Business Valuation: Why earnings don’t create value?


Traditional business valuations assume that historical earnings somehow create value.  Further compounding the problem and adding confusion to the process occurs when future income projections assume current favorable trends will continue or accelerate and are assumed to further demonstrate the value of a business.  In a fast paced, computer-driven world,  entrepreneurs are looking for a fast and easy way to value and sell their business.

Where is my business valuation calculator?  I want to buy a business! What rule of thumb should I use?

Unfortunately business valuation is more complicated than that. Historical earnings and future projections are important elements to support value arguments but assessing value primarily upon historical income alone is dangerous.

Assuming future projections are a solid and dependable valuation element can be more dangerous. It may be good enough for “government work” but it is not good enough if a valuation materially determines significant financial risk decisions.

More Accurate business value measurement requires much more analysis.

1) Accurate business valuation is predicated on income producing assets; Tangible and Intangible assets created income historically and those assets create income in the future.

2) All assets tend to have a life cycle;  Accounting and tax concepts try to value most assets by the cost of acquisition, reduce its value over time and measure their life cycle in terms of depreciation and amortization schedules,  These tax law driven concepts are helpful but insufficient for accurate business valuation. Asset value and life cycles vary widely and frequently bear no resemblance to the original acquisition cost or tax driven value measurements; sometime their value increases over time rather than depreciates.

3) Not all assets or liabilities are captured on a Balance Sheet.  Income is captured on a P&L and P&Ls represent economic activities between two Balance Sheets.  Financial Statements alone are incapable of being the primary value determinate of a business. Inaccurate or insufficient information often undermines the ability to measure risk or value the impact of the assets at work.  Reputation, customer lists and recurring income are frequently unseen, misunderstood and undervalued.

4) More Accurate business valuation arguments must identify and evaluate every important business attribute (booked and un-booked assets and liabilities) that created historical earnings and create future earnings expectations and their probabilities in ever-changing economic conditions.

Business Valuation is an imperfect process that requires competent and experienced  quantitative and qualitative analysis.  Every valuation is an argument and not a guarantee.

A more accurate business valuation combines science and art tempered by relevant experience. It is both objective and subjective. It is not a fill in the blank process if it is going to be accurate, dependable, useful and help clarify the economic risks and opportunities associated with why a business valuation is usually being undertaken.

For a free consultation about the most comprehensive valuation process for small to mid-sized privately held businesses contact: info@mbapartners.biz.Â