In explaining how he adjusts a company’s cash flow for investment analysis, Warren Buffet once quoted the economist John Maynard Keynes, “I would rather be vaguely right, than precisely wrong.”
Buffet’s comments mean it’s false to pretend that financial analysis is a precise exercise. Yet neither is it random guesswork. An appraiser looks at the reported numbers with a trained eye to try and understand the knowable facts of the business, and then must make several subjective judgements before arriving at some reasoned estimate of value.
Assessing a privately held business makes the appraiser’s task more challenging than with public companies. Private companies seldom use audited financial statements that are held to more rigorous reporting standards. Accordingly, the quality of privately held company’s financial statements varies widely, leaving some adjustments more prone to omission, misunderstanding, or misinterpretation.
There are four types of normalization adjustments an appraiser typically must apply to find a reasonable measure of cash flow (also referred to as benefit stream):
- GAAP related
- Non-recurring or extraordinary items
- Control-related (owner personal expenses need to be added back)
Assigning risk score is yet another subjective judgment that must be made. The intuitive logic is that as risk increases, an investor should be compensated with the potential for a higher return. There are numerous risk factors that can be industry, business, or company specific.
Using “rules of thumb,” simplistic formulas often found in buy-sell agreements, or software algorithms are easy to apply but likely will give you precisely wrong results. Whereas, an accredited and experienced appraiser using the proper application of theory, due diligence, professional judgement, and common sense will give you an opinion of value that more accurately reflects the fundamentals of your business.
Jerry Matecun helps business owners to discover key planning and investment considerations vital to build and protect the value of your business and personal assets. For a no cost, confidential conversation regarding your business valuation and exit plans call or email Jerry at 949-273-4200, 616-499-2000 or firstname.lastname@example.org.