Theory versus Reality
June 8th, 2009 by Brian Alwine | Tags: Reality, Theory, Value, Versus | Posted in Valuation Approaches |Business valuation is easy in theory. But, reality almost never cooperates.
For example, the concepts underlying the three main approaches to valuation are clear-cut.
Theory
- Asset Approach:
- Assets – Liabilities = Value
- Income Approach:
- Earnings / Risk = Value
- Market Approach:
- Market Price / Market Earnings x Earnings = Value
Of course, the devil is in the details…
Reality
- Asset Approach:
- Assets and liabilities missing
- Items not recorded at market value
- Income Approach:
- Past earnings fluctuations
- Unpredictability of future earnings
- Hidden expenses or income
- Nonrecurring events
- Income tax adjustments
- Problems in determining risk rate
- Market Approach:
- Difficulty of finding comparable market data, either public companies or private transactions
- Effects of market booms or busts
- Selection of multiples from ranges indicated
For the owner wanting a rough approximation of their business’ value, a simplistic application of the theory may be enough. The problem is in not knowing how far from the “true value” that simplistic calculation may be.
When money is on the line, the greater degree of confidence afforded by a comprehensive valuation analysis may pay for itself many times over. What would a 10%, 25% or 50% swing in value mean in facing the IRS, in a litigation matter, or a business acquisition or sale?
