Everyday companies, large and small, are subject to public or private business appraisal. Despite the great advances in assessment literature and the advanced educational pathways that enable practitioners to ‘upskill’, I am still amazed at the number of errors when taking this kind of preoccupation.
Here are three of my favorite tips to avoid these errors when evaluating your business:
1) Future Maintenance Income (“FME”) and ‘Average of 3’
When applying an income method and more specifically when applying FME capital, it is common for an FME to calculate the average earnings for the last three financial years. This practice is inherently flawed and contradicts the notion of FME that requires a forward-looking approach, not a pre-existing approach to evaluating earnings.
Errors in averaging historical results increase during periods where wages, rent or other material costs increase rapidly. In addition, recent changes such as relocation to a larger (and more expensive) premises or an expanded workforce are not properly captured. Any change from price change and historical gross margin is ignored in the average process.
With so much time spent working on multiple earnings, it is a shame that FME’s intentions do not guarantee the same scrutiny.
2) Understanding economic drivers
Now more than ever, business is a matter of seemingly constant change. Technological deviations are drowning some industries while others are not going to stop. It is important to be aware of the external factors from the context of an evaluation that affect the key driver of the subject business.
Research house IBISWorld publishes their views on the ‘flying and falling’ industry. History is clearly a weak guide when evaluating businesses on both sides of the spectrum. One proposed underperformer in 2015 is those involved in mining and construction machinery manufacturing. News agencies and video stores have been named in recent years. Outperformers include online groceries and hydroponic grain farming. A deeper understanding of the industry can help avoid unrealistic evaluation decisions.
3) Crosscheck failure
Evaluation practice is a highly disciplined discipline and it is rare to find absolute agreement between practitioners. Nonetheless, it is best to confirm or reject the cross-check conclusion process. This can tighten the scope of an assessment, disprove wrong decisions and ensure that the outputs relate to the ‘real world’.
Crossshakes should include alternative methods to validate or discredit the initial method. Further, decisions based on theoretical inputs such as betas, alphas and bond rates should be weighed against economic and industry expectations so that the decisions do not differ too much. If a hen looks like a duck and sounds like a duck, it could actually be a duck! In other words, if an appraisal of fair market value is required for evaluation opportunities, does the result represent a value that would be acceptable in the market?
For the thematic nature of business evaluation, practitioners have to strictly challenge methods, inputs, and especially outputs before moving away from the ‘autopilot’ and printing. There are currently only 98 CAANZ accredited business evaluation specialists across Australia and New Zealand. Contact one of our team who can navigate with you to navigate the complexity of the assessment and provide a suitable supplier for the purpose.