Valuation Methodologies and Evaluating Valuation Experts Presented to the North Carolina Association of District Court Judges by: T. Randolph Whitt, CPA, ABV Kelly A. Schmid, CPA, CVA, ABV Crisp Hughes Evans, LLP April 10, 2003
AGENDA • Evaluating a Valuation Expert • Evaluating a Valuation Report • Valuation Methodologies • Valuation for Equitable Distribution - Active v. Passive
What Must be Valued? • Pension and Retirement benefits - §50-20.1 • Business interests operating as; • C Corp • S Corp • General Partnership • Limited Partnership • Limited Liability Partnership • Sole Proprietorship • Other real and personal property
Who are Valuators? • Valuation Experts • Credentialed experts (ASA, ABV, CVA, CFA, CBA, AVA) • Educated in valuation theory • Adhere to published business valuation standards which address financial analysis, industry analysis, economic analysis, report writing in addition to business valuation theory. • Undergo examination, education and peer review of valuation reports to obtain designation. • Accountants • Core competencies of financial analysis and understanding of business operations • May or may not understand business valuation theory
Who are Valuators? • Valuation Experts • Economists • Core competency of understanding of economic theory • May or may not understand business valuation theory • Industry Experts • Core competency of understanding their industry • Usually have no knowledge of business valuation theory • Investment Bankers/Business Brokers • Core competency of understanding the structure of a business transaction • May or may not understand business valuation theory
Evaluating an Expert • Education - in general and in business valuation • Qualifications (designations) and experience • Knowledge of business valuation theory • Should not be an advocate for the client; only an advocate of his opinion
Evaluating an Expert’s Report • A well prepared valuation report will present the expert’s knowledge of: • Industry • National and Local Economies • Subject Company • Standard of Value • Cost, Income and Market Approaches • Discounts and Premiums
Evaluating an Expert’s Report • Subjective Areas of Valuation Reports: • Adjustments to the Balance Sheet and/or Income Statement • Selection of Estimated Future Income Stream • Calculation of Discount or Capitalization Rate • Risk factors • Growth rate • Selection of Valuation Methodology • Selection of Guideline Companies or Transactions in the Market Approach • Application of Discounts and Premiums
Definition of Value • Fair Market Value: • Revenue Ruling 59-60 - “. . the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.” • Is not equivalent to purchase price, replacement value, book value or the amount received in a sale of similar property.
Definition of Value • Fair Market Value: • International Glossary of Business Valuation Terms – “Fair Market Value -the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, where neither is under compulsion to buy or sell and when both have reasonable knowledge of the facts.” • Business valuation organizations that adopted the International Glossary of Business Valuation Terms include the American Institute of Certified Public Accountants, American Society of Appraisers, National Association of Certified Valuation Analysts, Canadian Institute of Chartered Business Valuators, and the Institute of Business Appraisers.
Valuation of Closely Held Business Interests • Definition: • Shares are owned by a relatively limited number of stockholders, often held by one family. • Shares not actively traded (usually)
Valuation of Closely Held Business Interests • Valuation factors to consider (Rev Rul 59-60) • Nature of the business and the history of the enterprise from its inception. • Economic outlook in general and the condition and outlook of the specific industry in particular. • Book value of the stock and the financial condition of the business. • Earning capacity of the company. • Dividend-paying capacity.
Valuation of Closely Held Business Interests • Valuation factors to consider (continued) • Whether or not the enterprise has goodwill or other intangible value. • Sales of the stock and the size of the block of stock to be valued. • Market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter
Valuation Approaches • 3 Approaches • Asset • Income • Market • All approaches must be considered, but various factors will influence which approach will be relied upon to value company.
Valuation Approaches • Asset Approach • Estimate the value of a business by valuing the tangible and intangible assets of the enterprise • Adjusted Net Assets Method • Excess Earnings Method
Valuation Approaches • Income Approach • Estimate the value of a business based on its future earnings stream • Discounting: Projecting all expected future economic benefits and discounting each benefit back to a present value at a discount rate that represents the return on investment for that investment time. • Capitalization: Dividing a single historical or projected economic benefit by a capitalization rate that represents the discount rate less the expected long-term growth rate.
Valuation Approaches • Market Approach • Estimate the value of a business by direct comparison to comparable guideline companies and similar investment that have been sold. • Guideline publicly traded company: Relating market value multiples for public company stocks to the subject company. • Guideline merger and acquisition : Relating value multiples from sales of entire companies to the subject company. • Prior transactions, offers and buy-sell agreements
Asset Approach • Adjusted Net Assets Method • Valuation analyst restates all of the assets and liabilities of the subject company from their historical cost basis to fair market value. • The fair market value of the assets minus the fair market value of the liabilities equals the fair market value of the business owners’ equity. • Value indication is typically that of 100 percent of the equity, on a marketable, controlling ownership interest basis.
Asset Approach • Adjusted Net Assets Method-Advantages • Easy to understand • Especially relevant in tangible asset intensive business if valuing controlling ownership • Liquidation value may exceed going-concern value
Asset Approach • Adjusted Net Assets Method-Disadvantages • Expensive and difficult to get reliable market-derived data for valuation of many assets and liabilities • Valuation of intangibles and contingent items may be considered speculative • Of questionable relevance in many going-concern premise valuations, especially minority interests
Asset Approach • Excess Earnings Method • Method is embodied in Revenue Ruling 68-609 • A derivation of this method is often used to value professional practices • A “normalized” level of economic earnings is estimated by “adjusting” the professional’s salary to comparable market salaries • Value indication derived from this method is on a marketable, controlling ownership interest basis
Asset Approach • Excess Earnings Method-Advantages • Seemingly simplistic • Widely used in family law courts, especially for professional practices and small service businesses
Asset Approach • Excess Earnings Method-Disadvantages • Wide disagreement on implementation • No empirical basis available for developing or supporting capitalization rate applicable to excess earnings • Does not provide mechanics for incorporating expected growth • Not widely used by financial community • IRS position (per RR68-609) is use “only if no better method is available”
Income Statement Analysis and Normalization Purpose is to better understand and interpret the earning power of the subject company Adjustments generally fall into three categories: Differences in accounting practices Nonrecurring events, discontinued operations, or other aspects of past operations that may not represent future earning power Discretionary items (management perquisites, bonuses, etc.); Only done for valuations of controlling ownership interests Income Approach
Income Approach • Project future economic income • Free Cash flow: Earnings before interest and taxes (EBIT) + Depreciation - Capital Expenditures - Change in Working Capital + Deferred Taxes • Accounting earnings: net income, net operating income, earnings before interest and taxes (EBIT) • Payouts: dividends, partnership withdrawals, S Corp distributions
Income Approach • Selection of projected earnings stream • If debt is included in what is being valued, the income stream to be used is Earnings Before Interest and Taxes (EBIT) or Net Cash Flow to Overall Invested Capital, which ignore capital structure and tax position • A weighted average cost of capital (WACC) discount rate is used • Resulting value is referred to as “Market Value of Invested Capital”
Income Approach • Selection of projected earnings stream (con’t) • If debt is not included in what is being valued, the income stream to be used is Net Income or Net Cash Flow to Equity • A cost of equity discount rate is used • Resulting value is referred to as “Market Value of Equity”.
Discount and Capitalization Rates The expected rate of return that would be required to attract an investor to invest in the subject company Instead of investing in available alternative investments that are comparable in terms of risk and other investment characteristics The discount or capitalization rate is the “cost of capital” for that particular investment. Income Approach
Discount Rate Must be appropriate for the definition of economic income in the numerator Components: Risk free rate (U.S. Treasury obligations) + Premium for risk (additional rate of return expected for investing in non-Treasury securities) Income Approach
Capitalization Rate Must be appropriate for the definition of economic income in the numerator Components: Risk free rate (U.S. Treasury obligations) + Premium for risk (additional rate of return expected for investing in non-Treasury securities) - Projected sustainable average annual rate of growth Income Approach
Discount and Capitalization Rate Weighted Average Cost of Capital (WACC) Blended costs of the company’s capital structure components, each weighted by the market value of that component If debt is being included in what is being valued, a WACC will be applied to an earnings stream which ignores capital structure (interest expense) Income Approach
Discount and Capitalization Rate Risk Premium: Equities are riskier than debt and warrant a higher expected return Most estimates of equity risk premium rely on historical market performance as an indicator of future Historically, small company stock have had higher returns and more risk than large company stocks Subject company may be riskier than the small companies analyzed in the empirical data Income Approach
Discount and Capitalization Rate Sources for Risk Premium data: Stocks, Bonds, Bills, and Inflation, published annually by Ibbotson Associates Standard & Poor’s Corporate Value Consulting Risk Premium Report, published annually by Standard & Poor’s Valuation analyst comparison of performance of subject company to publicly traded guideline companies and private company completed transactions Income Approach
Taxes and the Risk Premium Stock Market returns used in calculating the risk premium are after corporate taxes These are the returns realized by an investor. These returns are pre-investor taxes, after business taxes When applying discount rates calculated with this data, cash flows should be calculated on the same basis. Income Approach
Income Approach • Discounted Economic Income Method • Most appropriate for projected income streams with: • Predictable, but uneven changes • Short- or intermediate-term supergrowth • Changes that are erratic and unpredictable as to timing • Also referred to as Discounted Cash Flow Method (DCF)
Discounted Economic Income Method (con’t) If control-type normalization adjustments are made to economic benefit stream, resulting value is on a controlling, marketable basis Discount for lack of marketability applicable for minority interest valuation, possibly for control basis valuation (but would be considerably smaller, if applicable) Little or no difference in discount rate for control v. minority valuation (an assumed capital structure in a control valuation could change WACC) Income Approach
Discounted Economic Income Method-Advantages Theoretically most correct, captures present value of all future realizable cash Widely used in the financial markets for pricing and decision making. Income Approach
Discounted Economic Income Method-Disadvantages Requires projections of future economic benefits; may be controversial Requires estimate of appropriate discount rate (cost of capital); also subject to controversy May be difficult to explain to an audience without sufficient financial background (certainly not this group!) Income Approach
Another example of use of Present Value theory Pension valuations Value of benefit or payout is known What is the value of that benefit today? Example Present Value Theory
Present Value Definition Code of Federal Regulations (“CFR”), the Proposed Rule on Employee Benefit Plans [6 C.F.R. Part 31, 3121(v) (1986)]: “Present value” of a pension benefit in a defined pension plan means the value as of a specified date of an amount or series of amounts due thereafter, where each amount is multiplied by the probability that the conditions on which payment of the amount is contingent will be satisfied, and is discounted according to an assumed rate of interest to reflect the time value of money. The present value must be determined as of the date the value is required to be taken into account using actuarial assumptions and methods that are reasonable as of that date. Present Value Theory
Capitalization Method Most appropriate for projected income streams that are: Stable or evenly growing Erratic and unpredictable as to timing (if the company’s income is unstable and random as to timing, the Discounted Earnings Method may not be able to produce any more accurate a value indication than the capitalization method) Income Approach
Income Approach • Capitalization Method (con’t) • If control-type normalization adjustments are made to economic benefit stream, resulting value is on a controlling, marketable basis • Discount for lack of marketability applicable for minority interest valuation, possibly for control basis valuation (but would be considerably smaller, if applicable) • Little or no difference in discount or capitalization rate for control v. minority valuation (an assumed capital structure in control valuation could change WACC)
Capitalization Method-Advantages Widely used by investors (although not as much as Discounted Future Earnings) Does not require specific-period, long-term forecasts Simple to understand and explain Income Approach
Capitalization Method-Disadvantages Oversimplification of discounting method Implicitly assumes that a variable capitalized represents a reasonable base from which future benefits will proceed The measure of economic income to be capitalized and the capitalization rate may be controversial Difficult to use in start-up or high-growth companies Income Approach
Market Approach • Guideline Companies (publicly traded) • Market Transactions (private companies) • Prior transactions, offers and buy-sell agreements • Rules of Thumb
Market Approach • Guideline Companies (publicly traded) • EDGAR • Hoover’s online • If controlling interest being valued, there may be some control premium warranted • Discount for lack of marketability applicable if minority valuation, possibly if control valuation