Common Errors in the Income Approach to Business Valuation
By Mark W. Medwig, CPA, ABV, CFF
A discounted cash flows (DCF) analysis – often used in performing business valuations – may seem like basic finance. There are, however, numerous pitfalls that CPAs should be aware of when performing or reviewing a business valuation for their client.
Under the income approach there are two basic methods: DCF and capitalization of cash flows (CCF). While both use just two primary inputs (economic benefits, usually cash flows, and a rate of return), many factors should be considered to properly apply either method.
Below is a brief discussion of some of the more common technical and judgmental errors encountered when using the income approach.
Inadequate consideration of company-specific risks – The determination of the risk-adjusted rate of return is a crucial step under the income approach. Experts generally “build-up” the rate of return by adding together premiums for various risk factors, such as market, size, and industry. An important – and highly subjective – factor is the company-specific, or unsystematic, risk premium. This premium considers the specific characteristics of the subject company that make it more or less risky than the typical publicly traded company of similar size in the same industry. We often see valuations with little or no company-specific risk, even when the subject company lacks diversification or management depth, has an aggressive growth forecast, is over-leveraged, is a new entrant in a mature industry, and so on.
Use of the “excess earnings” method – This valuation method is a type of CCF in which tangible and intangible assets are valued separately. Its usefulness is generally limited to situations where there is a need to isolate the value of intangible assets, such as divorce cases in jurisdictions where goodwill is considered a nonmarital asset. Although useful as a sanity check of other methods, it should not be used when more suitable valuation methods are available. Unless there is a need to value intangible assets, the CCF method should be used.
Another common error under this method is the use of an unrealistic rate of return on intangible assets. The return on intangible assets generally should be higher than both the return on tangible assets and the overall return of the company itself. The blended rates of return on the company’s tangible and intangible assets (calculated by dividing the total cash flows by the indicated value) should approximate the company’s overall rate of return, developed, for example, using the build-up method.
Blindly averaging results – In a perfect world, each valuation method will result in essentially the same value. In reality, the results of one method may differ from the results of other valuation methods. A common mistake is to simply average the results, giving the same weight to each method. Valuation standards require experts to reconcile the results of valuation methods used, considering the strengths and weaknesses of each method in light of the specific facts and circumstances. Often, one method provides a more reliable result than the others, and some methods may have little or no reliability.
Inadequate support – Appraisers sometimes make unsupported assumptions and assertions, neglecting to explain the basis for what was done. For example, in a recently reviewed valuation report that used the excess earnings method, the expert did not explain why the excess earnings method was appropriate when there was no need to isolate the value of intangible assets. In addition, the expert failed to support his conclusion that the company had significant intangible assets – even though, due primarily to the company’s industry, it was unlikely that there would be significant value attributable to intangible assets.
Without a reasonable basis for key decisions and assumptions, the report may lack credibility and result in an unreliable conclusion of value.
Lack of professional judgment – A valuation performed using the income approach is not simply a mechanical calculation. As stated in Statements on Standards for Valuation Services No. 1, “The use of professional judgment is an essential component of estimating value.” The uncritical use of averages, including market multiples, discounts for control, and marketability, is a common example of this error. Another example is the unquestioning acceptance of assumptions that benefit the client.
Each valuation analysis should make sense in light of the specific facts and circumstances of the engagement. While it is important to get the technical details right, it is just as important to look at the big picture to make sure the analysis makes sense as a whole. In valuation, as in sports, errors in judgment can be most costly: you can make a technically flawless throw to first base, but that doesn’t help when the play was at home.
Mark W. Medwig, CPA, ABV, CFF, is an analyst for Gleason & Associates PC in Pittsburgh. He can be reached at email@example.com.
LAST UPDATED 6/29/2011