Business Valuation: Adding verses Subtracting Long-Term Sustainable Growth

This week, I am discussing (a business valuation report where the expert erroneously added the long-term sustainable growth instead of subtracting it and its impact on the value of a company.  The theory is incorrect and will always undervalue a company.

However, before I get started I want to reiterate that the example I am showing are from actual cases and this is what business valuation experts are actually doing.  I have found these errors in large and small firms.  They have been prepared by business valuation experts that hold the following designations: (1) Certified Valuation Analysts’ (CVA), (2) Accredited in Business Valuation (ABV), (3)  Accredited Senior Appraiser (ASA), (4) and even a Master Certified Business Appraiser (MCBA).

Adding the Long-Term Sustainable Growth Rate to Determine a Capitalization Rate

When determining a capitalization rate, the long-term sustainable growth rate is always subtracted from a preliminary estimated discount rate.  If the long-term sustainable growth percent is added to the discount rate, it will always undervalue a company.  In Exhibit 1, it can be seen that a 2.5% long-term sustainable growth has been added to the estimated discount rate and creates a value of $2,898,611.  Again, this value is incorrect because the long-term sustainable growth must be subtracted from the discount rate.

The capitalization rate is applied to one year’s net cash flows while the discount rate is applied to a series of annual forecasted cash flows.

Estimated Fair Market Value Adding Long-Term Growth Exhibit 1

Subtracting the Long-Term Sustainable Growth Rate to Determine a Capitalization Rate

When the business valuation expert is determining a capitalization rate, he/she should subtract the long-term sustainable growth instead if adding it to a discount rate.  The correct methodology for the treatment is to subtract it from the discount rate.  This can be seen in Exhibit 2.  In this example, the correct treatment would produce a value of $3,389,831.  The correct value is $491,280 greater than the incorrect methodology of adding the long-term growth rate.

Estimated Fair Market Value Adding Long-Term Growth Exhibit 2

Comment

On the surface, Exhibit 1 would appear reasonable to the untrained eye.  However, this will always result in an incorrect result and could harm the plaintiff or defendant in a disputed matter.

Why should the attorney care?

The attorney will be advised of an incorrect value and will be begin negotiating from a lower value.

The incorrect value may be to the detriment of your client and this may be embarrassing to explain to a client.

I provide a realistic supportable business valuation or damage claim report.

What value do we deliver?

I provide a more thorough analysis in a report so it will withstand scrutiny.

I provide calculations imbedded in the report for most analysis instead of just stating a result.

I have earned the most difficult business valuation designations for valuations of closely held companies.

I have earned a Master’s Degree in Business Valuations and apply those skills to my everyday business valuations.

Because you as the attorney need to detect the deficiencies in business valuation (damages reports).  The better informed you are, the better the outcome of your cases…for you and your clients!

Richard Claywell has been valuing closely held companies since 1985.  He has earned two of the highest designations in the business valuation field , the Certified Business Appraiser (“CBA”) and Accredited Senior Appraiser (“ASA”),  Richard is a Certified Public Accountant, has a Masters in Business Valuation and holds the ASA, CBA, ABV, ICVS, CVA, MAFF, CFD, CVGA, ICVS-A credentials.

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