Wiggins outlines the flaw with income and market approaches at ASA/CICBV

“Market comps have inherent limitations,” began Don Wiggins (Heritage Capital Group) in his keynote address at CICBV/ASA Business Valuation Conference today in Miami Beach.  The most common that the best practitioners immediately recognize are:

  • Majority and minority issues—does public stock represent a minority discount at all?
  • Size—can a billion dollar enterprise represent a small private company
  • Diversity—smaller companies are often “pure plays.”   Larger companies are often diversified.   But, in either case, do the publicly traded companies really match the business model of your target company
Private comps are equally limited—you need to find “recent transactions that are similar for which there is good financial information,” said Wiggins.  “This triple filter means that you’re often stuck with very weak or non-comparable market comps.”

“All of the databases tend to use financials as reported in the deal documents, though of course the economic reality of the transaction may be very different,” agrees Wiggins.  “We’ve all seen implied EBITDA multiples from deal financials and we know that they may not be very dependable for pricing purposes.”

“Deal terms also play a role—what are the baskets and caps, what is the earnout, and what are the considerations paid that did not go to the sellers,” asks Wiggins.

“As appraisers, we’re all limited by at least two factors,” he concluded.  “First, it’s unlikely that all clients will pay us to ferret out the true financial information.  Second, even if they would, the real data may simply not be available.

Sadly, the income approach also has weaknesses.   “You can make specific assumptions about CAPEX, growth, capital structure, and all the other factors that go into a forecast.”  Wiggins says at least then the assumptions are quantified and can be discussed or negotiated.  This holds for non-competes and other factors and conditions might be built in to future forecasts.   “Even the tendency to recapitalize in the future is an assumption, and of course this has a big impact on WACC.”

The same is true with key person discounts, marketability, and other factors that might be negotiated in a real sale.  “They are assumptions, but at least the assumptions are documented and can be discussed where disagreements occur,” reminds Wiggins.   “Income models are very sensitive to a few key assumptions like growth rate.   A small disagreement on assumptions as we all know can have a huge impact on value conclusions.”

A question:  “How many of you have seen a set of income statements that is less than high quality,” Wiggins asks.   This generated a round of laughter from the entire appraiser audience.  “Of course this is another problem with the income approach—if you’re starting with a set of financial statements that is unusable.”