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Human Bias & the ‘Build-Up MCF Methodology’

Unlike accountants, doctors, lawyers and insolvency trustees, there is no “license” required to do business valuations. The industry is unregulated and ungoverned, and there is little to no guidance on how valuations should be benchmarked, or how reports should be constructed.  

As a result, all valuators perform business valuations in their own way, whether they are a real estate agent, accountant, or accredited valuator.  Further, unlike other professions where suspensions, loss of license and criminal charges are commonplace, there are no such consequences for providing an overly biased or inaccurate valuation.  

The most common appraisal methodology is called Maintainable Cash Flows (MCF), which was developed around the mid-1900s. At the time, there was limited transaction data on private companies, allowing one to build up their own multiple.  Getting to ‘build-up’ your own multiple in valuations is as significant to value as changing the model and milage on a car, or the square footage or lot size of a home.  It can complete change the value from one end to the other.   

As a result, the MCF implicitly allows for human bias. Valuations Guru Aswath Damodoran notes, “bias is, by far, the biggest enemy of good valuations and that it is pervasive”, and “he who pays the prices sets the bias in motion, and the valuation reflects it.He also says there is a “payoff” to doing the valuation.  

Further, the courts, mediators and arbitrators expect bias with opposing valuators, and as a result, the most common practice used by triers-of-fact is to split the difference or arrive at some weighted split.  

Experienced lawyers can help swing the pendulum too. Perception of bias may not be present (good ‘experts’ can better disguise the bias under cross-examination, whereas poor ‘experts’ show their cards), but actual bias is pervasive. In each divorce and shareholder litigation matter, it is easy to predict the direction each valuator’s bias will take based on who their paying client is.  As a result, the freedom to ‘build your own multiple’ adds to the adversarial nature of litigation, instead of assisting the trier-of-fact. 

Common biases in valuation are as follows:

Purpose of ReportBias
Looking to Raise CapitalHigher Valuation
Business Owner in a DivorceLower Valuation
Non-Owner Spouse in a DivorceHigher Valuation
Corporate Litigation – Buying Out PartnerLower Valuation
Corporate Litigation – Being Bought OutHigher Valuation
Tax PlanningLower Valuation (Usually)
Financing / LoanHigher Valuation
Analyst – Buy SideHigher Valuation
Analyst – Sell SideLower Valuation

As seen in a simplified MCF Calculator, the valuator’s bias impacts the conclusion in three key variables (they are highlighted in red in steps 1 and 2).  As seen, the MCF is an arithmetic exercise valuators have built automated models for in Excel, and ultimately, can determine their own expected EBITDA and build their own multiples (Click here for the complete, six-step MCF methodology used by the most experienced valuators)

Bias #1 from Step 1:

Weighting placed on each historical year when calculating expected Normalized EBITDA.

BIAS:
Where the bias is to understate value, the valuator will place greater weighting on historical years with lower levels of EBITDA, and vice versa. 

CORRECT TREATMENT:
The impartial approach is to predict best what the ongoing (or ‘Forward Twelve Months’ aka FFM) level of Normalized EBITDA is as at the valuation date, and adjust the weightings accordingly to arrive at such a figure. A buyer is purchasing the company’s future – not their history, and thus, a buyer is interested in determining the best prediction for ongoing (FFM) Normalized EBITDA.

VALU8ER:
 Valu8er educates users on the importance of not treating historical EBITDA as a mathematical tool, but rather, as important data that can be relied upon to best predict what ongoing normalized EBITDA will equate to. Further, instead of providing weightings to input, Valu8er is more forthright and asks the user to input their best prediction for the ongoing expected normalized EBITDA.

Bias #2 from Step 2:

Debt portion of capital (as a % of the weighted average cost of capital). Debt is cheaper than equity – the more debt a buyer can use as part of their business purchase, the more they are willing to spend (i.e. increase value) on the business, and vice versa. As seen in Step 2, the debt portion of capital has a significant influence on the ultimate cash flow capital derived.

BIAS:
Where the bias is to understate value, the valuator will use a lower amount for the debt portion of capital (resulting in a lower cash flow multiple), and vice versa.  

CORRECT TREATMENT:
In today’s world – buyers of businesses no longer use Weighted Average Cost of Capital (WACC) to buy businesses. For example, with a WACC structure of 100% debt and lending rates of 4%, you don’t see dental practices sell for 25x EBITDA (= 1/0.04). In any event, he impartial approach is to analyze what comparable companies have sold for as a multiple of EBITDA, and further appropriate benchmark the company (adjusted for individual risk) to arrive at an appropriate EBITDA multiple, then perform simple reverse mathematical engineering to arrive at an appropriate debt portion of capital.

VALU8ER:
 Valu8er’s intelligence and advanced algorithms, built around the 15 Pillars of Valuation, automatically suggest the appropriate debt portion of capital and Company Specific Risk Premium (CSR) to arrive at a completely independent suggested implicit EBITDA multiple.

Bias #3 from Step 2:

Selection for Company Specific Risk Premium (CSR). The greater this risk factor is, the lower the multiple is, and thus, the lower the value, and vice versa.

BIAS:
Where the bias is to understate value, the valuator will use a greater value for the CSR, and vice versa.   

CORRECT TREATMENT:
The impartial approach is to analyze what comparable companies have sold for as a multiple of EBITDA, and further appropriate benchmark the company (adjusted for individual risk) to arrive at an appropriate EBITDA multiple, then perform simple reverse mathematical engineering to arrive at an appropriate CSR for the company.

VALU8ER:
Valu8er’s intelligence and advanced algorithms, built around the 15 Pillars of Valuation, automatically suggest the appropriate debt portion of capital and Company Specific Risk Premium (CSR) to arrive at a completely independent suggested implicit EBITDA multiple.

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