The Purpose of Valuations and More

A business valuation isn’t just a number on a page, it’s an estimate built on judgement, financial data and a deep understanding of your industry. In this audio blog, Jason Hofferica, CPA and Certified Valuation Analyst at CK, breaks down how valuations work, what their purpose is, what they can and can’t tell you and what common mistakes to watch out for.

Transcript:

My name is Jason Hofferica. I’m an assurance manager here at Cray Kaiser, and I’m a certified public accountant and a certified valuation analyst. The purpose of the valuation is to provide information to either the buyer or the seller as to what, based on the facts and circumstances that we are looking at, looks like a fair value for someone to pay. So whether it’s a minority interest, as I mentioned before, there’s an adjustment for a minority interest. There’s an adjustment for that fact that this person buying it will not have control of the company. They’ll have ownership in the company, but they won’t have control of the company. Now, as far as how they use that information, they could use it in negotiating. It’s you know, it is pretty accurate based on the information that we’re provided. However fair market value is essentially what two parties, unrelated parties will pay at an arm’s length transaction. It’s ultimately up to them what they want to determine what fair value is. We just come up with this is what we see, this is what we think the fair value is, and they could use that information to make their investment decision, whether it’s buying or it’s selling.

How accurate it can be? It is an estimate. If we’re coming up with a value of a business and they agree on a price that’s $10,000 different or something, but the information was provided to say this is where it should be around. So as far as exact, exact numbers, that’s not what it’s going to provide. It will provide a valuation, but it’ll provide an estimate.

Fair market value is what two unrelated parties would expect to pay at an arm-length transaction. So determining fair value, is for a lot of the time, for the businesses that we perform valuations for. There’s, of course, the market approach. However, the problem with that is that those companies aren’t. The market is usually a stock exchange and these businesses are nowhere near that size or complexity. So while using some of these companies for some information to see if things might be reasonable, it’s usually not the true indication of what these companies are worth. Usually it depends on the type of transaction we’re talking about, if it’s an asset only sale, if it’s just revenue, the nature of the business, but there’s all different approaches including the capitalization method and the capitalization of excess earnings. All of these factor in not only the assets in the business, but also the revenue streams of these businesses to come up with a true value of these businesses.

You might also have estate tax issues that are at play, to where you might want to go ahead and plan accordingly as to what is going to happen when the inevitable does happen so that you can have you or your estate pay the least amount of tax possible. There are different thresholds with federal and state and those are some considerations. That if somebody’s holdings are valuable enough to where they’ll start gifting some of it to their heirs, so that they can, you know, either defer some of that tax or come underneath the estate tax threshold.

Sometimes in a business, let’s say they’re a manufacturing business, some of these manufacturing pieces of equipment are fairly large and they cost a lot of money. There’s some clients that we have, that their assembly line equipment is a million dollars. Now, well, it costs them a million. Now, it may be carrying a value on the balance sheet of $150,000. Now, if an equipment appraisal is done, it says, yeah, this piece of equipment could be resold for $700,000 or so. We change that value on the balance sheet because it’s not capturing the true value of not only the assets in the business that are part of the sale or the purchase or whatever, but also in considering the revenue stream. So we adjust everything to what is it that is truly involved here.

There were some valuations wanting to be performed regarding the gifting of the shares. One of the considerations in there, of course, is there’s a lot of things that can be covered under home improvement and remodeling. So you had to really look at what does this company do? What market, what region are they in? How many competitors do they have? You have to look at all of this stuff in determining a valuation and coming up with an evaluation. And like I said, the valuation reports can be sometimes a bit lengthy, but it’ll tell you why something was or was not considered.

One of the nuances for that is, and one of the challenges too, especially in the last couple of years, has been when we analyze these revenue streams or what these businesses are capable of doing. Now the problem is, last couple of years, everybody was affected in some way by COVID, some more than others. And some of that, and some did just fine based on the industry they were in. Some saw a fall off in revenue. How much of an impact does that really have on what this company is worth? Were they able to weather the storm? Did they stay fairly consistent? So these were all kind of things to consider.

Now, on this valuation too, one thing that you also have to look at is what is the purpose of the valuation? And in this case, not only was it for gifting of the shares, but you have to consider what’s going to happen based on that purpose. So in this instance, you have to go ahead and value the company. It’s still at a fair value consideration, but your approach is you’re valuing basically a minority interest in this company. So other things that are considered on there is whether or not that person will not have control, how much is this of a value on a per share basis to them because they ultimately don’t have control over how much people get paid, how much dividends are paid out they don’t they don’t have any of that. So is what do we believe that a reasonable person at an arm’s length agreement would pay for not only not having control but we also have to consider whether or not the marketability of a company. That again comes down to what industry they’re in and how many sellers and buyers we believe that there are in the market.

Common mistakes I would say is, there is a lot of the valuation that is built off of judgment and variables, and certain variables. And it’s very important to make sure that you not only are solid with your analysis, but the reasoning for your analysis. One of the mistakes that you see, that I have seen sometimes is some have a tendency to overvalue a business because they won’t use the appropriate method. And what I mean by that is someone that is leaning too heavily on using market, so using these publicly traded companies as a large basis as to you know, this is what their EBITDA is or should be, or again, you can’t use a very, very large company, which also may have a lot more resources at their disposal, and they may be involved in a lot more things as a basis as far as we believe this company is worth just as much as this company. That is one of the errors that I sometimes see is using these methods that are not comparable to who you are evaluating, who the subject is.

We review the report internally, of course, and make sure it seems like nothing was missed. But we do issue a draft to that, and they have the opportunity to review it. They’ll read through it. They’re free to ask any questions, including why this, why not that. Sometimes there are things that, you know, we were not aware of that may or may not change something. So they get the opportunity to review it and come up with those ideas and those questions because ultimately we want them to also understand the valuation as well. Once they read through it, they, you know, have no more questions or they agree with it, then we’ll actually issue it a final report. So, yeah, it’s not just a, yeah, here’s what we think and that’s it. We provide it to, you know, the buyer, the seller, or the client, whoever is requesting the valuation and they have the opportunity to review that before we make it final.