Be wary of valuation calculators on the websites of many business valuation and M&A advisory firms. These calculators allow business owners to enter basic financial data and quickly retrieve the “value” of their businesses. Many of these products describe the final result as a “business valuation”. While it may be appealing for owners to receive a free, quick and easy valuation, the results should not be relied upon. Remember “you get what you pay for”.
Each Company is Unique
While companies might have similar valuation metrics, invariably there are subtle differences between businesses that prevent the valuation offered by these one-dimensional calculators from being accurate.
Most of these automated valuation programs collect data by manual entry from the business owner (the data collected often includes contact information which is then used in marketing). Generally, unadjusted financial information for a period of years is entered into a data collection system that feeds into a spreadsheet-type software program. Sometimes, owners are led through a series of questions intended to adjust the data into a more usable format. Included in the data is some indication of the industry in which the business operates.
The financial data is then broken down and “analyzed” in a way that allows the software to apply certain pricing multiples from “similar” companies and yield a value range for the company. This is appealing because owners can get results free and quickly, and maybe on an anonymous basis. However, there are real pitfalls in this process that result in a valuation that could skew important decisions made by the business owner who relied on the results. For example, the pricing multiples that these calculators apply to the operating results of the companies are generally derived from publicly traded companies. Blindly comparing what are usually relatively small privately held businesses to extremely large public companies is not easily accomplished. Adjustments to pricing multiples need to be made for many factors including size, leverage, profitability, patents, market share, and many other factors.
In addition, these programs do not attempt to differentiate the subject businesses from the publicly-traded companies with respect to anticipated growth. Remember that the value of an entity is the present value of all expected future cash flows. The cash flow is discounted at a rate which reflects the rate of return required by an investor, given the risks of investing in the company. Therefore, factors such as differences in expected growth are very important in the application of multiples and in the valuation process in general.
Algorithms Don’t Understand Your Business
Finally, there are factors that affect the value of every company that are distinctive to the business. No automated program can possibly assess these factors and apply that analysis to the valuation process. Without considering all of the above, it is extremely unlikely that any automated valuation will be even reasonably close to accurate. Relying on such a result is likely to lead to poor decision-making or inappropriate reporting. The only way to ensure that a business valuation not only meets the intended purpose and is produced in a way that is reasonable and accurate, is to hire a professional; one who is trained to understand the nuances of economic forces acting on a company and apply that knowledge to the financial and other data at hand. Obtaining anything less than a “qualified appraisal” produced by a “qualified appraiser” is likely to do more harm than good.
Imagine entering into a transaction process in which one side is relying entirely on the results of an automated valuation based on a flawed one dimensional method. Completing a transaction under these circumstances is extremely unlikely at best, or at worst the owner has sold at an unknowingly poor price.
Everyone wants to receive information quickly, easily, and especially free. However, when the issue is a valuation on an owner’s largest asset, then hiring of a professional is prudent and necessary.