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

3. 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
ASA - Accredited Senior Appraiser (American Society of Appraisers)
ABV - Accredited in Business Valuation (AICPA)
CVA - Certified Valuation Analyst (National Association of Certified Valuation Analysts) for CPAs
CFA - Chartered Financial Analyst (AIMR) Association for Investment Management and Research
CBA - Certified Business Appraiser (Institute of Business Appraisers)
AVA - Accredited Valuation Analyst (National Association of Certified Valuation Analysts) for non-CPAs

5. 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

6. 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 Expert’s Report
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. Evaluating an Expert’s 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

9. Definition of Value Fair Market Value:
Revenue Ruling “. . 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. 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.

11. 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)

12. 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.

13. 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

14. 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.

15. 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

16. 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.

17. 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

18. 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.

19. 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
Example case.

21. Asset Approach Excess Earnings Method
Method is embodied in Revenue Ruling
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. Asset Approach Excess Earnings Method-Advantages Seemingly simplistic
Widely used in family law courts, especially for professional practices and small service businesses

23. 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”
Example Case

24. 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
Example Case

25. 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

26. 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 (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. 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.

29. 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)

30. 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

31. Discount and Capitalization Rate Example

32. Income Approach 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. 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

35. Income Approach 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
Ibbotson’s Stocks, Bonds, Bills and Inflation computes the arithmetic average equity risk premium over each of the three maturities of Treasury obligations (30-day, 5-year, 20-year) relative to both the S&P 500 and the NYSE 1st and 2nd deciles. The S&P 500 is the benchmark Ibbotson recommends.
Standard & Poor’s Corporate Value Consulting Risk Premium Report;
-NYSE stocks broken down into 25 size categories, plus a high-financial-risk category
-8 different measures of size
-Universe filtered to exclude:
ADRs
Nonoperating holding companies
All financial companies
Companies lacking 5 years of publicly traded price history
Companies with sales below $1 million in any of the previous five fiscal years
Companies with a negative 5-year EBITDA

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.

37. 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 (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. 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.

40. 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!)

41. Discounted Cash Flows Example
Mid-year discounting used in forecast period. (assumes cash flows received evenly throughout the year).
Mid-year discounting not used in terminal value.
Terminal value calculation
126,310 * 1.03 = 130,099
130,099 / .201 = 647,260
647,260 * = 229,199

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

43. 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.

44. Income Approach 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. Income Approach 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. 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

48. 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

50. Market Approach Guideline Companies (publicly traded) EDGAR
Hoover’s 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

51. 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 (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. 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

54. Market Approach 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. Examples of Pricing Multiples

56. Market Approach Market Transactions (private companies) Pratt’s 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
Pratt’s Stats- receives data from a wide array of intermediaries nationwide.
- tracks sales of privately held companies, selling prices up to $100 million.
-variety of data points for 1,900 transactions are reported.
-about 2/3 of the transactions fall between $1 million-$30 million.
Done Deals-reviews SEC reports, focus on smallest acquisitions
-database of mid-market transactions, selling price range of $1 to $100 million, -20 data points on 3,000 transactions.
-50% of the transactions represent privately held companies, with the median price at $10 million.
BIZCOMPS -polls business brokers by region
-tracks sales of smaller businesses,selling price range $175,000 - $15 million
- reports 15 data points on 3,300 transactions
IBA-solicits information from business brokers, IBA members, others
-privately held companies, selling prices up to $20 million
-6 data points on 14,000 transactions (oldest database)

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(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. 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 arm’s-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 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. 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)

68. 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

71. Restricted Stock Studies

72. 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
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. Valuation in 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 (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. Valuation in Equitable Distribution
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. Valuation in Equitable Distribution
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. Valuation in Equitable Distribution
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. Valuation in Equitable Distribution
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. 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
Spouse’s 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)
Smith v. Smith, 111 N.C. App. 460, 481, 433, S.W.2d 196, 209 (1993)
Husband owned 90% of the stock of a holding company, Sonic, that was valued at $35.5 million at the date of separation. The trial court determined that Sonic was primarily marital property and had a separate property component of only $1.2 million. The Court of Appeals held that the appreciation of Sonic during marriage was the result of the husband’s sole efforts and was thus wholly active, and therefore marital property and subject to distribution.
Lawing v. Lawing, 81 N.C. App. 159, 344 S.E.2d 100 (1986)
The Court of Appeals of North Carolina ruled that the appreciation in value of inherited shares of a family corporation was not solely husband’s separate property, rather the case was remanded to determine what proportion of the increase in value of the corporation was due to “funds, talent, or labor that were contributed by the marital community, as opposed to passive increases due to the efforts of the husband’s brother.”

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? Example problem in handout
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