Common Errors in Business Valuations
Business valuations are prepared by a variety of professionals, including business appraisers, brokers, financial analysts, certified public accountants, and economists. There are quite a few common errors made in business valuations during divorce proceedings. All of these problems can be corrected before they arise.
I. Use of a Valuation Method Not Accepted by the Courts
A. Market Value Method
A common error in the valuation of businesses is the application of the market value method to privately-held companies. Using this method, the appraiser compares the price-earnings ratio of a similar public company to the business in question.
B. Discounted Future Earnings Method
Another valuation method occasionally used is the “discounted future earnings method.” It equates the value of a company to the present discounted value of the company’s projected future earnings. For example, the evaluator may determine that the company will earn $2 million, $2.5 million, and $3 million in successive two-year periods. The current discounted value of those earnings, after adding the residual value of the business at the end of the cash flow stream, constitutes the business’ value. This approach is acceptable for certain businesses, but should not be used in valuing a professional practice.
II. Use of Valuation Methods that Do Not Include All of the Assets of the Business
There are certain accepted formulas often used in valuing a small business. An appraiser relying on a rule of thumb should keep in mind that many formulas addressing small business value don’t consider all the business’ valuable assets, like cash in hand, pre-pad assets, and inventory.
III. Application of Value Multiples to the Wrong Income Stream
Certain valuation methods use income multiples to determine goodwill. To properly figure goodwill, an appraiser needs to determine whether goodwill in a given industry is based on post or pre-tax earnings. The difference could be significant.
IV. Omission of Minority Discounts
Company A and Company B have identical sales and profits, except Company A is owned by a single stockholder and Company B is owned by five equal shareholders. A valuation of both businesses concludes that each company is worth $25 million. That puts the stock value of Company A at $25 million and Company B at $5 million per shareholder.
The valuation assigned to Company B’s shareholders’ stock is wrong. The value of all five stocks must be discounted because each stockholder has only a minority interest in the company.
For more information about your business in your divorce, Call Certified Family Law Specialist Denise Lite (formerly Denise Placencio) at 877-317-8080 for more information.
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