Today I had a very interesting discussion with a fellow appraiser who is valuing an oil and gas exploration / development firm for divorce purposes. The subject company acquires oil and gas rights for specific properties all across the U.S. It then organizes limited partnerships to finance drilling and, if oil and gas are found, development and production. Significantly, it retains controlling (sole) general partnership interests in each property. It retains the great majority of these general partnership interests indefinitely, but occasionally sells off individual ones when the control owner thinks prices have peaked or when he needs to prune debt.
As of the valuation date (November 2009), the company is fully occupied developing existing successful wells. It is at its financial capacity, having borrowed as much as it can, and its lenders are pressing (but not forcing) it to sell off some producing interests to reduce its debt. Because of that and its operating workload, there are no current plans to acquire more drilling rights. Moreover, the sole shareholder (who owns all of the general partnership interests) believes that oil prices are going to decline, another reason he is not presently inclined to expand. He is in his early 50’s, has been in this business for 20 years, and has no plans to retire.
My colleague asked my opinion as to how I would consider the future growth potential of the business, particularly with reference to future rights acquisitions and property developments.
My conclusion was that (1) at some point in the future, it is highly likely that there will be more acquisitions and developments based on the shareholder’s age, experience, and intentions, but that (2) the specifics, timing, and magnitude of these projects and their financial consequences are not predictable. The latter uncertainties are reinforced presently by the company’s workload, debt pressure, and the owner’s bearish outlook for oil prices. In addition, I suggested that he consult with the matrimonial attorney regarding whether the value of highly speculative future projects would be considered a marital asset. (As an aside, he did so, the attorney answered emphatically “no”, and that was good enough for my colleague and me!)
All of this, however, got me thinking about how I would answer my colleague in different valuation contexts: taxation (fair market value), transaction (investment value), and financial reporting (fair value).
In a tax situation, my answer would be the same as in divorce. Revenue Ruling 59-60 Section 3, Paragraph 3 tells us to consider only facts known or reasonably knowable as of the valuation date. That to me rules out consideration of highly speculative future projects.
In a transactional situation (i.e. buying or selling shares of the subject company, which owns all of the general partnership interests), the parties would negotiate whether the buyer would have an interest in future (new) projects. This could be accomplished all sorts of ways: via earn-outs, options, etc.
I have not encountered this type of situation in a fair value engagement, and all I can say is that I would ask the auditors how they would prefer to handle it.
I can think of many examples of businesses or industries in which questions about the future scale of operations could be significant to the valuation. By “future scale” I mean the results of conscious decisions by the control shareholder to make discrete investments (with their own specific risks and uncertainties) that could materially affect cash flows and valuations. Leveraged buyout firms, industry consolidators (who acquire multiples companies in a specific industry) and real estate developers come immediately to mind. Historically, so would companies (and individuals) that bought and rehabilitated houses, trying to “flip” them profitably. (The credit crisis killed that business, at least for now.)
I now realize that I have run into this situation in a few appraisals during the last ten years. One involved a company that bought marketing rights to consumer products (glues and cleansers) that had not been fully exploited by their previous owners. It then built up distribution channels for them. It bought a new product perhaps once every five to ten years. Several involved metals service centers and scrap metal dealers that periodically borrowed heavily and took long inventory positions, speculating on price increases.
All of these businesses share the common element of growing (primarily) through major discrete acquisitions or business decisions rather than through internal growth from existing products. These decisions required them to commit large amounts of risk capital. It was impossible to predict with confidence how successful they would be and for how long: their business cycle extended over multiple years. Moreover, they faced various constraints (debt capacity, size of market, physical capacity, etc.) and operating uncertainties (is oil there, can they find distributors, will metals prices really go up).
Generalizing further, this line of thought suggests that there might be a third alternative to the traditional distinction between going concern value and liquidation value. This is an existential question: will the business continue to operate or not? Going concern value assumes it will do so for at least a year and probably much longer. The above situations raise the issue of scale: that is, going concern at current scale (growing internally or organically through existing products, markets, channels, etc.) and at (a presumably) larger scale as a result of ownership decisions to make acquisitions or investments (e.g. in research and development) that entail major risks.
In these cases, it strikes me that we need to discuss with ownership and management their intentions and preferences, consider the constraints and risks, in order to understand all of the available information as of the valuation date. We have to recognize that subsequent events (dry holes, unsuccessful product launches, etc.) could overturn a reasonable judgment made earlier in time, but that if we did our job right, this makes no difference.