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1 Valuation Methodologies and Evaluating Valuation Experts Presented to the North Carolina Association of District Court Judges by: T. Randolph Whitt,

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Presentation on theme: "1 Valuation Methodologies and Evaluating Valuation Experts Presented to the North Carolina Association of District Court Judges by: T. Randolph Whitt,"— Presentation transcript:

1 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 2 AGENDA 4 Evaluating a Valuation Expert 4 Evaluating a Valuation Report 4 Valuation Methodologies 4 Valuation for Equitable Distribution - Active v. Passive

3 3 What Must be Valued? 4 Pension and Retirement benefits - §50-20.1 4 Business interests operating as; –C Corp –S Corp –General Partnership –Limited Partnership –Limited Liability Partnership –Sole Proprietorship 4 Other real and personal property

4 4 Who are Valuators? 4 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

5 5 Who are Valuators? 4 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

6 6 Evaluating an Expert 4 Education - in general and in business valuation 4 Qualifications (designations) and experience 4 Knowledge of business valuation theory 4 Should not be an advocate for the client; only an advocate of his opinion

7 7 Evaluating an Expert’s Report 4 A well prepared valuation report will present the expert’s knowledge of: Industry National and Local Economies Subject Company Standard of Value Cost, Income and Market Approaches Discounts and Premiums

8 8 Evaluating an Expert’s Report 4 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

9 9 Definition of Value 4 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.

10 10 Definition of Value 4 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.

11 11 Valuation of Closely Held Business Interests 4 Definition: –Shares are owned by a relatively limited number of stockholders, often held by one family. –Shares not actively traded (usually)

12 12 Valuation of Closely Held Business Interests 4 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.

13 13 Valuation of Closely Held Business Interests 4 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

14 14 Valuation Approaches 4 3 Approaches –Asset –Income –Market 4 All approaches must be considered, but various factors will influence which approach will be relied upon to value company.

15 15 Valuation Approaches 4 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

16 16 Valuation Approaches 4 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.

17 17 Valuation Approaches 4 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

18 18 Asset Approach 4 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.

19 19 Asset Approach 4 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 20 Asset Approach 4 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 21 Asset Approach 4 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 professional’s salary to comparable market salaries –Value indication derived from this method is on a marketable, controlling ownership interest basis

22 22 Asset Approach 4 Excess Earnings Method-Advantages –Seemingly simplistic –Widely used in family law courts, especially for professional practices and small service businesses

23 23 Asset Approach 4 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”

24 24 Income Approach 4 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

25 25 Income Approach 4 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

26 26 Income Approach 4 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 27 Income Approach 4 Selection of projected earnings stream (con’t) –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”.

28 28 Income Approach 4 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.

29 29 Income Approach 4 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)

30 30 Income Approach 4 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

31 31 Discount and Capitalization Rate Example

32 32 Income Approach 4 Discount and Capitalization Rate –Weighted Average Cost of Capital (WACC) Blended costs of the company’s 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)

33 33 WACC - Example

34 34 Income Approach 4 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

35 35 Income Approach 4 Discount and Capitalization Rate –Sources for Risk Premium data: Stocks, Bonds, Bills, and Inflation, published annually by Ibbotson Associates Standard & Poor’s Corporate Value Consulting Risk Premium Report, published annually by Standard & Poor’s Valuation analyst comparison of performance of subject company to publicly traded guideline companies and private company completed transactions

36 36 Income Approach 4 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.

37 37 Income Approach 4 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 38 Income Approach 4 Discounted Economic Income Method (con’t) –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)

39 39 Income Approach 4 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.

40 40 Income Approach 4 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!)

41 41 Discounted Cash Flows Example

42 42 Present Value Theory 4 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

43 43 Present Value Theory 4 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.

44 44 Income Approach 4 Capitalization Method –Most appropriate for projected income streams that are: Stable or evenly growing Erratic and unpredictable as to timing (if the company’s 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)

45 45 Income Approach 4 Capitalization Method (con’t) –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 46 Income Approach 4 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 47 Income Approach 4 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

48 48 Capitalization of Earnings Example

49 49 Market Approach 4 Guideline Companies (publicly traded) 4 Market Transactions (private companies) 4 Prior transactions, offers and buy-sell agreements 4 Rules of Thumb

50 50 Market Approach 4 Guideline Companies (publicly traded) –EDGAR –Hoover’s online 4 If controlling interest being valued, there may be some control premium warranted 4 Discount for lack of marketability applicable if minority valuation, possibly if control valuation

51 51 Market Approach 4 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 52 Market Approach 4 Guideline Companies-Advantages (con’t) –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 53 Market Approach 4 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

54 54 Market Approach 4 Guideline Companies-Disadvantages(con’t) –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

55 55 Examples of Pricing Multiples

56 56 Market Approach 4 Market Transactions (private companies) –Pratt’s Stats –Done Deals –BIZCOMPS –Institute of Business Appraisers (IBA) database 4 Good for control valuations 4 If used for minority valuation, usually would have to discount for both minority interest and lack of marketability

57 57 Market Approach 4 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 58 Market Approach 4 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 59 Market Approach 4 Market Transactions-Disadvantages(con’t) –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 60 Market Approach 4 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 61 Market Approach 4 Prior transactions, offers, buy-sell agreements-Advantages –If on an arm’s-length basis, may be the best evidence of value –Accurate, detailed data often available

62 62 Market Approach 4 Prior transactions, offers, buy-sell agreements-Disadvantages –May be difficult to establish arm’s-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 63 Market Approach 4 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 64 Market Approach 4 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 65 Market Approach 4 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 66 Premiums and Discounts 4 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 67 Premiums and Discounts 4 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)

68 68 Sample Mergerstat Data

69 69 Premiums and Discounts 4 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 70 Premiums and Discounts 4 Sources for Discounts for Lack of Marketability –Restricted stock studies –IPO studies –Bid-ask spreads

71 71 Restricted Stock Studies

72 72 The Emory IPO Studies

73 73 Valuation Issues in Equitable Distribution 4 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 74 Valuation in Equitable Distribution 4 Equitable Distribution –North Carolina became an “equitable distribution” state in 1981 –N.C. GS§50-20 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 75 Valuation in Equitable Distribution 4 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 76 Valuation in Equitable Distribution 4 Equitable Distribution (con’t) 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 77 Valuation in Equitable Distribution 4 Marital Property - GS§50-20(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 GS§50-20.

78 78 Valuation in Equitable Distribution 4 Separate Property - GS§50-20(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 79 Valuation in Equitable Distribution 4 Divisible Property - GS§50-20(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 80 Valuation in Equitable Distribution 4 Divisible Property - GS§50-20(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 81 Active v. Passive Issues 4 An increase in value of separate property remains separate property 4 Increases in value of separate property resulting from contributions of time or money of one or both spouses is “active” appreciation

82 82 Active Appreciation 4 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 83 Passive Appreciation 4 “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 84 Active or Passive? 4 Determining Factors: –Nature of the Property –Impact of Market Conditions –Spouse’s expertise in managing the asset –Degree of management control over asset –Appreciation resulting from third party efforts –Influence of governments

85 85 Active or Passive? 4 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 86 Active or Passive? 4 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 87 Active or Passive? 4 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. 4 Example problem in handout

88 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


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