Most everyone has heard the term “comps” as applied to valuation. It means data from comparable sales of businesses.
But the data itself is problematic. The most common databases are Pratt’s Stats and BizComps. These sources of data are organized by Standard Industry Codes (SIC). This may seem reasonable, but in fact there is as much variation within a particular SIC as between different SICs. The reason is there are an infinite number of business models, and each produces a different return on investment. This, and other facts outlined below indicate that the so-called “data” is not really data at all as used in the statistical analysis sense. It is really a series of loosely correlated data points, which much be interpreted virtually as anecdotal evidence. It also is usually unverifiable, coming from third party volunteer sources.
The shortcomings generally are that they represent different:
3. accounting methods
4. business models
5. scale (i.e. gross sales)
6. geographic areas
7. economic climates
In analytical terms it is a multivariate array which makes attempts to analyze it with conventional statistical analysis tools, using normal distributions and standard deviations, meaningless.
So how do you deal with this information? American ValueMetrics uses a methodology known as “heuristics.”
What is Heuristics? Heuristics is a “decision support” methodology. It is a predictive method (in appraisal, predicting a value). It is an important methodology that appraisers, and users of appraisals, should become familiar with. It is an alternative to mathematical/statistical analysis that can be used when data does not meet the relatively rigid requirements for use of mathematical/statistical analysis methodologies.
The Source of the word “Heuristics” (pronounced hyu-RIS-tiks) is the Greek "heuriskein" meaning "to discover". This is the same source as the word “Eureka” meaning “I have found it.”
In the past twenty years it has been refined into a modern problem solving and analysis methodology, usually associated with systems science.
It deals with decision making where specific reliable data is not available, and/or the time and cost of obtaining such data necessary for a conventional statistical analysis is simply not feasible. Heuristics is the art of drawing inferences when faced with limited, incomplete or fuzzy data.
For valuations in the area of business assets, or unregistered, exempt, closely held securities or where transaction data is sparse, it is an appropriate methodology for determination of central tendencies, such as price/earnings ratios. It is especially valuable in evaluating minority and control discounts in a defensible way.
In practice, the information is ranked and weighted, based upon the judgment of the appraiser. This requires experience. The heuristics process is dependent upon an innate quality of the human brain called “pattern recognition.” We all operate this way. A good example is our understanding of words in a language context. Words are comprised of letters, which approximate sounds, which are strung together to convey ideas. When you hear a spoken sentence, your mind completes pattern recognition and you can intelligently understand (hopefully) what the speaker is saying without trying to analyze each letter or each sound.
The same process holds true in an appraiser’s analysis of comparable business sales data. An experienced appraiser sees patterns in the data, and can readily rank or weight the data as to relevancy to his subject business. The problem is broken into many small decisions, and reintegrated using a mathematical approach, usually a weighted average. When the resultant is a capitalization rate or a capitalized value, it is amazing how accurate it is.
So when data is not limited to one variable, and is not widely available, and is not verifiable, the heuristics approach is the most efficacious approach available for making sense of the comparable sales data.
THE AUTHOR OF THIS BLOG ARTICLE IS NOT A LAWYER AND HARVARD BUSINESS SERVICES, INC. IS NOT A LAW FIRM. THE ARTICLE ABOVE IS NOT INTENDED AS LEGAL ADVICE AND SHOULD NOT BE TAKEN AS LEGAL ADVICE. THIS SHORT ARTICLE IS STRICTLY TO MENTION SOME ASPECTS OF DELAWARE’S CORPORATION LAWS AND/OR LAWS RELATING TO OTHER FORMS OF ENTITIES WHICH YOU MAY NOT BE FAMILIAR WITH. WE RECOMMEND THAT YOU CONSULT WITH A LAWYER BEFORE FORMULATING A STRATEGY WHICH WILL BE SUITABLE FOR YOUR SPECIFIC CASE.