Shopping Cart Blog Search

Valuing the Whole Interest or The Sum of Its Parts

By Rand Curtiss | Published: December 7, 2011

The Asset Approach’s Asset Accumulation Method (“AAM”) is a procedure under which we develop the value of a business interest by appraising all of the individual (groups of) assets and liabilities that are included in it. If we are valuing a stock (or partnership / limited liability company) interest, this would include every single asset and liability, not only those recorded on the financial statements (even if fully depreciated or amortized) but also those not so recorded. Two of the best texts on the subject are by Reilly and Schweihs (Valuing Intangible Assets) and Hitchner (Valuation for Financial Reporting). This method is theoretically valid, but it is complicated to use (because it requires a great deal of supporting data and analysis, and there are complicated value interactions between various assets and liabilities).

We definitely need to use this method when:

1. The engagement requires it, as in the valuation and impairment testing of intangible assets for financial reporting, and in purchase price allocations for tax and financial reporting.

2. When we invoke the liquidation premise of value: a family limited partnership that owns marketable securities, or an operating company that is going out of business. We may need the help of equipment or real estate appraisers.

3. We use it when we value non-operating assets and liabilities (like excess cash or the proverbial Florida condo owned by a business).

4. When specific assets and / or liabilities are to be valued, not as part of a going concern interest (stock or asset sale).

In my opinion, when we are valuing the stock or operating assets (and maybe liabilities) of a going concern, we can usually use the Market and Income Approaches to value the entire interest, rather than using the AAM to value all of the parts and add them up. The Income and Market Approaches usually yield sound, defensible value indications, so there is no need to invoke the AAM, which gives us information that is not necessary (we need to know the value of the whole, not the values of all the parts), costs the client much more, and takes a great deal more time.

Sometimes, clients and referrers quite naturally think of the values of businesses in AAM terms, that is, as the sums of the values of all of the assets and liabilities. That is one way to look at it, and it is definitely not wrong. You will know this is occurring when you get questions about the values of things like:

1. Goodwill
2. Customer lists, patents, and other specific intangible assets
3. Equipment values
4. Lease values

When I get these questions, I explain that the goal is to value the subject interest in total. Unless it is a special case like those cited at the beginning of this post, there is no need to know the values of the parts (all of the individual assets and liabilities). My value conclusion will include all of them in the total: that is guaranteed by the methods I will use. I can provide the additional detail (the values of all of the parts), but that will drive up the cost and time required to complete the job. I would rather take an approach that gives them only what they need (the total value of the interest), at a lower cost, more quickly, and with equal quality. I can think of only one client who wanted the extra detail (even though none of the special cases requiring use of the AAM were relevant) and was willing to pay for it.

Posted in IBA Blog | Leave a comment

Non-Cash Flow Valuation Metrics Can Be Useful, Too

By Rand Curtiss | Published: December 3, 2011

My previous post pointed out the benefit of using cash flows to equity to value stock interests, because it can be used with cash-on-cash market-based discount rates that do not require adjustments. This is useful in tax valuations.

In M&A valuations, however, cash flows to equity may not be the best metric because:

1. Acquisitions often involve sales of some but not all assets and maybe liabilities, with the seller retaining some. This is usually motivated by buyer’s tax considerations and their desire to avoid assuming some (or all) liabilities. Since the seller’s entire equity is not being transferred, cash flows to that equity may not be an accurate metric for the benefits actually being transferred.

2. Even if the transaction is a straight stock purchase, cash flows to equity of the acquired business may change because the buyer is in a different tax bracket and because they may use a capital structure (debt / equity ratio) different from seller’s ratio. Moreover, it is not always clear who will get the benefit (or bear the cost) of those differences. Seller will say, “You can’t get those benefits without buying my company, so I deserve them.” Buyer will say, “YOU can’t get those benefits without my buying your company, so I deserve them.” Who gets how much of them will have to be negotiated.

Because of this, in most M&A transactions, the parties focus on operating income (earnings before interest and tax expenses, “EBIT” or maybe EBIT before depreciation and amortization expenses, “EBITDA” as the metric. This is convenient, because synergies such as cost reductions can be treated as additions to EBIT(DA). It sidesteps the issues in point 2; if you are working for either party, be aware of them.

If EBIT(DA) is the valuation metric, see my previous post on how to adjust discount and capitalization rates / multiples when cash flow to equity is not the value metric.

Posted in IBA Blog | Leave a comment

Non-Cash Flow Metrics, Discount and Capitalization Rates

By Rand Curtiss | Published: December 2, 2011

We are:

1. Valuing a common equity interest
2. Using the Income Approach
3. Using either the Single Period Capitalization Method (SPCM)or the Multi-Period Discounting Method (MPDM)
4. Using a benefit stream (value metric) other than cash flows to common equity
5. Trying to develop a capitalization rate / multiple (SPCM) or a discount rate (MPDM)

What data could we use to develop that rate / multiple?

1. Ibbotson / Duff & Phelps / CAPM (beta, etc.) / Private Cost of Capital (PCOC)
2. None: develop a subjective rate / multiple (as when Seller’s Discretionary Income is the value metric)
3. NOT guideline company data: that is the Market Approach

Obviously, the first choice is the best because it is the most supportable. The problem: all of those rates are based on cash flows to equity (dividend plus appreciation return after corporate and before investor taxes). Our value metric, however, is something other than cash flows to equity. We cannot apply rates and multiples based on cash flows to equity to non-cash flow metrics without adjustments. The only way to make those adjustments is to consider the ratios of the selected value metric to cash flow to equity. Because value is forward-looking (based on expected future benefits), we emphasize the ratios of the projected value metric to cash flow to equity, not the ratios of the historical value metric to cash flow to equity.

If those ratios are fairly close (a judgment call), we are in good shape. For example, assume the ratios of the projected metric to cash flow to equity for the next five years range from 1.08 to 1.12 and average 1.10, and that the projected metric averages $55 and projected cash flow to equity averages $50. Assume also that we use the SPCM and developed a 20% capitalization rate for cash flow to equity. Now, the key point is that whatever value metric we choose under the Income Approach, the resulting equity value should be the same (otherwise, we would be logically inconsistent. Since the selected benefit stream is 1.10 times cash flow, the capitalization rate for the selected benefit stream has to be 1.10 times the capitalization rate for cash flow to equity, or 22%, so both value indications are the same ($250):
SPCM value using selected metric = SPCM value using cash flow

Selected metric value / its capitalization rate = Cash flow value / its capitalization rate

$55 / 22% = $50 / 20% = $250

The same thing applies when we use the MPDM. The arithmetic is more complicated: we calculate the DCF value of the cash flows to equity at the cash flows to equity discount rate, and determine what discount rate for the selected (non – cash flow) metric is required to get the same value when we discount the selected metric.

Now consider these problems:

1. Under the SPCM, what if the ratios of the projected metric to cash flow to equity are unstable? Now an average does not mean much. What adjustment factor will we apply to get to the selected benefit capitalization rate?

2. This is not a problem with the MPDM! We do the same thing as above, calculating the DCF value of the cash flows to equity at the cash flows to equity discount rate, and determine what discount rate for the selected (non – cash flow) metric is required to get the same value.

Elevating to the big picture, we can avoid problem 1 by using the MPDM, which is why I favor it over the SPCM. Moreover, we can avoid the need to try to make this adjustment if we use cash flow to equity as our value metric!

The only complication of using cash flow to equity as the valuation metric is that clients and referrers are not usually familiar with it. We have to explain it to them: I like to say that it is the annual change in company cash balances before payment of common stock dividends, which reflects the cash available for dividends (regardless of whether it is actually distributed) after accounting for all obligations and receipts.

Posted in IBA Blog | Leave a comment

Nine Questions to Select Approaches and Methods

By Rand Curtiss | Published: December 1, 2011

Based on the following facts about a prospective engagement, what valuation approaches and methods would you use or rule out?

1. This is a tax-related valuation as of a given date.
2. A minority equity interest is to be valued.
3. The business is a going concern.
4. Its industry is disclosed.
5. There have been no prior transactions in its stock.
6. There is no buy-sell agreement.
7. The Company has sales of less than $10 million.
8. It has a small amount of debt (bank loan) with a repayment schedule.
9. There are no atypical facts or circumstances.

What we are doing is similar to doctors’ differential diagnosis: based on facts (symptoms) presented by the patient and answers to targeted follow-up questions, they deduce what is ailing us!

We know the engagement parameters (valuation date, fair market standard of value, non-marketable minority level of value, going concern premise of value, purpose, and use of appraisal) from points 1, 2, and 3.

We rule out the Market Approach (too small for comparison to public companies, no private guidelines, after a search finding there are too few to constitute a statistically valid sample) from points 4, 5, and 7.

We rule out the Asset Approach (liquidation premise inappropriate, no need to use Asset Accumulation Method to value specific assets, as we are valuing the stock, no need to use the Excess Earnings Method as it the IRS frowns on it), from point 3.

We will use the Income Approach, Multi-Period Discounting Method, and will use cash flow to equity as the valuation metric, not needing to use WACC because bank debt is to be repaid as scheduled, from point 8. We will not use the Single-Period Capitalization Method, relying instead on our multi-year financial forecast.

We will not adjust cash flow to control level, and not apply a discount for lack of control, since we are valuing the minority interest based on cash flows to minority shareholders.
We will apply a discount for lack of marketability from point 6.

At this point, there are no atypical complications, from point 9, but we will be on the lookout for them as we learn more.

We just laid out our selection of approaches and methods, which should enable us confidently to quote a fee and turnaround schedule and document our reasoning in our report.

I have found that most of my engagements (for tax related work) boil down to the above. This is why I spend so much time studying financial forecasting, developing the cost of equity capital, and developing the lack of marketability discount. They are used in just about every tax–related engagement I complete.

When you get an initial inquiry about such an engagement, listen carefully to the proffered data, and see how many of the nine questions you can answer from it. Follow up to get the rest answered, and you will have a good idea (except for whether there are sufficient private guidelines) to know exactly what you will need to do. This will allow you to quote fees that are not only profitable but also competitive, and to do so quickly. It will also prevent you, in an initial conversation, from getting into irrelevant issues or from getting into details best obtained in a management interview after you are retained. This will save both you and your client a great deal of time.

Look again at the nine statements at the beginning of this post. Those are the key questions to ask to help you diagnose your valuation methodology.

Posted in IBA Blog | Leave a comment

Liquidation Value

By Rand Curtiss | Published: November 29, 2011

If you are going to consider “liquidation value” in a business appraisal, be sure to think through (and ask about) how long the liquidation might take.
Some are forced (usually by creditors or other adverse developments) and may take only a few months. Be sure to request and obtain “forced liquidation values” of real estate and equipment.

Others are orderly (usually at the discretion of the control owner, arising, for example, when a business is solvent but not making much money). Be sure to request and obtain “orderly liquidation values” of real estate and equipment.

In either case, check whether there might be material interim cash flows (other than asset sale proceeds net of liabilities) while the business liquidates. For example, a real estate partnership that may take two years to wind down could earn net income during that time. Similarly, be sure to deduct liquidation fees and expenses, as well as capital gains taxes on embedded gains.

There is also an interesting twist regarding minority interests in entities liquidating on an orderly basis. Because there might be no compulsion to sell, the control owner might reject certain purchase offers, hoping for better prices, or even change their mind and stay in business. I think this warrants modest (say 5 to 10%) discounts for lack of control and marketability, but that is a judgment call that relies on facts and circumstances.

Posted in IBA Blog | Leave a comment

Option Questions

By Rand Curtiss | Published: November 23, 2011

If you use option models like Black-Scholes or the binomial version in Section 409A or FASB 718 assignments, here are a couple of good questions to ask management that will help you build a strong basis for your model input assumptions.

Most options have ten-year maturities, meaning that they exist for that long, as long as the company does (or does not have some kind of liquidity event). If management, however, believes that a liquidity event will happen inside of ten years, ask them to estimate when that might occur (even if they are not sure what kind of event it will be). Often then have a feel for it. (If they have a strong one, consider using the Probability Weighted Expected Return Method, PWERM, to value the equity.) Either way, use the (shorter) time to the liquidity event rather than the maturity time as an input. Better, run a sensitivity analysis to see how much difference the term makes. Also, make sure your risk-free rate is consistent with the term assumption.

For volatility, ask management what (public) companies they consider to be in their space. These can be used to gauge it, although you might increase the volatility assumption because the subject is smaller, riskier, and privately held.

Posted in IBA Blog | Leave a comment

Non-Operating Assets

By Rand Curtiss | Published: November 21, 2011

Supreme Court Justice Potter Stewart once defined his ability to identify child pornography as “I’ll know it when I see it.”

Until recently, I was comfortable with my ability to identify non-operating assets when I saw them. Some jumped out when I looked at the balance sheet (what is that “other investments” asset?). Others appeared after a comparative financial analysis (industry ratio of cash to assets is 5%; company’s ratio is 15%). Still others might come up when I asked (as I always do) management if there were any assets that were not essential to operating the business. You and I can think of many other potential non-operating assets: loans receivable from shareholders or affiliated parties; contingent claims (a collection lawsuit); idle but protected intellectual property; fully depreciated equipment; written-off (but salable) inventory; and assets “held for sale” (for operating businesses; those held for sale by investment or real estate development companies blur the line between operating and non-operating assets).

When a colleague asked me to define “non-operating assets” rigorously, my first answer was the textbook response: assets that could be sold or distributed to shareholders without “affecting operations.” Their follow-up question was “how do you measure the effect on operations?”

THAT made me think!

I finally came up with “the effect on operations is measured by changes in future net cash flows to invested capital (NCFIC).” Here are some explanatory comments:

1. I use cash flow as the valuation metric, so impairment has to be valued based on cash flow. You could use EBITDA (not EBIT, because asset sales might affect non-cash charges) as an alternative.

2. I use NCFIC because (for example), sale of a non-operating asset will have cash flow to equity effects (e.g. asset sale proceeds are used to reduce debt or are held as cash, increasing non-operating interest income). This is based on the principle of separating the investment decision from the financing decision. The non-operating asset sale is a (dis)investment decision; the use of the proceeds is a financing decision. Neither affects NCFIC, but both affect (and distort) net cash flow to equity.

3. NCFIC effects have to be considered over the forecast (and terminal) periods. A company might have excess machine capacity today (in a weak economy) that could be sold off. When (if?) things improve, however, they might run short of capacity and have to accelerate capital expenditures relative to if they held onto the current excess. Today’s non-operating asset (excess capacity) might not be so in the future.

Having said all this, if an asset can be sold or distributed to shareholders without affecting NCFIC, then it is non-operating. An equally valid way to think about this is to consider operating assets as those a buyer would have to purchase to generate unchanged levels of NCFIC. Any other assets would be non-operating. (This is a nice way to explain the difference between strategic and financial buyers. The strategic buyer might not need to buy some of the acquiree’s operating assets because it already owns assets like them. The financial buyer needs to buy all of the acquiree’s operating assets.

Thanksgiving is coming, so I am going to go into non-operating mode for a few days.

Posted in IBA Blog | Leave a comment

Estate and Gift Taxation: Rumors and Facts

By Rand Curtiss | Published: November 16, 2011

Rumors abound as to whether federal estate and gift laws will change…and I have no clue about what may happen. I am guessing, however, that two fundamental principles will NOT change:

1. In estate taxation, interests of different types in one entity are aggregated for valuation purposes regardless of dispositive provisions (wills and trusts) that dictate bequests. In my language, we value what the decedent owned, not what the heirs get.

If someone dies owning a controlling voting stock interest and some non-voting stock, a controlling general partnership interest and a limited interest, or a controlling managing LLC interest and a non-managing interest, they are each valued as one combined position, not as separate control and minority interests. You cannot discount the non-voting stock, limited partnership or non-managing LLC interest for lack of control because they are aggregated with the controlling positions.

2. In gift taxation, we value what the donees receive, not what the donor gave.

If a donor gives three or more identical 1/3 interests to three different donees, each is valued as a minority interest and discounted for lack of control, even if the whole business was donated. This is Revenue Ruling 93-12’s significance: these interests are not aggregated, and control is not attributed, to any of them. In this example, the donor’s original 100% controlling interest converts into three identical minority interests, thus reducing shareholder-level (not enterprise-level) values by the lack of control discount. (50-50 splits are somewhat controversial.)

In any given case, if you are unsure about whether control is eliminated in a gifting situation (perhaps because of complexities like voting trusts for multiple beneficiaries), ask the attorney!

Concerning lack of marketability, the IRS recently published its “DLOM Job Aid.” (Google that phrase and download it free). Although written for IRS reviewers, this document provides a fine overview of the state of the DLOM art and suggests how reviewers might attack DLOM conclusions. It is a must read!

Posted in IBA Blog | Leave a comment

Take Your Income Approach To The Next Level

By Rand Curtiss | Published: November 16, 2011

Here are 11 ways improve your Income Approach application to fair market valuations of minority common equity interests.

1. Use cash flow to common equity as the valuation metric (benefit stream), defined as the annual change in company cash before payment of common stock dividends.
Avoid the problem of using other metrics (like net income or EBIT), which have to be adjusted to cash flow equivalents in order to apply cash-flow based discount rates. Also, avoid all of the complexities and extra work associated with using WACC.
2. Prepare complete financial forecasts (income statements, balance sheets, cash flow statements).
Avoid guessing at working capital changes, etc. when you can calculate them as well as cash flow to equity explicitly, and reconcile changes in cash balances.
3. Do not make control adjustments (such as fair market value owner compensation) unless it is the control owner’s stated intent to make such changes.
Avoid the extra work implied by making these adjustments and then justifying a lack of control discount, which should offset them. State in your report that you used cash flow to minority equity, and therefore applied no lack of control discount. This is especially helpful when control adjustments are so large relative to unadjusted cash flows that the implied control premium and lack of control discount far exceeds those reported by Mergerstat.
4. Forecast annual cash flow to equity until it is stable, meaning that it grows thereafter at a constant percentage rate (because all of its components also do so).
Avoid discontinuity problems such as when debt is repaid in full after the forecast period, leading to higher cash flows.
5. Summarize historical results and the corresponding forecast assumptions, with reference to the economic, industry, and company analyses.
Avoid confusing the reader and presenting unsupported assumptions. This is a great way to highlight the assumptions that are most sensitive and to justify them.
6. Present your complete financial forecasts in dollar- and common-sized terms in your report.
Avoid making statements that are not replicable, and clearly explain your conclusion about projected cash flow to equity.
7. Calculate and report (bank) loan covenant ratios (usually current ratio and fixed charges coverage, which is EBIT divided by interest expense plus debt principal repayment) for each historical and forecast year.
Avoid assuming that (bank) credit will be automatically available in the amounts and at the times needed
8. Use the Multi-Period Discounting Method, not the Single-Period Capitalization Method.
Avoid having to decide what “next or a typical year’s” cash flow will be – you have already calculated it for many years.
9. Regardless of how you develop your cash flow discount rate, provide a reasonability test using Private Cost of Capital market data or perhaps data on guideline companies from the Market Approach. (The latter requires adjusting non-cash flow metrics to cash flow, a complicated process that is somewhat subjective.)
Avoid the inability to back up your discount rate and overemphasis of the subjective nature of the company-specific equity risk premium; if your overall discount rate is supportable, you are in good position.
10. Consider whether the discount rate should be the same for all forecast periods.
Since economic, industry and company uncertainties naturally rise over time, a rising discount rate (I raise mine by 1% each year and 5% for the terminal period) is not unreasonable.
11. Apply the justification of purchase test to your concluded value.
Avoid being open to these questions: does the forecast imply at least fair market value compensation to the owner-manager, compliance with (bank) loan covenants (and / or full repayment of debt), and an adequate return on equity investment?
If you follow this program:
1. You will apply the Income Approach the same way in each engagement, and become incredibly proficient at it, asking the right questions, exploring sensitivities, and backing your assumptions up.
2. Your financial analysis and report templates will become highly standardized, allowing you to set them up to virtually fill in the blanks. (I use red type to highlight inputs).
3. You will explain your assumptions and methodology clearly, succinctly, and persuasively.
4. By removing extraneous procedures, you will focus on the core assumptions and calculations, becoming extraordinarily productive.
5. Errors and omissions by other appraisers will become very apparent to you.
6. You will be able to reconcile the impacts of their different assumptions to yours, and highlight ones that can be challenged as opposed to those that are legitimate differences of opinion.
7. You will leave no obvious questions unanswered.
8. Your overall productivity will increase.
9. You will easily be able to incorporate new valuation procedures and / or advanced techniques such as scenario analysis (weighting the results of different forecasts) or even Monte Carlo simulation.

Posted in IBA Blog | Leave a comment

Percentage Versus Dollar-Value Adjustments

By Rand Curtiss | Published: November 2, 2011

In my October 31 post “Common Stock Cannot Be Worth Less Than Zero,” I wrote that control and liquidity adjustments are applied as percentages to some level of value to convert it to another. That statement is true if we base these adjustments on market data (such as control premium or restricted stock studies) and / or if we use models that calculate them as percentages (such as the QMDM). Whenever we use percentages to express these adjustments, we are using the “Top-Down” approach. We start with a value indication at one level (say control, marketable) and apply percentage discounts for lack of control and marketability to arrive at non-marketable minority value.

On the other hand, if we use the “Bottom-Up” approach to these value adjustments, we use actual dollar amounts, not percentages. For example, if cash flow to the minority shareholder is $10 and control-related adjustments (such as excess compensation) are $25, cash flow to the control shareholder is $10 + $25 = $35. Yes, this represents a ($25 / $10 =) 250% control premium, but we derived the percentage after the fact based on actual dollar amounts.

Wherever possible, I use the Bottom-Up approach because I can point to specific control prerogatives, their probability of exercise, and the economic consequences to justify my ultimate percentage adjustment. I can then reasonability test it against market data. It is also very useful when, as in the above example, minority cash flow is very small and a huge control premium results, one that is not justified by market data (because of that fact).

This procedure works very well for control adjustments, but I am not aware of any lack of marketability adjustment model that is based on dollar amounts. Even the QMDM is based on rates of return (percentages, not actual amounts). A dollar-amount-based marketability adjustment model would be a major theoretical advance!

Posted in IBA Blog | Leave a comment
© IBA 2008 | All Rights Reserved Privacy Policy | Site Managed by ITCS