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Valuations as junk science

THE methodology used by business brokers to value businesses was roundly criticised at an accounting forum in Perth early this week.

The speakers at the Institute of Chartered Accountants in Australia forum were critical of the methodology known as return on investment (ROI), which was likened to junk science.

They advocated the capitalisation of future maintainable earnings (FME) as a more rigorous and sound approach.

The unanimity was broken by one of the guests, Jarot Business Assessments’ principal Jim Thompson, who vigorously defended ROI.

The debate over business valuations is often played out in the family court, where accountants may be called as expert witnesses.

Judging by the conflicting opinions at the forum, the views expressed in court will depend on which witnesses are called.

Pickup Golding director Harvey Pickup was the most critical of ROI techniques, which he said “have no logic or basis in economic reality and are contrary to proper valuation methodology”.

“ROI valuations, being derived from the business broking industry, are more likely to reflect price rather than value, which are two different concepts and can differ significantly depending on imperfections in the marketplace,” Mr Pickup said.

William Buck manager Russell Morgan backed this view, saying ROI was “not a method of valuation but instead is a method of attempting to predict the selling price”.

Business Symmetry director Brenton Siviour, who chaired the forum in his capacity as convenor of the ICAA’s forensic accounting special interest group, said the FME approach was appropriate for businesses with a solid profit history and an expectation of continuing profits.

The FME method is based on two key variables – an estimate of future maintainable profits, and the calculation of an appropriate multiple.

Mr Siviour said the methodologies applied to small businesses should be no different than those applied to larger businesses.

Speaking after the forum, Mr Thompson rejected that view.

He said the ROI method was based on the same principles as FME but had evolved to cover what happened in the actual market for small to medium sized businesses.

One key difference between the two methods was that ROI normally calculated future earnings based on the latest year’s pre-tax profit.

Mr Pickup argued this approach was unreliable as it failed to account for business cycles and “its rigid adoption without any analysis of the circumstances of the individual business is methodologically incorrect”.

Mr Thompson believed the latest year’s profit was “likely to give the most accurate result” when valuing SMEs.

He also acknowledged that in some cases (e.g. rapidly growing companies) the use of an average of several years’ profit was often more suitable.

Another key difference between the ROI and FME methods was that valuers using the ROI method adjust the historical earnings by adding back depreciation and the owners’ salary (among other items).

Mr Thompson said salary was the most contentious addback.

“However this is one of the reasons why the ROI method explains what happens in the marketplace,” he said.

“Purchasers of small businesses make their decision when buying a small business on the total income, profit and wages, not just profit.

“Investors going into large companies look solely at the profit.”

Mr Thompson also claimed that purchasers of small businesses have a different investment philosophy than professional investors.

“Quite often they are buying themselves a job. This different outlook has to be considered,” he said.

Mr Pickup took a contrary view, arguing that valuations should reflect a proper market salary for all proprietors.

This would allow the valuer to distinguish between the profit generated by the skills and hard work of the proprietor and the profit generated from the assets of the business.

Yet another difference between the ROI and FME methods was that the former did not include working capital when calculating future earnings.

Mr Thompson said the ROI method normally generated a high multiple, in part to compensate for the treatment of depreciation, working capital and non-payment of wages.

Mr Pickup said this may be partially true but “cannot be relied upon to offset the fundamental flaws in the (ROI) approach”.

The calculation of earnings multiples was yet another area of difference between the two camps.

Mr Thompson said multiple “ranges” were readily available for most small businesses based on actual sales evidence from the marketplace.

Mr Siviour argued that it was “extremely difficult to assess the value of a business against other comparable businesses due to the diversity between businesses and lack of information”.

He said valuers should also assess the risk/reward position of what the purchaser could obtain for other like investments.

In addition, the calculation should address specific risks such as market position, surety of income, depth of personnel and potential for growth.

Mr Thompson maintained ROI was a practical method with a strong theoretical basis.

“More importantly, it incorporates sales evidence from the marketplace easily, which no other method does,” he said.

Mr Pickup even questioned the worth of this market data.

He claimed most buyers of SMEs were not content with their acquisition and “seem to end up thinking they have paid too much”.

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