Business Valuation & Automation

Business Valuation Automation: Future or Fantasy?

An opinion article analysing the successful of current attempts to automate business valuation, the likelihood of this happening in the near future and potential challenges that will arise in this area.

In late 2020, UNSW alumnae Benjamin O’Dea and Edward Johnson set out to solve a pervasive problem for business brokers: the fact that only 20% percent of listed businesses sell. According to O’Dea and Johnson, the reason for this is that businesses are often incorrectly valued. Their solution to this problem is the newly launched start-up, Negotium. Negotium creates automated business valuation reports, which are primarily based on the past performance of the business, and to a lesser extent, the assets owned by the business. However, whilst many attempts have been made to automate business valuation and to replace standard financial theory and analysis with machine learning, most have proven unsuccessful. This is because business valuation is largely dependent on factors which cannot be accurately assessed by an algorithm, and which require an expert, experience-based perspective.

Forensic Analysis & Auditing A valuation model is only as accurate as the data that it has relied upon. Whilst a valuation model may provide an adequate basis of methodology, all information must be appropriately qualified Firstly, tax efficient structuring is often implemented to reduce a business’ obligations, and this will impact the profitability of the business. Without appropriate adjustments, this can result in a radical undervaluation of a business, and a value that is not indicate of what it would sell for on the open market. Secondly, a forensic analysis is often required to ascertain the true value of the assets and liabilities on the business’ balance sheet. For example, the depreciated value of an asset is often not indicative of the true value and therefore must be appropriately adjusted, which will result in the financial position of the business shifting. Property values can sometimes be over or under-stated. When employing the discounted cash flow method, all projections must be appropriately qualified, and there must be an assessment of whether they are feasible and not overly optimistic or pessimistic.

Assessment of Risk & Industry Conditions Machine learning cannot accurately assess the current conditions and future outlook within an industry, especially when there is not enough data available to evidence the impacts and predict trends. Notably, O’Dea and Johnson neglect to apply any discount to their valuations of businesses in the hospitality industry and rely on pre-COVID-19 data for multiples. For example, the impact of COVID-19 on business valuations has been pervasive, with the pandemic having different impacts on all industries, resulting in some profiting greatly and others suffering significant pandemic induced losses. An experienced opinion is required to balance pre and mid-COVID performance and the likely risks and opportunities going forward for a business as the pandemic passes.

All of these factors must be considered when determining a value, and these vary widely from business to business. This evidences the fact that business valuation is not merely a rigid, formulaic calculation, but rather a holistic view of the business’ value. Business valuation is dependent on the individual characteristics of the subject, and requires a level of creativity to envisage the strengths, weaknesses, opportunities and threats and how these will be perceived in the market.

Market A nal ysis & S ubjecti ve Factors A valuation exercise will often require the assessment of the market value, which is defined as ‘the estimated amount for which an asset should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s length transaction, after proper marketing, wherein the parties had each acted knowledgeably, prudently and without compulsion’ (IVSC, 2020. It is crucial to understand the market for a business and the factors that will impact saleability. This feeds into the assessment of risk and industry conditions, as purchasers will generally be aware of this, and it will be factored into the sale price of the business.

It is important for business valuers to understand common features that impact saleability. A prime example of this is poorly kept accounts that make it difficult to ascertain the true revenue and profitability of the business. The price paid for a business is often directly related to the risk involved, and it is important to assess any factors of risk that a potential purchaser may be deterred by. Businesses are ultimately vehicles for making money, and the purchase of the business becomes a gamble when continuity of profit is not certain. Sometimes a business’ value must be adjusted for a myriad of reasons: a broken business model, hidden liabilities, inaccurate financial reporting or poor management. Valuation is therefore best viewed as an art, not a science. This is the fatal flaw of O'Dea and Johnson’s ambitious project: the fact that there is indeed sometimes no market for a business as the risks a potential purchaser must take on are too high, and without a willing purchaser, no goodwill value exists.

Comparable Sales E vidence A nal ysis Comparable sales are a meaningless indication of the value of a business if it is not appropriately selected and analysed. Important factors such as revenue, EBITDA, PEBITDA, industry benchmarking and operating expenses must be assessed to ensure that they can be deemed comparable to the subject business. A key criterion of value that can be neglected by business valuers is scale and market share. Finding appropriate comparable sales evidence is often the most challenging part of performing a business valuation, as the private sales of businesses are rarely published. A broker’s perspective is often required when analysing these sales, as saleability is a key consideration when assessing the market value.

Applica tion of Valua tion M ethodology There are a few common methodologies that are applied to determine business value: the discounted cash flow method, the capitalisation of future maintainable earnings and the net asset backing method. It is crucial to select the correct method of valuation, and this will often vary from business to business. Whilst the capitalisation of future maintainable earnings and discounted cash flow methods are the most common valuation methods for a business with known and expected trading performance, this one size fits all approach cannot be applied to every business.

Challeng es for Automation Whilst O’Dea and Johnson’s project proves that business valuation methods and formula can be automated and made widely accessible to the public, the expertise required to correctly apply these financial formulas is not. O’Dea and Johnson may have accurately identified an issue in the business broking industry, but their solution neglects the fact that these businesses are not merely incorrectly valued, but rather that there is no market for them. Furthermore, their solution to this perceived problem would unfortunately not solve it even if it was linked to over or undervaluation.

A significant hurdle for the automation of business valuation will be acquiring the data to enhance machine learning to the necessary standard. As most information about business sales and industry know-how relating to value is privately held, it is obvious that in the current environment, automation will not compete with a business valuer’s expert opinion anytime soon.