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Nobody’s Perfect!

By Rand Curtiss | Published: January 11, 2012

I found a small logical inconsistency in my general-purpose valuation report template (that lays out all three approaches to value).

Until now, when I calculated the liquidated value of a business, I often made a small (5% of liquidated value) deduction for expenses (such as sales commissions). Upon reflection, I think that was wrong. In the Market Approach, I do not take a deduction for these expenses (even though the premise of the approach is a sale of the business). In the Income Approach, I also do not take a deduction (because the premise is that the interest will be held indefinitely, not sold). It is inconsistent to take the deduction in one approach and not the others.

I still believe, of course, that deductions for income and capital gains tax liabilities should be taken under all approaches when indicated (even for “S” corporation distributions to cover shareholders’ personal income tax liabilities). I also believe that, under the Asset Approach, deductions for delayed receipt of asset sale proceeds (based on fixed asset appraisers’ input) as well as asset value erosion (uncollectible receivables, bad inventory, etc.) are still appropriate.

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The Cost of Capital is Forward Looking: Redux

By Rand Curtiss | Published: January 11, 2012

I have written about this before, but it is so important that it is worth repeating: the cost of capital is forward-looking.

The cost of capital – be it weighted average, debt, preferred stock, or common stock – is the rate of return that investors require to compensate them adequately for the risk of providing that form of capital (buying securities or lending) to a company. Because it is required to induce them to invest, it is – by definition – expected. It reflects their assessments of the risks confronting a business and its ability to generate satisfactory expected returns. Because the future is not certain, there is always uncertainty about any security’s rate of return. Even “riskless” U.S. Treasury Bonds have uncertainties: the real rate of interest, the rate of inflation, maturity risk (which is why longer-term bonds usually have higher yields than shorter-term bonds), and (perhaps during last year’s paralyzing debt ceiling debate) default risk.

If we were working with publicly traded securities, the task of determining the cost of capital would be much easier than it is for private securities. For bonds with fixed coupon interest rates, we can project the amounts and timing of interest and principal payments. Using current market prices, we can then compute their yields to maturity, which are the internal rates of return. That is the cost of public bond capital! If we use the Gordon Growth model, we project dividends (estimated by Wall Street consensus, albeit with more uncertainty) and calculate the cost of capital as the IRR using the current market price as the investment. That is the cost of public preferred and common stock capital!

In the private market, we do not know the value of the stock (or debt, for that matter) so we cannot use the IRR procedure. Instead, we project future returns (dividends or interest and principal) and estimate a discount rate (the cost of capital) to arrive at a (DCF-based) price. However, the discount rate is forward-looking, and not known with certainty.

THE BIG ASSUMPTION WE MAKE, whether using a build-up or CAPM, is that we can USE HISTORICAL DATA, WHICH ARE REALIZED RETURNS, to ESTIMATE EXPECTED RETURNS. If we use a build-up, we use Ibbotson and Duff & Phelps data or perhaps Private Cost of Capital survey data for our risk premiums. If we use CAPM, we look to beta data (!) based on HISTORICAL relative volatility.

I am not going to argue that this is correct, because it is not (will the future REALLY be like the past?), but I believe that this data gets us in the ballpark of reasonable costs of capital. It is the best we can do, since we do not possess crystal balls.

Whenever I am challenged on my cost of capital conclusions, I am willing to give a little (e.g. agree with someone who is within plus or minus 2% of my estimate using the same baseline data such as Ibbotson) because of the inherent uncertainties of estimating the future cost of capital, particularly the company-specific equity risk premium. I do not worry about sophisticated tweaks (such as the mid-year convention, supply-side cost of capital, adjustments to historical data to reflect expectations, and so forth) for the simple reason that they build on fundamentally imperfect estimates of the cost of capital and do not make it any more accurate.

As Clint Eastwood said, “A man’s got to know his limitations.” With regard to estimating the cost of capital, my masculinity is indisputable.

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Valuing Buy-A-Job Businesses

By Rand Curtiss | Published: January 10, 2012

A colleague called for help valuing what she called a “buy-a-job” business. The literature uses the term, and I have heard it many times, but I asked her anyhow, “How do you know it is a buy-a-job business?” I am glad I did, because her response was terrific:

“You cannot expect a buy-a-job business to generate return on a new owner’s equity.”

Wow, that says it in a simple sentence! As I thought about it, her response implies that:

1. If you calculated cash flow to equity with fair market compensation for the owner (and employed family members) and deducted debt service (interest and principal payments) based on the purchase price and terms, there would be little or none until the debt is (fully) repaid, and then only enough to maintain equity. Therefore, there is no return on equity.

2. Even if there is return on the CURRENT owner’s equity, it is not probable (or possibly feasible) that their personal goodwill (knowledge, reputation, customer relationships, etc.) could be transferred to the buyer, which in the limit implies an infinite discount rate (level of risk of associated cash flows) or zero capitalization rate for those intangible assets.

Alternatively, the buyer would have to pay the current owner such a high salary to keep working in it (or a covenant not to compete) that there would be no cash flow left over. Therefore, there is no return on equity.

I can also think of two other reasons why a business might be buy-a-job:

1. The outlook for the industry, region, or business is unfavorable and probably not fixable. (Since TV’s are so cheap that replacement is inexpensive, I would not want to be a TV repairperson.)

2. Perhaps return on equity is contractually restricted. Many professional practices have buy-sell agreements that do this. You get “your equity” when you retire, but it might not be calculated on a fully unrestricted (percentage of the value of the firm) basis.

The answer to her question follows directly from her apt definition. Since there is no cash flow to equity, we cannot use the Income Approach (based on cash flow to equity). We have to estimate a multiple of discretionary earnings or another ownership benefit stream – highly subjective, but doable. I prefer to rely on the Market Approach and hope to find a sufficiently large sample for statistical confidence.

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School Days, School Days

By Rand Curtiss | Published: January 10, 2012

I have taught undergraduate macroeconomics at a local university for the last three semesters. It has been a wonderful experience – and a quite fortuitous time to be studying and teaching the subject, which leads the news almost every day. It has also given me a chance to catch up on developments in the field, which have been numerous since my undergraduate days as an economics major, which ended during the Dark Ages (in 1972).

This term I am teaching a graduate corporate finance course and having another wonderful experience for the same reasons, in addition to the fact that I can illustrate its principles with cases and examples from my appraisal career.

As I planned the course and studied the materials, however, I realized that I had never been formally educated in the Capital Asset Pricing Model (CAPM) for the simple reason that it was not widely taught during my college and graduate days. It was invented in the 1960s and not fully developed or taught while I was a full-time student. I picked up CAPM knowledge along the way, in a rather piecemeal fashion, not through any formal academic program. There were (and are) several gaps in my knowledge.

If you find yourself in this situation, I suggest reading Fundamentals of Financial Management Concise by Brigham and Houston. I have been studying and teaching from this e-book, and find it indeed a concise explanation of the subject that has filled in many gaps for me.

My study of the book has also raised an issue that I have not resolved. One CAPM principle is that investors can eliminate company-specific risk (which we measure by the company-specific equity risk premium) through proper diversification. This makes perfect sense to me if we are talking about an investor owning a portfolio of (publicly traded) securities. On the other hand, most of my business owner clients hold their wealth primarily in their businesses and residences, and have relatively small (if any) portfolios of other investments. It is not clear to me that any of them consider their businesses, residences, and investments as a CAPM-type portfolio that can be diversified to reduce or eliminate company-specific risk. Food for major thought…

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On IRS Audits, Independence, and Objectivity

By Rand Curtiss | Published: January 4, 2012

As time goes by and I put more IRS audits under my belt, I am modifying my approach to dealing with them. Three facts are driving this:

1. Our professional standards require that we remain independent and objective. We can advocate for our opinion, but not for the cause of our client. Regardless of how independent and objective I am, there is always the risk that I will be perceived as advocating for the client, not my opinion.

2. The client’s appropriate advocate – usually their attorney – does not have objectivity and independence constraints. In addition, many of them are familiar with the most frequent appraisal issues, and are able to negotiate effectively because of these facts.

3. It is hard for me, in a live meeting or telephone conversation involving the IRS, the client’s advocate, and me, to avoid getting involved in negotiations, even though I make clear that I cannot do so. In the best case, everyone understands this. My involvement is limited to explaining and defending my opinion on its merits. In these cases, I do that, and then leave the meeting or call. The attorney dukes it out with the IRS. In worse cases, they start negotiating in my presence and draw me in, inadvertently or advertently, which is a no-no.

Here is an example from a recent audit. There were two points of contention:

1. A real estate partnership was valued on a liquidation basis. Both sides agreed on this premise, as well as on the values of the assets and liabilities. The partnership was cash flow negative, and the real estate appraiser who valued those assets had assumed values based on a one-year exposure (selling) time. I deducted from the appraised value one year of cash outflow (using the previous complete fiscal year’s outflow as a proxy). Any willing buyer would incur this cash outflow, as would an owner (seller), so it was a relevant, logical, and justified deduction from value. The IRS took the position that they “would not allow” this deduction based on certain statutory grounds (which I did not understand, not being an attorney.) This issue had big stakes: a large value adjustment, since the outflow deduction was $750,000 on a pre-deduction value of about $8 million.

2. A minority interest in an investment partnership (not the real estate partnership) was to be valued. I deducted a 32% combined discount for lack of control and marketability, justified with benchmarking and the QMDM. The IRS did not quarrel with the relevance of a discount, but took the position that they “would not allow” a discount greater than 27% based on “previous cases.” (I am not sure whether they meant Tax Court cases or previous settlements.) This issue had small stakes: a rather small value adjustment, since the 5% difference in discounts was worth about $60,000 on a pre-discount value of about $1.2 million.

Do you see my problem? In both cases, I had prepared and strongly supported my opinions concerning the controversial issues – the deduction of the cash flow and the size of the discount. The IRS was able to cite no independent market data, facts, circumstances, assumptions, or methodologies that would support their position. They were simply drawing lines in the sand: an apparent legal on the deductibility of the cash outflow and a wholly arbitrary one on the size of the discount. There was no way that I , while maintaining independence and objectivity, could respond to their statements other than to say “Please provide independent market data, facts, circumstances, assumptions, and methodologies that support your position,” a polite way of saying “Prove it!” In the absence of proof, I had nothing to say, and did not.

It would be easy to fall into the trap of saying to the IRS “You have made a totally unsupported claim contrary to my well-supported, independent, objective opinion.” In other words, I was at an insurmountable impasse with the IRS. I could say nothing else.

This is where the client’s advocate should take over. Anything that leads to bridging the gap between the positions is negotiation, which I will not be involved with because of my independence and objectivity.

Now I can get to the crux of my modified position. The first part is to just do my job – no change there – explain my opinion and reasoning and answer questions about it, including challenges to my market data, facts, circumstances, assumptions, and methods. If there is a flaw in any of them, I will modify my position accordingly. If not, I am done.

The second part is to act as a non-testifying expert in court would act: to help the attorney (the client’s advocate) make their case. This should be done BEFORE meeting with the IRS and (if an impasse is reached), in a caucus with the attorney. In both, I educate the attorney on the potential (or actual) issues so that they can defend them. I will point out, for example, assumptions that could be reasonably modified if there is going to be a negotiation. In the above case, I suggested that for negotiation purposes a shorter exposure time (six months, and thus lower cash outflow) could be proposed BY THE ATTORNEY. I also suggested that THE ATTORNEY offer to split the difference on the valuation discount. This armed the attorney with all the relevant information I could provide, and suggested negotiating points. If I do this job well, the attorney is in a strong position to negotiate (deciding to stick to the original position, make a deal, or capitulate) and I remain “above the fray,” which is where I must be! In this case, the IRS accepted both positions after some further obfuscation, and the case was settled.

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What Happens in Vegas…

By Rand Curtiss | Published: December 29, 2011

Building on the “How Do You Value a Business” post, a common misperception is that value reflects historical and current rather than expected financial results. We know that valuation is forward looking, but the facts are that:

1. Public stock price multiples are usually calculated on trailing twelve-month (TTM) bases.
2. Many acquirers – even sophisticated ones like private equity firms and merger professionals – use (or start negotiating from) multiples ofTTM results.
3. Accountants are trained and required to be conservative, and must follow strict standards when they prepare forecasts.
4. Historical results are known, the future is not.
5. People say, “Forecasts are almost always wrong,” with some justification (based, of course, on 20-20 hindsight).
6. They are not familiar with Revenue Ruling 59-60, Section 3, Paragraph 3, which defines value as a “prophesy” (what a poor choice of words).
7. Buyers are justifiably reluctant to pay cash at closing for uncertain future results that they, not sellers, will bear the risks of achieving.

I like to defuse the historical / current results objection by politely asking a simple question: “When you drive your car, where do you look?” (Pause for dramatic effect.)

You look forward and sideways, not in back!

The Income Approach looks forward. The Market Approach looks sideways! The Asset Approach (liquidation premise) occurs when you have a breakdown and get out of the car to find out what is wrong!

In Satchel Paige’s immortal words, “Never look back, something might be gaining on you!”

Alternatively, to paraphrase the Las Vegas slogan, “What Happened in the Past Stays in the Past.”

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Back Pressure from Clients

By Rand Curtiss | Published: December 29, 2011

All of us have been pressured to opine values that are more favorable for clients. This might involve higher sales prices, lower taxable values, and so forth. If case facts and circumstances allow it, we may be able to accommodate them by changing our assumptions, as long as our opinions are independent, objective, reasonable, and supportable. This is always an exercise of patience and diplomacy.

On the other hand, what if the pressure is to opine values that are LESS favorable for clients? I have experienced this numerous times in estate and gift tax work, when clients feared my values were “too low,” particularly when discounts for lack of control and marketability were relevant.

Most of the time, this “back pressure” arises because:

1. The client went through or fears an audit, and does not understand that these are almost always negotiated, with some additional legal / appraisal fees, taxes, but no penalties.
2. Despite explanation of the relevance of discounts, that fair market value excludes strategic buyers and what they consider a minimum selling price, they do not get it.

Consider this from our perspective. We opine the interest to be worth $X, they want it to be higher. Assuming our $X value is correct, we certainly have nothing to fear and nothing at risk if the value is higher. We just have to communicate that fact, and the client’s desire for a higher value. I have handled this in two ways, with the first preferred over the second:

1. I present my $X value conclusion just as I would otherwise do, and opine that as fair market value. I then state (in my summary and conclusion sections) that the client wishes to claim a higher than $X value, and that this is eminently reasonable given my $X conclusion. This is the equivalent of a fairness opinion.

2. I present the assumptions leading to the $X value as well as assumptions leading to the higher than $X value and all of the relevant calculations for both. I only do this is the higher assumptions are within the realm of reasonability.

This protects our interest in that we have maintained independence, objectivity, reasonability, and supportability. We could stop here, and sometimes I do.

If the client asks or seems receptive, I explain the potential costs of claiming a higher tax value: more estate or gift taxes now or later (if they use their exemptions). I suggest that their primary care advisors – their accountant and attorney – discuss this with them. Since my interest is protected, all I now care about is theirs. They may decide to leave money on the table, paying higher taxes as a hedge against an unfavorable audit result and its costs. That is fine with me, it is their prerogative, but I feel better if I know I have done everything I can to give them the benefits and costs of their choices.

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How Do You Value a Business?

By Rand Curtiss | Published: December 28, 2011

Here is another in my “How do you explain it?” series. Today’s question is “How do you value a business?” Almost every prospective client or advisor asks this, so we need an answer that educates and demonstrates our communication skill. Since their time and attention span are limited, we must respond briefly and clearly.

It is dangerous to assume that anyone has much knowledge of valuation. If your answer has terms like “guidelines,” prior transactions”, “discounted cash flows,” or “intangible assets,” they will not understand you. Use simple words and ideas. Start with the basics and defer complications. For example, assume we are discussing the “fair market value” of a “non-marketable” “minority” “interest” for “estate taxation” of a small private company. Your client will probably not know what any of those quoted items mean. First establish the fundamentals; maybe like this (parenthetical comments apply if I have data about the business with which to do preliminary research):

“There are only three things you can do with your business: sell, close, or keep it. The three ways to value it reflect selling, closing, or keeping it.

The selling approach uses prices of businesses like yours. This is how houses are valued. Prices are public information, and realtors easily access them. There are two problems with it. First, business sales are not public, so data are scarce. Second, businesses in the same industry often differ, so comparisons are hard. (I did some research and found that to be the case with your business. This approach is out.)

The closing approach assumes you sell what you own, pay what you owe, and keep the rest. There are problems with it. First, some of what you own is not recorded on your financial statements, like your customer list, and it could be very valuable. Second, assets like equipment are recorded at depreciated cost, which may not be near market value. (Third, and most important, your business is making money and does not owe much, so why close it? This approach is out.)

The keeping approach is the right one to use. It is based on what you expect to earn after paying yourself a reasonable salary for managing it. Earnings can be paid as dividends or reinvested to grow the business and increase its future value. This is how buyers value businesses. The problem is to forecast earnings. (Based on my research, the forecast for your industry is 4 to 5% growth per year, but there are risks in the U.S. economy and in your industry.) Based on risk, I will determine a multiple of earnings for your business. The higher the risk, the lower the multiple will be. You hear about multiples when people say that a stock is trading at a “price to earnings multiple of 10 times.”

The bottom line is that I will value your business based on a multiple of earnings. My report will detail all the research that supports that, probably about 20 to 25 pages, as well as other issues specific to your situation. Before we talk about them, did I answer your question?”

I just read that aloud, and it took about a minute, just about right! Do you think I answered the question simply, completely, clearly, and briefly?

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Helping Clients Review Draft Reports

By Rand Curtiss | Published: December 27, 2011

As email use gained popularity, people started asking me to send draft reports that way rather than meeting with them to present preliminary results. This was fine by me, as it saved time, but it also created communication problems:

1. Clients are not familiar with how appraisal reports are organized, and may not completely read them. After wading through the introduction, economic and industry sections, they often skim the rest, missing important points like the financial forecast assumptions. Long reports exacerbate this problem.

2. Low-impact items or details often sidetrack them from the big picture.

3. The technical aspects of the cost of capital, etc. overwhelm them.

My solution is to add an introductory bold-type section to the draft titled “Things to Consider as You Read This Draft Report.” This is usually not more than a half page of bullet points that:
1. Recite key (important and / or sensitive) assumptions and their basis (e.g., whether the client told me that cap ex would be $150,000 next year or how I arrived at that estimate, how a contingent item like a lawsuit was addressed, why there were no guidelines, etc.).

2. Describe things that might NOT be important (even though the client thought they were, such as immaterial amounts of control adjustments).

3. Ask specifically for their (or their advisors’) input on open items.

I have found that this works very well. I call them one week after submitting the draft. The review points are the basis for discussion (along with any other questions they have). This expedites things!

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Is the Fair Market Efficient?

By Rand Curtiss | Published: December 26, 2011

The Efficient Market Hypothesis (EMH) posits that publicly traded security prices reflect all published information. (Variants posit that they also reflect non-published “insider” information or that they instantly adjust when new information becomes available.)

There is a huge debate as to whether the EMH holds for individual securities or entire markets. If it does not, that eliminates the basis for a great deal of advanced financial theory and practice (such as the use of option valuation models). If it does, then the basis is valid.

Although interesting, the debate is not relevant to most business appraisals! The reason is simple. The EMH debate concerns ACTUAL markets. By contrast, tax and financial reporting valuations deal with HYPOTHETICAL markets: fair market value-based ones for tax valuations, and fair value-based ones for financial reporting valuations. Since both of these markets are hypothetical, their governing authorities – tax laws and financial reporting standards – define their characteristics.

Consider tax valuations per Revenue Ruling 59-60. Its introductory paragraph states, “All … available financial data as well as all relevant factors affecting fair market value must be considered.” Its Section 2.02 assumes that buyers and sellers have “reasonable knowledge of relevant facts” and are “well informed about the property and the market for such property.”

Consider financial reporting valuations per Accounting Standards Classification 820 (formerly Statement on Financial Accounting Standard 157). It states that “fair value measurement should be determined based on the assumptions that market participants would use” (preferably third-party observable data).

In my view, both authorities define hypothetical markets consistent with the EMH in that we must consider all available and relevant information. This means that the tax, accounting, and academic professionals are all talking about the same HYPOTHETICAL thing. This in turn implies that the use of EMH-based techniques in tax and financial reporting engagements is fully justified, regardless of whether EMH holds in the real world.

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