STATISTICS -WEIGHTED AVERAGES

A weighted average is one in which different data in the data set are given different “weights”

For example: where profits of a business were:

Year        Income

2008       25,000

2007       20,000

2006       15,000

2005       10,000

2004         5,000                   75,000

If we use a simple average the income is 15,000                (75,000 -:- 5 = 15,000)

 

If we use weighted average (5-4-3-2-1) the figures become

Year        Income

2008       25,000 X 5 =        125,000

2007       20,000 X 4 =          80,000

2006       15,000 X 3 =          45,000

2005       10,000 X 2 =          20,000

2004         5,000 x 1 =             5,000                 275,000

The weighted average income is 18,300 (275 -:- 15 = 18,300)

 

Here’s a test question. What do you think the likely income for the year 2010 might be:

[     ]  The average                       15,000

[     ]  The weighted average   18,300

[     ]  The projected figure      30,000

[     ]  Don’t know                        ?????

 

Here’s another situation. If the average income figures were decreasing rather than increasing

Year         Income

2008         5,000

2007       10,000

2006       15,000

2005       20,000

2004       25,000                   75,000

The simple average is still 15,000               (75,000 -:- 5 = 15000)

But if we use a weighted average (5-4-3-2-1) the figures now become

Year         Income 

2008         5,000 X 5 =         25,000

2007       10,000 X 4 =        40,000

2006       15,000 x 3 =         45,000

2005       20,000 x 2 =         20,000

2004       25,000 x 1 =         25,000                   155,000

The weighted average is now 10,333       (155,000 -:- 15 = 10,333

We have never seen a Broker use weighted averages when the income was decreasing, but they invariably want to use weighted averages when the income is increasing.

We don’t really care what the income was 5 years ago, or 3 years ago, or what the weighted average income was.  We believe the income for the most recent fiscal year is more pertinent. In fact the income for the trailing 12 months prior to the valuation date is the most pertinent. That’s what is happening now, and that is what the value of the business should be based on.

The most appropriate method used to value large corporations is to project their income for the next 5 or 10 years, and to discount it back to the present date, and to add a terminal value based on the value at the end of the term. It is ridiculous to use this method to try to value a small business when the ownership and management will be changing, and the present owner probably doesn’t know what is going to happen next month, let alone the next 5 years.