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.
accurate, but not
always. So what’s
to be done?
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.
What Goodwill Really Means
make the business
worth more than
Frequently in our valuation engagements we’ll be in the middle or near the end of explaining the valuation methodology and results to a client and, just when we’ve gotten to the number expressing our opinion of the value of the firm, the client pauses and asks with tremendous gravity, “OK, but what about the goodwill?” This is a question that universally dampens the mood of any valuator. Why? In the context of a valuation, the value of a firm’s goodwill—and everything else that drives value in an engineering or architecture firm—is already contained within the overall enterprise value estimated by the valuation consultant and sadly, we don’t get to add to the value expressed in our conclusion.
So let’s define what “goodwill” really means. When people talk about goodwill, they usually mean the value of a firm’s brand name, customer relationships, patents, proprietary technology, or other aspects of the business that are truly valuable, but do not have a defined place on the balance sheet or a hard number describing value. Goodwill, for most professionals in our industry, consists of the intangibles that make the business worth more than the numbers on financial statements. But according to GAAP (“generally accepted accounting principles”), goodwill is an intangible asset that arises when a buyer acquires an existing business and pays a price in excess of the identifiable value of the assets. It is the difference between the value of the tangible assets and the price actually paid to acquire the business. This difference represents the premium the buyer was willing to pay to acquire the selling firm above its net asset value, which may or may not include its brand name, client relationships, etc. While there is undoubtedly value in a firm’s presence in the market and long-standing lists of clients, the term “goodwill” has a specific meaning in accounting, so remember to define your terms when discussing the sensitive subject of firm valuation.
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