Anyone with a little business and financial knowledge can do a quick-and-dirty calculation using a industry rule of thumb, such as multiple of annual sales or earnings. But experienced valuation professionals apply tested valuation approaches that are based on real world market data — and they also possess strong verbal and written communication skills that enable them to explain and support why their appraisal conclusions are appropriate and reliable.
Verbal Reports vs. Written Reports
When valuators report their conclusions, they have two options: verbal or written reports. Some limited situations may call for verbal reports. For example, if management is curious about the company’s value and intends on using the valuator’s conclusion for internal decision making, a verbal report may pass muster. Or some attorneys might opt for a verbal report in a litigation setting to lower fees during the settlement process, or as a strategic move to prevent the opposing side from critiquing a written report.
But that strategy often backfires in the courtroom. During deliberations, many judges prefer to have a tangible written report to reference after the expert testifies. Verbal reports also require the attorney to be skilled in asking detailed, technical direct examination questions in order to tell the entire story behind valuing the business. In most litigation and tax situations, a comprehensive written report is the best option. But how do you know whether an expert’s report has covered all the bases?
A valuation report should tell the story of the business being valued. This shows the reader that the valuator understands the business. Reports should also document the research, analysis, and methods used to value the business. The valuator should build a clear and logical case for how and why the valuation conclusion was reached. After reading a valuation report, the reader should have a basic understanding of the business, understand how and why the valuation was reached, and see how the conclusion makes sense, even if the reader disagrees with it. A strong report provides enough detail to allow the reader to replicate the expert’s analyses, if he or she desires.
Assessing the Quality of a Written Report
A valuation report should not be judged by the number of pages alone, but it is not possible to explain the business and the valuation process in just a few pages. Often valuation reports start with an executive summary and provide expanded details that cover these elements:
Definition of the assignment. Your valuator should identify the company’s name, size of the subject interest (number of shares or percent), intended uses and effective date. It’s also important to identify the standard of value, such as fair market value, fair value or strategic value. Appraisals are valid for only the purposes and dates listed in the report.
Description of the business. Here’s where your valuator demonstrates that he or she understands the nature of the company’s operations, including its strengths, weaknesses, opportunities and threats. Errors or misstatements compromise the validity of a valuator’s conclusions.
Industry and economic trends. External factors affect future cash flows and perceptions of risk, which, in turn, impact how much a company is worth. This section tells whether an expert understands the environment in which the company currently operates.
Financial analysis and adjustments. Past performance can provide insight into future cash flows. Value is impacted by how well (or poorly) a company has performed in the past — or relative to other companies in the same industry. Sometimes the company’s financial statements require adjustment for discretionary or nonrecurring items — or for unusual accounting practices.
Valuation methods. Appraisers generally consider three approaches when valuing a business: the cost, market and income approaches. This section should discuss which methods were applied to the subject company and why. It also will provide detailed descriptions of the calculations underlying the appraiser’s conclusion.
Discounts and other considerations. Some valuation assignments call for discounts. The most common are discounts for lack of control and marketability, but other discounts — such as voting, key person and blockage discounts — might also apply. The section of the report discusses which discounts are appropriate and why. It also should provide empirical evidence to support the discount rates chosen. Comprehensive reports also provide nontraditional sources of valuation evidence — such as previous transactions and offers, loan applications, past appraisal reports and rules of thumb — and reconcile these sources against the values derived under the appraiser’s methodology.
Appraisal conclusion(s). You should be able to follow the valuator’s process throughout the report, similar to a story. When a conclusion is reached, it should make sense based on the evidence provided.
Various appendices often appear at the end of a comprehensive valuation report. These may include the valuator’s qualifications, statements of assumptions and limiting conditions, bibliographies, and numerical exhibits and graphs.
Litmus Test: Do You Understand?
A comprehensive report explains the valuator’s thought process and provides market evidence to support his or her assumptions, methods and conclusions. When evaluating a business valuation report, it’s easy to get caught up in the technical details and lose sight of the obvious: a report that can’t be understood or doesn’t make sense is worthless even if it’s technically flawless.
I have completed hundreds of business valuations involving businesses and related intangible assets in a wide spectrum of industries. When you combine our tax, accounting and financial expertise with our business valuation experience, it creates a unique environment to meet our clients’ needs. Call me today if our team can help you determine the value of your business.