Valuation is not a precise art or science. There is often considerable room for differences of opinion, depending on each valuer’s view of the risks and factors contributing to the overall value. However, a professional advisor called upon to provide a valuation must do everything reasonable to ensure the valuation is both technically competent and commercially realistic. Despite these efforts, valuers sometimes simply “get it wrong.” But why does this happen?

Here are five broad areas where valuers can slip up:

1. Failure to Observe Professional Standards

Valuers are expected to follow established professional standards, such as the Chartered Accountants AES2 guideline. This guideline emphasizes the need for a thorough understanding of the purpose of the valuation, the underlying business operations, assets, and the relevant industry context. A failure to adhere to these standards, including insufficient research or understanding of the economic conditions affecting the business, can lead to flawed valuations. Those engaged in business valuation are encouraged to read and understand the AES2 guideline in its entirety to ensure proper adherence to professional procedures.

2. Failure to Choose an Appropriate Valuation Method

Choosing the right valuation method is crucial. There is no single method suitable for every business, and relying on just one can lead to inaccurate results. Valuation methods are based on different principles and economic models, which often produce varying results. By comparing and reconciling these differences, valuers can refine their understanding of the business’s value. Importantly, methods developed for publicly listed companies are often not appropriate for SMEs. Valuers need to be well-versed in SME-specific approaches to ensure their valuations are relevant and realistic.

3. Common Errors in Valuation Process

There are several common mistakes valuers make during the valuation process:

• Failure to Follow Proper Process: Valuers should systematically gather information, normalize accounts, select appropriate valuation methods, and arrive at a well-supported opinion of value.
• Failure to Identify the Assets Being Valued: Not clearly identifying which assets are included in the valuation can lead to discrepancies.
• Failure to Define the Valuation Date: The date at which the valuation applies is crucial, as market conditions can change over time.
• Failure to Conduct a Site Visit or Interview Management: Site visits and direct interviews with management provide essential context that can significantly affect the valuation outcome.
• Reliance on Rules of Thumb: Over-relying on general industry multiples or simplistic valuation shortcuts often fails to capture the unique characteristics of a business, leading to inaccuracies.
• Reliance on Historical Earnings: Placing too much emphasis on past earnings without considering future potential can result in overvaluation or undervaluation.

4. Over-Reliance on Number Crunching

Valuations are not purely about numbers; they also require qualitative judgment. Valuers who focus too heavily on financial models and quantitative data without considering the qualitative aspects of the business can end up with an incomplete picture. Factors like management quality, market conditions, and strategic positioning are equally important and should be part of the valuation process.

5. Failure to Apply the Sanity Test

After completing the technical analysis, valuers should always apply a sanity test—asking if the valuation makes sense given the broader context of the business and its environment. Sometimes, a purely calculated valuation may seem out of line with market realities or common sense. Using comparable data from sources like Bizstats can help valuers validate their findings against real-world trends. Failing to apply this check can lead to unrealistic or impractical valuations that do not hold up under scrutiny.

Final Thoughts

Valuation requires a blend of art and science, technical skills, and a comprehensive understanding of the business and its environment. When valuations go wrong, it often stems from not following professional standards, using inappropriate methods, making common errors in the valuation process, misapplying comparable data, failing to account for intangible assets, or relying on overly simplistic approaches. Business owners and potential buyers should be aware of these potential pitfalls and work with experienced valuers who can provide a balanced and informed assessment.

For more insights into business valuation and to understand the factors that drive value, visit Bizstats.report.