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Business Valuation Essentials Trial Advocacy Institute Houston Texas May 2019 Jay Fishman, FASA Financial Research Associates [email protected] com
Three Major Elements of Any Business Valuation n Definition and Premise of Value n Valuation Date n Identification of Asset Being Appraised
Definition of Value n n Definition of value sets the framework for the appraisal In divorce matters definitions of value are determined on a state by state basis
Definition of Value n n Statute does not provide definition - left up to case law Must discuss with your expert as case law is often ambiguous
Fair Market Value. . . “the net amount which a willing purchaser, whether an individual or a corporation, would pay for the interest to a willing seller, neither being under any compulsion to buy nor to sell and both having reasonable knowledge of relevant facts. ”  Note: 1. Different definitions may apply in other jurisdictions. 2. Federal definition is a statutory and case law construct that takes the perspective of a hypothetical investor.  26 CFR 20. 2031 -3
Fair Value n Definition for dissent and minority oppression cases: “The value of the shares immediately before the effectuation of the corporate action to which the dissenter objects, excluding any appreciation or depreciation in anticipation of the corporate action unless exclusion would be inequitable. ”  n Fair Value in Divorce Cases: Pro-rata without discounts  Revised Model Business Corporation Act, Section 13. 01 (3) 1998
Investment Value to a particular investor based on individual investment requirements and expectations.  International Glossary of Business Valuation Terms
Intrinsic Value “The amount that an investor considers, on the basis of an evaluation of available facts, to be the ‘true’ or ‘real’ worth of an item, usually an equity security. ”  W. W. Cooper and Yuri Ijiri, eds. Kohler’s Dictionary for Accountants, 6 th ed. ( Prentice-Hall, 1983), p. 285
Premise of Value By premise of value, we mean an assumption as to the status of the business under which a transaction would be expected to take place.  Shannon Pratt, The Lawyers Business Valuation Handbook: Understanding Financial Statements, Appraisal Reports, and Expert Testimony. (Chicago: American Bar Association, 2000), p. 11
Premises of Value n Value as a going concern • Value in continued use, as a mass assemblage of income producing assets, and as a going-concern business enterprise. n Value as an assemblage of assets • Value in place, as part of a mass assemblage of assets, but not in current use in the production of income, and not as a going-concern business enterprise.
Importance of Valuation Date n Value is Dynamic n Information Known or Knowable n Multiple Dates • • • n Date of marriage Date of gift/inheritance Date of separation Date of complaint Trial date You inform the expert as to the appropriate date(s)
Identification of Asset(s) Being Appraised n How Many Entities Are Relevant? n Assets or Equity n Fractional Shares or Control of the Business n Tangible or Intangible n Personal or Professional Goodwill
What Kind of Information is Needed? n Financial Information • • Tax Returns (Personal & Business) Financial Statements Budgets and Projections Compensation Schedules
What Kind of Information is Needed? n Operational Information • • Product Line Data/Sales by Customer Marketing and Website Material Lease Information Site Visit
What Kind of Information is Needed? n Legal Information • • • n Articles of Incorporation Shareholder Agreements Buy-in and Buy-out Agreements Purchase/Sale of Business Segments Corporate Minutes Information for Certain Industries/Business Types • • Medical/Dental Practice Law Firm Automobile Dealership Hedge Fund
What Kind of Information is Needed? n How Many Years of Data is Necessary? n Importance of Management Interview
Adjusting Financial Information n Revenue Recognition n Unreported Income n Replacement Compensation n Perqs n Non-Recurring Events n Non-Operating Assets
Hierarchy of Approaches, Methods, and Procedures n Approach is the broadest of the three terms. n Method refers to general ways to implement approaches. n Procedure means the specific calculations, data used, and other details involved in a specific method.
Approaches to Value n n Three Approaches Exist: Income, Market and Asset They are essentially analogous to the three approaches used in real estate appraisal
Three Approaches to Value • Income approach: valuing the business or business interest on the basis of some form of economic income stream. • Market approach: valuation by reference to other transactions in real estate usually called the “comparable sales approach. ” • Asset-based approach: valuation on the basis of assets and liabilities. It is somewhat analogous to the ”cost approach” in real estate appraisal.
Methods Used in Income Approach n. Income n. Approach n n Discounted Future n. Returns Method Single Period n Multi Period
Methods Used in Market Approach Market n. Approach n n. Rules Guideline n. Past n. Buy-Sell n. Companies nof n. Transactions n. Agreements n. Thumb n
Methods Used in Asset Approach Asset n. Approach n Adjusted Net n. Asset Value n n n Going Concern n. Basis Liquidation Basis n n Excess Earnings n (hybrid) Hybrid Basis
Income Approach Methods n Present Worth of Future Benefits • Discounting: Multi-Period • Capitalizing: Single Period
Discount Rates n n Generally, the higher the discount rate, the higher the risk of achieving the expected cash flows in future All else equal, the higher the discount rate, the lower the value of the business
Discount Rates and Capitalization Rates n n Discount rates and capitalization rates are expressed in percentage terms Capitalization (“cap”) rate = Discount rate % – estimated long term future growth % for business
Capitalization Rates vs. Multiples n n The inverse of a cap rate is called a multiple. Example: • 20% cap rate • Inverse: 1 divided by 0. 20 = 5 x multiple
Income Approach n The type of economic benefit that is used in the calculations may vary. Examples: • • • Cash Flow Income Before Taxes Income After Taxes Seller’s Discretionary Earnings Before Interest and Taxes (EBIT) Dividends
Market Approach Methods n n Apply some type of financial multiples derived from companies in a similar line of business to the subject company. Guideline company method (sometimes called the “comparable company method”): • Multiples from prices and financial data of company stocks traded in the public market n Guideline transaction method: • Multiples from prices and financial data of companies that have been sold
Market Approach Methods Public company multiples can produce both controlling and non-controlling interest conclusions. The multiple is not the key; rather, the economic stream to which the multiple is applied determines the level of value.
Market Approach Methods Past Transactions Method: Uses multiples of economic data from the company’s own past transactions. • Past change of ownership of all or a controlling interest in the subject company • Past transactions of minority interests in the subject company • Past acquisitions made by the subject company • Past offers (but must examine whether bona fide and at arm’s length)
Market Approach Methods n Buy-Sell Agreements: • Placed very arbitrarily under the market approach with the idea that someone negotiated and agreed to the buy-sell terms at some point in the past. n Rules of Thumb: • “Ballpark” ranges of possible values derived from simple formulas used in an industry.
Asset Approach Methods Adjusted net asset value method—Adjusts all of the company’s assets (both tangible and intangible) and liabilities to current value, usually fair market value, and subtracts the liabilities from the assets. • Going-concern premise methods • Liquidation premise • Hybrid premise Note: “Adjusted net asset value” is synonymous with “adjusted net worth” or “net asset value. ”
Asset Approach Methods Excess earnings method: Discussed in RR 68 -609 n Adjusts the company’s tangible assets to current value. n Estimates the income needed to support the net tangible assets. n n If there is income over and above that amount, the excess is divided by a capitalization rate to estimate the value of all the company’s intangible assets (including goodwill) Adds the estimated value of the intangibles to the value of the tangible assets to produce a total entity value. Note: “Adjusted net asset value” is synonymous with “adjusted net worth” or “net asset value. ”
Excess Earnings Method – Common Inputs n Normalized Revenue, Profit Margin, Tax Rate • Usually Same as Used in Capitalization of Income n Net Tangible Assets n Capitalization Rate – Intangibles (Goodwill)
Excess Earnings Method - Inputs n Capitalization Rate – Tangible Assets • 8 -10% per Revenue Ruling 68 -609? • Based on Composition of Assets? • Rate of Return on Capital in Partnership Agreement? • Appraiser’s Judgment?
Excess Earnings Method - Inputs n Capitalization Rate – Intangibles (Goodwill) • May be Expressed as a Percentage or as a Multiple • Goodwill and Other Intangibles are Usually Riskiest Assets of a Business • Percentage Should Be Significantly Higher Than Return on Tangible Assets • Percentage Should also be Higher Than Return Used in Capitalization of Income Method • Pre or Post-Tax?
Excess Earnings Method – Example n Assignment: Valuing ABC Products as of December 31, 2004 n Normalized after-tax profit: $538, 000 n Net tangible assets: $3, 472, 565 n Normalized return on net tangibles: 8% n Excess earnings capitalization rate: 30%
Excess Earnings Method – Example After-tax profit $537, 900 Less: Return on Net Tangible Assets: Net Tangible Assets Return on Net Tangibles $3, 472, 565 x 8% - $277, 805 Equals: Excess Earnings Divided by Capitalization Rate Equals: Intangible Value Plus: Net Tangible Assets, from above Equals: Total Equity Value $260, 095 30% $866, 983 $3, 472, 565 $4, 340, 000
Wrapping Up a Valuation n Correlation and Conclusion of Value • • n Weighting of Methods (Mathematical or Subjective) Application of “Sanity Checks” Usually Results in Value of 100% of Subject Entity Calculation of Pro-Rata Value of % Subject to Appraisal Consideration of Discounts/Premiums
Discounts and Premiums Most common of these include: n Discount for Lack of Control n Discount for Lack of Marketability n Control Premiums
Discounts and Premiums n n Often, the value of a % interest is less than its pro-rata share of the whole Relevance of discounts/premiums depends on many issues, including but not limited to: • Appropriate Standard of Value • % Interest Subject to Appraisal/Ownership Characteristics • Methods Used in the Appraisal
Discounts and Premiums – Relevance of Standard of Value n n n Fair Market Value: Assumes Value to a Hypothetical Willing Buyer Investment Value: Value to Holder Fair Value: Depends on Jurisdiction
Discounts and Premiums n Ownership Characteristics of the Subject Interest • Minority or Control? • Breakdown of Other Ownership Interests • Relative Level of Marketability
Lack of Control Discounts Methods Used in the Appraisal Can Impact the Relevance/Degree of Discount Selected: • Asset Approach and Guideline Transaction Method: Usually on a Control Basis • Guideline Company Method: Minority Basis • Income Approach: Depends on the Variables Used
Discounts and Premiums n n Discounts are Multiplicative, not Additive Example: • A 20% lack of control discount, followed by a 20% marketability discount, equals a total discount of 36% (not 40%)