Possible, Plausible, and Probable – The Art of Valuation
The numbers don’t lie, so goes the old saying. We are taught early on to trust numbers. We learn that if Bob has three apples and Susie gives him two more, Bob now has five apples. This is easy to understand and there can be no ambiguity therein. Numbers and their associated equations are concrete, consistent, and reliable. Since the foundation of a business valuation is predicated on the use of financial numbers, it’s easy to see how many people assume that a valuation is just as concrete and reliable. However, if this was so, how can a business be valued by two different valuators and end up with two, vastly different valuations?
The truth is, business valuations are not that simple. Contrary to what many believe, the goal of a business valuation is to determine a realistic projection of the future earnings of a company, not the past earnings. While the past history of the company is used to help determine the projected future earnings, the past financials are only a part of a complex equation. Since businesses do not exist in a bubble, this equation contains many elements containing both internal and external factors that must be taken into consideration. Furthermore, the unique nature of each individual business will affect how the elements come into play. Examining the specific circumstances, determining which factors to consider, and then analyzing how all of the pieces fit together is where business valuation turns from being a science to becoming more of an art. Or in other words, this is where one valuation can drastically differ from another.
As Aswath Damodaran, a Professor of Finance at the Stern School of Business at New York University, teaches, a good valuation should tell a story; the story of the business. As such, each value in a report should be able to be explained within the context of the story being told. Being able to craft a realistic and reliable narrative for a business is the difference between being a number cruncher and a valuator.
For each step of the valuation process, the valuator must determine whether the narrative represents something that is not only possible or plausible, but more importantly, probable. Many things can be possible but unlikely to happen. For instance, it’s possible that the local Italian restaurant will be bought out by a national chain for twice its value, but it’s not likely to happen. Plausible means that something has the appearance of being true but that doesn’t necessarily mean it is or will be true. For instance, it’s plausible that a competing local Italian restaurant across town will buy out the restaurant for a third more that what it’s worth in order to eliminate competition. It is plausible for this scenario to happen as reducing the competition would tend to increase revenue enough to justify paying more than the business is worth. However, chances are still against this scenario. Probable, on the other hand, implies that something is more likely to happen than not happen. For instance, it’s probable that the owner will sell the restaurant for what It’s worth to someone that just wants to own an Italian restaurant. Each element in the narrative needs to be probable for a valuation to be both valid and reliable.
A qualified valuator needs to be experienced and knowledgeable, not only in the principals of valuation but also in business in general. Without an appropriate understanding of business practices and the environment in which they operate, one will not be able to differentiate between critical factors and to those that are on the periphery. When deciding on a valuator, it’s also important to choose one that can competently narrate the story of the business should litigation support be required. Remember that while the numbers themselves may not lie, the story behind the numbers can either be fiction or non-fiction.