5 Reasons Valuations Vary 

A common question when it comes to business valuations is: “Why is there a wide range of values for a business?” And the simple answer is: business valuations are always one person’s opinion. An opinion of value can vary based on who performs the appraisal, what they’re looking for, and the methods they use. That being said, the real answer is much more complicated. There are many reasons a business can have a wide range of values. Here, let’s look at some of the major factors that affect that range. 

Factor 1: Information is Limited

Comparable Transactions are Often Unreliable

There is a limited amount of information available on comparable transactions for the sale of small to mid-sized businesses. Information is readily available on public companies, but there are vast differences between valuing private and public companies. The market for small-to-mid-sized businesses is inefficient and relevant information is scarce, to say the least.

The information available in transaction databases for small and mid-market transactions is often submitted without being verified, and only pieces of the story are provided, such as high-level financial information. Critical transaction information may be missing from the database, such as the terms provided, how EBITDA was calculated, whether the parties are related, whether the seller was distressed and other relevant information. This makes it difficult to adjust transactions to make them truly comparable.

Not only is information limited or biased but it can also be incomplete or inaccurate. Appraisers must rely on information from ownership or management, which can be biased; or on accounting and financial information, which is often incomplete. An appraiser’s opinion of value will continue to evolve as they acquire new information, or as their understanding of existing information changes.

Value Is Only Determined in a Sale

Price does not equal value. Actual value is only determined when a business is sold. Just because “ABC Corporation” was valued at $100 million does not mean it’s worth $100 million until someone actually pays $100 million. Just because your friend’s company was valued at a six multiple does not mean your company is also worth a six multiple because you’re both in the same industry and have similar-sized businesses. Just because your uncle received an offer on his business for $10 million, which works out to 70% of revenue, doesn’t mean your business is worth $14 million just because it generates $20 million in revenue.

An appraisal or the asking price of a similar business is not a comparable transaction. A comparable transaction must come from an actual transaction – not an appraisal, the asking price from a similar business, or other hypothetical non-transactions. 

Price does not equal value. Actual value is only determined when a business is sold. 

Factor 2: Predicting Human Behavior and the Future Is Difficult

Market Variability Is Hard To Predict

The essence of valuation is predicting how other people will behave, such as anticipating the price they will actually pay for a business. Predicting human behavior is perhaps one of the most universally challenging problems on the planet. Even the world’s most respected mutual and hedge fund managers, with billion-dollar budgets and thousands of employees on staff, whose sole objective is to predict the future value of publicly traded companies, can’t consistently beat the markets. 

In 2007, Warren Buffett bet $1 million that the S&P 500 would outperform a collection of hand-picked hedge funds. Buffett wasn’t betting against the “average” hedge fund. Far from it. Buffett allowed the opposing party to hand-select from among the best-managed funds in the world. Protégé Partners took him up on his offer and meticulously selected five hedge funds. What were the results at the end of the decade-long bet? The results were calamitous for the hedge funds. From 2007 to 2017, the S&P 500 gained over 125% while the five hedge funds gained a paltry 36% in comparison. The bet was open to anyone in the industry that wished to participate but only one stepped forward. And despite their ability to actively monitor the funds with the assistance of hundreds of analysts, their performance was crushed by a passive investment in an index fund that required no work and a staff of exactly zero.

What’s the lesson? The market is impossible to predict, even for those with teams of hundreds of people who professionally manage billions of dollars.

Fear and greed drive human behavior and even the world’s best investors can’t accurately predict movements in the markets with any consistency. Even Warren Buffett, considered by many to be the greatest investor of all time, admits he can’t predict the price of a stock in the short term, or even predict how the economy will do in the mid-to-long-term. From the tulip bulb craze in Holland in the 1630s, to the dot-com bubble in 1999, humans’ irrational behavior has proven impossible to accurately forecast. Predicting the behavior of a single individual is difficult enough, let alone predicting the impact of fear, greed, and herd behavior. Changes in the macroeconomic environment can have an enormous impact on the value of a business and such changes have proven impossible to foresee.

Estimating Cash Flow Is a Challenge

The fundamental premise of most methods of valuing a business is placing a value on expected cash flows. After all, a buyer is buying future cash flows, not historical ones.

Most projections prepared by owners of small businesses are based on assumptions that are impossible to substantiate. History is not an accurate representation of what is expected to happen in the near future for any business, especially in a volatile or unpredictable economic environment. Assessing future cash flows for a small business is especially difficult if there is a lack of consistent, historical financial projections that have been met. Assessing future growth rates is inherently difficult for any business, even one with well-documented and predictable growth, let alone a small business with inconsistent financial results.

Not only must future cash flows of a business be predicted, but the potential risk of receiving the cash flow must be assessed as well. Accurately assessing risk is impossible, and the presence of risk must be built into any financial model.

When valuing a business, one must estimate the future cash flows as well as their potential for growth and associated risk. Such an estimate is subjective at best, even if based on strong, historical financial results, and even more so if historical financial information is limited. The degree to which a business’s value is tied to future results, and the great degree of risk associated with estimating future cash flow upon which a business’s value is based, must always be considered when reviewing any business appraisal. 

The fundamental premise of most methods of valuing a business is placing a value on expected cash flows.

Impact of Future Factors Is Unpredictable

Future value is dependent on factors beyond our immediate control and the impact of these factors can’t be predicted.

Price depends on demand, which itself is dependent on a wide variety of factors, from interest rates to the availability of financing to unemployment rates in the case of individual buyers. There are also manifold other macroeconomic, demographic, industry, competitive, political factors, and social factors such as seen in consumer products.

The economy impacts some types of industries to a great degree, especially those selling a discretionary product or service, or consumer product companies, or companies that operate in a cyclical market. The impact of a protracted recession can be disastrous for cyclical businesses. Other industries, such as finance or healthcare, are susceptible to the impact of external factors, such as governmental regulations, and one can only conjecture at their likelihood and potential impact. Our lawmakers wield power to determine the fate of many industries, some with motives that are questionable, which introduces an additional layer of guesswork for any business operating in such an industry.

Even the world’s most widely esteemed economists can’t predict the future trajectory of the broad economy, let alone the outlook for specific industries or businesses within those industries. Such a requirement introduces a level of uncertainty, so the best one can do is to make an educated guess based on a limited amount of information. These limitations on the ability to predict such uncertainties must be considered when weighing the merits of any business valuation.

Factor 3: Wide Universe of Buyers With Diverse Criteria

Perceptions of Risk Are Subjective

The group of potential buyers for a business is diverse, thereby greatly expanding the potential for a wide range of opinions. For example, a lower mid-market business may have the following potential buyers: wealthy individuals with varied ethnicities or business backgrounds, direct competitors, indirect competitors, financial buyers, and possibly publicly traded companies. 

Any valuation should first explore the potential universe of buyers, and then calculate a range of potential values those buyers may pay.

The views, perspectives, expectations, and tolerance for risk among a diverse group of buyers can vary greatly, resulting in a wide range of potential values. The tolerance for risk also varies widely from buyer to buyer. Their opinion of value varies significantly as the price a buyer can afford to pay is a direct function of their assessment of the risk of the potential investment. A buyer’s assessment of risk may also be limited by their ability to acquire accurate information on the business and industry. The value of a business is ultimately determined by a buyer’s perception of risk, which can’t be accurately predicted or measured. Any valuation should first explore the potential universe of buyers, and then calculate a range of potential values those buyers may pay.

Lost Opportunity Cost to the Buyer Varies

The value of a small business is highly dependent on the lost opportunity cost to the buyer. Someone with an earning potential of $300,000 per year wouldn’t invest in a small business that requires their full-time involvement and only earns $200,000 per year, even if it were given to them for free. This is because it would cost them $100,000 per year in lost opportunities ($300,000 – $200,000 = $100,000). On the other hand, some buyers might see tremendous opportunity in a business that has the potential to earn them six-figures. 

Lost opportunity costs also vary for corporations. The lost opportunity cost of an acquisition for any corporate buyer is the cost of not completing another transaction, or any other form of corporate development. Some examples include launching a new product, forming a joint venture, or expanding distribution channels. Because the lost opportunity cost varies from buyer to buyer, the value of a small business will also vary from buyer to buyer, and such a variation adds another layer of complexity to any business appraisal.

Synergies Are Impossible To Calculate

The financial benefit of potential synergies is also impossible to anticipate. When selling a small to mid-sized business, the potential universe of buyers normally includes direct or indirect competitors. Often, competitors bring synergies to the table in the form of potential increased revenue or decreased expenses. To properly value a business sold to a synergistic buyer, one must calculate the amount of the synergies so they can be analyzed and valued. 

As an example, if a company with an EBITDA of $2 million per year is purchased by a competitor that brings an additional $1 million in increased EBITDA in the form of synergies to the table, the valuation could look like this:

Before Synergies: $2 million EBITDA x 4.0 multiple = $8 million value

After Synergies: $3 million EBITDA x 4.0 multiple = $12 million value

Implicit in this valuation is that we know the amount of the potential synergies and, therefore, the post-sale EBITDA, which forms the basis of the valuation. In most cases, this information can’t be obtained. Buyers rarely provide the target access to their financial models, let alone their reasons for the acquisition. As a result, a target may not understand the buyer’s true motives for a transaction. They will rarely be privy to a buyer’s financial models, projections, or other analyses, which can be used to calculate the amount of the synergies. The best they can do is to reverse-engineer the buyer’s potential synergies, estimate their value, and then negotiate the highest purchase price possible, ideally with multiple buyers, in the form of a private auction. 

A valuation based on synergies is, at best, an educated guess and normally only serves as a baseline upon which the company may be valued. Any excess of the baseline value can only be achieved, and therefore determined, in the actual marketplace through a competitive marketing process.

Factor 4: Biases and Conflicts of Interest Cloud Judgment

Appraisers Lack Real-World Experience

Most business appraisers lack an important requirement – experience. Most of them have never sold a company in the real world, yet the appraiser’s job is to make an educated guess as to what a buyer will pay for a business. While the majority of appraisals are commissioned for tax or legal purposes, those prepared for selling a business should be put together by a professional with real-world experience in the marketplace, such as an investment banker or M&A advisor.

Brokers’ Compensation Can Impact Objectivity

Business brokers’ and M&A advisors’ form of compensation may also affect their opinion. If their estimate is too low or too high, a potential client may go elsewhere. As a result, an advisor may pad their opinion so as to not lose a client, and then later backtrack on the valuation in an attempt to bring the owner back into the “real world.” Interests should be aligned, if possible, and the true beneficiary of any valuation should always be questioned. 

Most business appraisers lack an important requirement – experience.

Cognitive Biases Cloud Rational Judgment 

Humans are biased, and analysts are no different. Not only must an appraiser deal with an enormous amount of uncertainty, they must also cope with their own biases, which are often subconscious and therefore undetectable.

Here is a list of cognitive biases and potential examples that may come up when valuing a business:

  • Confirmation Bias: The appraiser seeks information to confirm their bias. For example, they may have a long-term belief that the range for multiples for radio stations is 8 to 10 times EBITDA, and they may ignore information that doesn’t support this bias. They may also form an initial opinion regarding the value of a business and then fiddle with the valuation to ensure it aligns with their initial expectations.
  • Recency Bias: The analyst may assign more weight to companies they have appraised or sold recently and forget about data or transactions that aren’t recent.
  • Anchoring Bias: The appraiser first learns through another appraiser, who is widely considered a leader in the field, that multiples in the aerospace industry are in the range of 6 to 7 times EBITDA. This becomes the “anchor” and the advisor then seeks information to confirm this anchor, ignoring factors that conflict.
  • Availability Bias: The appraiser may place too much emphasis on data that is readily available and not perform an exhaustive search for information that is less available.
  • Conservatism Bias: The appraiser may cling to their long-held belief that multiples never exceed 6 if EBITDA is below $5 million, and then consciously ignore information that doesn’t support this personal belief.
  • Contrast Effect: The investment banker may hear of a transaction with a 20 multiple in an industry in which they are valuing a business, so they push up their estimate to a 6.0 multiple from 5.0. After all, an increase in the multiple by a factor of one “isn’t a big deal” if a larger company in a related industry sold at a much higher multiple.

In preparing any valuation, an advisor should attempt to be aware of their biases and take efforts to mitigate the impact of their biases on their opinion. Readers of appraisals should also be aware of the potential for biases to be built into any valuation and be cognizant of the impact such biases can have on the appraisal.

Factor 5: Significant Time and Effort Required

Software Is Not Designed for M&A Valuations

Most software to appraise businesses is designed for legal or tax purposes. The methods used in the courtroom are entirely different from those used by buyers in the real world. Most software is inadequate to address a variety of situations and must be designed to handle the highest level of complexity the appraiser might encounter. An appraiser can be faced with having to arbitrarily input information into a program simply because it’s required by the software, despite it being irrelevant to the business’s stage of growth or its industry. 

For example, many appraisal software programs analyze key financial ratios, such as debt to equity. These ratios may be irrelevant for a small tech company in which the transaction is structured as an asset sale.

For owners considering a sale, an M&A advisor’s oral opinion can sometimes be more valuable than a written appraisal. 

At Morgan & Westfield, for example, we combine a financial assessment of the business with an exit strategy and an in-depth consultation with the owner to develop a full understanding of the business. We then explain our opinion of value in detail during a phone call with the owner. We can best assess and communicate our opinion of value if we aren’t encumbered by the built-in limitations of external software. 

If you’re considering paying for a written appraisal, ask for a sample report. Be sure you can understand it and that the information is relevant for your business and industry before you pay for a valuation.

Significant Time and Effort Is Required

Properly valuing a business takes a significant amount of time, especially when it comes to understanding and predicting future cash flows. The more sweat equity that’s invested in preparing the appraisal and predicting cash flows, the more accurate those predictions are likely to be. But most small business owners understandably don’t want to pay tens of thousands of dollars for an advisor to spend hundreds of hours developing an understanding of their business. As a result, many valuations, particularly oral valuations, are predicated on input from the owner or management team, whose views are biased.

Second, even if sufficient time is spent understanding the business and the industry, how accurately can future cash flow be predicted for a small business? The best one can do is to make an educated guess. A small business is highly dependent on the aptitude and drive of the entrepreneur, and predicting the long-term drive of one individual is difficult, to say the least. Larger businesses are less dependent on one individual, making them less vulnerable to the concentration of skills and effort that may be present in smaller businesses. 

The value of any appraisal is in direct relation to the skill and experience of the appraiser, and the amount of time spent understanding your business and industry. As a business owner, you should be aware of such limitations and accept that you’re paying for a professional’s opinion, and the accuracy of such an opinion is related to the amount of time and effort spent by the appraiser.