giving rise to many misconceptions. So let’s set the record straight concerning five common valuation myths.
1. Net income and net free cash flow are synonymous.
Net income is an artificial accounting concept that is separate from cash flow. Net income includes a deduction for depreciation expense, which many small businesses base on accelerated tax schedules rather than assets’ useful lives. And net income excludes debt service, financing proceeds, owner distributions, capital expenditures and changes in working capital. Accordingly, net income is a poor substitute for net free cash flow.
For example, consider a fictitious business with obsolete fixed assets. Its equipment is in dire need of repair and replacement, because the owner pays himself excessive distributions in lieu of making regular capital improvements. On the surface, the company may appear more profitable than its competitors because its assets have been fully depreciated and current net income includes no depreciation expense.
Substituting net income for net free cash flow may overvalue this hypothetical business. Net income disregards the company’s need to update equipment and the shareholder’s reluctance to reinvest in future operations, whereas net free cash flow accounts for capital expenditures and working capital requirements. In sum, free cash flow is more inclusive and more relevant to value because it represents the amount of cash available to investors in excess of the current operating needs of a business-the essence of value.
2. Unprofitable companies aren’t worth much.
Historic profits are relevant in business valuation only to the extent that they may help predict future cash flow. For example, startups and high-tech ventures may incur losses until they are up and running. Despite being unprofitable, these businesses often possess value because of their potential to generate future cash flow. Hard assets and internally generated intangibles such as patents and proprietary software also contribute value.
Profit also may be artificially suppressed for tax reasons. For example, some professional service firms intentionally minimize net income for tax purposes through partner bonuses. Cash businesses, such as car washes or restaurants, may underreport cash receipts to evade taxes. Values for these companies are often higher than their reported income would otherwise indicate.
3. If its competitor sold for 1.5 times revenues two years ago, a business should sell similarly today.
Although comparable transactions may seem to provide objective, convenient valuation evidence, a lone transaction doesn’t provide a representative sample. A competitor’s sale might include buyer-specific synergies or unique terms, such as an earnout or employment contract for the seller. Consider, too, the reliability of the informant. Like fish stories, transaction details often become exaggerated.
Take, for example, public companies in the funeral industry. In the late 1990s, they aggressively acquire small funeral homes, driving industry pricing multiples to record highs. Although these roll-ups intended to introduce economies of scale and professional management, the strategy failed and forced many acquirers into bankruptcy or reorganization. Today the industry has largely recovered, and pricing multiples have returned to more realistic levels.
4. Tax status has no impact on value.
In several landmark cases-including Gross v. Commissioner, Wall v. Commissioner, Heck v. Commissioner and Adams v. Commissioner – the Tax Court accepted IRS arguments that S corporations (and other pass-through entities) are worth more than otherwise identical C corporations because of their numerous tax benefits.
The most notable advantage to electing Subchapter S status is exclusion from corporate-level income taxes, including corporate-level capital gains tax after a statutory holding period. And S corporation shareholders may receive tax-free distributions as long as their equity basis in the company remains positive.
When valuing S corporations, valuators must decide on a case-by-case basis whether to apply after-tax discount rates and pricing multiples to either tax-affected or pretax earnings. Factors to consider when making this complicated decision include the valuation’s purpose, relevant case law, the company’s distribution history and whether the business interest possesses elements of control.
5. Business value matters only when it’s time to buy or sell.
This is perhaps the biggest valuation myth of all. In truth, virtually every business could benefit from a regular valuation study. From an operational perspective, many business owners have no idea what their asset is worth. An informal valuation can teach management what drives value and ways to increase short- and long-term cash flow. Furthermore, a valuator can shed light on economic conditions and industry trends. This knowledge can improve operating efficiency and, ultimately, increase sales proceeds when the time comes.
Understanding business value is also an important part of contingency planning for key person life insurance, buy-sell agreements and succession plans.
One universal truth
If you’re confused about business valuation, you’re not alone-its ins and outs are frequently misunderstood. An experienced valuation professional can help clear up any myths and ensure your company is accurately appraised.