Canada: 5 Common Business Valuation Errors

Last Updated: September 28 2015
Practice Guide by Duff & Phelps

Business valuations are required for a variety of purposes, ranging from notional valuations such as income tax reorganizations, related party transactions and shareholder disputes, to open market acquisitions and divestitures. Despite the abundance of literature available on the subject, business valuations often contain errors and inconsistencies that render the conclusions meaningless, or worse, misleading. The consequences can be significant when the business valuation conclusion forms the basis of an actual transaction. This guide sets out five errors that are commonly made in business valuation.

Unrealistic Cash Flow Projections

The value of a business is a function of the cash flow that a company is expected to generate in the future and the risks relating thereto. Cash flow forecasts are often prepared to aid in this regard. However, cash flow forecasts often contain errors and inconsistencies that cause the valuation conclusion to be meaningless or misleading. Common deficiencies in this regard include the following:

  • Optimistic revenue expectations: most forecasts have an upward bias. There is a natural tendency to overstate a company’s growth prospects. A breakdown of revenue by customer, product and service offering and other metrics can help in assessing the degree to which growth will be generated by existing customers vs. new customers; existing product and service offerings vs. New offerings, etc. Where revenue growth is expected through new customers or new product and service offerings, there can be added challenges or costs involved. While developing a detailed forecast is onerous and subjective, doing so forces the consideration of how growth can be achieved.
  • Inconsistency with operating expenses: adequate consideration must be given to the operating costs required to generate projected revenues. In many cases, those preparing forecasts believe that the existing cost infrastructure cash be leveraged, such that profit margins increase over time, thereby resulting in much higher value conclusions. To help avoid these types of errors, the financial model should incorporate analytical tests, such as revenue per employee and other operational metrics that aid in assessing the reasonableness of the expense projections.
  • Capital expenditure requirements: growing companies often require additional fixed assets. In some cases this can be significant, such as where facilities expansion is required to accommodate revenue growth. The valuation model should incorporate capacity-related metrics relating to equipment; facilities; distribution assets and other categories in order to assess when capital additions are required.
  • Working capital requirements: growing revenues generally leads to higher accounts receivable, inventories and other current assets. In many cases, these requirements are partially offset by higher accounts payable, accruals and deferred revenue. However, net working capital requirements usually increase, which represents a drain on cash flow and value. Metrics such as days’ sales in receivables, inventory turnover and net working capital as a percentage of revenues can help in ensuring working capital requirements are adequately considered.

Reliance on the Multiple of EBITDA Methodology

Business values are often expressed as a multiple of EBITDA (earnings before interest, taxes, depreciation and amortization). Despite the popularity of the multiple of EBITDA methodology, it is fraught with challenges. The multiple of EBITDA methodology does not explicitly consider key value drivers such as capital expenditure requirements, income taxes or working capital to support growth. Rather, these variables are inherently buried in the valuation multiple adopted. While the multiple of EBITDA methodology is useful as a preliminary indication of value, or as a test of reasonableness on the value conclusions derived pursuant to other valuation methodologies (such as the discounted cash flow methodology), sole reliance on this methodology can result in misguided decisions.

Reliance on Comparable Company Multiples

There is a natural tendency to look at the multiples of similar companies when conducting a business valuation. Comparable company analysis is sometimes helpful in ensuring that valuation conclusions are reasonable in the context of prevailing industry and economic conditions. However, the application of comparable company multiples, be it from public companies or recent industry transactions - can be fraught with challenges.

With respect to public company data, it’s important to recognize the fundamental differences between valuation multiples applicable when valuing a company en bloc, and those implied by the trading prices of publicly listed shares. Shares of public companies represent small lots of highly liquid securities with known prices. This degree of liquidity and price discovery is not inherent in the valuation of a company en bloc, which leads to additional risk.

Furthermore, public companies are usually much larger and more diversified than private companies that are the subject of a notional valuation or open market transaction. As a general rule, smaller companies within a given industry segment trade at lower valuation multiples than their larger counterparts.

Over-reliance on the valuation multiples implied by open market transactions can also be hazardous. Transaction multiples (where they are disclosed) can be misleading for a variety of reasons, such as the following:

  • The EBITDA base: reported EBITDA multiples may be calculated based on actual EBITDA as opposed to normalized EBITDA, which adjusts actual results for unusual items and excessive or deficient payments to related parties.
  • Terms of the deal: non-cash terms such as promissory notes, share exchanges and earn-outs can distort the stated purchase price, which in turn distorts the implied valuation multiples.
  • Relative negotiating position: in some cases, the buyer or seller may have been in a weak negotiating position (such as a seller being compelled to transact for health reasons), which influenced the price paid. Such factors would not be known outside the parties to a transaction.

Technical Errors in Rates of Return and Valuation Multiples

The determination of an appropriate rate of return or valuation multiple to apply in a particular business valuation inherently is a subjective exercise. However, rates of return and valuation multiples must be reasonable and internally consistent, in order to develop a meaningful valuation conclusion. There are a variety of technical errors that are commonly made when determining and applying rates of return and valuation multiples. Among the most common are the following:

  • Inconsistency in the rate of return and the cash flow against which it is applied: for example, where the cash flow to be discounted is determined on an “unlevered” basis (i.e. before consideration of debt servicing costs), the discount rate should be expressed as a “weighted average cost of capital”.
  • Double-counting of risk factors: for example, where a risk premium is added on account of “small business risk”, that same risk premium should not be afforded for considerations such as limited market presence.
  • Double-counting of growth: where the cash flow forecast incorporates an element of growth, that same growth factor should not be incorporated in the rate of return or valuation multiple.
  • Overstating the long term growth rate: a capitalization rate is calculated as the discount rate (which is a function of the risks relating to the business itself, the industry in which it operates and general economic conditions), less a long-term growth rate. The long term growth rate incorporates long-term inflationary growth and, in some cases, real growth (beyond inflation). The real rate of growth represents the extent to which a company can generate a return on its capital in excess of its cost of capital. In most cases, high rates of real growth are difficult to achieve over the long-term, due to competitive pressures that exist in any given industry. Overstating long-term growth can cause the value conclusion to increase geometrically, thereby significantly overstating the value conclusion.

Missing the Balance Sheet

Those preparing business valuations typically focus on the future cash flow that a company will generate. In many cases, the balance sheet is not given adequate consideration. The balance sheet sets out the net operating assets a company requires to generate the cash flow upon which the valuation is premised.

An appropriate business valuation exercise should include an analysis of the normalized level of non-cash working capital (e.g. accounts receivable, inventories, accounts payable, deferred revenues, etc.) required to support the company’s operations. Where appropriate, an adjustment to the equity value conclusion should be made where the actual amount of working capital at the valuation date (or the closing date of a transaction) is greater than (or less than) the estimated normalized amount. Adjustments are particularly applicable (and often missed) where the business is seasonal in nature.

Another common error is to automatically add cash on hand to the equity value conclusion (or apply cash on hand against outstanding debt) without assessing whether that cash is required in order for the company to maintain an adequate level of working capital.

Finally, the balance sheet may include redundant assets that can be withdrawn without disrupting the operations of the company. In some cases, redundant assets are not obvious. Missing these redundant assets can understate the value conclusion. Examples of where hidden redundant assets may exist include the following:

  • Accounts receivable: which may include non-trade receivables, such as amounts owing from shareholders or employees.
  • Fixed assets: which may include unused equipment that can be disposed of.
  • Real estate: where a company owns the property in which it operates, it may be better to assess the value of the real estate separately from the business itself. Quality real estate assets often fetch higher valuation multiples than operating businesses, which can significantly impact value.

Business valuation is as much an art as it is a science. A realistic value conclusion requires a thorough and objective analysis of the company itself and the industry in which it operates; supported by appropriate valuation methodologies that are applied in a proper and internally consistent manner.

This document is not intended to create an attorney-client relationship. You should not act or rely on any information in this document without first seeking legal advice. This material is intended for general information purposes only and does not constitute legal advice. If you have any specific questions on any legal matter, you should consult a professional legal services provider.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Contact the Author?
Click here to email the Author
In Association with
In Partnership with
Other Canada Advice Centres
Competition and Antitrust
Mergers and Acquisitions
Labour and Employment
More Advice Centers
Useful Resources
CBVs are experts in their field. The following articles and papers have been written by CBVs, several articles have been featured in various national publications.
Tools
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions