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his article is based on an actual experience within the past year and is intended to remind
my fellow CPAs and consultants that we should be wary when reviewing reports of alleged
valuations. We should go beyond the simple mathematical calculations and make sure that the
valuation preparer is qualified to consult with his, and our, clients. The names, of course, have
been changed to protect the unqualified, my client relationships and my career. Admittedly, this
is only one example, but it illustrates the perils business owners and buyers face if they don’t
obtain a thorough, professionally prepared valuation prior to entering into a transaction.
I share the opinion that there can
be legitimate differences of opinion
among professionals (even valuation
professionals!) and that proper application
of valuation methodology can lead
to disparate results given different
understandings of the underlying facts.
This article is admittedly somewhat
sarcastic because the preparer1
apparently did not get an understanding
of the underlying facts and has little to
no understanding of actual valuation
methodology.
Mr. Penny Pincher was responsible
for obtaining a valuation on behalf of a
company in which he holds a 10 percent
ownership interest. Mr. Control owns 70
percent of the company, and the remaining
20 percent is owned by two other
individuals. Mr. Penny Pincher is going to
use the valuation to establish the amount
to be inserted into a buy-sell agreement.
Too often, owners of companies view
this valuation clause as simply a
documentation issue required by terms
of the buy-sell agreement. This valuation
becomes a very important piece of
information when the buy-sell agreement
is triggered; therefore, placing the
valuation in the hands of an unqualified
or inexperienced person can lead to a
terrible result for one party in the buysell agreement - and a windfall to the
remaining parties.
Mr. Control has used our firm for many
services in the past and forwarded the
valuation document for my review to
determine whether or not it can be relied
upon to establish value pursuant to terms
of the buy-sell agreement. I immediately
noticed two things:
1. The report was called an “Informal
Business Valuation.”
2. The preparer had five designations,
but I didn’t immediately recognize
any of them as financial or valuation
credentials.
These two initial observations immediately
led me to search for the standards under
which the “Informal Business Valuation”
had been performed. Standards that we
typically see include the following:
1. The Statement on Standards for
Valuation Services (SSVS), as
promulgated by the AICPA.
2. Uniform Standards of Professional
Appraisal Practice, as promulgated by
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the Appraisal Standards Board of the
Appraisal Foundation.
5. Discounted Future Earnings Method
(Preparer Assumes a Three-Year Life
Based on Contractual Relationships).
The SSVS was created, at least in part,
to prohibit CPAs from preparing informal
valuations upon which our clients might
rely at their own peril. The preparer of this
Informal Business Valuation was not a
CPA. Thankfully.
The preparer used these five methods
to derive separate indications of values
ranging from $25,000 to $2.44 million. He
then weighted these five methods evenly
to calculate an Informal Business Valuation
of $1.58 million (Table 1). On the surface,
this Informal Business Valuation falls near
the values indicated by the fourth and fifth
methods applied and is mathematically
correct, leading a potential client to reason
that the valuation makes sense.
I found no mention of any standards
under which the valuation was prepared.
As I continued my review, this was not
surprising. The report contained 16 pages,
of which only two pages were actually
related to the subject business. One
page had a schedule of ownership and
an allocation of the Informal Business
Valuation among the owners. The second
page had several formulas for various
methods to derive the Informal Business
Valuation. Apparently, this single page
gave Mr. Penny Pincher the impression
that the Informal Business Valuation
yielded a reasonable valuation for use in
the buy-sell agreement.
Table 2 shows how the Discounted Future
Earnings Method was calculated.
Upon receiving the Informal Business
Valuation, I dug just a little below the
surface and found a few of the problems
common to valuations prepared by
unqualified individuals:
- Randomly assigning weights to all
methods performed whether or not
they are relevant.
- Randomly assigning weights to prior
years’ earnings for multiple years in
spite of the fact that the company is
growing significantly.
- Failing to gain an understanding of the
valuation subject.
The following table provides a quick
summary of the methods used in the
“Informal Business Valuation” and serves
only to highlight the problems with the
report obtained by Mr. Penny Pincher.
This article will not address the proper
application of these methods, nor is the
discussion that follows intended to imply
that the various methodologies were
correctly or incorrectly applied.
These three failures resulted in my
conclusion that the preparer failed to
understand valuation theory and related
methodologies. My impression is that
the preparer indeed had his “black box,”
and he used the same methodology and
weighting for all of his Informal Business
Valuations.
The five methodologies employed by the
preparer were as follows:
1. Book Value Method, based upon net
tangible book value (NTBV).
2. Straight Capitalization Method.
3. Capitalization of Earnings Method
(Preparer Assumes a Going Concern).
4. Years’ Purchase Method.
Weighting Randomly Assigned to
Methods
First, I questioned why the Book Value
Method was assigned a weighting equal
Informal Business Valuation
Average annual earnings
Capitalization rate
Estimated earnings on NTBV
Excess earnings
Capitalization rate
Capitalized excess earnings
Goodwill multiplier
Goodwill value
Plus: NTBV
Indicated value
Weighting
Weighted
Divide by total weighting
Weighted average valuation
I
$ 25,000
$ 25,000
1
$ 25,000
II
$ 483,333
20%
2,416,667
1
2,416,667
Rounded
III
483,333
IV
483,333
(386)
482,947
20%
2,414,737
(386)
482,947
25,000
2,439,737
1
2,439,737
V
Valuation
3
1,448,842
25,000
1,473,842 1,562,213
1
1
1,473,842 1,562,213 $ 7,917,458
5
$ 1,583,492
$ 1,580,000
Table 1
Historical net income (growth for 2014 - 2016)
2011
$ 100,000
Average historical and forecasted net income
Periods
Present value factor
Discounted earnings
Indicated value
2012
450,000
2013
900,000
2014
10%
2015
10%
2016
10%
$ 483,333
531,667
1.0
0.9434
$ 501,572
584,833
2.0
0.8900
520,500
643,317
3.0
0.8396
540,141
$ 1,562,213
6%
Table 2
to the other four methods. Generally
speaking, a going concern will have far
more value than that indicated by its
reported book value unless that going
concern was recently acquired and all
assets have been stepped up to fair value.
In this case, the Book Value Method yields
a valuation of $25,000, which is far below
the values indicated by the remaining four
methods used by the preparer.
I talked with Mr. Control, who stated
that the subject company will remain in
business indefinitely and is not asset
intensive. Accordingly, I suggested that
no weight should be assigned to the Book
Value Method. While I was not engaged
to perform a valuation, the simple math
would result in a revised indication of value
amounting to $1.97 million, or 25 percent
higher than concluded in the Informal
Adjusted average annual earnings
Capitalization rate
Estimated earnings on NTBV
Excess earnings
Capitalization rate
Capitalized excess earnings
Goodwill multiplier
Goodwill value
Plus: NTBV
Weighting
Weighted
Divide by total weighting
Weighted average valuation
I
$ 25,000
$ 25,000
$ -
out that the preparer used a straight
average ($483,333) of the past three
years’ earnings performance, which would
indicate that there is a high likelihood
that earnings will recede from the levels
achieved over the past two years. As noted
in the table above, earnings grew from
$100,000 in 2011 to $900,000 in 2013.2
Mr. Control stated that there was a low
probability that earnings would recede
given that the company is adding new
customer contracts.
Mr. Control stated that earnings are
expected to grow by 10 percent over
the next three years, so I again made
an adjustment to the preparer’s Informal
Business Valuation by using the most
recent year’s earnings performance for the
basis of mathematically recalculating the
indications of value derived under methods
II
$ 483,333
20%
2,416,667
1
2,416,667
Rounded
III
483,333
IV
483,333
(386)
482,947
20%
2,414,737
(386)
482,947
25,000
2,439,737
1
2,439,737
V
Valuation
3
1,448,842
25,000
1,473,842 1,562,213
1
1
1,473,842 1,562,213 $ 7,892,458
4
$ 1,973,115
$ 1,970,000
Table 3
Business Valuation. See Table 3.
Upon eliminating the random weighting
assigned to the Book Value Method,
the revised indication of value is $1.97
million, falling in between the value of
approximately $2.4 million derived under
the second and third methods and the
$1.5 to 1.6 million derived under the fourth
and fifth methods. At least we are in the
ballpark!
I dug a little further.
Weighting Randomly Assigned to
Historical Earnings Streams
I talked with Mr. Control and pointed
two through four. In doing so, I replaced
average annual earnings of $483,333 with
the most recent year’s earnings, $900,000.
The Discounted Future Earnings Method
was recalculated to be $2.9 million, as
seen in Table 4.
Combining our two changes, eliminating
the random weighting assigned to the
Book Value Method and eliminating
the random weighing assigned to 2011
and 2012 earnings streams that are not
reflective of the company today, yielded
a revised mathematical calculation
of $3.7 million, or 132 percent higher
than reflected in the Informal Business
Valuation.3 See Table 5.
Understanding of the Valuation Subject
We now have a valuation range of
approximately $2.7 million (methods four
and five) to $4.5 million (methods two and
three). The key driver behind the difference
in these numbers is that the former
methods assume that the company will be
a going concern while the latter methods
assume that the company will continue for
only three years and there is no residual
value due to the nature of the customer
contracts in place and the business itself.
The preparer did not bother to gain an
understanding of the company. He had
his black box with built-in formulas and
defined weightings, and the arithmetic
worked. However, the built-in formulas and
defined weighting do not apply to every
company, and certainly not to this one. Mr.
Penny Pincher had his slick-looking 16page report and he was ready to insert a
valuation of $1.58 million into the buy-sell
agreement. That amount was a far cry
from the amounts ranging from $2.7 million
to $4.5 million indicated in the immediately
preceding table.
Impact on My Client
In my discussion with Mr. Penny Pincher,
he made it clear that he valued a low fee
and assumed that the valuation service
would be equal to the service that he
would receive from a credentialed and
seasoned valuation professional. He
definitely saved money compared to what
he would have spent with a qualified
valuation professional; however, he
received nothing of value in exchange for
his expenditure.
For the sake of discussion, let’s assume
that the company is a going concern,
will be in existence for more than three
years and is appropriately valued using
an income approach. The revised value of
$4.5 million indicated by methods two and
three in the preceding table are reflective
of a going concern value, whereas the
values indicated by methods four and five
are reflective of customer contracts that
will cease in three years for a company
that will have no remaining value.
If the true value of the company is $4.5
million and Mr. Penny Pincher is allowed
to use the Informal Business Valuation
of $1.58 million, then there could be dire
consequences for my client, who owns 70
percent of the business. If he agreed to
the buy-sell agreement and passed away
within the next year, then his estate would 
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2011
$ 100,000
Historical net income
Average historical and forecasted net income
Periods
Present value factor
Discounted earnings
Indicated value
2012
450,000
2013
900,000
2014
10%
2015
10%
2016
10%
$ 900,000
990,000
1.0
0.9434
$ 933,962
1,089,000
2.0
0.8900
969,206
1,197,900
3.0
0.8396
1,005,780
$ 2,908,948
6%
Table 4
Endnotes
1
I refer to the person who created the
“valuation” as “preparer” due to the fact
that he is not a valuation professional.
2
You might be asking yourself if I am
referring to a client interaction that
occurred a year ago due to the fact that
we are dealing with earnings from 2011
through 2013. In fact, this was a recent
client interaction. In spite of the fact that
this company is growing significantly,
the preparer apparently did not find it
important to ask for trailing 12 months
data.
be bought out at a price that would be
understated by at least $2 million.4
This Informal Business Valuation,
obtained to fill in the blank of the buy-sell
agreement, is haphazard at best and
is no real indication of value. As valued
consultants to our clients, we should
remember to go beyond the math and
truly understand the value drivers for the
companies and their owners, whom we
serve. 
Adjusted average annual earnings
Capitalization rate
Estimated earnings on NTBV
Excess earnings
Capitalization rate
Capitalized excess earnings
Goodwill multiplier
Goodwill value
Plus: NTBV
Weighting
Weighted
Divide by total weighting
Weighted average valuation
I
$ 25,000
$ 25,000
$
-
II
$ 900,000
20%
4,500,000
1
4,500,000
Rounded
Tennessee CPA Journal
IV
900,000
(386)
899,614
20%
4,498,070
(386)
899,614
25,000
4,523,070
1
4,523,070
V
Valuation
3
2,698,842
25,000
2,723,842 2,908,948
1
1
2,723,842 2,908,948 $ 14,655,860
4
$ 3,663,965
$ 3,660,000
Table 5
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III
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MAY/JUNE 2015
In light of the possibility that someone
reading this article will desire to cut the
preparer some slack, I calculated a revised
indication of value using an average of
earnings for 2012 and 2013 (eliminating
only the lowest year of earnings in 2011),
and this resulted in a revised indication
of value amounting to $2.75 million, or
74 percent higher than calculated by the
preparer.
4
($4.5 million - $1.58 million) times 70
percent.
3
About the Author
Christopher M. Lovin, CPA, ABV, CFF,
CFE, is Partner-in-Charge of LBMC’s
Litigation and Valuation Services Division.
He can be reached at 615/309-2264 or
[email protected].
Come see Chris Lovin at
the 2015 Southeastern
Forensic & Valuation
Services Conference
on Oct. 26-28 at the
TSCPA Meeting Center in
Brentwood, Tenn.
For more information
visit www.tscpa.com/
forensic2015.
Don't Forget the EBITDA Multiple:
An Additional Commentary
By Andrew K. Lowe, ASA, MAFF
O
ne of the most common metrics for buying and selling a
business is an Earnings Before Interest, Taxes, Depreciation
and Amortization (EBITDA) multiple. Phrases like, “I can get
you six times” or “I wouldn’t pay more than four times for that
company” are commonplace among business brokers, but to
the layperson these terms can be somewhat misleading. It is
customary for buyers and sellers alike to talk in terms of EBITDA
multiples as a simplistic approach to derive a perceived value
for a particular business.1 While an EBITDA multiple may get
someone in the ballpark, it is certainly lacking a number of critical
elements, which if not considered could result in a very poor
transaction for the buyer or seller.
The primary reason that buyers rely on an EBITDA multiple when
valuing a company is that EBITDA is erroneously viewed as the
“cash flow” of the business, and the multiple is “what the market is
paying.” However, EBITDA fails to consider other aspects of cash
flow such as expected ongoing capital expenditures and working
capital required by the business, while the “market multiple” fails
to capture the specific risks associated with the subject company’s
cash flow.
Let’s assume for a minute that Company A and Company B
are both going on the market. They are both manufacturing
companies that produce the same widget. Processes and
procedures for the two companies are identical. Company A has
revenue of $7 million and EBITDA of $1 million, while Company B
has revenue of $5 million and EBITDA of $800,000. Mr. Jones, a
potential buyer, has been doing some research and found that the
“going rate” for a manufacturing company is five times EBITDA
based on the transactions he reviewed. Therefore, Mr. Jones has
used market transactions to price the companies at $5 million and
$4 million respectively, with the assumption that an investment in
either would result in a similar return on his investment. On the
surface, this may seem reasonable. However, a number of pitfalls
may be encountered.
of approximately $50,000, Company A has an immediate
expenditure that must be considered.
Pitfall No. 3: Company A maintains only $100,000 of working
capital, much less than others in the industry. Company A’s
management has utilized a “timing” strategy for its payables that
has allowed it to maintain a lower amount of working capital, but
any hiccup could result in a liquidity problem for the company.
Company B, on the other hand, maintains working capital of
$400,000, which is an appropriate level of working capital based
on industry ratios and the company’s annual revenue of $5 million.
Based on industry ratios, Company A may have a working capital
deficit of $460,000.2
An investment in Company A at an EBITDA multiple of five
will result in an additional investment of $760,000 for capital
expenditures and working capital, whereas no such additional
investments will be required for Company B. The result: the
investment in Company B at a multiple of five times EBITDA will
produce a greater rate of return than an investment in Company A
at the same multiple of EBITDA. 
Endnotes
1
EBITDA multiples are not derived when negotiating the
transaction, but are rather the result of a math exercise following
the completion of the transaction. Educated buyers evaluate
businesses based upon comparable rates of return.
2
Assumes a 12.5 sales-to-working-capital ratio.
About the Author
Andrew K. Lowe, ASA, MAFF, is Manager of Valuation, Litigation
& Business Transition Services for the LBMC Knoxville Group. He
can be reached at 865/862-3027 or at [email protected].
Pitfall No. 1: Mr. Jones’s blanket application of a five times
multiple fails to consider the risk of each specific company. While
some portions of a company’s risk are truly market-related, others
are very specific to the business being acquired, and a blanket
application without further analysis could greatly overstate or
understate the value of the target.
Pitfall No. 2: Mr. Jones did not consider future capital
expenditures necessary to continue the operations of each
respective business. Due diligence might reveal that industry
trends are leading these companies to require a $300,000 piece
of equipment by June 2015. Company B made the investment
in this piece of equipment in 2014, while the management of
Company A decided to push this investment until the last minute.
Although each expects annual maintenance capital expenditures
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