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Models Behaving Badly

By Rand Curtiss | Published: December 25, 2011

My holiday vacation reading included a terrific, brief book by Emanuel Derman titled “Models Behaving Badly.” Do not get excited: it is not about the inappropriate behavior of individuals like Petra Nemcova (sigh) and others. Do get excited: it is about the unavoidable imperfection of financial theory.

The author, a finance professor, started his career as a particle physicist and transitioned to a role as one of Wall Street’s leading “quants”, giving him a lofty vantage point from which to compare physical science (like physics and chemistry) with social science (like economics and finance). He points out that physical scientists benefit from being able to conduct controlled experiments that lead to theories – complete, self-contained, replicable and accurate descriptions of reality, an example of which is Einstein’s famous equation E=MC squared. By contrast, social scientists cannot conduct controlled experiments, so they can never come up with complete, self-contained, replicable, and accurate descriptions of society. In short, we can model objects and forces, but not people and their motivations.

His thesis is that, since finance is a social science, no financial model can be perfect. There are always factors that cannot be included, measured, or predicted. This does not mean that financial equations such as the formula for cash flow to equity are wrong. They are accounting identities, true by definition. It does mean that there is no way to predict cash flow to equity with an acceptable degree of certainty because (for example), we cannot accurately predict sales.

He has a great deal to say about the Black-Scholes model, on which he did extensive theoretical work, and how volatility, for example, is an incomplete measure of risk. I will leave it to you to read his book and learn why. There is a great deal of food for thought in it!

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Don’t You Just Pick Value Out of the Air?

By Rand Curtiss | Published: December 15, 2011

As I wrote in my last post, in most situations, our responsibility is to express value as a single number or point estimate, even though it really is a reasonable range. The same thing applies to every assumption (what will next year’s sales be?) or intermediate result (the discount for lack of marketability).

When we think of value as a reasonable range, say from $1 to $2, we usually implicitly assume that any number inside the range is equally probable, as when we express the value conclusion as $1.50, the range midpoint.

Value is sometimes a probability distribution (such as a bell shaped curve), even though we never know the shape of the curve (the actual probabilities). When we use option valuation models, we assume a normal probability distribution, a bell shaped curve with specific parameters. This is done because the resulting mathematics is tractable, not because the probabilities are normally distributed. A contributing cause of the Crash of 2008 was financial modelers who assumed normality, when the probabilities of much more extreme values (ones that led to costly consequences) turned out to be higher than expected.

A client was teasing me about what I do, claiming that I “pick numbers out of the air.” Instead of taking the bait and getting mad, I (for once in my life!) thought for a few seconds and gave this response:

“Actually, what I do is start with facts and logic to come up with a reasonable range of value. Then I use my expertise and judgment to narrow the range. THEN I pick a number out of the air!”

Though I said this with a smile, it is true! Consider the lack of marketability discount. Logic tells us it cannot be greater than 100% or less than 0% (duh). Market data (facts) and various methods narrow the reasonable range to (say) 20 to 25%. THEN we conclude (pick it out of the air) 23%!

Have a safe and happy holiday season!

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The Key Question When Control Changes

By Rand Curtiss | Published: December 13, 2011

Control of a business can transfer in many ways, among them:

1. Sale of the entire business (asset or stock sale)
2. Sale of a controlling stock interest
3. Redemption of an interest: if initially the ownership is 45%-27.5%-27.5%, and one 27.5% interest is redeemed, the new ownership will be 62%-38%.
4. Purchase of an interest: if initially the ownership is 50%-50%, and one shareholder purchases a 1% interest from the other, the new ownership will be 51%-49%.

Let us call the first two transactions “outside deals”: a third party is going to acquire control. Let us call the second two transactions “inside deals”: only existing shareholders and their company are involved. I will explain the significance of this distinction in this post.
Whenever there is a transfer of control, we have to answer three essential questions.

First, what is the standard of value?

If it is a tax or ESOP valuation, it is fair market value. The value of control is “financial,” since the business remains independent. Financial control derives from the control shareholder’s ability to earn higher returns than minority shareholders earn (through exercise of prerogatives such as raising his or her compensation).

If it is a merger / acquisition, it is investment value (the value to the specific buyer and / or seller). The value of control is “strategic,” since the business will not be independent. In addition to potential financial control benefits, there may be synergies leading to higher revenue, lower expenses, and / or lower risks due to the combination of the businesses, and thus higher investment value. Revenue and expense synergies are obvious. An example of risk reduction synergy is when buyer, a manufacturer, buys a major customer, assuring that it will be able to sell future production through the acquiree. Note also that buyer and seller negotiate the sharing of synergies: we can only appraise their value, not to whom they should accrue.

Second, regardless of whether the value of control is financial or strategic: what is the value of control? I always try to quantify it explicitly through the Income Approach, measuring incremental cash flows to equity and changes in risk levels. This uses case-specific facts and circumstances. I much prefer this to the Market Approach, which involves a rather blind application of control premiums based on other transactions’ case specifics (which are never fully disclosed) and which therefore may not be comparable (similar or relevant) to the subject.

The last three paragraphs above are full of technical jargon. We understand it, but most clients do not. This brings me at last to the third essential question, the one that I ask of my clients:

“How, if at all, will the business operate differently after the (change of control) transaction?”

For inside deals, I ask this question of all shareholders (ideally together in a meeting or telephone conference). This will get me the information I need, even if there are differences of opinion. I can handle those by using different assumptions in my Income Approach valuation. It is up to the shareholders to negotiate a value based on agreed assumptions.
For outside deals, it is usually much harder to an answer. I can get one from my client (say, the selling company), but what about the buying company? If the sellers have retained me before talking to any buyers, we have to make educated guesses (some at elementary school level, some at postgraduate level) as to what a buyer might change, and the risk / return consequences. If they are already talking to buyers, chances are that I was or will not be part of those discussions. I thus have to work through my client to get the information I need. I urge them to ask the third question – how will the business operate differently – listen carefully to the answer, and follow up with specific questions about revenue, expense, and even risk.

Some buyers – usually tough negotiators, those with negotiating advantages, or those who use formulaic valuations (“We pay 4 times trailing twelve-month EBITDA”) will try to duck the question. I would, too! As a buyer, I would say, “I am going to take all the risk of making the deal work, so I should get all of the benefits.” The seller’s counter, of course, is to say, “Yes, but if we do not do this deal, you will not get any benefits. To do it, I need to know what they are.”

After this preliminary fencing is completed, both sides usually relax and open up, and the buyer becomes responsive. To help that along, sellers can ask specific questions, such as:

1. What will be my post-sale role, responsibilities, title, and compensation?
2. Which of my managers will have no post-sale roles? Financial, accounting, and other staff managers jobs are often at grave risk when their employers’ businesses are sold. I think it is pretty brutal, not to mention risky, to ask staff managers to cooperate with a buyer’s legitimate and necessary due diligence requests when it is likely or certain that they will be out of jobs after the sale closes. Sellers ought to inform their staff managers of the possible deal and arrange for appropriate severance benefits as a condition of the transaction. I was downsized years ago in the sale of a business, and I still bear the scars of a poorly communicated (to me) situation. (On the other hand, it led to my starting my business appraisal practice, so the subsequent benefits make those scars a more than bearable badge of honor!)
3. What assets and expenses are duplicated between our businesses?
4. What opportunities will we have to increase sales by cross selling, introducing new products or services, selling to new markets or channels, changing our pricing, etc.?
5. Can you borrow more cheaply than we can?

All of these questions are part of the essential one: how will the business operate differently after the transaction closes?

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Fantasy Island?

By Rand Curtiss | Published: December 12, 2011

In any valuation context with the exception of actual transactions, litigation settlement negotiations (which are really actual transactions) and certain expert testimonies, the rule is that value has to be opined as a single number – a point estimate, or an “amount certain” – rather than as a range. This is because (for example), tax returns require a single number for value to calculate the tax liability.

The reality is different. Value is usually a reasonable range, nowhere near an “amount certain.” The reasonable range might be defined by the highest and lowest supportable, appropriate indications developed using various approaches and methods. The only examples of values that I can think of that have no ranges (are really amounts certain) are the values of fully marketable securities and the values of the equity of liquidating businesses whose liabilities dwarf their assets.

Given that value is a reasonable range, our job is to define that range and then, weighting multiple value indications subjectively, to reduce it to a single number. The only part of Revenue Ruling 59-60 that is clearly incorrect is the prohibition against weighting (in Section 7). Whenever we have multiple value indications, we either consciously or unconsciously weight them every time. How else could we combine them into a single number? Beats me!

Wouldn’t it be great if appraisal standards required a mandatory statement about the range of reasonable values or more formally a statement of the risk or confidence associated with a point estimate of value? The zero value of the bankrupt businesses above would have extremely high levels of confidence (almost no risk), while the values of startup businesses would have extremely low ones (with enormous risk).

That kind of statement would go a long way toward adding greater reality, truth, honesty, and full disclosure to appraisal reports and conclusions. It would also give appraisers who are fearful of over-valuation and under-valuation penalties (even though their conclusions are sound) some protection against them. It would also eliminate the shenanigans that cross-examiners pull on honest experts, trying to paint their valuations as “wrong” when instead they are (highly) uncertain.

Well, at least I can fantasize.

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The Valuation World, At Least, Is Not Flat

By Rand Curtiss | Published: December 12, 2011

I am fascinated, and quite flattered, by the rising number of blog replies received from those of you outside the United States. The power of free, unfettered global communications never ceases to be amazing.

Most of what I write about is, I believe, globally applicable because I focus on the practical aspects of valuation: gathering the relevant data, analyzing it, and applying valuation approaches and methods carefully to arrive at supportable, replicable conclusions.

Having said that, however, I think that those of you outside the U.S. should always remember that your countries probably have:

1. Different types of data about the economic, political, cultural, and other environmental factors that drive valuations.
2. Different industrial structures in terms of concentration, regulation, competition, and size.
3. Different capital markets and data about them.
4. Different markets for the sales of businesses, and data about them.
5. Different accounting, tax, reporting, regulatory, and disclosure rules, precedents, and laws.
6. Different legal and financial standards of value.
7. Businesses / industries with much higher exports / imports of goods and services, with higher exposures to international business and financial market conditions.
8. Different standards that constitute appropriate and generally accepted appraisal practices.

I confess to being somewhat provincial: most of the businesses I appraise are located in Northeastern Ohio (in the Midwestern United States), a region that has experienced rather difficult economic times during the last 30 years. Your clients may be in very different, and I hope much better, circumstances, a wish I also have for you during this holiday season!

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How Does This Business Make Money: Follow Up

By Rand Curtiss | Published: December 12, 2011

Yesterday’s post laid out a way to analyze how a business generates cash flow to equity using a series of ratios multiplied together. Here are some follow-up thoughts:

1. You can use this procedure with any desired value metric, not just cash flow to equity.

2. You can use whatever ratios you like or make sense. For example, an S corporation pays no federal or state taxes (and maybe there are no local ones either). Take out the ratio of pretax to operating income and replace it with net to operating income. Alternatively, you can introduce new ratios (as long as they multiply and cancel out), or break them into parts. (You could break Invested Capital into debt and equity, and thus show the ratios of debt to equity and equity to equity).

3. The ratios do not have to be just financial ones. You can add operating ratios. For example, if we are valuing a business that makes telephone sales solicitations for third parties and earns sales commissions, you could analyze its commission revenue as:
Calls Made X Sales Made / Calls Made X Sales Dollars / Calls Made X Commission Dollars / Sale.

4. In brief, there is no hard and fast way to do this. Be as creative as you like, taking care to make sure you have the data to calculate the various ratios (historical and forecast), and that it makes sense.

5. Regardless of how detailed your ratio analysis becomes, it really takes very little time to set up in a spreadsheet. Fear not: the more supporting ratios you have, the more closely you can analyze your results and the more strongly you can support your conclusions.

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How Does This Business Make Money?

By Rand Curtiss | Published: December 11, 2011

This might seem like a dumb question, but in my view, there are no dumb questions, only dumb answers.

If you define “making money” as earning a profit, then the obvious answer is that this happens when revenues exceed expenses. Accounting profit, however, is not the same thing as generating cash flow to equity! You have probably valued a number of businesses that were profitable but cash flow negative because of things like high working capital, capital expenditure, or debt service requirements. In the long run, cash flow negative businesses cannot survive.

This gets to the heart of why appraisers use cash flow to equity (or cash flow to invested capital and WACC) to value stock interests. Value is based on cash flow to equity, the annual change in company cash balances after accounting for all receipts (not just revenue) and all obligations (not just expenses). Moreover, cash flow-based rates of return are directly comparable to market rates of return (such as Ibbotson and Duff & Phelps data as well as bond yields to maturity), which allows us to use them without adjustment (except for company-specific risk premiums) to discount cash flows to equity to present value. Similarly, cash flow return on equity (where equity is the appraised cash-equivalent value, not accounting book value), is the ultimate measure of rate of return on investment: the cash on cash rate of return on equity.

In yesterday’s post, I wrote about my marketing professor, who always asked us, “What is this business selling?” My finance professor had a similar approach, always asking us “How does this business make money?”

I have always used an expanded version of the classic DuPont formula (developed by DuPont Corporation back in the 1920’s) that breaks the return on equity ratio into three parts:

Return on Equity = Net Income / Book Value of Equity

= (Net Income / Sales) X (Sales / Assets) X (Assets / Book Value of Equity)

This formula uses accounting-based values of net income, assets, and equity. Its three component ratios measure operating efficiency, asset use efficiency, and financial leverage. It breaks return on equity into these three distinct elements, enabling analysis of the sources of superior (or inferior) return by comparison with companies in similar industries (or between industries).

I have used an expanded and modified version of the DuPont formula to analyze how a company makes (cash flow to equity) money. I start by defining return on equity in cash on cash terms as cash flow to equity (equity cash flow) divided by the appraised value of equity. I use eight rather than three component ratios to analyze it. I did not invent this: I have seen it used by many other analysts.

The modified analysis formula is as follows, with explanations of what each ratio measures at right in parentheses:

Cash Flow Return on Equity = Equity Cash Flow / Value of Equity

= Operating Income / Sales (operating profitability)

X Pretax Income / Operating Income (interest expense leverage)

= Pretax Income Margin

X Net Income / Pretax Income (tax expense leverage)

= Net Income Margin

X Operating Cash Flow / Net Income (working capital leverage)

= Operating Cash Flow Margin

X Equity Cash Flow / Operating Cash Flow (investment / capex, financing leverage)

= Equity Cash Flow Margin

X Sales / Invested Capital (capital intensity)

= Return on Invested Capital

X Invested Capital / Equity (debt to equity ratio)

= Return on Equity

X Equity Value (level of equity)

= Cash Flow to Equity

This analysis provides insight which ratios contribute the most (least) to return on equity. If you calculate the ratios it for each historical and projected year, you can also gain insight as to which ones are volatile and / or sensitive to the forecast assumptions, which suggests which ones are the most or least risky. You can easily add it to your financial analysis template.

There are two weaknesses with this analysis. First, many of the component ratios are not reported (or derivable) from comparative industry financial data like RMA or Integra, so only a partial comparative analysis is possible. On the other hand, even without comparatives, you can still get a feel for which ratios are the most important, just from the subject company’s numbers alone, and also compared to other companies you have appraised. Second, you have to take care to use either book values of equity and invested capital or market values of both to avoid inconsistency. I concentrate on market values, because I want to tie cash flow to equity and the market value of equity together.

I hope you can use this type of analysis to … make money!

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What Are We Selling?

By Rand Curtiss | Published: December 10, 2011

My marketing professors taught that to be successful in business, we have to find a need and meet it. We learned by the case study method. The professor started every class by asking, “What is this business selling?” (What need did it meet?) Some cases I remember are:

1. A cosmetics company was selling HOPE!
2. An airline was selling ARRIVALS! (Preferably live, unharmed ones.)
3. A stove company was selling CONVENIENCE!

So what is it that we business appraisers are selling?

1. Tax valuations: tax savings and reduced audit risk
2. Transaction valuations: higher wealth (better deal prices and terms)
3. Litigation support (as a testifying expert): objective, valid evidence
4. Litigation consulting (as a non-testifying advisor to an attorney): higher client wealth and reduced risk
5. Compliance (financial reporting, ESOPs, fairness opinions): quality assurance.
6. Arbitration / mediation (as de facto judges / facilitators): fair verdicts / resolutions (at costs less than those of litigation)

It is easy to overlook what we are selling – client benefits – and to talk instead about features that create them. Do so at your peril! For example, in tax valuations, we prepare objective reports that appraise the fair market value that hypothetical willing buyers and sellers would negotiate (under all of the requisite conditions).

Zzzzzzzzzz!

That is the sound of a sleeping client! What we just said was true, but it is a feature of our work, not a benefit to the client.

Try this instead:

I will help you take appropriate, legal, and fair advantage of certain tax laws that can save you money, and do so in a way that reduces your risk of an adverse audit.

You will close more sales because you are meeting their need!

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Handling Complexities: How Much Knowledge Is Enough?

By Rand Curtiss | Published: December 8, 2011

The subject of this post has been simmering on my mental back burner for several years. It has many threads, all of which I was finally able to weave together because of a colleague’s comments. Each thread involves appraisals with atypical complicating facts or situations, some examples of which are:

1. A contingent event (such as the outcome of a lawsuit)

2. A heavily regulated industry (such as health care providers)

3. A cross-ownership (such as when Company A owns part of Company B, which owns part of Company A)

4. A complex security (such as options that vest based on the attainment of performance goals)

I am sure you can think of many other “curveballs” or “rocks” that you have encountered in your experience. These examples just give you the flavor of my thinking.

The point of this post is not to describe how to handle these examples, although I comment on them. It is to suggest, in general terms, what we must be able to do and how we can tell if we have done it.

Obviously, some complications may be so great that we simply decline the engagement, either because we know we cannot handle it or because we believe the risk of accepting it is not worth the fee. Duh!

Equally obviously, if we decide to take the assignment, we need the help of other professionals to gather information. Duh again!

The questions to ask ourselves are:

1. How much information do we need?

2. How do we know when we have enough of it?

I think the answer to these questions is that we have enough when we can, to a reasonable degree, identify the relevant cash flows and risks associated with the complicating facts. By relevant cash flows, I mean those that accrue to the interest being valued. In some cases (like the lawsuit), it is clear how the outcome will affect them, but there may be huge (not appraisable, other than perhaps to provide wide ranges and take a midpoint) uncertainties about their timing and magnitude. In other cases (like cross-ownership), the cash flow effects might not be clear until the accountant explains the rules, at which time they are easily ascertained.

1. Regarding the lawsuit, I would press the responsible attorney to estimate when the case might be resolved, how much it will cost, and what the prospective financial award / penalty will be.

2. Regarding the heavily regulated industry, I would consult an industry expert to understand the relevant rules and regulations. (For health care, talk to Robert Cimasi at Health Capital Consultants in St. Louis.)

3. Regarding cross-ownership, the Company’s accountant will guide you on the rules.

4. Regarding the complex security, see its term sheet for specifics, and incorporate them in your financial forecast.

We do not have to be legal, industry, accounting, or financial engineering experts to do our job. One could spend years becoming a health care expert of Bob Cimasi’s stature or earning a law degree or a C.P.A. We do not have years – only weeks – and we have limited budgets, time, and talent at our disposal. We rely on other experts to help us identify the relevant cash flows, their timing, magnitude, and uncertainties. We do not possess crystal balls: we cannot predict the future. Nevertheless, we can, given boundary parameters from others (such as the nature of industry regulations or the attorney’s assessment of the lawsuit) address the cash flow impacts and their risks. If we can do that (even with considerable uncertainty), we have done our job and done it well.

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Anticipate Questions

By Rand Curtiss | Published: December 8, 2011

One of the ways I constantly try to improve my sales skills is by anticipating questions that prospective clients or advisors will have. I take careful notes about their questions, even if I have anticipated them.

By doing this over time, I have come to realize that many people, quite naturally, do not fully understand either what our final product will contain, how we are going to support our conclusion, and the legal status of our report. As examples:

1. They may not realize that we will issue a draft report for review by them, their advisors, and anyone else who can contribute to making the final one better. (I welcome all input from any source the client wants to consult.) This give them the opportunity to correct any mistakes we have made, check our assumptions, add information we did not ask about or they did not disclose to us, or perhaps disguise confidential or proprietary information (such as the names of key customers or suppliers). They often think we will talk with them at the beginning, go off and do our thing, and present “the final number,” with no opportunity for them to review it. That scares them. We need to explain that they are entitled to, and we very much want, their considered input all through the process.

2. They may think that we are just going to give them a value (number) with no backup at all, or maybe just a formula and value. After all, they have probably seen residential real estate and maybe equipment appraisals that do not provide a great deal of backup information. We need to explain that we are going to consider and report everything that is relevant in terms of the economic, industry, and company outlooks, conduct a complete financial analysis (but not an audit) and forecast, and so forth, all supported in detail, in writing.

3. They may think that our report automatically becomes part of the permanent legal / financial record. Of course, this happens only if it submitted along with a tax return or other government compliance form, or if the company’s auditors accept it. In litigation support, if the attorney retains us, attorney-client privilege shields drafts from discovery. This is not true if the plaintiff / defendant retains us, so be careful with drafts, meeting notes, or telephone conversation notes in that situation. Every attorney I have worked with in litigation has been glad to retain me to create privilege. I would be extremely hesitant to take on a litigation support engagement without that protection. If I am mutually retained as a consultant, testifying expert, or mediator, that is different: everybody on both sides is entitled to see everything I produce, whether draft or final.

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