Formulas: Special Sauce or Snake Oil?
Most valuation reports are about as approachable as your average IRS publication, only less engaging and with more footnotes. Confusion abounds when a typical valuation discusses everything from a discounted cash flow analysis of a firm’s future earnings to the expected growth of the national economy to the effect of the weather on construction. So unless a firm is an ESOP or carries a buy-sell agreement that requires an annual third-party valuation, many firm owners in our industry choose another solution: the valuation formula—easy to understand and generally simple enough to calculate on your iPhone calculator app. Problem solved, year in and year out, right? Not so fast.
While intuitive, valuation formulas introduce a degree of uncertainty because formulas lack flexibility and are often not structured to consider the effect of conditions external to the firm. Valuation formulas are best used in stable economic environments where overall economic growth is consistent, interest rates are not fluctuating, and the firm is financially stable and not experiencing wild swings in profit margins. In design terms, using formulas to the exclusion of all other valuation methods is analogous to designing a road for vehicles of the same mass that always travel at 40 miles per hour in dry weather. Potentially accurate, but not always. So what’s to be done? We recommend the following:
Use the averages. In the same way a stock on a publicly traded exchange may be priced too high or too low from one time period to the next, the value of a privately held firm may vary significantly from one year to the next on the basis of a handful of very good or very bad contracts or clients. Given that many firms in the industry assess their value only once per year, we suggest averaging formula results over the past three to five years to help mitigate the effect of an outlier year—fair or foul.
Keep it simple. At heart, using a valuation formula is about simplicity, so take care not overcomplicate the matter. Too many inputs or variables in the formula—six would be our recommended limit—can lessen the effectiveness of the calculation and obscure the factors that drive the most value in the enterprise.
Get a checkup. No system yet designed by the human race was meant to last forever and your valuation formula is no different. It’s a good idea every few years to invest in a third-party expert to provide an opinion of the validity of the formula, especially when the firm has grown or contracted or is facing a significant transfer of shares from one or more partners to another.
Formulas are an excellent solution for firm owners that want to regularly and consistently assess the value of their business, but in valuation as with medicine, a measured dose used in the proper context yields the best results.
A guide to help you better understand how AE firms are valued and – perhaps more importantly – what you can do to build value now.Read Newsletter