Valuation multiples: beware of garbage in, garbage out

If you are looking to appraise a business, looking at market evidence to support your conclusions is very useful. After all, the market is the final arbiter of what a company is worth. Short of test driving the market by putting your company up for sale, looking up recent business selling prices is the next best thing.

So far, so good. But the answer you get is only as good as the data you are able to gather. The old adage of ‘garbage in, garbage out’ applies to business valuations as well.

Beware of questionable data brokers

You may be tempted to delve into data sources touted as treasure troves of valuable data by their vendors. So let’s say you compare your company to similar firms that actually sold recently. This could help you work up a set of valuation multiples to estimate your business market value.

The devil, as the saying goes, is in the details. High quality data on private companies is scarce. Aside from filing tax returns with the Federal and local government, private companies are not obligated to disclose their financial and operational data to anyone. In fact, most private business owners consider such data highly proprietary and confidential.

Business brokers keep their data under wraps

So where do the data resellers get their data from? Usually, private company sales data comes from participating business brokers. Some brokers may disclose the details of their transactions. But most consider such data their competitive advantage, and keep it under lock and key. When business seller prospects look around for a broker to sell their business, those with the most knowledge of the market tend to attract future customers.

Most private business sales go unreported

The result is that most private company sales never get published. If you consult a data source on private business sales, you are likely to see only a small fragment of the deals actually made.

Most business brokers are sales people. Many lack the financial reporting skills and may report data that obscures the actual financial picture of the company. There is no compliance requirement with financial reporting standards, such as the Generally Accepted Accounting Principles or GAAP, as is the case for public companies.

Creative addbacks and apples to oranges comparisons

Private business owners are famous for their skill at creative accounting in order to minimize taxable income. That’s why business appraisers spend considerable time adjusting company financials before appraisal. Data on private companies does not include detailed background information. So it is very difficult to adjust reported financials to reconstruct a true picture of company’s financial performance.

The result is your valuation multiples can be quite misleading.

As the saying goes, if something looks too good to be true, it probably is. If you doubt the valuation multiples you get by crunching the numbers obtained from a data reseller, it’s time for a ‘second opinion’.

Reliable data on the public companies

The best way is to source data on small capitalization public companies in the same industry. These firms are subject to the rules that mandate consistent financial reporting and full disclosure of the company’s current situation and prospects.

To make an ‘apples to apples’ comparison to a private company, adjust the valuation multiples you get for lack of marketability. The factor, known as DLOM, accounts for the relative reduction in business value because a private company cannot sell its stock freely to the public.

Now you can compare your valuation multiples from both public and private sources.

See Valuation Tour