Business owners and private equity managers who want businesses valued correctly should buck conventional wisdom and take a more comprehensive approach to valuation.
This is the advice of a specialist on valuations who believes that private equity firms and bankers who think mainly in terms of transactions can overlook elements that better determine the true value of an enterprise.
"The private equity world sometimes arrives at valuations by using standard Wall Street back-of-the-envelope assumptions," says Donald M. May (pictured), a director in the litigation and corporate financial advisory services group at New York accounting firm Marks Paneth & Shron.
"But Wall Street assumptions are very quick and very general – they’re designed for a transaction environment and often don’t take into account the realities of operating a business. A business-savvy financial economist can look at a business in more detail – and by making more assumptions, he or she can actually be more accurate in valuing a business as a going concern."
According to May, it is better to make many small assumptions instead of a few big ones.
"Wall Street often uses quick, rule-of-thumb calculations – multiples of earnings and operating costs – that often aren’t applicable, particularly in the current environment," says May. "It’s rare to find a real-world company that’s identical to the model. A banker might say, ‘Use a revenue multiple of two.’ I would prefer to say, ‘Let’s look at a more sophisticated model. Let’s project out cash flows, understand if there are any potential imbedded options, work out the assumptions and see if they make sense. If sales growth is off, let’s look at the industry forecast, and use third-party data to test the assumptions. Let’s take the rule of thumb as a guideline and then do a deeper analysis – breaking it down into smaller more tangible pieces instead of making one big assumption.’"
May says that private equity firms sometimes do not realise how imperfect their assumptions are. Big assumptions may not reflect the reality of the business.
“Using many small ones, you can find measurements that are closer to reality and if they are not you will understand why and be able to adjust accordingly. The multiple approach unless it mimics a specific peer that is identical to the company you are valuing will not allow you to pinpoint areas of distortion and examine the potential range of values under alternative scenarios and assumptions,” he adds.
