Presentation on theme: "Valuation Methodologies and Evaluating Valuation Experts"— Presentation transcript:
1 Valuation Methodologies and Evaluating Valuation Experts Presented to theNorth Carolina Association of District Court Judgesby:T. Randolph Whitt, CPA, ABVKelly A. Schmid, CPA, CVA, ABVCrisp Hughes Evans, LLPApril 10, 2003
2 AGENDA Evaluating a Valuation Expert Evaluating a Valuation Report Valuation MethodologiesValuation for Equitable Distribution - Active v. Passive
3 What Must be Valued? Pension and Retirement benefits - §50-20.1 Business interests operating as;C CorpS CorpGeneral PartnershipLimited PartnershipLimited Liability PartnershipSole ProprietorshipOther real and personal property
4 Who are Valuators? Valuation Experts Credentialed experts (ASA, ABV, CVA, CFA, CBA, AVA)Educated in valuation theoryAdhere 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.AccountantsCore competencies of financial analysis and understanding of business operationsMay or may not understand business valuation theoryASA - Accredited Senior Appraiser (American Society of Appraisers)ABV - Accredited in Business Valuation (AICPA)CVA - Certified Valuation Analyst (National Association of Certified Valuation Analysts) for CPAsCFA - Chartered Financial Analyst (AIMR) Association for Investment Management and ResearchCBA - 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 theoryMay or may not understand business valuation theoryIndustry ExpertsCore competency of understanding their industryUsually have no knowledge of business valuation theoryInvestment Bankers/Business BrokersCore competency of understanding the structure of a business transaction
6 Evaluating an Expert Education - in general and in business valuation Qualifications (designations) and experienceKnowledge of business valuation theoryShould 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:IndustryNational and Local EconomiesSubject CompanyStandard of ValueCost, Income and Market ApproachesDiscounts and Premiums
8 Evaluating an Expert’s Report Subjective Areas of Valuation Reports:Adjustments to the Balance Sheet and/or Income StatementSelection of Estimated Future Income StreamCalculation of Discount or Capitalization RateRisk factorsGrowth rateSelection of Valuation MethodologySelection of Guideline Companies or Transactions in the Market ApproachApplication 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 AssetIncomeMarketAll 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 enterpriseAdjusted Net Assets MethodExcess Earnings Method
16 Valuation Approaches Income Approach Estimate the value of a business based on its future earnings streamDiscounting: 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 understandEspecially relevant in tangible asset intensive business if valuing controlling ownershipLiquidation 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 liabilitiesValuation of intangibles and contingent items may be considered speculativeOf questionable relevance in many going-concern premise valuations, especially minority interestsExample case.
21 Asset Approach Excess Earnings Method Method is embodied in Revenue RulingA derivation of this method is often used to value professional practicesA “normalized” level of economic earnings is estimated by “adjusting” the professional’s salary to comparable market salariesValue 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 implementationNo empirical basis available for developing or supporting capitalization rate applicable to excess earningsDoes not provide mechanics for incorporating expected growthNot widely used by financial communityIRS 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 companyAdjustments generally fall into three categories:Differences in accounting practicesNonrecurring events, discontinued operations, or other aspects of past operations that may not represent future earning powerDiscretionary items (management perquisites, bonuses, etc.); Only done for valuations of controlling ownership interestsExample 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 TaxesAccounting 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 positionA weighted average cost of capital (WACC) discount rate is usedResulting 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 EquityA cost of equity discount rate is usedResulting 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 companyInstead of investing in available alternative investments that are comparable in terms of risk and other investment characteristicsThe 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 numeratorComponents: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 numeratorComponents: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
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 componentIf debt is being included in what is being valued, a WACC will be applied to an earnings stream which ignores capital structure (interest expense)
34 Income Approach Discount and Capitalization Rate Risk Premium: Equities are riskier than debt and warrant a higher expected returnMost estimates of equity risk premium rely on historical market performance as an indicator of futureHistorically, small company stock have had higher returns and more risk than large company stocksSubject 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 AssociatesStandard & Poor’s Corporate Value Consulting Risk Premium Report, published annually by Standard & Poor’sValuation analyst comparison of performance of subject company to publicly traded guideline companies and private company completed transactionsIbbotson’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:ADRsNonoperating holding companiesAll financial companiesCompanies lacking 5 years of publicly traded price historyCompanies with sales below $1 million in any of the previous five fiscal yearsCompanies 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 taxesThese are the returns realized by an investor.These returns are pre-investor taxes, after business taxesWhen 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 changesShort- or intermediate-term supergrowthChanges that are erratic and unpredictable as to timingAlso 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 basisDiscount 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 cashWidely 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 controversialRequires estimate of appropriate discount rate (cost of capital); also subject to controversyMay 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 calculation126,310 * 1.03 = 130,099130,099 / .201 = 647,260647,260 * = 229,199
42 Present Value Theory Another example of use of Present Value theory Pension valuationsValue of benefit or payout is knownWhat 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 growingErratic 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 basisDiscount 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 forecastsSimple to understand and explain
47 Income Approach Capitalization Method-Disadvantages Oversimplification of discounting methodImplicitly assumes that a variable capitalized represents a reasonable base from which future benefits will proceedThe measure of economic income to be capitalized and the capitalization rate may be controversialDifficult to use in start-up or high-growth companies
49 Market Approach Guideline Companies (publicly traded) Market Transactions (private companies)Prior transactions, offers and buy-sell agreementsRules of Thumb
50 Market Approach Guideline Companies (publicly traded) EDGAR Hoover’s onlineIf controlling interest being valued, there may be some control premium warrantedDiscount 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 industriesMarket is regarded as final arbiter of valuePrices of guideline publicly traded companies available as of any effective valuation dateExcellent quantity and quality of data for each company from SEC filingsMost 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 interestEspecially relevant if subject company could go public
53 Market Approach Guideline Companies-Disadvantages Public companies not available in all industriesDifficult to find adequately similar companiesMost public companies are much larger than private companies being valuedMany 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 companiesIf valuing a controlling interest, adjustment for control may be difficult and controversial
56 Market Approach Market Transactions (private companies) Pratt’s Stats Done DealsBIZCOMPSInstitute of Business Appraisers (IBA) databaseGood for control valuationsIf used for minority valuation, usually would have to discount for both minority interest and lack of marketabilityPratt’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 transactionsIBA-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 neededGenerally understood and accepted by courtsIf 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 availableData not readily accessible on a single databaseNot all databases included full terms of the dealTransactions 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 quantifyIf the acquired company was private before acquisition, financial data are limited and may not be possible to verifyOften 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 transactionsMust consider adjustments for differences in time, if applicable
61 Market ApproachPrior transactions, offers, buy-sell agreements-AdvantagesIf on an arm’s-length basis, may be the best evidence of valueAccurate, detailed data often available
62 Market ApproachPrior transactions, offers, buy-sell agreements-DisadvantagesMay be difficult to establish arm’s-length characterRemoved in time from effective valuation date; may require adjustments for differences in timeIn 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 industryUsually simple to applyShould 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 themUsually do not know details of transactions that allegedly underlie the ruleFor 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 controlCan not be observed in the marketMust be inferred from control premiums
67 Premiums and Discounts Sources for Discount for Lack of Control (minority interest discount)Mergerstat ReviewClosed end mutual funds (for FLPs owning marketable securitiesLimited partnership secondary markets (for FLPs owing real estate)
69 Premiums and Discounts Discount for Lack of MarketabilityAn amount or percentage deducted from an equity interest to reflect lack of marketabilityThe standard for marketability of minority interests is public securities markets - cash in three daysThe 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 MarketabilityRestricted stock studiesIPO studiesBid-ask spreads
73 Valuation Issues in Equitable Distribution Valuation of :Marital propertySeparate propertyActive v. passiveDebts (marital and separate)Property composed of both separate and marital elementsChanges 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 1981N.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 divisibleValue the separate property and assign to appropriate partyValue each item of marital propertyConsider 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 themApportion or distribute the marital debts in an equitable mannerDistribute 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 marriageThe 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 spousepassive 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 separationincreases 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 propertyIncreases in value of separate property resulting from contributions of time or money of one or both spouses is “active” appreciation
82 Active AppreciationArises from “financial or managerial contributions of one of the spouses to separate property during marriage.”Increases in value are marital propertyAllows 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 ConditionsSpouse’s expertise in managing the assetDegree of management control over assetAppreciation resulting from third party effortsInfluence 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 theNorth Carolina Association of District Court Judgesby:T. Randolph Whitt, CPA, ABVKelly A. Schmid, CPA, CVA, ABVCrisp Hughes Evans, LLPApril 10, 2003