5.15 Reasonableness testing in valuation reports
A typical business valuation report prepared by a CBV will involve some assumptions and several areas where the CBV exercises professional judgment. There is a risk therefore that the resulting valuation conclusion could be academic and/or detached from reality. It helps therefore for the CBV to reflect on the conclusion and consider if the calculated result is reasonable for the business in its circumstances. At MVI, we generally include some level of reasonableness testing as part of the valuation report; it helps to provide an “anchor” to the real world.
Reasonableness tests look initially at the implied payback periods, especially for goodwill. Given that goodwill is the one major asset that is unlikely to retain its value if the business declines, the expected payback period for goodwill is a good indicator of the real risk in the business.
A low-risk business would expect a long payback period for goodwill. For a high-risk business, a notional buyer would expect to recover its investment quickly (i.e. a short payback period) as they have less confidence in the business’s long-term continuity.
The exercise of judgment in valuation reports suggests that “gut-checks” would add credibility.
Other reasonableness tests use the market method of valuation to compare the valuation metrics of the target business to the valuation metrics of comparable businesses that have been exposed to arm’s length negotiations and concluded transactions.
A negotiated sale between informed and independent parties acting in their self interest is a good indicator of “real-world” values. Given the difficulty of finding truly comparable businesses, caution is needed. Some reconciliation may be useful between results for similar but inexact comparables.
At MVI, we prefer to rank the sample data, if sufficient, into percentiles and compare client valuation metrics to the ranked data. This may indicate, for example, that the preliminary valuation conclusion places the client at the 75th percentile. If it seems that the client deserves to be considered among the most valuable of its peers, such positioning would lend support to the valuation conclusion. The comparisons may, however, provide new insight that causes the valuator to revisit and check the calculations before finalizing the report.
Contact MVI if you feel that a valuation conclusion is unreasonable.