Does Your BV Model Have Any of These 10 Common Mistakes?
This article was originally published in the August 2011 issue of Business Valuation Update
While the valuation report is the end product, most of the heavy lifting is performed in the valuation model. Careless errors and bad habits can lead to incorrect or unclear valuation conclusions, and poor and unclear formatting choices are almost as bad as valuation errors. If schedules look sloppy and unclear, people can question the entire analysis performed.
A useful starting project for analysts is entering the financial statements of a company. You can quickly gauge an analyst's modeling skills if they hardcode the entire balance sheet or calculate intermediate totals such as current assets. Listed below are some of the more prevalent and damaging oversights made by new entrants to the business valuation profession.
- Hardcoding—Did you calculate your compound annual growth rate for sales by hand or in the model? All calculations that can be determined within the spreadsheet should be. Only key input data and management-provided data should be hardcoded into the model.
- Sign mix-ups—Are you subtracting capital expenditures, or are you adding them? A sign error is easy to miss, but it will create havoc on the value conclusions. Comments in cells can help clear up confusion for analysts on how the data should be entered.
- Not checking calculations—Are you summing all years of the present value of cash flows? All calculations in a valuation model should be checked. It is very easy for a mistake to be made such as dragging over a common sizing balance sheet formula that refers to the wrong year, or a terminal value that is not discounted by the right present value factor. Double-checking calculations is a necessity before handing the model off to a reviewer.
- Assumptions not clearly shown and explained—What does your 5% in cell A500 mean? All of your critical drivers should be easily identified for ease of update. If a key calculation such as the weighted average cost of capital is not calculated on the DCF tab, it should be linked to the DCF tab in a designated area. The use of an assumption box can help guide users of the model to the key inputs driving it. Many valuation firms have adopted color schemes to help valuation professionals differentiate between calculations and inputs, such as blue text for hardcoded inputs and black text for calculated numbers.
- Entering the same data more than once—Do your footnotes automatically update when your assumptions change? If not, analysts may forget to update them. The simple TEXT formula in Microsoft Excel, for example, can help integrate all of your footnotes with your assumptions.
- Lack of check figures—Does your balance sheet balance? Does your net income from the income statement equal the net income from your cash flow statement? Simple check figures help keep the models error-free.
- Not thinking about formatting—Is your concluded value from a valuation method clear? Do you fill up the spreadsheet schedule that will be inserted into your report? When you use your model for supporting schedules in your report, proper formatting is critical. Clean, clear, and understandable schedules can help guide users of your report and impress your clients.
- Not breaking out complex calculations—Are your calculations auditable? Complex calculations should be broken into smaller calculations to allow for auditability. Trying to put too many calculations into one cell can easily lead to order-of-operation errors.
- Lack of footnotes—Where did those projections come from? Many analysts forget to put in simple footnotes, such as projections for the first five years being provided by management and subsequent projections being built by the analyst. Footnotes should be included to help guide the analyst, review appraiser, and users of the report. Nothing is worse than seeing a spreadsheet full of numbers where no one can explain the source of the numbers and the assumptions underlying those numbers.
- Overcomplicated models—Do you need a sledgehammer to pound in a nail? The simplest model that is necessary to complete the given task should be used. Any increased complexity added to a model should be weighed against the increased precision of the valuation conclusion.
As we mature as analysts, we learn that a little bit of time in planning out a model will increase auditability, increase usability, and decrease errors. Strong modeling skills are not developed overnight, but are the culmination of learning from many past mistakes. Above all else, analysts need to think about what they are doing when they create or use a valuation model.
Steven J. Siefert, CFA, AM, is an associate with AccuVal Associates, Inc.
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