Valuation Methodologies and Evaluating Valuation Experts

1
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

2
AGENDA

• Evaluating a Valuation Expert
• Evaluating a Valuation Report
• Valuation Methodologies
• Valuation for Equitable Distribution - Active v.
  Passive

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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

4
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

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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

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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

7
Evaluating an Experts Report

• A well prepared valuation report will present the
  experts knowledge of
• Industry
• National and Local Economies
• Subject Company
• Standard of Value
• Cost, Income and Market Approaches
• Discounts and Premiums

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Evaluating an Experts 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

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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.

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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.

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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)

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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.

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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

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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.

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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

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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.

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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

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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.

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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

20
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

21
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 professionals
  salary to comparable market salaries
• Value indication derived from this method is on a
  marketable, controlling ownership interest basis

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Asset Approach

• Excess Earnings Method-Advantages
• Seemingly simplistic
• Widely used in family law courts, especially for
  professional practices and small service
  businesses

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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

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Income Approach

• 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

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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

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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

27
Income Approach

• Selection of projected earnings stream (cont)
• 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.

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Income Approach

• 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.

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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)

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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

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Discount and Capitalization Rate Example
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Income Approach

• Discount and Capitalization Rate
• Weighted Average Cost of Capital (WACC)
• Blended costs of the companys 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)

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WACC - Example
34
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

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Income Approach

• Discount and Capitalization Rate
• Sources for Risk Premium data
• Stocks, Bonds, Bills, and Inflation, published
  annually by Ibbotson Associates
• Standard Poors Corporate Value Consulting Risk
  Premium Report, published annually by Standard
  Poors
• Valuation analyst comparison of performance of
  subject company to publicly traded guideline
  companies and private company completed
  transactions

36
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.

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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)

38
Income Approach

• Discounted Economic Income Method (cont)
• 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)

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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.

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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!)

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Discounted Cash Flows Example
42
Present Value Theory

• 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

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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.

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Income Approach

• Capitalization Method
• Most appropriate for projected income streams
  that are
• Stable or evenly growing
• Erratic and unpredictable as to timing (if the
  companys 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)

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Income Approach

• Capitalization Method (cont)
• 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)

46
Income Approach

• 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

47
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

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Capitalization of Earnings Example
49
Market Approach

• Guideline Companies (publicly traded)
• Market Transactions (private companies)
• Prior transactions, offers and buy-sell
  agreements
• Rules of Thumb

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Market Approach

• Guideline Companies (publicly traded)
• EDGAR
• Hoovers 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

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Market Approach

• Guideline Companies-Advantages
• There are many guideline publicly traded
  companies available for different industries
• Market is regarded as final arbiter of value
• Prices of guideline publicly traded companies
  available as of any effective valuation date
• Excellent quantity and quality of data for each
  company from SEC filings
• Most investors and judges familiar with method

52
Market Approach

• Guideline Companies-Advantages (cont)
• Inexpensive to acquire data with readily
  available databases and software (although proper
  data analysis is time consuming)
• Extensive empirical data available to support
  quantification of a discount for lack of
  marketability if valuing minority interest
• Especially relevant if subject company could go
  public

53
Market Approach

• Guideline Companies-Disadvantages
• Public companies not available in all industries
• Difficult to find adequately similar companies
• Most public companies are much larger than
  private companies being valued
• Many public companies have higher growth
  potential, which may require a difficult
  adjustment in the comparison

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Market Approach

• Guideline Companies-Disadvantages(cont)
• For small companies, factors driving value may be
  different than for public companies
• If valuing a controlling interest, adjustment for
  control may be difficult and controversial

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Examples of Pricing Multiples
56
Market Approach

• Market Transactions (private companies)
• Pratts Stats
• Done Deals
• BIZCOMPS
• Institute of Business Appraisers (IBA) database
• Good for control valuations
• If used for minority valuation, usually would
  have to discount for both minority interest and
  lack of marketability

57
Market Approach

• Market Transactions-Advantages
• If valuing controlling interest, no premium for
  control needed
• Generally understood and accepted by courts
• If the acquired company was public before
  acquisition, excellent comparative financial data
  usually available

58
Market Approach

• Market Transactions-Disadvantages
• Fewer comparative merger and acquisition
  transactions than guideline publicly traded
  companies are available
• Data not readily accessible on a single database
• Not all databases included full terms of the deal
• Transactions are not on the same date as the
  effective valuation date and may require
  adjustments for differences in time

59
Market Approach

• Market Transactions-Disadvantages(cont)
• If valuing minority interest, discounts for
  minority ownership and/or lack of marketability
  may be controversial and hard to quantify
• If the acquired company was private before
  acquisition, financial data are limited and may
  not be possible to verify
• Often includes synergistic or strategic value
  therefore may not represent fair market value

60
Market Approach

• Prior transactions, offers, buy-sell agreements
• Resulting value depends on whether they were
  applicable to control or minority transactions
• Must consider adjustments for differences in
  time, if applicable

61
Market Approach

• Prior transactions, offers, buy-sell
  agreements-Advantages
• If on an arms-length basis, may be the best
  evidence of value
• Accurate, detailed data often available

62
Market Approach

• Prior transactions, offers, buy-sell
  agreements-Disadvantages
• May be difficult to establish arms-length
  character
• Removed in time from effective valuation date
  may require adjustments for differences in time
• In case of offers and incomplete contracts, may
  be difficult to establish if it is a bona fide
  offer from a qualified buyer

63
Market Approach

• Rules of Thumb
• Universally relate to control value
• If using for minority value, need to consider
  adjustments for minority and/or lack of
  marketability

64
Market Approach

• Rules of Thumb-Advantages
• Should be considered if they are widely
  publicized in a particular industry
• Usually simple to apply
• Should be used as a sanity check

65
Market Approach

• Rules of Thumb-Disadvantages
• No empirical verification as to extent to which
  market actually tends to follow them
• Usually do not know details of transactions that
  allegedly underlie the rule
• For most industries, the various sources of rules
  of thumb usually produce a very wide range of
  values

66
Premiums and Discounts

• Discount for Lack of Control (minority interest
  discount)
• An amount or percentage deducted from an equity
  interest to reflect minority position or lack of
  control
• Can not be observed in the market
• Must be inferred from control premiums

67
Premiums and Discounts

• Sources for Discount for Lack of Control
  (minority interest discount)
• Mergerstat Review
• Closed end mutual funds (for FLPs owning
  marketable securities
• Limited partnership secondary markets (for FLPs
  owing real estate)

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Sample Mergerstat Data
69
Premiums and Discounts

• Discount for Lack of Marketability
• An amount or percentage deducted from an equity
  interest to reflect lack of marketability
• The standard for marketability of minority
  interests is public securities markets - cash in
  three days
• The discount necessary to generate a sufficient
  increment of return to the holder of a minority
  interest to induce him to make a particular
  investment

70
Premiums and Discounts

• Sources for Discounts for Lack of Marketability
• Restricted stock studies
• IPO studies
• Bid-ask spreads

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Restricted Stock Studies
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The Emory IPO Studies
73
Valuation Issues in Equitable Distribution

• Valuation of
• Marital property
• Separate property
• Active v. passive
• Debts (marital and separate)
• Property composed of both separate and marital
  elements
• Changes in value of marital assets between date
  of separation and date of distribution

74
Valuation in Equitable Distribution

• Equitable Distribution
• North Carolina became an equitable distribution
  state in 1981
• N.C. GS50-20 states that the court shall
  determine what is the marital property and
  divisible property and shall provide for an
  equitable distribution of the marital property
  and divisible property between the parties. . .

75
Valuation in Equitable Distribution

• Equitable Distribution
• In assigning a value to the property, the court
  will
• Classify all property of the parties as separate,
  marital, or divisible
• Value the separate property and assign to
  appropriate party
• Value each item of marital property
• Consider active and passive components of value
  in marital, separate and divisible property

76
Valuation in Equitable Distribution

• Equitable Distribution (cont)
• Classify the debts of the parties as separate or
  marital and value them
• Apportion or distribute the marital debts in an
  equitable manner
• Distribute the marital and divisible property
  equitably

77
Valuation in Equitable Distribution

• Marital Property - GS50-20(b)(1)
• All real and personal property acquired by either
  spouse or both spouses during the course of the
  marriage and before the date of the separation of
  the parties
• It is presumed that all property acquired after
  the date of marriage and before the date of
  separation is marital property except property
  which is separate property under subdivision 2 of
  GS50-20.

78
Valuation in Equitable Distribution

• Separate Property - GS50-20(b)(2)
• All real and personal property acquired by a
  spouse before marriage or acquired by a spouse by
  bequest, devise, descent, or gift during the
  course of the marriage
• The increase in value of separate property and
  the income derived from separate property shall
  be considered separate property.

79
Valuation in Equitable Distribution

• Divisible Property - GS50-20(b)(4)
• All real and personal property as set forth
  below
• all appreciation and diminution in value of
  marital property and divisible property of the
  parties occurring after the date of separation
  and prior to the date of distribution, except
  that appreciation or diminution in value which is
  the result of postseparation actions or
  activities of a spouse
• passive income from marital property received
  after the date of separation

80
Valuation in Equitable Distribution

• Divisible Property - GS50-20(b)(4)
• all property, property rights, or any portion
  thereof received after the date of separation but
  before the date of distribution that was acquired
  as a result of the efforts of either spouse
  during the marriage and before the date of
  separation
• increases in marital debt and financing charges
  and interest related to marital debt

81
Active v. Passive Issues

• An increase in value of separate property remains
  separate property
• Increases in value of separate property resulting
  from contributions of time or money of one or
  both spouses is active appreciation

82
Active Appreciation

• Arises from financial or managerial
  contributions of one of the spouses to separate
  property during marriage.
• Increases in value are marital property
• Allows the marital estate a fair return on its
  investment of time and money

83
Passive Appreciation

• Enhancement of the value of separate property
  due solely to inflation,changing economic
  conditions, or such other circumstances beyond
  the control of either spouse
• Burden of proof falls upon the party claiming the
  appreciation was passive

84
Active or Passive?

• Determining Factors
• Nature of the Property
• Impact of Market Conditions
• Spouses expertise in managing the asset
• Degree of management control over asset
• Appreciation resulting from third party efforts
• Influence of governments

85
Active or Passive?

• Appreciation of Closely Held Corporations
• Often centers around the degree of management
  control a spouse exercises over the asset (Smith
  v. Smith)
• Not always clear cut (Lawing v. Lawing)

86
Active or Passive?

• How to determine?
• Court must determine value of the business at the
  time of marriage, at separation, and near date of
  trial or distribution.
• Court must then determine what portion of the
  increase is attributable to the efforts of the
  parties during marriage. This increase is marital
  property and subject to division.
• Remainder is separate property.

87
Active or Passive?

• How to determine?
• Court must also determine the appreciation or
  diminution in value between the date of
  separation and trial or distribution date.
• If this appreciation or diminution is passive, it
  is divisible property.
• If this appreciation or diminution is active, it
  is separate property.
• Example problem in handout

88
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