Read the attached WORD document called “2020 Cruise-Tesla Case” with care andanswer the questions in it.
Please watch “Multiples for Public Companies” in the Panopto folder on your left. You should pick at least four comparable companies (i.e., comparable in some way to Cruise), at least one of which is conceptually related, but is not actually a traditional auto company. For example, you might pick Ford, GM, Uber or Amazon, Lyft, or Zoom Video, because they are high-tech companies. Your choice— but be sure to explain your reasoning.
This news article might give you some ideas about the EV industry 2021 January Cruise and Microsoft link up
In choosing your comparables, which are known in accounting as “guideline companies,” and in our text as “yardstick companies,” you can look at the nature of the business, as well as beta, ROE, and other financial ratios. They help you choose the comparables, and then you proceed to useand weigh (weighted average) P/E, P/B,P/S and DCF.
Note: I am the author of the attached case. I intend to publish it, I welcome any suggestions to this draft version.
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I attach two very detailed spreadsheets about TSLA. You can use it to see the likely cash flows in future years, which you will use for the DCF (discounted cash flow) part of the valuation.
I also attach a chapter on business valuation that I used in the Forensic Accounting course that I teach (ACCT 412/601). The document name is ACCT 412 601 Crumbley Forensic Accting Ch 17. I think it is more approachable and relevant to this assignment than our book’s chapters 10 and 11.
This assignment is a very significant portion of the course grade. Therefore, your team need to begin work on this now! I am willing to see at least one draft (submit drafts right here in the ASSIGNMENT FOLDER, I have set it to allow unlimited re-submissions. Always have all names on the first page. If someone does nothing, note that on the first page, also).
QUICK AND DIRTY ACTION PLAN
1-Read the case, it is the fifth attachment. We will skip the DCF approach, to save you time.
2-Read the first attachment, to see a clean approach to using multiples.
3-Open the second attachment. It has the numbers you need.
4-From your comparables list, apply P/Earnings, P/Sales and P/Book value.
5-State the value of Cruise, by averaging those three metrics.
Tesla Inc. (TSLA)
Fiscal Year Ends December Mar Q1 Jun Q2 Sep Q3 Dec Q4 2009 Mar Q1 Jun Q2 Sep Q3 Dec Q4 2010 Mar Q1 Jun Q2 Sep Q3 Dec Q4 2011 Mar Q1 Jun Q2 Sep Q3 Dec Q4 2012 Mar Q1 Jun Q2 Sep Q3 Dec Q4 2013 Mar Q1 Jun Q2 Sep Q3 Dec Q4 2014 Mar Q1 Jun Q2 Sep Q3 Dec Q4 2015 Mar Q1 Jun Q2 Sep Q3 Dec Q4 2016 Mar Q1 Jun Q2 Sep Q3 Dec Q4 2017 Mar Q1 Jun Q2 Sep Q3 Dec Q4 2018 Mar Q1 Jun Q2 Sep Q3 Dec Q4 2019 Mar Q1 Jun Q2 Sep Q3 Dec Q4 2020 Mar Q1E Jun Q2E Sep Q3E Dec Q4E 2021E Mar Q1E Jun Q2E Sep Q3E Dec Q4E 2022E Mar Q1E Jun Q2E Sep Q3E Dec Q4E 2023E
Earnings Model
(Dollars in millions)
Revenue 20.9 26.9 45.5 18.585 112 20.8 28.4 31.2 36.3 117 49.0 58.2 57.666 39.375 204 30.2 26.7 50.1 306.3 413 561.8 405.1 431.3 615.2 2,013 620.5 769.3 851.8 956.7 3,198 939.9 955.0 936.8 1,214.4 4,046 1,147.0 1,270.0 2,298.4 2,284.6 7,000 2,696.3 2,789.6 2,984.7 3,288.2 11,759 3,408.8 4,002.2 6,824.4 7,225.9 21,461 4,541 6,349.7 6,303.0 7,384.0 24,578.1 5,985.0 6,036.0 8,771.0 10,744.0 31,536.0 8,733.4 10,344.7 12,758.2 15,691.9 47,528.2 12,213.1 13,453.2 15,751.6 18,201.0 59,619.0 14,308.4 15,709.7 18,308.2 20,291.6 68,617.8
Sequential change 29.0% 69.0% (59.2%) 12.0% 36.5% 10.0% 16.1% 35.1% 18.6% (0.9%) (31.7%) (23.4%) (11.6%) 88.0% 511.4% 83.4% (27.9%) 6.5% 42.6% 0.9% 24.0% 10.7% 12.3% (1.8%) 1.6% (1.9%) 29.6% (5.5%) 10.7% 81.0% (0.6%) 18.0% 3.5% 7.0% 10.2% 3.7% 17.4% 70.5% 5.9% (37.1%) 39.8% (0.7%) 17.2% (18.9%) 0.9% 45.3% 22.5% (18.7%) 18.5% 23.3% 23.0% (22.2%) 10.2% 17.1% 15.6% (21.4%) 9.8% 16.5% 10.8%
Year-over-year change (0.4%) 5.4% (31.4%) 95.2% 4.3% 135.6% 104.8% 84.6% 8.5% 74.9% (38.5%) (54.2%) (13.1%) 678.0% 102.3% 1762.3% 1420.1% 760.9% 100.8% 387.2% 10.5% 89.9% 97.5% 55.5% 58.8% 51.5% 24.1% 10.0% 26.9% 26.5% 22.0% 33.0% 145.4% 88.1% 73.0% 135.1% 119.6% 29.9% 43.9% 68.0% 26.4% 43.5% 128.6% 119.7% 82.5% 33.2% 58.7% (7.6%) 2.2% 14.5% 31.8% (4.9%) 39.2% 45.5% 28.3% 45.9% 71.4% 45.5% 46.1% 50.7% 39.8% 30.0% 23.5% 16.0% 25.4% 17.2% 16.8% 16.2% 11.5% 15.1%
Cost of sales 23 25 38 17 102 17 22 22 25 86 31 40 40 32 143 20 22 59 282 383 465 285 300 429 1,479 444 538 583 669 2,234 633 680 628 872 2,813 806 951 1,662 1,849 5,268 2,028 2,123 2,536 2,849 9,536 2,952 3,383 5,301 5,783 17,419 3,976 5,428.6 5,112.0 5,993.0 20,509.4 4,751.0 4,769.0 6,708.0 8,678.0 24,906.0 7,094.0 8,429.1 10,073.6 12,289.4 37,886.1 9,683.6 10,556.9 12,242.2 14,202.4 46,685.1 11,543.3 12,528.2 14,392.2 15,919.6 54,383.3
Percent of revenue 109.8% 92.2% 83.1% 90.4% 91.5% 81.5% 78.0% 70.2% 68.8% 73.7% 63.2% 68.2% 70.1% 80.1% 69.8% 66.2% 82.1% 117.5% 92.2% 92.7% 82.9% 70.4% 69.5% 69.7% 73.5% 71.6% 69.9% 68.5% 69.9% 69.9% 67.4% 71.2% 67.1% 71.8% 69.5% 70.3% 74.9% 72.3% 80.9% 75.3% 75.2% 76.1% 85.0% 86.7% 81.1% 86.6% 84.5% 77.7% 80.0% 81.2% 87.5% 85.5% 81.1% 81.2% 83.4% 79.4% 79.0% 76.5% 80.8% 79.0% 81.2% 81.5% 79.0% 78.3% 79.7% 79.3% 78.5% 77.7% 78.0% 78.3% 80.7% 79.7% 78.6% 78.5% 79.3%
Gross profit (2.0) 2.1 7.7 1.8 9.5 3.9 6.3 9.3 11.3 30.7 18.0 18.5 17.2 7.8 61.6 10.2 4.8 (8.8) 23.9 30.1 96.3 119.8 131.6 186.4 534.1 176.5 231.6 268.4 287.8 964.3 306.5 275.3 308.5 342.8 1,233.0 340.9 319.3 636.7 435.3 1,732.3 667.9 666.6 449.1 438.8 2,222.5 456.5 618.9 1,523.7 1,442.9 4,042.0 565.7 921.0 1,191.0 1,391.0 4,068.8 1,234.0 1,267.0 2,063.0 2,066.0 6,630.0 1,639.3 1,915.6 2,684.6 3,402.6 9,642.1 2,529.5 2,896.3 3,509.4 3,998.6 12,933.8 2,765.1 3,181.5 3,916.0 4,372.0 14,234.5
Gross margin (9.8%) 7.8% 16.9% 9.6% 8.5% 18.5% 22.0% 29.8% 31.2% 26.3% 36.8% 31.8% 29.9% 19.9% 30.2% 33.8% 17.9% (17.5%) 7.8% 7.3% 17.1% 29.6% 30.5% 30.3% 26.5% 28.4% 30.1% 31.5% 30.1% 30.1% 32.6% 28.8% 32.9% 28.2% 30.5% 29.7% 25.1% 27.7% 19.1% 24.7% 24.8% 23.9% 15.0% 13.3% 18.9% 13.4% 15.5% 22.3% 20.0% 18.8% 12.5% 14.5% 18.9% 18.8% 16.6% 20.6% 21.0% 23.5% 19.2% 21.0% 18.8% 18.5% 21.0% 21.7% 20.3% 20.7% 21.5% 22.3% 22.0% 21.7% 19.3% 20.3% 21.4% 21.5% 20.7%
Research & Development 7.9 1.9 1.3 8.1 19.3 13.3 15.4 26.7 37.6 93.0 41.2 52.5 54.1 61.2 209.0 68.4 74.9 61.9 68.8 274.0 54.9 52.3 56.4 68.5 232.0 81.5 107.7 135.9 139.6 464.7 167.2 181.7 178.8 190.2 717.9 182.5 191.7 214.3 246.0 834.4 322.0 369.8 331.6 354.6 1,378 367.1 386.1 350.8 356.3 1,460 340.2 323.9 334.0 345.0 1,343.1 324.0 279.0 366.0 522.0 1,491.0 497.8 512.1 523.1 533.5 2,066.5 549.6 558.3 567.1 582.4 2,257.4 572.3 581.3 604.2 608.7 2,366.5
Percent of revenue 38.0% 7.2% 2.8% 43.8% 17.2% 63.7% 54.3% 85.5% 103.7% 79.7% 84.0% 90.3% 93.8% 155.4% 102.3% 226.7% 280.8% 123.5% 22.5% 66.3% 9.8% 12.9% 13.1% 11.1% 11.5% 13.1% 14.0% 16.0% 14.6% 14.5% 17.8% 19.0% 19.1% 15.7% 17.7% 15.9% 15.1% 9.3% 10.8% 11.9% 11.9% 13.3% 11.1% 10.8% 11.7% 10.8% 9.6% 5.1% 4.9% 6.8% 7.5% 5.1% 5.3% 4.7% 5.5% 5.4% 4.6% 4.2% 4.9% 4.7% 5.7% 5.0% 4.1% 3.4% 4.3% 4.5% 4.2% 3.6% 3.2% 3.8% 4.0% 3.7% 3.3% 3.0% 3.4%
SG&A 6.6 8.2 10.7 16.563 42.2 16.6 22.2 20.4 25.3 84.6 24.2 24.7 27.6 27.6 104.1 30.6 36.1 37.8 45.9 150.4 47.0 60.0 77.1 101.5 285.6 117.6 134.0 155.1 197.0 603.7 195.4 201.8 236.4 288.7 922.2 318.2 321.2 336.8 440.2 1,416.4 603.5 537.8 653.0 682.3 2,477 686.4 854.2 756.1 673.1 2,970 747.4 764.6 596.0 687.0 2,795.0 627.0 661.0 888.0 969.0 3,145.0 960.7 982.7 988.8 1,020.0 3,952.1 1,038.1 1,076.3 1,102.6 1,146.7 4,363.6 1,159.0 1,139.0 1,190.0 1,217.5 4,705.5
Percent of revenue 31.6% 30.6% 23.6% 89.1% 37.7% 79.7% 78.2% 65.4% 69.9% 72.4% 49.4% 42.5% 47.9% 70.0% 51.0% 101.4% 135.4% 75.4% 15.0% 36.4% 8.4% 14.8% 17.9% 16.5% 14.2% 18.9% 17.4% 18.2% 20.6% 18.9% 20.8% 21.1% 25.2% 23.8% 22.8% 27.7% 25.3% 14.7% 19.3% 20.2% 22.4% 19.3% 21.9% 20.7% 21.1% 20.1% 21.3% 11.1% 9.3% 13.8% 16.5% 12.0% 9.5% 9.3% 11.4% 10.5% 11.0% 10.1% 9.0% 10.0% 11.0% 9.5% 7.8% 6.5% 8.3% 8.5% 8.0% 7.0% 6.3% 7.3% 8.1% 7.2% 6.5% 6.0% 6.9%
EBITDA (14.6) (9.8) (4.8) (24.0) (53.2) (27.0) (35.6) (31.4) (48.5) (142.5) (45.3) (54.4) (60.7) (76.5) (237.0) (85.6) (101.1) (103.1) (77.3) (367.0) 29.4 (6.1) (7.0) 24.6 40.9 (1.2) 1.6 0.9 (28.1) (26.8) (67.0) (83.5) (110.2) (159.7) (420.4) (110.2) (91.8) 357.2 281.8 437.0 170.9 176.9 (101.9) (68.5) 177.4 (138.2) (55.0) 1,006.2 832.8 1,645.9 (54.2) 361.6 884.9 894.0 2,086.3 740.0 862.0 1,233.0 1,217.0 4,052.0 974.9 1,339.8 2,091.7 2,868.1 7,274.5 2,060.8 2,405.7 3,088.8 3,593.5 11,148.8 2,457.8 2,885.3 3,645.8 4,069.7 13,058.5
EBITDA margin (69.9%) (36.3%) (10.6%) (129.1%) (47.5%) (129.9%) (125.2%) (100.7%) (133.7%) (122.1%) (92.3%) (93.6%) (105.3%) (194.4%) (116.0%) (283.7%) (379.2%) (205.7%) (25.2%) (88.8%) 5.2% (1.5%) (1.6%) 4.0% 2.0% (0.2%) 0.2% 0.1% (2.9%) (0.8%) (7.1%) (8.7%) (11.8%) (13.2%) (10.4%) (9.6%) (7.2%) 15.5% 12.3% 6.2% 6.3% 6.3% (3.4%) (2.1%) 1.5% (4.1%) (1.4%) 14.7% 11.5% 7.7% (1.2%) 5.7% 14.0% 12.1% 8.5% 12.4% 14.3% 14.1% 11.3% 12.8% 11.2% 13.0% 16.4% 18.3% 15.3% 16.9% 17.9% 19.6% 19.7% 18.7% 17.2% 18.4% 19.9% 20.1% 19.0%
D&A – 0 – 0 – 0 – 0 – 0 2.1 2.5 3.1 2.9 10.6 3.5 4.3 4.3 4.8 16.9 4.2 4.3 7.5 12.8 28.8 17.9 22.2 28.5 37.6 106.1 44.3 54.7 65.0 68.0 231.9 77.1 91.4 110.4 143.7 422.6 156.5 183.2 280.5 326.9 947.1 376.6 389.2 400.6 469.6 1,636.0 416.2 485.3 502.8 496.7 1,901.1 467.6 578.6 530.9 577.0 2,154.0 553.0 567.0 584.0 618.0 2,322.0 765.0 915.0 915.0 1,015.0 3,610.0 1,115.0 1,140.0 1,240.0 1,315.0 4,810.0 1,415.0 1,415.0 1,515.0 1,515.0 5,860.0
Percent of revenue 0.0% 0.0% 0.0% 0.0% 0.0% 10.3% 8.7% 10.0% 8.0% 9.1% 7.2% 7.4% 7.4% 12.2% 8.3% 13.8% 16.3% 15.0% 4.2% 7.0% 3.2% 5.5% 6.6% 6.1% 5.3% 7.1% 7.1% 7.6% 7.1% 7.3% 8.2% 9.6% 11.8% 11.8% 10.4% 13.6% 14.4% 12.2% 14.3% 13.5% 14.0% 14.0% 13.4% 14.3% 13.9% 12.2% 12.1% 7.4% 6.9% 8.9% 10.3% 9.1% 8.4% 7.8% 8.8% 9.2% 9.4% 6.7% 5.8% 7.4% 8.8% 8.8% 7.2% 6.5% 7.6% 9.1% 8.5% 7.9% 7.2% 8.1% 9.9% 9.0% 8.3% 7.5% 8.5%
Operating income (loss) (16.6) (8.1) (4.3) (22.9) (51.9) (26.0) (31.4) (37.8) (51.6) (146.8) (47.3) (58.7) (64.5) (80.9) (251.5) (88.8) (106.2) (108.5) (90.9) (394.3) (5.6) 7.6 (1.8) 16.4 16.6 (22.6) (10.1) (22.6) (48.8) (104.1) (56.1) (108.3) (106.6) (136.1) (407.1) (159.8) (193.5) 85.6 (250.9) (518.5) (257.5) (240.9) (535.5) (598.1) (1,632.1) (597.0) (621.4) 416.8 413.5 (388.1) (521.8) (167.5) 261.0 359.0 (69.3) 283.0 327.0 809.0 575.0 1,994.0 180.9 420.8 1,172.7 1,849.1 3,623.5 941.8 1,261.7 1,839.8 2,269.5 6,312.8 1,033.8 1,461.3 2,121.8 2,545.7 7,162.5
EBIT margin (79.5%) (30.0%) (9.4%) (123.4%) (46.4%) (124.9%) (110.4%) (121.1%) (142.3%) (125.8%) (96.6%) (101.0%) (111.8%) (205.5%) (123.1%) (294.2%) (398.4%) (216.5%) (29.7%) (95.4%) (1.0%) 1.9% (0.4%) 2.7% 0.8% (3.6%) (1.3%) (2.6%) (5.1%) (3.3%) (6.0%) (11.3%) (11.4%) (11.2%) (10.1%) (13.9%) (15.2%) 3.7% (11.0%) (7.4%) (9.6%) (8.6%) (17.9%) (18.2%) (13.9%) (17.5%) (15.5%) 6.1% 5.7% (1.8%) (11.5%) (2.6%) 4.1% 4.9% (0.3%) 4.7% 5.4% 9.2% 5.4% 6.3% 2.1% 4.1% 9.2% 11.8% 7.6% 7.7% 9.4% 11.7% 12.5% 10.6% 7.2% 9.3% 11.6% 12.5% 10.4%
Interest & other income (expense) 0.6 (2.7) (0.2) (0.4) (2.7) (1.1) (0.8) (0.1) (0.3) (2.3) (0.0) 0.3 (0.2) 0.2 0.3 (1.2) 0.5 (1.0) 1.8 0.1 6.3 (0.2) (2.9) 2.7 5.9 3.4 (8.4) (9.7) (8.2) (22.9) (29.2) 7.3 (22.6) (28.3) (72.7) (1.3) (19.7) (55.6) (30.4) (107.0) (114.4) (144.9) (136.0) (181.8) (576.9) (182.0) (107.6) (145.4) (181.6) (616.7) (122.9) (202.4) (85.0) (185.0) (595.3) (213.0) (177.0) (254.0) (196.0) (840.0) (121.0) (80.5) (79.3) (78.0) (358.8) (66.8) (65.5) (59.3) (58.0) (249.6) (56.7) (55.2) (53.8) (52.3) (218.0)
Interest income 0.0 0.0 0.1 0.062 0 0.0 0.0 0.1 0.1 0 0.0 0.0 0.1 0.1 0 0.1 0.1 0.0 0.1 0 0.0 0.0 0.1 0.1 0 0.1 0.5 0.3 0.2 1 0.2 0.2 0.3 0.8 2 1.3 2.2 2.9 2.2 9 3.1 4.8 5.5 6.3 20 5.2 5.1 6.9 7.3 25 8.8 10.4 15.0 10.0 44.1 10.0 8.0 6.0 6.0 30.0 10.0 10.0 10.0 10.0 40.0 20.0 20.0 25.0 25.0 90.0 25.0 25.0 25.0 25.0 100.0
Interest expense (1.4) (1.1) (0.0) -0.025 (3) (0.2) (0.5) (0.3) – 0 (1) – 0 – 0 – 0 (0.0) (0) (0.1) (0.1) (0.1) (0.0) (0) (0.1) (1.9) (2.2) (1.9) (6) (3.5) (7.6) (6.9) (7.9) (26) (7.1) (6.2) (7.5) (11.9) (33) (11.7) (14.5) (46.7) (65.1) (138) (99.3) (108.4) (117.1) (146.4) (471) (149.5) (163.6) (175.2) (174.7) (663) (157.5) (172.0) (185.0) (170.0) (684.4) (169.0) (170.0) (163.0) (246.0) (748.0) (175.0) (134.5) (133.3) (132.0) (574.8) (130.8) (129.5) (128.3) (127.0) (515.6) (125.7) (124.2) (122.8) (121.3) (494.0)
Other (expense) income, net 2.0 (1.7) (0.3) (0.4) (0) (0.9) (0.4) 0.1 (0.4) (2) (0.1) 0.3 (0.3) 0.2 0 (1.2) 0.5 (1.0) 1.7 0 6.4 1.7 (0.7) 4.6 12 6.7 (1.2) (3.1) (0.6) 2 (22.3) 13.2 (15.4) (17.1) (42) 9.2 (7.4) (11.8) 32.5 23 (18.1) (41.2) (24.4) (41.7) (125) (37.7) 50.9 22.9 (14.2) 22 25.8 (40.8) 85.0 (25.0) 45.0 (54.0) (15.0) (97.0) 44.0 (122.0) 44.0 44.0 44.0 44.0 176.0 44.0 44.0 44.0 44.0 176.0 44.0 44.0 44.0 44.0 176.0
Profit before income taxes (loss) (16.0) (10.8) (4.5) (23.3) (54.6) (27.1) (32.2) (37.9) (52.0) (149.1) (47.4) (58.4) (64.7) (80.7) (251.2) (90.0) (105.6) (109.5) (89.1) (394.2) 0.7 7.3 (4.7) 19.2 22.5 (19.2) (18.5) (32.3) (57.0) (127.0) (85.2) (101.0) (129.2) (164.4) (479.9) (161.1) (213.2) 30.0 (281.3) (625.5) (371.9) (385.8) (671.4) (779.9) (2,209.0) (779.0) (729.0) 271.3 232.0 (1,004.7) (644.8) (369.8) 176.0 174.0 (664.6) 70.0 150.0 555.0 379.0 1,154.0 59.9 340.3 1,093.5 1,771.0 3,264.7 875.1 1,196.2 1,780.5 2,211.5 6,063.2 977.1 1,406.0 2,068.0 2,493.4 6,944.6
PBT margin (76.4%) (40.2%) (9.9%) (125.3%) (48.8%) (130.1%) (113.2%) (121.4%) (143.3%) (127.7%) (96.6%) (100.4%) (112.1%) (205.0%) (123.0%) (298.2%) (396.4%) (218.5%) (29.1%) (95.4%) 0.1% 1.8% (1.1%) 3.1% 1.1% (3.1%) (2.4%) (3.8%) (6.0%) (4.0%) (9.1%) (10.6%) (13.8%) (13.5%) (11.9%) (14.0%) (16.8%) 1.3% (12.3%) (8.9%) (13.8%) (13.8%) (22.5%) (23.7%) (18.8%) (22.9%) (18.2%) 4.0% 3.2% (4.7%) (14.2%) (5.8%) 2.8% 2.4% (2.7%) 1.2% 2.5% 6.3% 3.5% 3.7% 0.7% 3.3% 8.6% 11.3% 6.9% 7.2% 8.9% 11.3% 12.2% 10.2% 6.8% 9.0% 11.3% 12.3% 10.1%
Provision for income taxes 0.0 0.0 (0.2) 0.2 0 0.1 0.0 0.1 (0.0) 0 0.2 0.1 0.1 0.1 0 0.1 0.1 0.1 (0.1) 0 0.2 0.3 0.8 1.4 3 0.8 1.2 3.7 3.7 9 3.0 3.2 1.8 5.0 13 3.8 3.6 8.1 11.1 27 25.3 15.6 (0.3) (9.1) 32 5.6 13.7 16.6 21.9 58 22.9 19.4 26.0 42.0 110.3 2.0 21.0 186.0 83.0 292.0 10.0 100.0 275.0 300.0 685.0 350.0 350.0 350.0 365.0 1,415.0 350.0 350.0 355.0 385.0 1,440.0
Tax rate (0.1%) (0.1%) 4.8% (1.0%) (0.0%) (0.4%) (0.0%) (0.2%) 0.1% (0.1%) (0.3%) (0.2%) (0.1%) (0.1%) (0.2%) (0.1%) (0.1%) (0.1%) 0.2% (0.0%) 21.4% 4.1% (16.5%) 7.1% 11.5% (4.2%) (6.2%) (11.6%) (6.5%) (7.4%) (3.6%) (3.1%) (1.4%) (3.1%) (2.7%) (2.4%) (1.7%) 27.1% (3.9%) (4.3%) (6.8%) (4.1%) 0.0% 1.2% (1.4%) (0.7%) (1.9%) 6.1% 9.4% (5.8%) (3.5%) (5.3%) 14.8% 24.1% (16.6%) 2.9% 14.0% 33.5% 21.9% 25.3% 16.7% 29.4% 25.1% 16.9% 21.0% 40.0% 29.3% 19.7% 16.5% 23.3% 35.8% 24.9% 17.2% 15.4% 20.7%
Net income (loss) (16.0) (10.8) (4.3) (23.5) (54.6) (27.2) (32.2) (38.0) (51.9) (149.3) (47.5) (58.6) (64.7) (80.8) (251.7) (90.0) (105.8) (109.6) (89.0) (394.4) 0.6 7.0 (5.5) 17.8 19.9 (20.0) (19.7) (36.0) (60.7) (136.4) (88.3) (104.1) (131.0) (169.5) (492.9) (164.9) (216.8) 21.9 (292.4) (652.2) (397.2) (401.4) (671.2) (770.8) (2,240.6) (784.6) (742.7) 254.7 210.1 (1,062.6) (667.6) (389.3) 150.0 132.0 (774.9) 68.0 129.0 369.0 296.0 862.0 49.9 240.3 818.5 1,471.0 2,579.7 525.1 846.2 1,430.5 1,846.5 4,648.2 627.1 1,056.0 1,713.0 2,108.4 5,504.6
Minority interest – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 (98.1) (98) (78.5)
Dossena, Bruno [GIR]: Dossena, Bruno [GIR]: adjusted for losses related to the acquisition of SolarCity (65.0) (70.0) (123.4) (337) (75.1) (25.2) (56.8) 70.6 (86) 34.5 19.1 7.0 27.0 87.6 52.0 25.0 69.0 26.0 172.0 25.0 50.0 50.0 50.0 175.0 60.0 60.0 60.0 60.0 240.0 60.0 60.0 60.0 60.0 240.0
Net income (loss) attributable to common stockholders (16.0) (10.8) (4.3) (23.5) (54.6) (27.2) (32.2) (38.0) (51.9) (149.3) (47.5) (58.6) (64.7) (80.8) (251.7) (90.0) (105.8) (109.6) (89.0) (394.4) 0.6 7.0 (5.5) 17.8 19.9 (20.0) (19.7) (35.984) (60.731) (136.4) (88.3) (104.1) (131.0) (169.5) (492.9) (164.9) (216.8) 21.9 (194.3) (554.1) (318.7) (336.4) (601.2) (647.4) (1,903.7) (709.6) (717.5) 311.5 139.5 (976.1) (702.1) (408.3) 143.0 105.0 (862.5) 16.000 104.0 300.0 270.0 690.0 24.9 190.3 768.5 1,421.0 2,404.7 465.1 786.2 1,370.5 1,786.5 4,408.2 567.1 996.0 1,653.0 2,048.4 5,264.6
Basic reported EPS ($0.12) ($0.28) ($0.12) ($0.67) ($1.56) ($0.74) ($0.84) ($0.08) ($0.11) ($0.59) ($0.10) ($0.12) ($0.12) ($0.15) ($0.50) ($0.17) ($0.20) ($0.21) ($0.16) ($0.73) $0.00 $0.01 ($0.01) $0.03 $0.03 ($0.03) ($0.03) ($0.06) ($0.10) ($0.22) ($0.14) ($0.16) ($0.20) ($0.26) ($3.84) ($0.25) ($0.31) $0.03 ($0.25) ($0.77) ($0.39) ($0.41) ($0.72) ($0.77) ($2.30) ($0.84) ($0.84) $0.36 $0.16 ($1.14) ($0.81) ($0.46) $0.16 $0.12 ($0.97) $0.02 $0.11 $0.32 $0.28 $0.74 $0.03 $0.20 $0.79 $1.45 $2.48 $0.47 $0.79 $1.37 $1.77 $4.42 $0.56 $0.98 $1.61 $1.98 $5.14
Diluted operating EPS (Inc. SBC) ($0.71) ($0.31) ($0.12) ($0.67) ($1.56) ($0.74) ($0.84) ($0.08) ($0.11) ($0.59) ($0.10) ($0.12) ($0.12) ($0.15) ($0.50) ($0.17) ($0.20) ($0.21) ($0.16) ($0.73) $0.00 $0.01 ($0.01) $0.03 $0.03 ($0.03) ($0.03) ($0.05) ($0.10) ($0.19) ($0.14) ($0.16) ($0.20) ($0.26) ($3.84) ($0.25) ($0.31) $0.03 ($0.25) ($0.77) ($0.39) ($0.41) ($0.72) ($0.77) ($2.30) ($0.84) ($0.84) $0.35 $0.16 ($1.12) ($0.81) ($0.46) $0.16 $0.11 ($0.96) $0.02 $0.10 $0.27 $0.24 $0.65 $0.02 $0.17 $0.67 $1.23 $2.10 $0.40 $0.67 $1.16 $1.50 $3.75 $0.47 $0.83 $1.36 $1.68 $4.35
Basic Average Shares Outstanding 129.6 38.2 35.1 35.3 35.1 36.5 38.2 461.4 471.2 253.6 475.9 488.8 520.4 522.0 501.9 524.0 526.2 527.8 568.8 536.7 573.6 591.0 608.4 614.0 597.1 617.4 621.3 624.6 627.5 622.9 629.7 633.4 645.0 655.5 128.2 663.4 699.9 745.0 775.1 721.1 810.6 826.1 836.5 841.6 828.8 845.7 850.0 854.5 860.1 852.6 864.9 883.3 895.0 900.0 885.8 915.0 930.0 937.0 951.0 933.3 958.5 965.5 972.5 979.5 969.0 986.5 993.5 1,000.5 1,007.5 997.0 1,014.5 1,021.5 1,028.5 1,035.5 1,025.0
Diluted Shares 22.5 34.8 35.1 35.3 35.1 36.5 38.2 461.4 471.2 253.6 475.9 488.8 520.4 522.0 501.9 524.0 526.2 527.8 568.8 536.7 621.3 591.0 608.4 688.9 667.7 701.1 704.7 713.7 627.5 711.1 629.7 633.4 645.0 655.5 128.2 663.4 699.9 784.7 775.1 721.1 810.6 826.1 836.5 841.6 828.8 845.7 850.0 891.0 895.1 870.5 864.9 883.3 920.0 935.0 900.8 995.0 1,035.0 1,105.0 1,124.0 1,064.8 1,132.5 1,140.5 1,147.5 1,154.5 1,143.8 1,164.0 1,173.5 1,180.5 1,187.5 1,176.4 1,197.0 1,206.5 1,213.5 1,220.5 1,209.4
Stock based compensation
Stock based compensation 0.1 0.2 0.2 1.0 1.4 3.4 6.1 3.8 7.8 21.2 5.9 6.9 7.9 8.7 29.4 10.7 12.5 12.5 14.4 50.1 14.9 19.3 21.4 28.1 83.7 37.0 35.8 39.2 44.5 156.5 43.0 43.3 56.0 55.6 198.0 89.7 67.3 89.5 87.7 334.2 103.7 116.0 112.7 134.3 466.8 141.6 197.3 204.7 205.3 749.0 208.4 209.9 199.0 281.0 898.2 211.0 347.0 543.0 633.0 1,734.0 625.0 625.0 625.0 635.0 2,510.0 630.0 630.0 635.0 635.0 2,530.0 650.0 650.0 650.0 650.0 2,600.0
Cost of goods sold 0.0 0.0 0.0 0.0 0.1 0.0 0.0 0.1 0.1 0.2 0.2 0.2 0.2 0.2 0.7 0.0 0.1 0.5 1.6 2.2 1.5 1.1 3.0 3.5 9.1 3.1 3.9 5.4 5.1 17.5 4.6 4.8 3.8 6.0 19.2 6.4 6.5 8.9 8.6 30.4 10.0 7.5 10.2 16.2 43.8 15.1 13.2 21.0 22.6 71.8 16.6 16.7 16.6 16.6 66.3 16.7 17.0 30.0 50.0 113.7 50.0 50.0 50.0 50.8 200.8 50.4 50.4 50.8 50.8 202.4 52.0 52.0 52.0 52.0 208.0
Operating expenses 0.1 0.1 0.2 1.0 1.4 3.3 6.1 3.7 7.8 20.9 5.8 6.7 7.7 8.5 28.8 10.7 12.5 12.0 12.8 48.0 13.3 18.2 18.4 24.6 74.6 33.9 31.9 33.8 39.5 139.0 38.4 38.5 52.2 49.6 178.8 83.3 60.8 80.6 79.1 303.8 93.7 108.6 102.5 118.2 422.9 126.6 184.1 183.8 182.7 677.2 191.8 193.2 182.4 264.4 831.9 194.3 330.0 513.0 583.0 1,620.3 575.0 575.0 575.0 584.2 2,309.2 579.6 579.6 584.2 584.2 2,327.6 598.0 598.0 598.0 598.0 2,392.0
YoY Growth 3663.3% 3896.7% 1750.0% 696.2% 1375.3% 75.0% 13.3% 106.9% 10.7% 39.1% 80.7% 81.1% 58.2% 66.0% 70.4% 38.8% 53.5% 71.9% 94.8% 66.8% 149.1% 85.8% 82.6% 58.5% 87.1% 16.2% 21.1% 43.1% 24.9% 26.5% 108.4% 55.3% 59.8% 57.7% 68.8% 15.7% 72.4% 25.8% 53.2% 39.7% 36.6% 70.1% 81.7% 52.8% 60.5% 47.1% 6.3% (2.8%) 36.9% 19.9% 1.3% 65.3% 172.9% 125.3% 93.0% 196.2% 80.1% 15.1% 0.3% 44.8% 0.8% 0.8% 1.6% 0.0% 0.8% 3.2% 3.2% 2.4% 2.4% 2.8%
Impact of SBC $0.00 $0.00 $0.01 $0.03 $0.04 $0.09 $0.16 $0.01 $0.02 $0.08 $0.01 $0.01 $0.02 $0.02 $0.06 $0.02 $0.02 $0.02 $0.03 $0.09 $0.02 $0.03 $0.04 $0.04 $0.13 $0.05 $0.05 $0.05 $0.07 $0.22 $0.07 $0.07 $0.09 $0.08 $1.54 $0.14 $0.10 $0.11 $0.11 $0.46 $0.13 $0.14 $0.13 $0.16 $0.56 $0.17 $0.23 $0.23 $0.23 $0.86 $0.24 $0.24 $0.22 $0.30 $1.00 $0.21 $0.34 $0.49 $0.56 $1.63 $0.55 $0.55 $0.54 $0.55 $2.19 $0.54 $0.54 $0.54 $0.53 $2.15 $0.54 $0.54 $0.54 $0.53 $2.15
Implied opex ex SBC 926.9 1,056.2 923.1 846.6 3,752.9 895.8 899.6 750.9 779.1 3,325.4 756.7 627.7 765.3 921.3 3,071.0 896.0 932.3 949.3 982.0 3,759.6 1,020.7 1,067.6 1,098.2 1,157.6 4,344.0 1,146.3 1,135.2 1,209.2 1,241.2 4,732.0
EBIT ex SBC (455.3) (424.0) 621.5 618.8 361.0 (313.5) 42.4 460.0 640.0 829.0 494.0 674.0 1,352.0 1,208.0 3,728.0 805.9 1,045.8 1,797.7 2,484.1 6,133.5 1,571.8 1,891.7 2,474.8 2,904.5 8,842.8 1,683.8 2,111.3 2,771.8 3,195.7 9,762.5
EBIT margin ex. SBC -13% -11% 9% 9% 2% -7% 1% 7% 9% 3% 8% 11% 15% 11% 12% 9% 10% 14% 16% 12.9% 13% 14% 16% 16% 15% 12% 13% 15% 16% 14%
EBITDA ex SBC (15) (10) (5) (23) (52) (24) (29) (28) (41) (121) (39) (48) (53) (68) (208) (75) (89) (91) (63) (317) 44 13 14 53 125 36 37 40 16 130 (24) (40) (54) (104) (222) (21) (24) 447 369 771 275 293 11 66 644 3 142 1,211 1,038 2,395 154 572 1,084 1,175 2,985 951 1,209 1,776 1,850 5,786 1,600 1,965 2,717 3,503 9,784 2,691 3,036 3,724 4,229 13,679 3,108 3,535 4,296 4,720 15,659
EBITDA margin ex. SBC (69.5%) (35.7%) (10.1%) (123.8%) (46.2%) (113.6%) (103.7%) (88.5%) (112.1%) (104.0%) (80.3%) (81.7%) (91.6%) (172.3%) (101.6%) (248.2%) (332.1%) (180.8%) (20.5%) (76.7%) 7.9% 3.3% 3.3% 8.6% 6.2% 5.8% 4.9% 4.7% 1.7% 4.1% (2.5%) (4.2%) (5.8%) (8.6%) (5.5%) (1.8%) (1.9%) 19.4% 16.2% 11.0% 10.2% 10.5% 0.4% 2.0% 5.5% 0.1% 3.6% 17.7% 14.4% 11.2% 3.4% 9.0% 17.2% 15.9% 12.1% 15.9% 20.0% 20.2% 17.2% 18.3% 18% 19% 21% 22% 20.6% 22% 23% 24% 23% 22.9% 22% 23% 23% 23% 22.8%
Basic operating EPS (ex. SBC) ($0.12) ($0.28) ($0.12) ($0.64) ($1.52) ($0.65) ($0.68) ($0.07) ($0.09) ($0.51) ($0.09) ($0.11) ($0.11) ($0.14) ($0.44) ($0.15) ($0.18) ($0.18) ($0.13) ($0.64) $0.03 $0.04 $0.03 $0.07 $0.17 $0.03 $0.03 $0.01 ($0.03) $0.03 ($0.07) ($0.10) ($0.12) ($0.17) ($2.30) ($0.11) ($0.21) $0.15 ($0.14) ($0.30) ($0.27) ($0.27) ($0.58) ($0.61) ($1.73) ($0.67) ($0.61) $0.60 $0.40 ($0.27) ($0.57) ($0.22) $0.38 $0.43 $0.04 $0.25 $0.48 $0.90 $0.95 $2.60 $0.68 $0.84 $1.43 $2.10 $5.07 $1.11 $1.43 $2.00 $2.40 $6.96 $1.20 $1.61 $2.24 $2.61 $7.67
Diluted operating EPS (ex. SBC) ($3.52) ($0.31) ($0.12) ($0.64) ($1.52)
Dossena, Bruno [GIR]: Dossena, Bruno [GIR]: 5.57 as reported ($0.65) ($0.68) ($0.07) ($0.09) ($0.51) ($0.09) ($0.11) ($0.11) ($0.14) ($0.44) ($0.15) ($0.18) ($0.18) ($0.13)
Dossena, Bruno [GIR]: Dossena, Bruno [GIR]: 0.65 reported ($0.64)
Dossena, Bruno [GIR]: Dossena, Bruno [GIR]: 3.20 reported $0.02 $0.04 $0.03 $0.07 $0.16 $0.02 $0.02 $0.00 ($0.03) $0.03 ($0.07) ($0.10) ($0.12) ($0.17) ($2.30) ($0.11) ($0.21)
Dossena, Bruno [GIR]: Dossena, Bruno [GIR]: 1.06 $0.14 ($0.14) ($0.30)
Dossena, Bruno [GIR]: Dossena, Bruno [GIR]: reported ($2.87) the delta is from non-cash interest expense and lease accounting adjustments which were included in quarterly adjustements but not in annual ($0.27) ($0.27) ($0.58) ($0.61)
Dossena, Bruno [GIR]: Dossena, Bruno [GIR]: 3.04 reported ($1.73)
Dossena, Bruno [GIR]: Dossena, Bruno [GIR]: 8.66 reported ($0.67)
Dossena, Bruno [GIR]: Dossena, Bruno [GIR]: reported 3.35 ($0.61) $0.58 $0.39 ($0.26) ($0.57) ($0.22) $0.37 $0.41 $0.04 $0.23 $0.44 $0.76 $0.80 $2.28 $0.57 $0.71 $1.21 $1.78 $4.30 $0.94 $1.21 $1.70 $2.04 $5.90 $1.02 $1.36 $1.90 $2.21 $6.50
Net income (loss; ex.SBC) (15.9) (10.7) (4.1) (22.5) (53.2) (23.8) (26.1) (34.20) (44.10) (128.2) (41.6) (51.6) (56.9) (72.2) (222.2) (79.3) (93.2) (97.1) (74.6) (344.2)
Dossena, Bruno [GIR]: Dossena, Bruno [GIR]: 15.424 26.3 15.9 45.9 103.6 17.0 16.13 3.17 (16.21) 20.1 (45.2) (60.8) (75.0) (113.9) (294.9) (75.3) (149.5) 111.4 (106.5) (219.9) (215.0) (220.4) (488.5) (513.1) (1,436.9) (567.9) (520.2) 516.2 344.8 (227.1) (494) (198) 342.0 386.0 35.8 227 451 843.0 903.0 2,424.0 649.9 815.3 1,393.5 2,056.0 4,914.7 1,095.1 1,416.2 2,005.5 2,421.5 6,938.2 1,217.1 1,646.0 2,303.0 2,698.4 7,864.6
GAAP to Non-GAAP reconciliation
GAAP net income (16.016) (10.867) (4.615) (24.242) (55.740) (29.519) (38.517) (34.935) (51.358) (154.329) (48.941) (58.903) (65.078) (81.488) (254.410) (89.873) (105.603) (110.804) (89.932) (396.212)
Dossena, Bruno [GIR]: Dossena, Bruno [GIR]: reported 396.213, delta due to rounding 11.248 (30.502) (38.496) (16.264) (74.014) (49.800) (61.902) (74.708) (107.629) (294.039) (154.181) (184.227) (229.858) (320.397) (888.663) (282.267) (293.188) 21.878 (121.337) (674.914) (330.277) (336.397) (619.376) (675.350) (1,961.4) (709.551) (717.539) 311.516 139.483 (976.1) (702.135) (408.334) 143.000 105.000 (862.5) 16.000 104.000 300.000 270.000 690.0 24.860 190.322 768.450 1,421.042 2,404.7 465.051 786.188 1,370.494 1,786.512 4,408.2 567.072 996.028 1,653.012 2,048.439 5,264.6
Losses (Gains) related to the acquisition of Solarcity – 0 – 0 – 0 – 0 – 0 – 0 – 0 (88.727) (88.727) 11.571 – 0 18.225 27.950 57.7 – 0 – 0 – 0 – 0 – 0 – 0
Non-cash interest expense – 0 – 0 – 0 – 0 18.177 4.260 4.299 26.736 8.393 23.639 22.160 20.826 75.018 19.510 18.171 21.850 26.716 86.247 28.902 31.823 60.725 – 0 – 0 – 0 – 0 – 0 – 0 – 0
Lease accounting adjustments – 0 – 0 – 0 – 0 19.349 28.732 29.796 77.877 21.384 18.607 16.564 26.072 82.627 46.396 61.907 77.022 124.190 309.515 88.458 44.538 132.996 – 0 – 0 – 0 – 0 – 0 – 0 – 0
Acquisition related expenses – 0 – 0 – 0 – 0 – 0 – 0 – 0 15.807 15.807 – 0 – 0 – 0 – 0 – 0 – 0 – 0
Other 0.048 0.025 0.306 0.724 1.103 2.332 6.349 (3.071) (0.587) 5.023 1.421 0.340 0.340 0.649 2.750 (0.155) (0.154) 1.205 0.958 1.854 (10.692) (10.692)
Non-GAAP net income (inc. SBC) (15.968) (10.842) (4.309) (23.518) (54.637) (27.187) (32.168) (38.006) (51.945) (149.306) (47.520) (58.563) (64.738) (80.839) (251.660) (90.028) (105.757) (109.599) (88.974) (394.358) 0.556 7.024 (5.504) 17.831 19.907 (20.023) (19.656) (35.984) (60.731) (136.394) (88.275) (104.149) (130.986) (169.491) (492.901) (164.907) (216.827) 21.878 (194.257) (554.113) (318.706) (336.397) (601.151) (647.400) (1,903.7) (709.551) (717.539) 311.516 139.483 (976.1) (702.135) (408.334) 143.000 105.000 (862.5) 16.000 104.000 300.000 270.000 690.0 24.860 190.322 768.450 1,421.042 2,404.7 465.051 786.188 1,370.494 1,786.512 4,408.2 567.072 996.028 1,653.012 2,048.439 5,264.6
Check – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0
Gross margin analysis
Cost of revenue (inc. SBC)
Automotive 22.9 24.8 37.8 16.8 102.4 16.9 20.3 19.5 23.4 80.0 27.0 30.5 32.8 25.2 115.5 13.9 20.2 58.9 278.7 371.7 461.8 303.6 324.9 453.6 1,543.9 462.5 554.1 598.5 695.0 2,310.0 631.7 666.4 628.7 896.4 2,823.3 779.3 909.3 1,517.1 1,544.4 4,750.1 1,662.7 1,648.0 1,930.8 2,191.2 7,432.7 2,195.9 2,666.7 4,525.2 4,786.2 14,174.0 2,973.3 4,360.1 4,131.0 4,934.0 16,398.4 3,821.0 3,862.0 5,506.0 7,070.0 20,259.0 5,693.6 6,788.2 8,219.1 10,208.9 30,909.8 7,750.5 8,363.8 9,804.5 11,450.1 37,369.0 8,897.7 9,587.4 11,147.8 12,311.2 41,944.1
Energy generation and storage – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 – 0 127.8 127.8 151.8 203.8 237.3 281.7 874.5 375.4 330.3 330.6 328.7 1,364.9 316.9 325.5 314.0 385.0 1,341.4 282.0 349.0 558.0 787.0 1,976.0 489.4 626.3 753.3 815.8 2,684.8 566.6 706.9 806.2 920.5 3,000.1 667.3 806.3 917.3 1,046.3 3,437.1
Serivce and other – 0 – 0 – 0 – 0 – 0 0.1 1.9 2.5 1.6 6.0 4.0 9.1 7.7 6.3 27.2 6.0 1.7 – 0 3.8 11.5 3.7 1.1 3.6 5.1 13.4 2.9 2.3 1.5
Dossena, Bruno [GIR]: Dossena, Bruno [GIR]: Development services revenue prior to 4Q14 – 0 6.7 48.1 75.2 76.6 99.4 299.2 115.3 86.0 144.6 177.2 523.0 213.9 271.2 367.4 376.6 1,229.0 381.0 386.4 445.0 668.0 1,880.4 685.5 743.0 667.0 674.0 2,769.6 648.0 558.0 644.0 821.0 2,671.0 911.0 1,014.5 1,101.2 1,264.7 4,291.4 1,366.5 1,486.2 1,631.5 1,831.8 6,316.0 1,978.3 2,134.5 2,327.2 2,562.1 9,002.2
Gross profit lease accounting adjustment
17 Business Valuations
A valuation analyst should be able to explain and defend his or her valuation, including both the valuation analysis and conclusion. Further, this explanation and defense may often be performed within a contrarian’s environment.
-G. S. Gaffen 1
OBJECTIVES
After completing Chapter 17, you should be able to:
1. Understand the importance of business valuation. 2. Determine the many reasons for business valuations. 3. Appreciate why business valuations can be contentious. 4. Understand the basic principles and methods used by business valuation specialists. 5. Comprehend the complexity and rigor involved in business valuations.
17-2 FORENSIC AND INVESTIGATIVE ACCOUNTING
OVERVIEW
Forensic practitioners are asked to perform a variety of economic and accounting measurements for many important purposes that relate to legal rights. One of the most complex and pervasive measure- ments made is the business valuation. Business valuations require professionals who are knowledgeable and skilled in finance, law, and accounting. Valuations can be so complex that most professionals who perform them are specialists. Nevertheless, a forensic accountant who is not a business valuation special- ist may be asked to review specific issues involved in a valuation. Thus, all forensic accountants need to understand the basic principles involved.
Business valuation is an increasingly specialized field with a variety of guidelines, case law, and techniques affecting valuations for different purposes, and continually advancing the state of the art. However, with adequate training and experience (ideally with a mentor), the field of business valuation is a rewarding area for practitioners from a variety of backgrounds including accounting, finance, and economics. The quality of a business valuation and its report findings is directly related to the skill, training, and experi- ence of the professional.
Entire university and professional seminar courses are devoted to the issues of business valuations and even those courses do not fully cover the complexities of the topic. This chapter provides an overview of the most significant business valuation concepts and reviews common methods of valuing businesses. Much of this chapter is derived from the CCH service entitled Business Valuation Guide, 2015, by George Hawkins and Michael Paschall. Specifically, the Fundamentals, The Three Valuation Approaches, Gather- ing Initial Information, Financial Analysis, Business Valuation Standards, and Business Valuation Reports sections appear in part in the CCH Business Valuation Guide. The author of this chapter is indebted to Hawkins and Paschall for its use.
This chapter concentrates on business valuations of specific closely held businesses that are performed for specifically stated needs at a single point in time. Most publicly traded companies, on the other hand, have market-determined values at any given date in time.
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Fundamentals VALUATION AND APPRAISER ACCREDITATIONS2
Organizations Certifying Valuation Professionals
17-3
Rapidly growing demand for qualified business valuators has led to the development of a number of na- tional certifications. Each certification was developed by the associated national accrediting organization, which provides its own education and testing programs. Business appraisers have traditionally come from either a finance or accounting background. Some organizations cater more to individuals with one or the other background. Some of the most visible designations offered by organizations are as follows:
■ Accredited Senior Appraiser (ASA) and Accredited Member (AM) awarded by the American Society of Appraisers (ASA).
■ Certified Valuation Analyst (CVA), Master Analysis in Financial Forensics (MAFF), and Accredited in Business Appraisal Review (ABAR) awarded by the National Association of Certified Valuators and Analysts (NACVA).
■ Accredited in Business Valuation (ABV) awarded by the American Institute of Certified Public Accountants (AICPA).
All of the organizations provide excellent training for prospective business appraisers, and their certifica- tions strive to enhance valuation professionalism. Some of these organizations offer additional accredita- tions with less stringent requirements for those professionals wanting to limit their business valuation engagements to pursue litigation support engagements that relate to business valuation. Each group offers an array of introductory and advanced valuation courses, along with continuing education programs, seminars, and conferences. All of the groups also work closely together in various ways to develop valua- tion standards and terminology.
Financial Analyst Accreditation Another accreditation and organization is the Chartered Financial Analyst (CFA) awarded by the CFA Institute. Although not specifically a business valuation certification, the CFA covers valuation in depth, both of public and private companies, along with a broad-based, inclusive study of other investment subjects. Some believe the CFA is among the most prestigious of all certifications in the field of corporate finance and on Wall Street.
Certified in Entity and Intangible Valuations A relatively new certification, Certified in Entity and Intangible Valuations (CEIV), has recently been developed to help bring some certainty to the fair value measurement process for financial statement ac- counting worldwide. “To address regulator concerns and protect the public interest on a global scale, the American Society of Appraisers (ASA), the American Institute of Certified Public Accountants (AI CPA) and the Royal Institution of Chartered Surveyors (RICS) have championed the co-development of (the) credential to demonstrate member competency and enhance their professional standing.” 3 Accountants involved in “estimating the fair values of businesses and/or business interests for goodwill impairment testing and stock compensation purposes, and intangible assets for purchase price allocation and impair- ment testing purposes” may find this certification helpful with implementing the requirements of FASB ASC 820. 4 This credential is offered to members of the ASA, AICPA, and RICS organizations, and the website is: https:l/ceiv-credential. org.
ENGAGEMENT AGREEMENTS THAT CREATE SUCCESSFUL CLIENT RELATIONSHIPS5
An engagement agreement is needed in any valuation or client-related undertaking. An engagement agreement should:
■ Clearly set forth the expectations of the business valuator and client ■ Reduce the chance for misunderstanding and, therefore, the risk of malpractice litigation and claims
against the business valuator ■ Increase the likelihood of the valuator being paid, since it establishes a clear obligation on behalf of
the client
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FORENSIC AND INVESTIGATIVE ACCOUNTING
A standardized engagement agreement should be drafted and reviewed by an attorney to meet the needs of the valuation practice. Although attorneys draft many types of contracts, they may not be familiar wi th issues chat are unique to business valuation.
The following items should be considered in drafting an engagement agreement:
■ Identify the client ■ Specify the interest, dace, purpose, and intended use of the valuation ■ Define the standard of value ■ Assign responsibility for fees and coses ■ Price the engagement ■ Specify responsibility for real estate and ocher appraisal costs ■ Obtain a retainer ■ Protect against the use and misuse of forecasts by clients ■ Include indemnification language ■ Include other terms and conditions
PURPOSES FOR OBTAINING BUSINESS VALUATIONS Valuations are needed for various purposes:
■ Tax purposes (estate tax, gift tax, charitable contributions, casualty loss, sale of securities, state tax, ad valorem tax)
■ Divorce distributions (often referred to as marital distributions) ■ Liquidations (partnerships, sole proprietorships, and corporations) ■ Employee stock ownership plans (ESOPs) ■ Lost business value ■ Mergers, reorganizations, and acquisitions ■ Minority shareholder distributions ■ Buy-sell agreements ■ Bankruptcies ■ Recapitalizations ■ Management buyouts ■ Allocations of purchase price (financial reporting and tax) ■ Incentive/Restricted stock options ■ Insurance disputes ■ Fairness opinions ■ Damages disputes
In business valuations, a practitioner is asked to provide a valuation for a business or some other eco- nomic unit. The vast majority of all businesses in the United Scates are privately held companies in which ownership (stock, partnership, LLC, LLP, or proprietorship interests) is held by a small number of people. These types of ownership rights are not typically traded on any market such as che New York Stock Exchange (NYSE), the NASDAQ, or the NYSE MKT, LLC (formally known as the American Stock Exchange) .
Conflicts Giving Rise to Business Valuations
Many situations involving business valuations of partnerships are resolved quite amicably with departing and remaining partners agreeing on the amount that is paid for the departing partner’s interest. Sometimes, the partnership’s value or methodology for determining the value is spelled out in advance in the partnership agree- ment. Many other times, however, there are differences of opinion about the amount chat should be paid for the business interest chat is being sold. Such disputes are often litigated in a legal forum in “forensic” fashion.
Additionally, many business sales or dissolutions are fraught with conflict from che start. Family business dissolutions chat result from divorce are ofren contentious. Typically, divorces involve significant conflict already, and when the issue of valuing large commonly owned assets such as a business is involved, there are major disagreements.
m ,J 17,031
BUSINESS VALUATIONS 17-5
Even in the best of situations, however, generally the seller of the business interest wants to receive payments based on a high value, while the buyer wants to pay as less as possible for purchasing chat busi- ness ownership interest. To resolve such differences, business valuators are asked to provide an impartial valuation chat is developed in a professional and systematic manner.
Often business valuations are presented in court where they may be attacked or defended. For example, the business appraiser who performs the valuation for the seller is one expert, but the buyer may introduce another expert to give testimony on the possible flaws in the valuation report of the seller’s business ap- praiser. Some experts may be brought in to look at only specific pares of the appraisal, and some expercs may be asked to look at the entire appraisal. Thus, in some situations, expert appraisal witnesses may need extensive and broad understanding of the process and issues; in other disputes, the expert may need specialized knowledge on a narrow portion of the appraisal or specific issues regarding it.
General Types of Valuations In general, there are three types of valuations:
■ Asset-based. This type of valuation is used to value asset-intensive businesses such as retail and manu- facturing. The focus is on what the inventory, equipment, and real estate are worth .
■ Income approach. This type of valuation is useful for service companies. The focus is on how much profit or cash a buyer can earn from the business.
■ Market approach. This type of valuation looks at what the market is paying for similar businesses and is used to value many different types of businesses. The focus is on the marketplace: what others have paid for similar type of companies.
Alt hough most bus iness va lua ti ons are performed for close ly held co mpa ni es, publicly t raded co mpanies wit h establis hed market va lu e may have issues t hat require add iti onal analysis. For exam ple, t he ma rket price at a parti cular dat e may have bee n det ermin ed usi ng fina ncial info rm ation t hat was distorted, fra udu le nt, or now out of date. Additiona lly, investors look for firms t hat they believe are underva lu ed by the market for investment op- portuni ties, and some bus iness ap praisals may be do ne in invest ment research situations.
STANDARDS OF VALUE 6
The standard of value used in a business valuation is crucial because it determines the guidelines under which the valuation is performed. The use of different standards may result in vastly different values for the same company; therefore, the forensic accountant must know the standards under which he or she should proceed. In many valuation situations, statutory or case law dictates the standard of value.
The fo llowing six standards of value and their common uses are explained below in more detail:
■ Fair market value (often used for gift/estate taxes, purchase or sale, buy-sell agreements, and divorce valuations).
■ Fair value-100 percent controlling interest value (commonly used in dissenting minority shareholder valuations).
■ Fair value-minority interest and marketable value (often used in dissenting minority shareholder valuations).
■ Fair value-minority interest and nonmarkecable value (commonly used in dissenting minority share- holder valuations) .
■ Investment value (sometimes used in the purchase of businesses in examining the value to a specific buyer).
■ Intrinsic value (often used in equitable distribution valuations).
Fair Market Value The Internal Revenue Service (IRS) defines fair market value (FMV) as the amount at which property would change hands berween a willing seller and a willing buyer when neither is acting under compulsion and when both have knowledge of the relevant facts. FMV is usually the governing standard for gift and estate tax valuations, asset purchase or sale, divorce, and ocher situations calling for a valuation.
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Fair Value The fair value concept is used most often in conjunction with dissenting minority shareholder situations. Fair value is generally a judicially determined concept of value that can vary widely in interpretation in various states. “Fair value” can be interpreted in at least three different ways:
■ Minority shareholder’s pro-rata share of the 100-percent controlling interest value. This concept of fair value is perceived as favoring the minority shareholder because it affords the maximum protection to the dissenting minority shareholder and does the most harm to the remaining shareholders in the business (as well as to the business itself).
■ Fair market value of the minority shareholder’s specific shares, discounted for minority interest status only, without discounts for lack of marketability. This approach is a compromise view that attempts to give some value to the shares of the dissenting minority shareholder without unfairly penalizing the busi- ness and its remaining shareholders.
■ Fair market value of the minority shareholder’s specific shares ordinarily discounted for minority interest status and lack of marketability. This view of fair value tends to favor the company at the expense of the minority shareholder, because it does not give the minority shareholder anything more than he or she already has.
Investment Value Investment value is the value to a specific buyer of a business. Investment value incorporates all of the
synergies and other factors that arise from a particular purchase of a business. The extra value may be because a business is far more attractive to a particular buyer due to various advantages that the purchase of that business brings to the buyer. Examples include a beverage distributor trying to purchase a fellow distributor to fill in its geographic territory or a manufacturer/wholesaler trying to purchase a retailer to form a more integrated company.
To accurately estimate investment value, a forensic accountant must analyze and predict what the par- ticular benefits of ownership will be to the potential purchaser. Often, investment value may be above fair market value, and “backward-looking” valuation techniques, such as capitalization of income method, m ay be oflitde use in arriving at an accurate value. “Forward-looking” valuation techniques, such as a discounted future income method, are more likely to be better. The advantage of a forward-looking valuation model is its ability to capture the anticipated competitive advantages and synergies expected by a potential buyer.
Intrinsic Value Intrinsic value is the value to a particular individual. Intrinsic value often arises in a divorce situation where the sale of a business may not be possible, however, the court still finds that the business has value to its owner or owners. Although this approach may be an appealing concept, in reality, the ability to support a logical conclusion of value under the intrinsic value standard can be quite difficult.
Size of Ownership Interest Affects Final Value The percentage of ownership interest being valued is of crucial importance to an interest’s ultimate value. The key issue is the amount of control:
■ How much power and influence does the ownership interest have by virtue of its size and its relation- ship to the overall distribution of ownership?
■ Can the ownership interest force the sale or liquidation of all or a part of the company’s assets? ■ Can the ownership interest declare and pay dividends?
With control, ownership interest is able to potentially receive some value (e.g., immediate cash divi- dends) from the interest. If the ownership interest does not have such power (e.g., to declare dividends), the owner has fewer and more difficult avenues to realize immediate value for the interest.
Shareholder value can occur along various levels of value, ranging from 100-percent control to minor- ity interest status.
A middle level is called “minority marketable” because the price-earnings multiples or capitalization rates applied to a private company’s earnings are derived from the returns on public company stocks. Public company stocks are fully marketable and represent small minority interests (e.g., one share of Exxon). ·
BUSINESS VALUATIONS 17-7
Business Enterprise or 100-Percent Controlling Interest Value The owner of a 100-percent controlling interest has unilateral control of all the decisions affecting the company, including the sale and liquidation of the company as well as the declaration and payment of dividends.
A 100-percent controlling interest value often includes a premium for control. Some data suggests that this premium may be about 30 percent to 40 percent above the value afforded to freely traded minority interests. One excellent source of control premium data is FactSet MERGERSTAT® Review. Control premium data is developed by comparing the market price per share before any takeover of- fer has been made (a minority value) to the price later paid in the takeover (a 100-percent controlling interest value). Any increase in price represents the premium for control.
In 2016, Microsoft purchased Linked In for $26.2 billion, representing a 50% premium over Linked In’s stock price
just a day before the proposed acquisition was announced. Note: Discounts and premiums are discussed later. A
minority discount is the opposite of a control premium.
Control, But Less Than 100-Percent Interest In some situations, an ownership interest ofless than 100 percent may still be able to exercise a significant amount of control over a business, therefore warranting a control premium adjustment to the ownership interest.
51- Percent Own ership Interest
A 51-percent ownership block in a company where the corporate bylaws and relevant state law call only for a majority vote for all corporate action has the same force and impact on control as a 100-percent owner. Because of the power and influence held by the 51-percent owner under this scenario, an added premium value for control may be appropriate. However, a 51-percent interest is not as valuable as the 100-percent interest on a pro-rata basis. Whereas the 100-percent owner has unfettered control over the company and can do as he or she wishes, a 51-percent owner still must deal with the rights and concerns of minority shareholders. This factor may limit the 51-percent owner from specific actions that a 100-per- cent owner could do.
SO-Percent to 100- Percent Ownership Int erest
There are situations where ownership of interests between 50 percent and 100 percent does not carry all the benefits of full, 100-percent control of the business. For example, a greater-than-50-percent inter- est may not always give an owner full control of the business if bylaw provisions or state laws require a greater-than-majority vote for various corporate actions. Although a 51-percent-and-above interest is often called a “controlling interest,” this may not actually be the case if, for example, the corporate bylaws call for a two-thirds majority to effect various corporate actions. In this instance, the 51-percent block may be effectively powerless if owners of at least 34 percent of the other shares oppose the action desired by the 51-percent holder.
Minority Interest: Technically Less Than 50 Percent The value of a minority holder’s interest might be worth less (and possibly substantially less) than a pro-rata share of the total 100-percent value. The major factor influencing the value of a minority interest is the amount of control that the minority interest can exert over the corporation. Minority interests limited in their power to influence corporate action are worth less than the pro-rat~ sh~re ~f the total 100-perc~nt value because they generally cannot force the corporation to allow the mmonty mterest holder to rea!1ze any value from his or her interest (generally through payment of dividends or salaries; the implementation of business strategy and plans; or the merger, sale, or liquidation of the company).
The influence of a minority interest may be limited by a combination of statute, case law, and the gov- erning corporate documents. A minority interest does not necessarily have to be as small as one percent or less to lack the ability to influence corporate action.
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If the corporate bylaws call for a supermajority voting approval of 80 percent for various corporate actions, a 79-percent interest is essentially a minority interest, because its holder cannot by himself or herself affect corpo- rate action.
“Swing Vote” Interests
There may be times when a miniscule minority interest is worth more than a pro-rata share of the total 100-percent value. A small minority share may be the “swing vote” in a business.
Example 17.1 There are two 49-percent ownership interests and one 2-percent ownership interest. Assuming that the relative statutes and corporate bylaws call for a simple majority for approval of various corporate action, the 2-percent interest becomes much more valuable because without its vote, the 49-percent interests are powerless to direct the corporation. The 2-percent interest, thus, becomes extremely valuable to the 49-percent interest holders who would be willing to pay a premium (i.e., a value greater than its pro-rata share of the total 100-per- cent value) to acquire the 2-percent interest.
Analyzing the Distribution of Ownership
In determining the proper discount (if any) for a minority interest, one must analyze the distribution of ownership. There may be other situations in which the dynamics of share ownership call for a smaller or larger discount for minority interest than would be considered “normal.”
Example 17.2 One shareholder of Public Corporation A owns a 30-percent interest, with all other shareholders owning less-than-1-percent interests. If the other minority shareholders cannot consolidate their stock for a vote, conceivably, this factor justifies a lower minority interest discount for the 30-percent block. In this scenario, even an ownership level far higher than any other individual shareholder may not be as valuable if other needed votes cannot be counted upon to gain the required percentage for a corporate vote (e.g., 51%).
Buy-Sell Agreements May Impact Value
Another situation influencing the value of a minority interest to become equal to or greater than its pro-rata share of the total 100-percent value occurs when a buy-sell agreement governs the disposition of a depart- ing or deceased shareholder’s interest. In this situation, a “formula” calculation of value may be mandated by the agreement that yields a value equal to or greater than the pro-rata share of the total 100-percent value. Alternatively, the buy-sell agreement may specifically require the departing minority shareholder to be paid his or her pro-raca share of the total 100-percent value of the company.
Other Discounts and Premiums Applied to Business Valuations The information above provides a number of reasons why premiums might be added to a valuation, or discounts might be deducted from a valuation in response to some characteristic of the business level of ownership (e.g., controlling interest or a minority interest). However, there are many other business characteristics or personnel characteristics having an impact on the application of premiums or discounts in arriving at a business valuation. Some of those issues include the general lack of marketability for non- trading stocks, loss of key or critical personnel, the company’s lack of diversification, restrictive agreements of the company, exposure from pending litigation, potential environmental liability, the cost ofliquidation, and the risk associated with being a small company, or a non-crucial supplier. The preceding examples are only a few issues that may cause a business valuation expert to adjust a value upward or downward to compensate for some characteristic chat has not already been included in the calculations. Of course, the adjustments rest heavily on the valuation expert’s knowledge of the facts and an understanding of the relevant issues in assigning appropriate premiums or discounts under the circumstances. Some experts believe that “discounts and premiums” are the result or “fallout” of using data in the valuation analyses that are “less-chan-perfecc.”7
Although the concept of premiums and discounts are intuitively logical in many valuation situations, one must be cognizant that some valuation factors can be addressed in more than one way. For example, some valuation professionals adjust for known or expected business risks by applying a discount to their
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BUSINESS VALUATIONS 17-9
base valuation, while other valuation professionals may factor known or expected risks into the discount rate used in the business valuation. One challenge facing a valuation professional is to not incorporate risk measure into both components of the valuation process , thereby double counting the risk impact.
The AI CPA, in Statement on Standards of Valuation Services No. 1, suggests chat any adjustments (discounts or premiums) should be made to the pre-adjustment value. According to the guide, examples of valuation adjustments for businesses, business ownership interest, or security include a discount for lack of marketability or liquidity and a discount for lack of control. A valuation adjustment for an intangible asset is needed when the asset is obsolete. 8
Given the large number of possible reasons for applying premiums and/or discounts to the base valua- tion of an organization, valuation professionals must carefully weigh the issues giving rise to the valuation adjustments , and they must fully understand the purpose of each valuation that is performed.
Flow-Through Business Valuations Flow-through or pass-through business structures can raise a variety of interesting and challenging valua- tion issues. Some people argue that flow-through businesses, such as Subchapter “S” corporations, have a greater value than an identical corporation that is organized as a traditional “C” corporation. The primary reason for this difference is that C corporation earnings are taxed at applicable corporate tax rates, and then when a C corporation’s after-tax earnings are distributed to its stockholders as dividends, stockholders pay taxes on the dividends (distributed earnings). C corporation earnings, then, are taxed twice, and S corpora- tion earnings are taxed only once. Using this logic, one can argue that two corporations that are identical, except that one is a C corporation and the other is an S corporation, would cause the S corporation to be valued higher than the C corporation because of the tax effect. The IRS and Tax Court suggest chat the valuation of flow-through entities should include a premium over traditional C corporation entities.
As per Tax Court decisions and the IRS ,9 no deduction should be made for the income tax of a pass- through entity because the taxes are passed through to the owners. Thus, using the no tax deduction approach, there can be a significant premium for flow-through entities (e.g., S corporations and LLCs). In addition, there is no definitive opinion as to whether a flow-through entity should be valued before or after taxes. 10
A simple example to demonstrate the difference between a valuation of a C corporation and a pass- through entity follows:
Before tax income
Corporate income tax
After tax income
Capitalization rate
Value
Premium
C Corporation
$10,000
3 000
$7,000
.;.15%
$46,667
Pass-through Entity
$10,000
~ $10,000
.;.15%
$66,667
43% [1 – ($66,667.;. $46,667)]
Other valuation professionals believe that the flow-through premium should be lower than suggested by the IRS or perhaps not exist at all. Therefore, to correctly value flow-through entities, valuation profes- sionals must address this challenge and decide what (if any) adjustment should be made for S versus C corporation entities that are otherwise identical business organizations.
A CLOSER LOOK AT VALUATION DISCOUNTS Two issues identified earlier in the chapter that, if present, may trigger the discounting of an ownership interest during valuation are: (1) minority interest, and (2) lack of marketability. These are two of the most common reasons why discounts are used in valuing a specific interest, with any discount for a minority interest being applied before a discount for lack of marketability. 11 While not as common as the previous two discounts mentioned, there is another possible discount that should be considered (if the situation exists): loss of a “key person” discount.
Minority Interest Discount A minority interest discount is, essentially, a discount for lack of control. The minority interest holder may be subject to the whims of the controlling interest holder and might possibly have very little input
17-10 FORENSIC AND IN V ESTIGATI VE ACCOUNTING
into the decision-making process within the business. Of course, this lack of power depends on how the bylaws of the business are structured, but, in general, discounts are commonly applied to minority inter- ests because of the lack of control while, alternatively, controlling interests demand a premium. Reven ue Ruling 59-60 states:
“The size of the block of stock itself is a relevant factor to be considered. Although it is true that a minority interest in an unlisted corporation’s stock is more difficult to sell than a similar block of listed stock, it is equally true that control of a corporation, either actual or in effect, representing as it does an added element of value, may justify a higher value for a specific block of stock.” 12
To determine the percentage amount of the minority interest discount for a particular valuation, the financial expert must analyze the relevant dynamics present within the company, and then decide which ~iscount valuation method(s) to use. There are, in general, three methodologies for valuing minority mterests: 13
1. 2. 3.
Horizontal-Computed by comparison with other minority interest transactions. Top Down-Control value less applicable discounts. Bottom Up-Start with minority value and add premiums for control interest valuations.
[Most practitioners prefer the horizontal and/or top down approach; however, all approaches are viable.] The actual amount of the minority interest discount depends on the relevant factors identified in
the method used, and on those factors’ influence, positive or negative, on the interest’s value . For example, the actual economic voting power of the shares of stock must be assessed if present. But sometimes voting power does not exist because the stock shares at issue may be non-voting, which is common in _family business transfers. Minority ownership of stock without any voting power would tend to be discounted more than minority ownership with certain important voting rights (such as for board members, or on major business decisions). 14 The assessment as to whether a minority discount should be applied is considered not only for C corporations, but also for other types of business entities including S corporations. 15
The spec_ific discount ~erc~nt~ge is, of ~ourse, determined on a case-by-case basis. One study, covering a ~3-year penod, found mmonty mterest discounts ranged from 21.5 percent to 30.8 percent. 16 This range 1s not a set range for all valuators, however, because other studies may be found with different discount range amounts. In fact, it is possible that for a particular business, no minority discount might be foun d because of the “swing vote” possibility given the existing levels of other ownership interests; this situation could even cause a premium to be present.
Lack of Marketability Discount
The AI CPA defines marketability as “the ability to quickly convert property into cash at minimal cost.” 17 The person must be free to sell an interest in a company and then be able to find a ready buyer who wants to own that particular interest to affect marketability. For an owner of a small percentage interest in a publicly traded company, these issues are usually not of concern because numerous shares are traded daily, and a ready market (buyers) as well as market value (daily stock price) are immediately at hand. For owners of a privately held company, however, the ability to sell as well as find a willing buyer becomes a greater issue.
For closely held businesses, a variety of factors can influence the amount, if any, of a lack of market- ability discount that could be used to value an ownership interest. Such factors can include the followi ng as indicated by the Tax Court: 18
■ Private vs. public sales of stock-Sales of public company stocks in the same industry can be used as a starting point to determine the amount of discount for the private company stock.
■ Financial statement analysis-Stronger financial results and solid ratios would tend to call for a lower discount.
■ Company dividend policy-Some investors might be seeking a dividend stream for a potential invest- ment, while other investors might be only interested in long-term growth in per share value.
■ Nature of the company, its history, its position in the industry, and its economic outlook-Positive aspects of these factors would call for a smaller discount.
■ The company’s management-A strong management team would be reason for a lower discount, and a weak team running the company would call for a higher discount.
BUSINE SS VALUATION S 17-11
■ Amount of control in the shares being valued-If the shares of stock do not have much control pos- sibilities for the potential buyer, a higher discount is needed.
■ Restrictions on the transferability of the stock-If stock in a private company can only be sold to ex- isting shareholders or back to the company itself, then the potential buyer pool is small making the stock less attractive.
■ Holding period of the stock-Stock that must be held for a specific period of time before being sold or traded, would be less appealing to a potential investor.
■ The Company’s stock redemption policy-If a company has a policy that it will redeem stock only for certain purposes and/or only for a specific price (below fair value) , the stock of course would not be as attractive to an investor and a higher discount factor might be used.
These factors are among many that can be used to evaluate the need for a lack of marketability discount. 19
As shown above, factors relevant to the particular business interest being valued should be identified and assessed as to their impact and degree of influence on a discount amount; some factors may have significant impact, others very little impact, and still others no impact. Also, a lack of marketability discount can be applied to not only a minority interest, but just as easily to a majority/controlling interest. Even with a majority interest being valued, some factors may still be present that will negatively impact the value to a potential investor. These may include the lack of a buyer (because of restrictions related to future stock transfer opportunities) or a company with weak financial statements in an industry experiencing downward trends.
There is no set percentage that is used for a lack of marketability discount; the specific amount, if any, is to be determined by the financial expert after assessing the impact relevant factors have on the value. In the Tax Court case which produced the factors listed above, one valuation expert determined the discount to be 30 percent, while the opposing expert determined a 70 to 75 percent discount. 20 [The Tax Court ruled a 30 percent discount was appropriate in that case.]
Loss of a Key Person Discount The Internal Revenue Service defines a “key person” as “an individual whose contribution to a business is so significant that there is certainty that future earning levels will be adversely affected by the loss of that individual.” 21 Business valuations typically face the possibility of this discount in a scenario where the owner of the interest being sold is a key person who will no longer continue working for the company, or for estate valuation purposes where the decedent was a key person owning an interest that became part of the estate. The valuator must establish that the person in question was indeed a key person whose absence will affect future company earnings, rather than solely being a highly paid employee or corporate officer who did not harbor special talents and could be somewhat easily replaced. Revenue Ruling 59-60 addresses this potential discount:
The loss of the manager of a so-called “one-man” business may have a depressing effect upon the value of the stock of such business, particularly if there is a lack of trained personnel capable of succeeding to the management of the enterprise. In valuing the stock of this type of business, therefore, the effect of the loss of the manager on the future expectancy of the business , and the absence of management-succession potentialities are pertinent factors to be taken into consideration. On the other hand, there may be factors which offset, in whole or in part, the loss of the manager’s services. For instance, the nature of the business and of its assets may be such that they will not be impaired by the loss of the manager. Furthermore, the loss may be adequately covered by life insurance, or competent management might be employed on the basis of the consideration paid for the former manager’s services. These, or other offsetting factors, if found to exist, should be carefully weighed against the loss of the manager’s services in valuing the stock of the enterprise. 22
The specific discount percentage amount to be used will, like all other discounts and premiums, depend on the relevant factors. For a key person discount, the assessment will be as to whether a key person has left the company, and that person’s impact on earnings both before and after departure. The Tax Court in one decision found that the loss of a key person discount of 10 percent was appropriate when a highly visible company founder left a large percentage of stock in his estate. 23 If a key person discount is deter- mined to be present for valuation purposes, it will be applied before both the minority interest and lack of marketability discounts.
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PURPOSE OF THE VALUATION AFFECTS
THE VALUATION METHODS USED24
The purpose of the valuation impacts the “standards of value” employed and the valuation methods used. The applicable statutes, regulations, specific case law, and acceptable professional standards govern the valuation techniques used for the various possible purposes. It is crucial for the valuation expert to understand the relevant governing authority and make sure the business valuation complies with the required guidelines.
Business valuators are supposed to be totally unbiased about the outcome of their valuation. Under this premise, the business valuator is to select those methods he or she feels are most applicable and reason- able in a particular case. However, in some instances there may be a controlling standard or case law that dictates a particular method or methods to use that may result in an estimate of value that is different from that obtained under “normal” circumstances. Following are some examples of how purposes affect the choice of methods.
Gift and Estate Tax Planning
Certain IRS revenue rulings and relevant case law may contain standards that dictate the appropriate method of valuation.
Revenue Ruling 59-602s
The controlling authority on gift and estate tax valuations is Revenue Ruling 59-60 and subsequent rul- ings. Promulgated in 1959, this revenue ruling lists eight broad factors requiring careful analysis for the valuation of closely held stocks for gift and estate tax purposes. The eight factors are as follows:
1. The nature of the business and the history of the enterprise from its inception. 2. The economic outlook in general and for the specific industry. 3. The book value of the stock and the financial condition of the business. 4. The earnings capacity of the company. 5. The dividend-paying capacity of the company. 6. Whether the enterprise has goodwill or other intangible value. 7. Sales of the stock and the size of the block of stock to be valued. 8. The market price of stocks of corporations engaged in the same or similar line of business having thei r
stocks actively traded in a free and open market, either on an exchange or over the counter.
Revenue Ruling 59-60 also identifies the nature of valuations that any financial expert will face, and that sound, reasonable judgment is required:
“A determination of fair market value, being a question of fact, will depend upon the cir- cumstances in each case. No formula can be devised chat will be generally applicable co the multitude of different valuation issues arising in estate and gift tax cases …. A sound valuation will be based upon all the relevant faces, but the elements of common sense, informed judg- ment and reasonableness must enter into the process of weighing those facts and determining their aggregate significance.”26
Dissenting Minority Shareholder Actions
Owners of closely held businesses may not get along. Unlike a public corporation where disgruntled shareholders can easily sell their stock and move on, a minority shareholder in a closely held company often does not have such an option and is forced to hold his or her shares despite a conflict with other owners. Often, the only redress a minority shareholder has is to file a dissenting minority shareholder lawsuit. Generally, this type of action is governed by the laws of the state in which the company is incor- porated. Although the laws vary from state to state, one recurring provision allows for dissenting minority shareholders to be paid the “fair value” of their stock upon selling their shares. Unfortunately, in many states, “fair value” is not a defined, objective term and, therefore, is subject to interpretation. Ultimately, the decision on “fair value” may rest with a business valuation or through the determination of value by state courts and applicable state law.
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Equitable Distribution {Divorce): Impact of State Statutes and Case Law Another area of business valuation in which the valuator must be aware of controlling law is in equitable distribution or divorce valuations. All states have statutory requirements applying to this area, and a valu- ation expert must know the ground rules before starting a valuation.
Relevant Valuation Date-A Key Issue
State laws vary as to how long couples must wait before they can be divorced. Some states allow an im- mediate divorce with the property settlement decided lacer; others require a period of separation before the actual divorce is granted. Some states requiring a separation period before the divorce require the valuation to be the fair market value as of the date of separation.
Marital Versus Separate Property and Related Appreciation Issues
A business valuator must understand state guidelines as to the differences between marital and separate property. Suppose a man owns a business worth $1 million on his wedding day. Twenty-five years later, when the couple divorces, the company is worth $4 million. Many states will consider the original $1 million value to be separate property that was brought to the marriage. However, the $3 million in ap- preciation that occurred during the marriage may be considered marital property and, thus, subject to equitable distribution. Under this hypothetical situation, $1 million of the business value remains the sole property of the husband, but the $3 million of appreciated business value will be divided equitably between the husband and wife. In other states, however, the original $1 million can also become “tainted” and turn into community property.
Divorce Situation Valuations. Divorce is a highly emotional event for those involved. Since the emotions are typically negative-anxiety, anger, mistrust-it is common for one spouse to suspect the other is hiding or under- valuing significant assets in an attempt to keep them out of the divorce settlement. This suspicion often arises when a family-owned business is at stake. So, determining whether one spouse has hidden assets requires that a valuation professional investigate the business’s financial records and documents. The valuator then can under- stand the location of assets, track any significant changes in spending habits of either spouse prior to the date of separation, and look for patterns or breaks in patterns that may point to suspicious activities.
Discovering hidden assets can be a painful process because the spouse involved in the business may have taken steps to cover his or her tracks in anticipation of the increased level of scrutiny. Careful investigation of the busi- ness and the industry (as well as consideration of other factors, such as the individuals involved) can often reveal the trends that will show an investigator how and where assets have been moved. 27
The valuation issue does not end there, however, because there may be an issue as to whether the $3 million appreciation noted above is “active” or “passive.” In some states, if the entire appreciation is con- sidered to be “passive,” the $3 million appreciation also remains the separate property of the husband. If the entire appreciation is considered co be “active,” then the $3 million appreciation is marital property and, thus, subject to division. In general, “passive” appreciation is appreciation that happens regardless of the actions of the owners (e.g., owning stocks or bonds in an investment portfolio). In contrast, “active” appreciation is appreciation that is the result of the action and hard work undertaken by the owners (e.g., running the day-to-day operations of the business).
Under the passive appreciation argument, the husband’s attorney will argue that, at an average historical annual inflation rate of 3 percent, for example, the husband’s original $1 million business value grew to $2.09 million. Given the total business value of $4 million on the date of separation, only $1.91 million ($4 million less $2.09 million) of the $3 million appreciation is “active” and, thus, subject to division. The remaining $2.09 million is the separate property of the husband. In this inflation example, the $4 million business value would be allocated as follows: $3.045 million to the husband [$2.09 million+ (1/2 X $1.91 million)], and $955,000 to the wife [1/2 X $1.91 million].
The wife’s attorney may argue chat this inflation argument makes no sense, and the entire $3 mil- lion appreciation in the value of the business is active and, thus, subject to division. Her attorney will argue that, unlike a piece of raw land that appreciates passively over time, a closely held business is an entity that requires constant care and attention. No owner can leave a business alone for 25 years and expect to come back to a value that has increased at the rate of inflation-the business will have been long dead.
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Increases in company values result from factors such as the development and production of a produce superior to those of competitors (Microsoft), filling a niche in the market that previously had been unsatis- fied (H?~e Depot)’. consolidating similar operations and achieving economies of scale (Bank of America), or prov1dmg a consistently excellent and popular product year after year (Coca-Cola) . Inflation has little if anything, to do with the rise or fall of corporate value . In fact, some studies indicate that inflation ha~ a negative correlation to the value of a business. Indeed, much of the tremendous bull market of the ’80s and ’90s was arguably the result of a low-inflation environment.
Lack of Case Guidance as Typical Issue
As discussed above, resolution of the separate/marital and active/passive issues is important to a valuator reaching a correct estimate of value in an equitable distribution dispute. Unfortunately, in many states these issues have not been heavily litigated, and there is a paucity of case law for guidance. Alternatively, many court decisions are never appealed, making a determination of judicial valuation trends and their application to a specific situation difficult to ascertain. A business valuator must work closely with the family law attorney to be sure the valuator understands the relevant standards applicable to the jurisdiction.
Professional Practices Valuations in Equitable Distributions
Even if the relevant statute mandates that the measure of value for the valuation of professional practices is “fair market value,” this concept may be interpreted differently for equitable distributions than in an estate or dissenting minority shareholder situation. In some states, the value of a professional practice may not be what a willing buyer would pay a willing seller for the practice. Instead, some state equitable distribution statutes direct that the value of the professional practice be measured by its worth to the owner.
A wife with a lucrative law practice might not be allowed to sell the goodwill to a buyer. Under the fair market value standard, the practice may have little value; however, in an equitable distribution context, the practice may have a significant value.
Again, a valuator must work closely with qualified legal advisors to determine the proper valuation standard to apply in equitable distribution cases.
Personal Versus Practice Goodwill Issues
A related issue to consider in the valuation of professional practices is the treatment of “personal” versus “practice” goodwill. Goodwill is that portion of practice value that is beyond the hard assets (including accounts receivable) of the practice. If a medical practice has a total value of $4,000,000, with $500,0 00 in fixed assets and $100,000 in accounts receivable, that practice is said to have a goodwill value of $3,400,000. Goodwill is that intangible asset that keeps existing patients coming back for treatment and attracts new patients to the practice. Goodwill includes, but is not limited to, reputation, name recogni- tion, employees, location, years in the community, and even telephone number.
Personal goodwill is the goodwill that attaches to a particular individual or individuals. Practice goodwill, on the other hand, is the goodwill that attaches to a particular entity. In reality, the two can be difficult to isolate and quantify. Do patients go to a particular medical practice because it is a long-standing, well- respected practice in their community? Or do they go to see a particular physician whom they really like? If a physician left practice A and joined practice B, would practice A suffer a drop-off in business because a number of patients followed the departing doctor to practice B? Or would practice A continue to th rive as the patients continued to come to the practice seeing different physicians? These questions can be dif- ficult to deal with in a valuation context.
The reason it is so important to understand and be able to segregate personal versus practice goodwill is that state law may dictate whether one qualifies as a marital asset. In a situation where one or bo th spouses have a lucrative professional practice, this issue becomes pivotal in valuing the marital estate for an equitable distribution case.
Employee Stock Ownership Plans {ESOPs) Employee stock ownership plans (ESOPs) represent another fertile field for business valuation. In general, ESOPs are tax-favored devices that encourage employee ownership of businesses. By giving employees an equity stake in the company, the hope is that they will work harder to improve the value of the com- pany. Furthermore, by allowing employees to annually add to their shares held in the ESOP, it is hop ed that employees will have additional resources upon their retirement. ESOPs are encouraged by means of
BUSINESS VALUATION S 17-15
various tax advantages. Some of these advantages include tax deferral for the owner selling more than 30 percent of the company’s stock to the ESOP and company deduction of both the interest and principal of the ESOP loan.
Valuation issues arise in the ESOP context in several areas. First, if the ESOP is leveraged (i.e., if the company must borrow money to fund the ESOP), the newly created ESOP trust will be the primary source of repayment. However, the company, in effect, is the ultimate source of repayment for the loan. This debt service must be a key part of any discount cash flow forecast done as a part of the company valuation.
Another key issue to consider in the valuation of the ESOP shares is the mandatory put option required under the Employee Retirement Income Security Act (ERISA). ERISA requires that an ESOP must provide a market for an employee’s company shares upon the employee’s retirement or termination of employ- ment. This share repurchase liability of the company ensures that employees will have some degree of liquidity to their investment and will not be forced to sell their company shares in what otherwise would be an illiquid market.
Indeed, the ERISA-mandated put option is why most business valuations are prepared in the ESOP context. A put option creates another issue to be considered in the valuation because it provides a degree ofliquidity to the closely held shares that would not exist without the ESOP. Therefore, a smaller discount for lack of marketability of the stock may be appropriate, given that the ESOP does create some market, albeit limited, for the shares.
Company Purchase or Sale The key issue to consider in a valuation done in the context of a purchase or sale is the value of the subject company to the specific buyer. A specific buyer may place a value on a subject company that is substantially different from the normal concept of fair market value. Reasons for this difference include synergies or competitive advantages gained from the purchase of the subject company that otherwise are not present or available to the normal “willing buyer.” Indeed, in the public company realm, company values are of- ten bid to ever-higher levels as buyers seek to supplement their businesses by purchasing complementary operations, as opposed to having to develop competing operations. This concept is discussed later in this chapter; however, the business valuator needs to be cognizant of the buyer’s perspective in a purchase or sale valuation.
Buy-Sell Agreements Buy-sell agreements are common in many closely held companies. A buy-sell agreement can serve several purposes, including ensuring the continuity of management and ownership, providing liquidity to de- ceased or withdrawing owners, and (in some cases) establishing company values for estate tax purposes. Buy-sell agreements may be drafted in several ways; however, the most common valuation provision calls for either a formula provision to calculate value or the appointment of a third-party valuator or valuators to determine company value.
Formula provisions, although usually easy to calculate, run the risk of severely over- or undervaluing the business. Many buy-sell agreements calling for formula calculations of value have been in place for many years, and the company and its industry may have undergone changes in the interim that render the company unrecognizable from the day the document was drafted. As an example, a formula buy-sell calculation at “accounting book value” for a real estate holding company may grossly understate the value of the business if the land is in an area that has experienced rapid development over the years.
In addition to antiquated formulas, some buy-sell agreements may suffer from vague or ambiguous language that renders them all but unusable. A valuation professional hired to help an attorney draft a buy-sell agreement must consider these potential risks and pitfalls. The most efficient way to derive an accurate company value for a buy-sell agreement is to provide for a current valuation at the time the buy- sell is activated. However, the owners may want to keep the buy-sell simple and peg the price at an easily calculated figure. Some owners may be happy with the formula after enacted, but this still does not mean it is necessarily a valid indicator of the current “real world” fair market value of the shares.
Another problem occurs when the buy-sell agreement valuation measure sets an artificially low price that would minimize the potential exposure of the shareholder’s spouse in a divorce. For example, professional practice buy-sell agreements will sometimes establish a value based on accounting book value per share measures, ignoring the inclusion of any goodwill value, even though other valuation techniques clearly demonstrate the existence of goodwill value. The family law attorney will vigorously argue on behalf of the shareholder spouse that book value is all he or she can receive, and that goodwill value is irrelevant. This view is not necessarily universally accepted by the courts. Whether a buy-sell value will prevail in
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a family law setting that is at odds with other valuation methods varies from state to state. Therefore, a valuator should address this issue with the attorney involved.
Problems can arise, however, when either the buying or selling party is upset with a formula-derived value that does not accurately reflect the true value of the business. Problems also arise if the buying and selling parties cannot agree on how the buy-sell specifies that the value be calculated. All of these issues make the buy-sell agreement a potentially contentious issue for a business valuator.
Bankruptcies Business valuators are often used when private companies become bankrupt. Potential valuation services include the valuation of a business to determine an allocation to creditors or as part of a proposed reor- ganization plan. In valuing businesses within these scenarios, the valuator must consider the value of the business from the perspective of the creditor(s). For companies that are troubled financially, the valuator may appropriately place more emphasis on the cost approach to valuation as opposed to the income or market approach. Because creditors generally have the option oflooking to collateral as a secondary source of repayment for their loan, they may possess many of the same attributes of control as the majority or 100-percent owner of a business. Given this power possessed by the creditors, one may appropriately value the business on a 100-percent control basis.
Bankruptcy valuations also can view fair market value in a hypothetical vacuum. For example, the court might direct that the valuation ignores a company’s crushing debt load and value it as if the company had a normal level of debt. This approach enables a court to decide how to allocate the going concern val ue to the various classes of creditors.
Business Damages Business damages cases generally arise in a litigation context. A typical case involves a plaintiff business owner who alleges that someone or something caused a diminution in his or her private company’s value. Generally, the plaintiff asks for business damages measured by the difference between what the company would have been worth without the damages and what the company is worth. Business damages disputes call for creative valuation solutions because of the difficulty of estimating the difference between a busi- ness’s actual value and its hypothetical value.
Common methodologies include the extrapolation of company performance from the before-damages period throughout the period of damages. This process may be as simple as forecasting lost revenue that resulted from the damages; however, the valuation also may require a forecast of the alleged damages’ effect on the operating structure and margins of the company. Alternative valuation methods include the comparative analysis of the damaged company to companies in the same or similar industries.
In any case, valuations involving business damages unavoidably involve some subjective degree of analysis and/or forecasting. A business valuator must be able to logically support his or her conclusions. This support is particularly true for valuators engaged by the plaintiff because they shoulder the burden of proof on business damages. See Chapter 10 for more information about commercial damages.
Medical Practice Acquisitions by Tax-exempt Entities One field in valuation that has seen explosive growth over the past decade is medical practice acquisition by hospitals. Several forces drive this acquisition activity, including the continued consolidation of healthcare providers in the country, as well as continued private and public pressure to control ever-increasing health care costs. In many situations, the acquiring hospitals are not-for-profit organizations that must follow strict federal and regulatory guidelines to preserve their tax-exempt status. Failure to follow these guidelin es can generate serious tax and legal ramifications for both the selling and acquiring parties.
The Three Valuation Approaches Like the valuation of real estate, business valuation involves three basic approaches: income, market, and cost.
INCOME APPROACH 28
There are numerous methods within the income approach category, including capitalization of income, discounted future income, discounted future cash flow, capitalization of excess earnings, and others.
BUSINESS VALUATIONS 17-17
Capitalization of Income Method All capitalization methods estimate value by converting a company’s estimated future income stream into a value. This conversion involves the application of an appropriate capitalization rate, which incorporates both an investor’s required rate of return for risk and a factor for future growth in income. The resulting value is ultimately based on the present worth, today, of anticipated benefits the buyer will receive in the future (in the form of income, cash flow, or dividends). An offshoot of the Gordon-Shapiro dividend discount valuation model, the capitalization of an income stream is a single-period valuation approach. 29
Discounted Future Income Method Discounted projected future income methods involve projecting the possible future income streams (e.g., earnings, cash flow) on a year-by-year basis, usually for five or 10 year~. Future incom~ streams _are then discounted at an appropriate discount rate (required rate of return on investment for nsk) required by a buyer, back to a present value. For the final projection year, a terminal value is determined that represents the estimated value for the sale of the company at that time. This terminal value is then discounted back (at the discount rate) to its present value. The summation of the present value of both the income streams and the terminal value yields a fair market value estimate of the company.
When an “invested capital” approach is employed, the income streams are discounted to present value at a “weighted average cost of capital,” a discount rate incorporating the costs of debt and equity. The resulting present value represents the value for the total capitalization of the company, includi~g debt an~ equity. From this value, total long-term debt is subtracted, and the present value of the terminal value 1s added to obtain the fair market value of equity in the company benefiting common shareholders.
If a company’s income or cash flow is growing at a constant rate into perpetuity, the discounted future income method does not need to be employed because the formula is then mathematically equivalent to the results achieved by the capitalization of income method discussed earlier. However, when a compan_y is experiencing a recent rate of growth that is above a sustainable long-term trend, or when ther: are cycli- cal or unusual near-term factors that are influencing results (and which can be reasonably predicted), the discounted future income method can more reliably capture the impact of those changes on valuation than a capitalization approach.
Discounted Future Cash Flow Method The discounted future cash flow method is nearly identical to the discounted future income method de- scribed earlier. The essential difference between the two methods is that the discounted future cash flow method requires the estimation and projection of a company’s future cash flows ~at_her than incoi:ne. _This process requires the consideration of a company’s noncash charges (such as deprec1at1on a~d ~mort1zanon), a company’s working capital needs, anticipated capital expenditures and related deprec1anon schedules, the retirement or assumption of debt, and other associated calls on company cash flows. These types ~f noncash items will be subtracted from, or added to, net income to arrive at a cash flow amount. After this process, the methodologies and procedures are identical to the future earnings method. One important adjustment the valuator must make is to be sure the discount rate employed is applicable to cash flows (as opposed to earnings or some other income measure).
Capitalization of Excess Earnings Method The excess earnings (formula) method is really a hybrid of the cost and income approaches because it involves the determination of the portion of the earnings that may be attributed separately to the tangible and intangible assets of a company. This method is available to estimate intangible value.
This method involves the following steps:
1. Multiply the net tangible assets of the company by the rate of return such assets might reasonably be required to earn.
2. Deduct this estimate of earnings from the total earnings to derive that portion of the earnings that might be attributed to the intangible assets.
3. Divide the earnings attributed to intangibles by a capitalization rate for intangibles to estimate the total value attributed to the intangibles.
4. Sum the value attributed to intangibles and the market value of the net tangible assets of the firm to estimate an overall fair market value.
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Michael Paschall from Banister Financial, Inc., a business valuation firm, states about the capitalization of excess
earnings method: “The IRS indicates that this method should only be used as a last resort when better methods
are not available. In practice, this method has a significant number of logical flaws and inconsistencies in its ap-
plication. This method has been heavily criticized by the IRS and the business valuation community and is rarely,
if ever, used any more. In fact, the use of this method is usually a strong indication of an unsophisticated business
appraiser who is out of touch with current valuation methodologies.”
Weighted Average Cost of Capital One of the challenges faced by valuators when finding the present value of future income or cash flow streams is to determine the appropriate numerical value of the discount rate used in the calculation. The discount rates mentioned above are often based on the weighted average cost of capital (WACC) , a com- monly used rate in valuations. In computing the WACC, a combination of the cost of debt and the cost of equity is used to find an approximate cost to the company of the funds used to finance operations and assets. While the cost of debt is easier to determine because loan interest rates are readily available, the cost of equity is more uncertain. In part, the cost of equity relates to dividends that the company m ust distribute to keep shareholders and the financial markets comfortable with the return on the investment into the company.
The formula for computing the weighted average cost of capital is:
WACC = (D/TC x (CD x (1 – T))) + (E/TC x CE)
Where: D – Amount of debt in the capital structure at market value E -Amount of equity in the capital structure at market value TC – Total amount of capital; in other words, debt plus equity CD – Cost of debt CE – Cost of equity T-Tax rate
Example 17.3 Compute the weighted average cost of capital given the following information. Cost of debt: 6%
Cost of equity: 17%
Tax rate: 30%
Debt in the capital structure at market value: $400,000
Equity in the capital structure at market value: $600,000
Using the formula above, WACC = {D/TC x {CD x {1 – T))) + {E/TC x CE), the WACC is: WACC = {$400,000/$1,000,000 x {.06 x (1 – .30))) + {$600,000/$1,000,000 x .17) WACC = 11.88%
MARKET APPROACH 30
Some of the numerous market approaches include the identification of comparable publicly traded com- panies whose securities sell on a free and open market, the examination of definitive and verifiable trans- action data available on actual sales of similar privately held concerns, the existence of actual or potential markets for a security, such as buy-sell or shareholder agreements, and past transactions in the shares or other interests in the business itself.
Guideline (Public Company) Method Under the guideline (public company) method, the valuator seeks to identify publicly traded companies in the same or a similar line of business as the subject private company. The assumption is that a private company in the same line of business as public companies is influenced by the same economic, industry,
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and market conditions. Therefore, one may reasonably assume that a public company’s prices and multiples should be a reasonable proxy of a private company’s prices. This comparison, however, is not done on an equal footing basis because there likely are numerous differences between the public comparables and the private company that the valuator must take into consideration. Some of these considerations include size differences (assets and revenues) between the public com parables and the private company, differences in accounting methods used, the degree of marketability of the public shares, the size and control features of the private shares being valued, differences in company operations, and many more.
Market Data Method Another useful method under the market valuation approach is to analyze recent sales of entire companies that are in the same line of business as the subject private company. As with the public market for trades of very small minority interests (the guideline method just described), market data on what 100-percent controlling interests of companies are selling for can also lend insight into the value of the subject private company. As with the guideline method, however, direct application of sale multiples is probably not ap- propriate to the subject private company due to the considerations mentioned earlier. Detailed analysis is required by the valuator to ensure that differences between the company sale data and the subject private company are properly accounted for in the valuation estimate.
Past Transactions Method A third useful method under the market valuation approach is to examine past transactions in the shares of the private company. Share liquidity is a spectrum that ranges from companies whose shares have not, do not, and are not expected to trade at all to companies whose shares trade daily by the hundreds of thousands on national, public exchanges. Some “privately held” companies do experience some trading activity among their shares. Other “public company” shares trade quite infrequently through local market makers or as noted in such publications as the “pink sheets.” Some private companies may create their own “market” for the shares by offering to match up willing sellers with willing buyers.
Past transactions in the shares of a company can be useful indicators of value if the trades were re- cent enough, were under a true arm’s length relationship, and were not forced, coerced, or dictated by a prearranged formula. In using past trade data, a valuator must be careful to inquire into and analyze the circumstances surrounding each prior trade. Many times, in the private company context, trades among shareholders are intrafamily transfers, distress sales by financially strapped shareholders, or forced sales dictated by a formula. Shares trading under these and similar circumstances may not meet the appropriate criteria (such as fair market value) for valuation of the subject private company’s shares.
COST APPROACH 31
The cost approach involves adjusting a company’s assets and liabilities up or down to reflect their “fair market value.” This method considers tangible and intangible assets and any contingent liabilities. Although tangible assets can be appraised and their actual balance sheet values adjusted to reflect those results ac- cordingly, the major problem with this method is dealing with the valuation of the intangible assets, such as the company’s name, reputation , trained workforce, and other factors.
The cost approach is a reasonable approach for valuation only in the context of a liquidation of a com- pany. The implication of a cost approach that generates a value higher than values generated by the income or market approaches is that the company may be worth more “dead” than “alive.” In other words, the economically logical course of action to take to maximize value would be to sell the assets of the company, pay off the liabilities, and distribute the proceeds to the shareholders. To continue to operate the business under this scenario is an inefficient and illogical use of economic resources.
Book Value: Not Really a Valuation Method In accounting terms, book value is the difference between total assets and total liabilities. Alternatively, book value is known as “net worth” or “equity.” Although book value may be of some use when used in conjunction with other valuation measures (such as the “price to book value” of public comparables), as a stand-alone measure, book value is generally of little use in valuing a business. The primary reason for its uselessness is that book value is basically an accounting convention that has little or nothing to do with the actual value of a company. Many companies may have had significant land and improvements on their balance sheet for many years. Over time, the land value remains unchanged on the company’s balance sheet while the value of the improvements is depreciated to zero. If the land and improvements have appreciated over time and are in fact quite valuable, the book value significantly understates the
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value of the company. Similar problems ari se with potential differences between actual and book values of ocher assets and liabilities.
Adjusted Book Value (Adjusted Net Asset Value) If a cost method approach to valuation is appropriate, adjusted book value provides a much more accurate method of valuation. In its most basic sense, the adjusted book value method calls for an item-by-item adjustment of each balance sheet component (both assets and liabilities). In addition , the estimation or reservation for anticipated windfalls or liabilities is an integral part of adjusted book value.
Tangible Assets
Tangible assets include physical assets and liabilities chat can actually be seen or couched (such as inventory and fixed assets) or can be evidenced by documentation chat verifies their existence (such as investments, receivables, payables, and bank debt). Adjustment of tangible assets can cake several forms. As previously mentioned, some tangible assets (such as land or fixed assets) can be adjusted from their book value to their appraised value. Ocher tangible assets, such as accounts receivable, can be valued based on their es- timated collectability. Assets such as corporate debt can be valued based on their existing interest rate and repayment schedule, as compared to the similarly risky publicly traded debt instruments on the m arket.
Intangible Assets
Intangible assets are chose assets of a company chat cannot be verified in a physical sense, yet still add value to a business. Examples of intangible assets include:
■ Name ■ Company reputation ■ The existence of a skilled and trained workforce ■ Customer base ■ Patents and trademarks
As compared to tangible assets, intangible assets can be far more difficult to value for the business valu- ator. Challenges arise with the analysis of such issues as:
■ What would the company be worth with a different name? ■ What would the value be without chis particular patent?
Valuation techniques for intangible assets vary widely. One technique is the capitalization of estimated value derived from the intangible asset. Another is “what-if” analysis, where the company is valued as it exists today, and compared to its estimated value as if a certain intangible asset had never been associated with the business.
Gathering Initial lnformation32 The two most important parts of any valuation assignment are the preparation before the company inter- view and the focus and depth of the interview itself. Every company is unique. Although corporations, partnerships, and limited liability companies (LLCs) are merely legal creations, each business is its own mix of management, people, customers, suppliers, competition, industry, regulations, and numerous ocher internal and external factors. These elements come together in unique ways to make the company what it has been, what it is today, and what it might become in the future. The valuator’s job is co iden tify how these elements are present in a specific company and to discern what each implies about the risks, opportunities, and future of the business from the viewpoint of a buyer.
Unlike the shareholders and management of a company, the business valuator is an outsider looki ng inside, albeit for a brief amount of time. Therefore, the valuator must quickly identify key risk factors and opportunities and how they impact the company’s valuation. Details are important, but a valuator also must not get lost in the minutiae and miss the big picture. The most substantial risks and opportunities facing most businesses usually come down to a handful of critical issues. The ability co identify these issues depends on the thoroughness of the valuation effort.
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INITIAL INFORMATION REQUEST33
Prior co the management interview, a valuator performs an initial analysis to prepare the appropriate questions co be asked. Because every company is different, some of the items might not apply to a specific assignment, and additional items might be added after consideration of the specific issues raised at the time of the initial pre-engagement contact with the client.
Goals of Pre-engagement Phone Contact In the initial pre-engagement phone contact with a client, the valuator should gain a broad understanding of the company’s activities. The information needs list can then be modified with any unique needs before it is transmitted co the client. Pre-engagement phone conversations with the client should be aimed at reaching the following goals:
■ Develop trust and rapport. Clients are asked to share a substantial amount of confidential information they might not even share with their banker, accountant, or perhaps even their spouse about the busi- ness. Proactively assure the client chat any information requested will be kept confidential. Additionally, establish a dialogue with clients. One of the best ways to start is co ask clients how they started the business , since most owners enjoy sharing this information with ochers.
■ Gain a brief understanding of the business. In order co ensure chat the information needs list is complete, obtain a brief overview of the company. The following questions are helpful: ■ Obtain a brief overview of what the company does and how it is done. Who are its customers
and suppliers? Is there any major change about to occur that is different than what gave rise to che firm’s historic financial results? (If a major change has just occurred, or is about to occur, the valuator must request additional information on the impact of the change.)
■ How cyclical is the business and why? When was the last downturn experienced? (These questions help in determining how many years of financials to request to see the full industry cycle.)
■ Determine who will be responsible for gathering information. Because the information needs list is broad and covers a variety of areas (financial, legal, etc.), ask the client who will be responsible for gathering the data (chief financial officer, controller, outside accountant, law firm, etc.). This information tells the valuator who co contact if there is a delay in receiving information, and for follow-up purposes to see whether any questions have arisen from the data chat is being requested. Information needs lists have a habit of sitting in an in-box somewhere in an organization and are often low on an individual’s “co do” list, because chis information is not fun to gather and copy. Knowing who is gathering the data allows follow-up by the valuator to make sure the project does not languish.
■ Explaining the valuation process and timing. Many clients have never had their company valued, have no clue about the valuation process or timing, and may be intimidated by the process. Explain the nature of the information needs list, its role in gaining a clear picture of the business, and how the list will be used co prepare for the company interview. Additionally, because information needs lists are generic, the client should be told not to be surprised to find items on the list chat are not applicable. If so , they should not be concerned and should move on to the next item. Additionally, the valuator can cell clients co call once the list is received to go over any questions they might have and to avoid any misunderstanding of what is being requested. Finally, explain the timing of meeting with the client for che interview once the information has been received, and then the expected time for an issuance of a draft valuation report for client review.
■ Methods of corresponding with the client. A valuation is a confidential matter; therefore, find out how the client wants the valuator co handle correspondence, faxes, e-mail, phone messages, and voicemail messages pertaining to the assignment. For example: ■ Mail. Should mail be sent to the business or the individual’s home to avoid the possibility that
someone at the company might inadvertently open it? If items should be sent to the home, what is the address? Do clients have individuals they wish to receive copies of all correspondence, such as their estate or corporate attorney?
■ Faxes. Is it acceptable co fax questions or correspondence to the company? If so, is there a special fax number chat should be used? Should the valuator call and receive approval before each fax to ensure chat the appropriate person can stand by the fax machine to receive confidential information?
■ E-mail. Do clients prefer correspondence by e-mail? Is the e-mail read by ochers in the company who might not be authorized to see chis type of sensitive correspondence? While corresponding by e-mail yields a significant time advantage, unless files of sensitive data are encrypted, there is a risk chat unauthorized persons could gain access to the information. Even encryption is not foolproof.
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■ Phone messages. Is it acceptable to leave detailed phone messages with a secretary, and if so, with whorn? ■ Voicemail messages. If the client has voicemail, is it acceptable to leave confidential m essages on
that sys tem? ■ Texting. Is it acceptable to correspond with confidential information in text messages?
DISCERNING WHAT DATA IS REQUIRED 34
Request Forecasts of Future Financial Results One of the items on the information needs list is a request for the client to provide copies of forecasts of a company’s future financial results. The larger the company, the greater the likelihood that fo recasts have been prepared or that management has the expertise to prepare them. However, many small and mid-sized closely held businesses have never prepared forecasts and may lack the sophistication or the willingness to do so. This factor means that the burden of developing forecasts may fall on the shoulders of the valuator. Just because there are no forecasts does not absolve the valuator from the responsibil- ity of preparing them. Remember that the income valuation approach is based on the worth, in today’s dollars, of a company’s expected future income streams. If income streams are expected to be different than a company’s past results, forecasts are crucial in arriving at the value impact through the use of the discounted future income method.
Review Articles on Industry-Related Valuation Issues If the valuator has limited experience with valuations in an industry, articles on the industry-related valuation issues might be reviewed to determine if there are unique factors in the industry that warrant additional information needs. A good place to start would be to review past issues of valuation periodicals, such as ASNs Business Valuation Review, NACVNs The Value Examiner, and the various industry coverage publications, by Mercer Capital, to see if past articles have been written on valuing companies in that industry or profession.
Request Client Information Prior to Company Interviews Clients are eager to have valuations prepared quickly, and often have unrealistic expectations of the time requirements. Rather than sending information to the valuator for a prior review, clients prefer to give it to the appraiser at the time of the company interview. This is ill advised. Few people can scan through a variety of financial and other documents and then ask appropriate questions . Important issues will be overlooked, the valuator will be unprepared, and the interview will be a waste of everyone’s time.
Financial Analysis35 A thorough financial analysis is an important aspect of any valuation assignment. Examining the financial condition and performance of a company provides crucial insight into its risks, the factors that impacted its historic results, and what this portends about the future. A purchaser of a company is always looking forward and assessing the risks and rewards associated with owning shares in the business. Although a company’s history is not guaranteed to repeat itself, the analysis of past results assists valuators in identify- ing forces internal and external to the business that may impact future performance.
HOW MUCH HISTORY IS ENOUGH? 36
To begin a financial statement analysis, a valuator needs sufficient years of historical financial statements to provide an accurate picture of the business, and to identify positive or negative trends. Valuation firms, banks, and other creditors often request the last five years of financial statements. However, five years is an arbitrary number, and is sometimes insufficient to gain perspective on broad and long-term financial trends.
For example, if a company is in a cyclical industry, five years may not be enough to see all aspects of the cycle, including the peak and the trough. Another problem is that abnormally long economic expan- sions obscure the presence of cycles.
m
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Homebuilding exemplifies a cyclical industry because it tends to have periods of booms and busts tied to the general economy, interest rates, and other macroeconomic forces. If the last few years represent the “boom” part of the cycle, and if information only for those years is requested, the valuator might erroneously conclude that the financial trends are always onward and upward. In the next few months, the bust portion of the cycle may occur, devastating t he industry and its participants, causing a sharp contraction in revenues and profitability (perhaps even losses), and forcing a significant number of homebuilders to go bankrupt.
Thinking in broad terms about what drives an industry and whether i_t might be cyclical i~ helpf~I in deciding how many years of financial information is enough. In the ininal phone contact with a client, valuation analysts should ask whether there are cyclical aspects to the company, and when the current cycle last turned up or down. Then the investigator should request ~nancials_ going_ back at least several years prior to those dates to capture the full length of the cycle. While the client will oft~~ have a good understanding of the typical length of an industry cycle, the valuator should perform addmonal research to verify the client’s information.
SPREADING FINANCIAL STATEMENTS37
It is difficult to discern broad trends over time or to put the results in perspective by merely looking at a company’s printed financial statements. “Spreading” a company’s historic financial st~tements pro;ide an added level of insight in a simple, yet powerful way. Spreading financial statements mvolves put~mg the results in a common format that is more easily reviewed and analyzed. Financial spreadsheet reports mclude:
■ Actual and common-sized income statements and balance sheets ■ Financial statement ratios ■ Trend analyses
Actual and Common-Sized Income Statements Placing a company’s historic annual income statements side-by-side enables the trends and variations over time to be identified. “Common-sized” income statements are prepared so that each revenue and expense item is shown in terms of its relationship to the overall revenues of the business (i.e. , expressed as a percentage of total annual net revenues). In che common-sized report, revenues, coses of goods sold, gross profit, and operating expenses are shown both in d?llar terms an_d as a percentage of net revenues. Then, che percentages for other income and expense items are detailed, followed by the net
profit of the company.
Actual and Common-Sized Balance Sheets Common-sized balance sheets are much like their income statement counterpart, with the only differ- ence being chat each asset, liability, and shareholders’ equity dollar item is shown as a percentage of the company’s total assets. In many textbooks, preparing common size income statements and balance sheets is called vertical analysis.
Financial Statement Ratios Financial statement ratios enable the valuation analyst to spot the individual results of the income state- ment and che balance sheet, both separately and in terms of how the statements are linked together. The ratios help forensic practitioners to assess the company’s performance and financial risks, and to identify
positive and negative trends.
Trend Statements Trend statements are an important cool in analyzing the income statements and balance ~heet results _of a company. Trend statements show the changes for key income, expense, and balance sheet items over nme, in terms of actual dollars, as well as percentage changes. Typically, three to five years of statements are presented, with the earliest year considered the base year, and the percentage chan?es are then calculated for the lacer years compared co the base year. This is often called horizontal analysis.
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ANALYZING FINANCIAL STATEMENTS FOR TRENDS AND RISKS 38
The purpose of analyzing a company’s historic financial statements is to provide information about these factors chat are crucial in the preparation of a valid valuation:
■ Trends and what they say about the possible future . Although the future might not resemble the past, past trends and actual resulcs provide insight into what the future might look like.
■ How well or how poorly a company performs compared to industry peers. Knowing chat a client company makes a five-percent pretax profit margin says little about how well or poorly the company is managed if it cannot be compared against some meaningful yardstick. Using financial performance and ratio studies from a company’s specific industry allows meaningful comparisons and conclusions concerning a company’s performance, and provides insight into its strengths, weaknesses, and risks.
■ Key elements of company strategy. Analyzing historic results gives a clearer perspective of how the company operates. Such an analysis provides an indication of the company’s financial reliance on customers, suppliers, and banks. Finally, this analysis helps valuators determine whether a company’s approach is more or less financially risky than industry peers.
Sources of Industry Financial and Ratio Information Perhaps the most comprehensive source of information on financial statements and credit analysis by industry is the Risk Management Association (RMA) , a financial services industry association. Financial statement and credit analysis is the lifeblood of RMA’s members, including banks and nonbanks, which must make daily decisions about which companies to finance, the risks associated with extending credit, and the prospects that loans can be repaid. RMA has an array of publications on credit and financial analysis, including literally hundreds of articles on specific industry analysis.
RMA also produces Annual Statement Studies, an annual ratio publication chat is a required publication for any valuation practice. Based on data submitted by thousands of member banks, the publication contains financial performance and ratio data on companies in hundreds of industry classifications, with the data stratified by company size (based on either total annual revenues or total assets). Such data is essential as a yardstick to help assess the financial performance and risk of a private company being valued. The study is available in print and electronic formats, and optional regional ratio editions can also be purchased.
A valuable part of the Annual Statement Studies is an element many business appraisers who use it daily freq uen tly overlook. Near the end of the publication is a detailed, comprehensive list of financial statement ratio and compensation surveys available from literally hundreds of different industry and professional associations, covering different unique industry segments. 39
Income Statement Profitability Analysis A company’s net income (or net earnings) on its income statement is the result of revenues, costs of the goods sold (or services provided), and operating expenses. How these items combine to produce the res ulting net income depends on numerous factors, such as management’s skill, the impact of competition, industry forces, the economy, pressures from customers and suppliers, and ocher issues chat may affect all companies or are unique to a specific company. Income statement profitability analysis helps accountants determine the following:
■ Judgments about the historical performance of the company and the variability of results. This step provides insight into the risks associated with the business and the earnings outlook.
■ Results against which to assess management’s strengths and weaknesses, and how this analysis would impact an investor’s perception of the shares as an investment, and their associated risk.
■ An objective basis for comparing a company’s performance relative to its industry peers. This seep assists valuators in determining the relative attractiveness of the company as an investment.
■ Insight into a company’s economics and how the business achieves its net profit on a given level of revenues. This seep assists valuators in identifying fixed and variable cost components in the company’s operating structure. Understanding these elements assists valuators in preparing more reliable forecasts of earnings and cash flow for use in the discounted future income and cash flow valuation methods.
■ Clues concerning the internal and external forces that affect the business, and what this suggests about risk, future threats, and opportunities. Spotting trends and changes in the income statement enables the development of questions to pinpoint the causes of observed changes, and to determine their sig- nificance to the valuation process.
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REVENUES40
Without revenues, there is ultimately no business, no need for employees, and no reason to exist. Addition- ally, many of a company’s expenditures are directly or indirectly tied to generating revenues. Given this important role, factors chat influence a company’s historical actual revenues muse be understood, along with what they suggest about the future.
Before one considers the details behind a company’s actual reported revenue numbers, one should first look at historical trends.
Then, using the common-sized income statement, efforts are made to find any noticeable trends or issues that might be apparent related to the company’s level of returns and allowances, which are produces chat were sold to its customers but later returned, or for which allowances were given to the customer. Furthermore, one must understand why returns and allowances are increasing in recent years. The forensic practitioner would want to address the following issues with management:
■ Is the high level of returns a function of problems with product quality? ■ Has the company changed its return policies? ■ Is industry and customer demand slowing, forcing the company to accept returns from customers who
are themselves experiencing slowing growth? Is this an indicator chat the company and its industry are about to enter a cyclical downturn?
Essentially, the analysis of revenues is largely commonsense, involving the consideration of past trends, growth rates, the variability in individual annual results, and overall observed results, as well as the identification of the appropriate questions. Additionally, revenue analysis raises issues the valuator may need to explore through industry research . What do the answers imply about the company’s out- look? Finally, what do these revenue-related issues indicate about the level of risk associated with owning shares in the company?
GROSS PROFITS 41
Gross profits of a business represent che actual profit realized on the sale of a company’s goods or services after considering the expenses associated with the cost of producing the product or service, but before considering the impact of general and administrative and other types of costs.
Components of Cost of Goods Sold The components chat make up the calculation of cost of goods sold can differ materially, depending upon the type of enterprise. For example, a wholesaler’s only cost may be the product the company purchases from its suppliers. However, in a manufacturing business, cost of goods sold may include the cost of raw materials purchased from others; labor, factory, and other coses incurred to produce the product; and depreciation expense.
Calculating Cost of Goods Sold The accountant needs to determine how cost of goods sold is calculated, and whether chat calculation dif- fers from chat used by competitors in the industry. If it differs, comparisons of the company’s performance with industry financial ratios become more difficult. Also, what type of inventory accountin g me thod is used: lase-in-first-out (LIFO), first-in-first-out (FIFO), or some other method?
Analyzing Gross Profit As with revenues, the same aims of financial statement analysis are present for assessing a company’s gross profit. This assessment involves the consideration of past trends, growth rates, and the variability in in- dividual and overall observed results . The “gross profit margin” is computed by dividing gross profit (net revenues less cost of goods sold) by net revenues, with the margin expressed as a percentage. In beginning the process of analyzing the gross profit margins, it helps to compare the common-sized income statement data of the company against industry peer average results.
Industry data and comparisons studies are used as a general guideline, and not as abso lute industry norms. In these industry studies, data is organized by standard industrial classification (SIC) codes; a review of the industry descriptions at the front of the RMA publication suggests the SIC code fit for the company being valued. SIC codes are gradually being replaced by the North American Industrial Clas-
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sification System (NAICS) codes. Initially developed in 1997, the five-digit NAICS codes offer far more details and specification of industry classification than the four-digit SIC codes.
OPERATING EXPENSES 42
A company’s ability to manage operating expenses can be a critical variable impacting its overall p rofit- ability. Even if the company has a solid revenue base and gross profit margins on its sales, if the business does not control its operating expenses there will be poor operating profits , or perhaps even losses.
The company’s operating expenses, expressed as a percentage of revenues, should be compared to the industry average.
OPERATING PROFITS 43
Opera~ingprojits represent the gr?ss profit of a business, less its operating expenses, but before considering other mcome and expenses, and mcome taxes. The amount of a company’s debt affects its interest expense and reported profits. As operating profit measures are considered before interest and taxes, they allow the company’s underlying profitability to be analyzed without respect to how the company is financed.
OTHER INCOME AND EXPENSE 4 4
A practitioner also should compare the company’s net other income ( or expense) levels with the industry average.
PRETAX PROFITABILITY4 5
The pretax profit margin is a measure of the profitability of a company after considering all revenues and expenses except income taxes. This margin is calculated by dividing the company’s pretax profit by revenues and is expressed as a percentage. The higher the pretax profit margin, the more pretax profit the company earns on each dollar of sales, and vice versa.
Practical Illustrations Virtually all business valuation methods use the company’s financial statements over some period of ti me and/or at some point in time. This section applies concepts, approaches, and methods described throughout the chapter to the valuation of hypothetical businesses, such as the Fenton Trucking Company.
EARNINGS HISTORY To illustrate the process, five years of financial information for the Fenton Trucking Company are presented in Table 17.1, showing income statement data for the five years ending December 31, 2013, through D e- cember 31, 2017. Many practitioners believe that income statements provide the most useful information in valuing profitable operating businesses. Indeed, Revenue Ruling 59-60 indicates that earnings should be the most important element in valuing operating businesses.46 Many practitioners prefer some form of earnings model or discounted cash flow model for purposes of valuing businesses. The common belief is that earnings and cash flow business valuation models are the best methods for predicting future streams of cash inflows to investors. In some situations, however, earnings data may not be the most appropriate valuation method.
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Table 17.1. Fenton Trucking Company Income Statements
for the Years Ending 12/31/13 Through 12/31/17
2013 2014 2015 2016 2017
Revenue $6,000 ,000 $5,500 ,000 $5 ,800,000 $6,700,000 $7,500,000
Operating exp. 3,600 ,000
Vehicle exp. 3,100,000 2,700,000 2,800,000 3,300 ,000
Other oper exp. 1,400,000 1,420,000 1,320,000 1,550,000 1,700,000
Admin and mark. exp. 1210 000 1200 000 1230 000 1320 000 1 375 000
Total oper. Exp. 5 710 000 5 320 000 5 350 000 6170 000 6 675 000
Income from oper. 290,000 180,000 450,000 530,000 825 ,000
Other rev. or gains: 70,000
Gain on sale of assets 130,000 250,000 -0- 190,000
Other exp. or losses: (90 000) (90 000)
Int. on bonds pay (90 000) (90 000) (90 000)
Loss on sale of assets (110 000)
Income before taxes 330,000 340,000 250,000 630,000 805,000
Income taxes (115 500) (119000) (87500) (220 500) (281 750)
Net income $214,500 $221 ,000 $162 ,500 $409,500 $523,250
INCOME STATEMENT METHODS OF DETERMINING
A BUSINESS VALUATION Earnings measures of valuation are preferred because they are presumed to provi_de the best surr_ogate fo_r cas~
inflows to the business over the life of the business. Although assets clearly play an important role m a busmess s ability to generate profits and provide cash inflows over the life of the business, m:my experts argue that a firm’s earnings as presented in its income statements are the real testament_ to th~ effecuven~, or lack th_ereof, ~f the use of those assets. But merely stating that earnings are the key factor m busmess valuaoon does not immediately provide an answer about the value of the business. Earnings, and more specifically past earnings that are relevant to a valuation, only cover a period of time, usually around five years. .
Table 17.2 presents a five-year earnings (net income) history for Fenton Trucking Company. The earnmgs during the five years vary from a low of $162,500 to a high of$523,250.
Table 17.2. Fenton Trucking Company Income Summary
for the Years Ending 12/31/11 Through 12/31/15
Yea r Income
2013 $214,500
2014 221,000
2015 162,500
2016 409,500
2017 523,250
Using a series of years’ earnings is logical because it gives a more re~iscic pictur~ of the company’s earn- ings ability over an extended period of time. Using five years of ear:1mg~ data adJusts or smooths out the effects of an unusual earnings performance. For example, the earnmgs m the year 2015 are much lower than for the ocher four years. By using five years of earnings data in the analysis, the valuator can reduce che impact of che lower earnings using four ocher years whose earnings appear t~ be more norm~ for the firm. Some may argue chat the $162,500 of earnings indicates 2015 wa~ an outlier year _f~r earnmgs, and that year’s income should not be included at all in the analysis. Ochers might state the opm1on that Fen~on has some bad years in the normal course of its business and chat omitting bad years from the valuanon
analysis would result in an overstatement of the firm’s value.
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Calculating Average Earnings
~i:~~~:o:a:~: ~s}r~: ~~7} t~;;:et 2
earning histo ry to d~termine the value of the business by sum –
($214,500 + $251 ,000 + $162,500 ! $4gt,~i~ :e$;~~al2~a;)1~f fo~ cheJeriod-i~ _chis case, $1 ,530,750 to fi~d t~e _average earnings for the five-year period, $ l ‘.530,750e:c; ;e:rs ~a~o;O~~;~~~ the total earnings Cap,talmng Earnings
Applying a Discount Rate
Next the valuator determines what discount race co use to · al· h · •
~:~;:~;,eo~f~;:l:~~:re~:::g:r:a~~o~Because the valu~tor is~~~:i::c,c_l:o:~;;;;·z:;rf~:~~~:: ~a;;~;
chat there are six firms chat have simila~:::~ a:/;cerm’.ne chhe appr~p~1ace pnce earnings ratio. Assum e d h h . . peracmg c araccensncs to Fenton Trucking Comp an t at t elf pnce earnings ratios currently range from 9 co 14 . h f any, l · 1· h wit an average o 12 The valuato th mu tip ies t e average earnings of Fenton ($306,150) b the aver . . . . . . r en
nies, 12, to get a valuation of $3,673,800 ($306,150 /12) Al age ~n~e ernmgs rano of s11:11_lar co~pa- 1 to get a capitalization rate of 0 08333 . . . tern~t1v~ y, t evaluator can d1v1de 12 mto 0.08333333 = $3 673 800 Th . . /33_- This ra~e is used co cap1tal1ze earnings as follows: $306,150 +
a steady scream of inc;me i~ di~J:r;~ ;;~~~/:~~; ~:te~ us_ed to ~termine a per~entag~ rate by which
income, income before interest, or any base deemed app~oi:;~c:s:~ a ~;:~~::fc1~~t:~en~et mcome, pretax
Weighted Values
J!1c:.v~u:~~oe: ~!~~~t:::~~~;ee~!:~s eq~al weight to ~ento_n’s earnings for each of the five years of
valuation of the business and the earnin t;: ;~a~~~~i:a:~1ven Just as much weight i~ ~etermining the ~:;~e~:~t\more ~ec~nt e_arnings da~a-ar! more indicative of :tb:~~:::.:;~~:7~ f ;;~:;~~;::n7~;e:~~
• n sue s1tuat1ons, practitioners may choose to give · · earnings less weight in determining the val f h b . Thr~cent_ ear?mgs more weight, and earlier
d h ue o t e usmess. is we1ghtmg can be done in a . f w;;s~:; ; v: pra~titioner can use wh~tever :,veighting scale he or she determines is best for that ~~~:~oon ; w~igh~ of 0 :;, ~~)!e 1~~ ;::e::: ~~~0J:~eh:7: most rtn~ year a weight o~ five and the earliest year the five years used in the valuation. g g sea e or t e Fenton Trucking Company income for
Table 17.3. Fenton Trucking Company Weighting Scale for Income for the Years Ending 12/31/13 Through 12/31/17
Year Income Weight Total 2013 $214,500 1 $214,500 2014 221,000 442,000 2015 162,500 478,500 2016 409,500 4 1,638,000 2017 523,250 .2. 2,616 250 Total
~ $5,389,250
The calculation for a weighted average income amount is as follows:
Average annual earnings, weighting most recent earnings heavier= $5,389,250 + 15 = 5 359
, 283
Using the same average price earnings ratio of 12 to ca ital· h · a valuation of $4,311,396 ($359 283 x 12) Th . _P ize t_ e average earmngs, the valuator gets
$63 1 8,000 cau~ed by the fact that,recent an~ual :::~:;:::;r:1:e~;~:~t~fg~~t:h:~ t~eo~:~tss
1 !s almost
n attemptmg to value a busines £ . . ear 1er years. firm’s earnin If . s, a o~en~1c pracmioner must consider the nature and quality of the questions ab~:t wrea::~e;~::
1 ::!~~e::~:t it~ e~:;r~ to earn~ ddesire~ level of profit, there may be
ue s ou e recogmze dunng the period and questions
BUSINESS VALUATIONS 17-29
about whether all expenses chat have been incurred are actually recorded. If there is some question about the quality of the earnings, the practitioner may need to reflect that in the valuation. In the extreme, ex- ceptionally aggressive accounting practices can result in fraudulent financial reporting. In such cases, che company’s financial statements may be less useful for purposes of business valuations.
Another issue is the distinction between operating income and income from other sources. For the Fenton Trucking Company, the firm had a material amount of gains and losses from the sale of assets. Here the gains and losses resulted primarily from the sale of trucks the company used in its business. The company reported gains on the sale of trucks for four years and a loss on the sale of assets for one year. Averaging the amounts of gains and losses over the five years, the average gain is $106,000 per year [($130,000 + $250,000 – $110,000 + $190,000 + $70,000) + 5 years= $106,000]. The average annual earnings used for this valuation analysis was net income after taxes, so the average annual pretax gain on the sale of assets of $106,000 should be adjusted to an after-tax basis. For Fenton Trucking, that would translate into about $68,900 per year on an after-tax basis.
What should be done with the $68,900 average after-tax gain on the sale of assets? Some would argue to do nothing because the company experiences gains on the sale of its assets on a regular basis. As a result, these gains should be considered a normal component of bottom-line net income and should be treated like the operating income components of the income statement. Other valuation practitioners might argue that these gains are not as indicative of the firm’s ability to sustain earnings during a longer period of time. Thus, the gains and losses on the sale of assets should be discounted or, in the extreme, ignored in the valuation analysis. To ignore the gains and losses altogether would have a significant impact on this valuation of Fenton Trucking. For example, in the first valuation calculation of Fenton Trucking, the earnings were weighted equally for the five-year period. By ignoring the gains and losses on the sale of assets in making the business valuation calculation, the valuator would average total earnings minus the average after-tax gains and losses times the price earnings ratio ($306,150 – $68,900) x 12 = $2,847,000. This value is $826,800 less than the original valuation. As demonstrated in the Fenton Trucking Company example, the business valuator will need to use experience, current literature, continuing education, and research to decide what information is necessary, and how to use that information, when estimating a company’s value.
Minority Interest and Lack of Marketability Discounts Applied Suppose chat the interest being valued in the example above is a 20 percent share of the voting common stock of the Fenton Trucking Company owned by James Fenton. James wishes to retire from the company and sell his minority interest. The Fenton Trucking Company holds the right of first refusal to redeem the shares at fair market value. This right held by the company does not impact the value of the 20 percent interest because first, fair market value is to be the value placed on the shares, and second, if the company does not buy the shares, James is free to sell the interest to someone else.
The valuation computations performed above would sti ll be valid, but additional computations are now necessary to find the value of the 20 percent minority interest. First, the valuator decided to use the weighted earnings results for 100 percent interest in the company that resulted in a valuation of $4,318,600. The starting point for valuing James’s interest would be his percentage ownership times the value of the entire company: 20% x $4,318,600 = $863,720.
Upon assessing the relevant factors relating to the company’s operations, dynamics, and control that would have impact on James’s 20 percent interest, it was determined that a 25 percent minority interest discount rate is appropriate. As the minority interest discount is applied before any lack of marketability discount, the next computation chat reflects the value allowing for only the minority interest discount is: (1 – 25%) X $863,720 = $647,790.
Next the valuator would assess the factors relevant to marketability. Even though James is free to sell his interest to anyone if the company does not exercise its right of first refusal, a buyer still might not be readily at hand because it may not be easy to find an outside buyer of a noncontrolling 20 percent interest in a privately held company. Of course, any of the other current shareholders could be potential purchasers, and this may positively impact the marketability. After full consideration of all factors, a 30 percent lack of marketability discount was determined. The final estimated value of James”s 20 percent interest would then be $453,453 [$647,790 x (1 – 30%)) after the lack of marketability discount is applied.
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FORENSIC AND INVESTIGATIVE ACCOUNTING
CASH FLOW METHODS OF DETERMINING THE BUSINESS VALUATION
Discounted Cash Flow Method The discounte~ cash flow CI?CF) valuat_ion method is a favorite among many practitioners. Typically, the cash flow used m t~e valuanon ~rocess 1s fee cash J!,ow: the after-tax operating earnings of the company+ nonca~~ charges – mves~ments m operatmg working capital, property, plant, and equipment, and other assets. However, there 1s no consensus as to the definition of free cash flow or even cash flow. 48
Palepu, Healy, and Bernard, the authors of Business Analysis & Valuation Using Financial Statem ents suggest these three steps in calculating discounted cash flow methods: ‘
1. Forecast the free cash flows available over a finite period (e.g., 5-10 years), 2. Forecast the cash flows beyond the terminal period using some simplifying assumption, and 3. Discount the free cash flows. 49
To illustrate this approach, estimate the future free cash flows for some finite time period such as 5 to 10 years. Next,_estimate cash_flows for the future time period beyond the estimated cash flow period. Of course, forec~tmg c~sh flows into the future can be difficult, but often the discounted present value of such cash flow esnmates 1s not that large when compared to the total value. Table 17.4 presents estimated free cash flows for the Uptown Company, a real estate venture that builds and operates apartment complexes. Year 10 is called the terminal year.
Table 17.4 . Uptown Company Estimated Free Cash Flows for Years 1 to 30
Estimated Free PVof Free Year Cash Flows PV Factor Cash Flows
$30,000,000 0.8929 $26,787,000
35,000,000 0.7972 27,902,000
40,000,000 0.7118 28,472,000
40,000,000 0.6355 25,420,000
45,000,000 0.5674 25,533,000
50,000,000 0.5066 25,330,000
50,000,000 0.4524 22,620,000
40,000,000 0.4039 16,156,000
40,000,000 0.3606 14,424,000
10 30,000,000 0.3220 9,660,000
11-30 25,000,000/yr. 2.4052 60130 000
Present value using discounted free cash flows $282,434,000
~eyond the 10-year period, assume a steady free cash flow of $25 million a year. Forecasting is always a difficult process, because there are so many variables that may enter into the determination of earnings and free cash flows. These factors are not easy to estimate more than a few years into the future. The more technol~gical_ a business’s products and services, the harder it is to forecast earnings and free cash flows fo r Ion? penods into the future. An offsetting variable is that cash flows that are discounted for long periods of nme have_ a low prese~t value. For_example, the $25 million per year expected free cash flows for years 11-30 _are d1scoun~ed ~smg an annuity factor at 12 percent, starting in year 11 and going to year 30. To find this factor, which 1s 2.4052, the valuator goes to the present value of an annuity table for 12 percent an~ finds the value for 30 periods. From chat amount, the valuator subtracts the present value of an an- nuity at 12 perc~n_t for 10 periods. The resulting factor of 2.4052 yields a present value of the 20 years’ worth of $25 m1lhon annual free cash flows of $60,130,000. The total projected free cash flow for the 20-year period is $500 million, bur the present value of those cash flows is only $60,130,000.
BALANCE SHEETVALUATION METHODS Account_ants sometimes ~acrifice one financial statement for another. For example, using last-in-first-out (~IFO) inventory valuan~n during periods of rising prices tends to match the current cost of inventory with current revenues. This approach may make the income statement more current and relevant for us-
BUSINESS VALUATIONS 17-31
ers, but typically it leaves old, noncurrent values in the inventory account on the balance sheet. Similarly, accelerated depreciation methods and historical cost data may mean that the book values of long-lived assets are reported in the balance sheet at amounts much lower than their current market values.
When there are difficult choices to make between relevant treatment of accounting items on the balance sheet or the income statement, the income statement tends to win our. This “residual value” problem is one of the reasons that many practitioners do not believe balance sheet or book value valuations are relevant in most valuation situations. In addition, as the argument goes, asset values per se are not good indicators of the ability of a firm to generate future earnings and cash flows. Instead, recent earnings experiences of the firm are viewed as more indicative of the ability to generate future earnings and cash flows. The AICPA’s Small Business Consulting Practice Aid 8, Valuation of a Closely Held Business, indicates that the Internal Revenue Service believes that “earnings should be the most important criterion when appraising an operating company,”50 so the use of earnings-based valuation models for valuing businesses is usually recommended.
Nonetheless, there are situations where balance sheets or book value measures are considered relevant in valuing a business. In a closely held business, there may be contract stipulations that state that in the event one owner wants to sell his or her shares to the other owners, the shares will be transferred at book value. Also, the valuator may decide, upon a detailed analysis of company earnings, that in a particular situation an earnings model is not appropriate because of some abnormalities or unusual factors that affected earnings.
Table 17.5 presents the past four balance sheets of Burt Manufacturing Company. Unlike income state- ments that cover a period of time, individual balance sheets capture the financial position of a company at a point in time. A simple way to use the balance sheet approach is to take the value of the equity at the last balance sheet (in this example, 12/31/20). Here the value (book value) of the firm would be the same as total stockholders’ equity: $1,900,000 ($500,000 + $300,000 + $1,100,000). Because there are 10,000 shares of common stock issued and outstanding, the per share value would be $190. This value is adjusted for a variety of issues that are discussed in the next section.
Table 17.5. Burt Manufacturing Company Balance Sheets
for the Years Ending 12/31/17 Through 12/31/20
2017 2018 2019 2020
Current assets: Cash $110,000 $270,000 $300,000 $350,000
Accounts receivables 970,000 940,000 1,080,000 1,020,000
Inventory 1,165,000 1,245,000 1,250,000 1,330,000
Prepaid expenses 175 000 125 000 160 000 180 000
Total current assets 2,420,000 2,580,000 2,790,000 2,880,000
Fixed assets: Fixed assets 2,200,000 2,000,000 2,400,000 2,600,000
Accumulated Depreciation 1300 000 1100 000 1320 000 1380000
Net fixed assets 900 000 900 000 1080000 1220 000
Total assets $3,320,000 $3,480,000 $3,870,000 $4,100,000
Liabilities and Owners’ Equity Current liabilities: Accounts Payable $520,000 $480,000 $660,000 $605,000
Accrued payables 80000 85 000 90 000 95 000
Total current liabilities 600,000 565,000 750,000 700,000
Long-term liabilities 1500000 1500000 1500000 1500 000
Total liabilities 2,100,000 2,065,000 2,250,000 2,200,000
Stockholders’ Equity: Common stock 500,000 500,000 500,000 500,000
Add paid in capital 300,000 300,000 300,000 300,000
Retained earnings 420 000 615 000 820 000 1100 000
Total liabilities and Stock Equity $3,320,000 $3,480,000 $3,870,000 $4,100,000
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FORENSIC AND INVESTIGATIVE ACCOUNTING
Other Factors That May Be Relevant
Level of ownership interest (minority vs. controlling interest) discussed previously is one of the most im- portant factors in valuing a business. Another common issue in the sale of ownership interest in a closely held company is the loss of a key employee. Commonly, when two or more people join together to for m a business, they bring different supporting skills and knowledge to the business. One person may be excellent at marketing and customer relations, another person might be great with finances and fund raising, and yet another might be good at organization and operations. If one of these individuals leaves the firm and wanes to sell his or her interest in the business, there may be much more than the loss of capital at stake. The entire character and competitive nature of the business may change. If so, the value of the remain- ing business interest must be discounted, perhaps significantly, to reflect the value of the “new business.” Here again, the size of the adjustment to the business valuation, however determined, will require skill, experience, and an understanding of the nature of the business.
Another issue that forensic accountants may face is the diversity of results that may arise from using different business valuation approaches. A practitioner may use two or more business valuation models and obtain values based on different measures of value. Which one is correct? Commonly, a valuation practitioner prefers one method depending on the circumstances in the case and the evaluator’s own preferences and experiences. If, however, the professional feels there is some merit to using more than one method or approach in the business valuation, he or she may develop a weighting for the various methods and compure a weighted average value.
Suppose that three valuation methods were used in estimating the value of a business. Method A resulted in a value of $3,500,000, Method B found a value of $3,200,000, and Method C resulted in a value of $4,500,000. The practitioner believes that Method A is the most reliable, bur the other two methods h ave some merit as well. Weights are assigned to each of the three valuation approaches as follows. Method A is assigned a weight of 60 percent, and a 20 percent weighting is assigned to each of the other two methods. The final weighted valuation is computed as follows:
Table 17.6 . Final Weighted Valuation Computation
Valuation Method Valuation Amount Weighting Value A $3 ,500,000 .60 $2,100,000
B 3,200,000 .20 640,000
C 4,500 ,000 . 20 900 000
Weighted average valuation $3,640,000
Selling the Results
In most valuation engagements, the practitioner is not the only person performing a valuation of the business. Typically, a practitioner prepares a business valuation for one party in a dispure, and the ocher party may have a forensic expert preparing a business valuation as well. The two experts then present their valuation positions at trial, in arbitration, or in some other form of dispute resolution . Why do professionals operating with the same business information not arrive at similar dollar valuation for the business? Business valuation is as much an art as it is a science, and each party is approaching the dispute from a different direction .
To prevail with the judge and/or jury, an expert must present a position in the most effective way pos- sible. The work product must be well-reasoned and logically sound. Like other areas of forensic accounting practice, communications skills are essential to effectively present a business valuation. The inability to communicate properly is a fatal career flaw in the practice of forensic accounting. Effective communica- tion requires at least three distinct skills in forensic practice. One is the ability to write clearly, concisely, and understandably if you are to persuade your readers . The second communications skill area is speaking. Typically, at trial one may be speaking co a nai:ve audience, as the jury, and juries rend to have little or no knowledge of accounting. Even the simplest accounting concepts must be presented in a clear, simple, understandable manner if an accountant is to succeed in persuading jury members that the accountant’ s position is the correct one. Finally, an expert must have the ability to listen carefully. During depositio n testimony and during cross-examination at trial, the expert must be intent on hearing and understanding the questions being asked. The witness must not chink about the answer co a previous question and fai l to understand the next question. If one is to be successful in “selling” a position, the expert must listen intendy to the questions and then formulate the best possible answer to the questions asked.
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RULES OF THUMB-VALUATION ON THE CHEAP Formulas, or rules of thumb, are sometimes suggested as a way to more quickly valu~ a business. These rules have their uses and are common among business brokers, bur generally a profess10nally per’.ormed, objective business valuation with supporting data is necessary. There are several books chat provide sug- gested formulas, but che author of one of these books says chis about the formula approach:
No single formula will work for every business. Formula multipliers o~er ~ase of calc~lacion, bur they also obscure derails. This can be misleading. Net revenue muluplt~rs are pa~ucularly troublesome because they are blind to the company’s expense and profit history. Ir 1s easy to see how two businesses in any given industry group have the same annual net re~enue yet show very different cash flows. A proper valuation will go beyond formulas and mclude a
full financial analysis whenever possible. 5′
Business Valuation Standards
UNIFORM STANDARDS OF PROFESSIONAL APPRAISAL PRACTICE (USPAP) 52
Producing a professional, objective, and supported business valuation sho_uld be th~ object(ve_ of any business appraiser. Fortunately, che major national accredit(ng bodi_es have 1ssu_ed rhelf own s1m1la~set~ of business valuation standards, covering required content m a busmess valuanon. All r~al estate ~ ua tions used in connection with any federally related transactions are required t? comply with the ~mto\~
1
Standards of Professional Appraisal Practice (USPAP), issue~ by rhe ‘.1-ppra1sal Standards Boar o t e Appraisal Foundation. The Appraisal Foundation is a recogmzed p_rov1der of standards not only for real estate valuations but also for business and personal property valuauons. . . . .
Appraisal society members of rhe North American Council of ‘:p~ra1sal Orgamzanons, and six ~on- a raiser s ecial members, including rhe American Bankers Assooauon an~ the u_.S . ~eague of Savmgs I~~icucion~, incorporated The Appraisal Foundation in 1987. Of the appra_1sal ~ooe~ 1_ncorporators, all were real estate-related except the American Society of Appraisers (ASA)’ wh ich, m addmon to ta!· era re, certifies appraisers in business appraisal, machinery and equipment, pers?nal property, and ocher iscip mes. The Appraisal Standards Board of rhe Appraisal Foundation develops, interprets, a_nd,ai:nends the USPAP which sets appraisal standards to be fo llowed by members of each of the Foundan ons mcorporators .
In 1989, Congress passed che Financial Institutions Reform, Recovery, and E~forcementAct (FI~), which led to the bailout of failed lending institutions. Tide XI of the act r_equ1res real estate appraisers to become licensed or certified by their respective states and to follow appraisal standards mandated by the A praisal Standards Board of The Appraisal Foundation. Additionally, USPAP must be followed ~henever a ~eal estate appraisal is used for any loan or other transaction involving t~e federal government, mcludmg home loans guaranteed by governmental and quasi-governmental agencies. .
Although it clearly pertains to real estate appraisal, there has _been _some uncertamty abou~ wh~rh~r or not business appraisers are required to follow USPAP in a valuanon with fe~eral government 1mpltcanons (for example a valuation to be submitted to the IRS with an estate or gift tax return!. In many ways, USPAP mer;ly codifies many commonsense standards of pr~fessionalis?1 char appraisers should have been following anyway, so it seems hard to imagine why~ busmess a~pra1ser would not ~an~ to comply with USPAP, required or not. However, given rhe increas_mg expecra_nons_ of federal officials, It would be foolhardy for a business appraiser not to prepare reports m conformity with USPAP
Obtaining USPAP The Uniform Standards of Professional Appraisal Practice, which are quire lengthy (aroun~ 90 pages), are periodically modified and updated. Therefore, new and experienced busi~ess valuators alike are encour- aged to obtain a copy of US PAP and its periodic updates from the fo llowmg:
The Appraisal Foundation 1029 Vermont Ave., NW Washington, DC 20005-3517
Phone: (202) 347-7722 Fax: (202) 347-7727 Internet: www.appraisalfoundation.org
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FOREN SIC AND INVESTIGATIVE AC COUNTING
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS (AI CPA) Unlike the previous appraisal organizations, the AI CPA is much more broadly based, and issues standards pertaining to certified public accountants in all types of accounting practices. Other than the general standards to which CPAs must adhere, those providing consulting services are governed by Rule 201 of the AI CPA Code of Professional Conduct.
CPA valuation analysts must follow the Statement on Standards for Valuation Services No. 1, VS Sec- tion 100, Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset, published June 2007. They should be aware of government regulations and other professional standards including Statement on Standards for Consulcing Services (SSCS) No. 1. Non-AI CPA members need to verify with their state boards of accountancy the regulations they must follow.
VS Section 100 indicates there are two types of engagements: a valuation engagement and a calculation engagement. A valuation engagement occurs when an engagement (1) calls for the valuation analyst to estimate the value of an interest, and (2) the analyst estimates the value and is free to apply the valuation approaches (or methods) he/she deems appropriate under the circumstances.
Conversely, a calculation engagement occurs (1) when the analyst and client agree on the valuation approaches the analyst will use and the extent of the procedures, and (2) the analyst calculates the value in comp liance with the engagement agreement. In both types of engagements, the calculated value m ay either be a single figure or a range.
The AICPA has a Forensic & Valuation Services Library (which includes a SSVS ToolKit), a FVS Webcast Library, and an ABV Credential Overview.
COMMON REQUIREMENTS OF BUSINESS VALUATION STANDARDS
OF VALUATION SOCIETIES 53
The three major valuation societies-the American Society of Appraisers (ASA), The Institute of Business Appraisers, Inc. (IBA), and the National Association of Certified Valuation Analysts (NACVA)-each has its own set of rigorous business valuation standards. Each society requires its accredited members and candidates to adhere to these strict standards in each business valuation assignment. These standards have led to greater professionalism within the valuation community.
FEATURES OF THE STANDARDS54
All the standards are similar in that each requires the following broad elements in any business appraisal.
Independence The appraiser or valuator must be unbiased and independent, and not act in any way as an advocate for the client or any ocher party. If independence and ethics are abandoned, how can users place any reliance on an appraiser’s opinion of value?
Fee Not Contingent on Appraised Value Appraisers and valuators cannot accept valuation assignments where the fee paid depends on the finding of value. For example, it is unethical for an appraiser to accept a fee chat is contingent on the outcome, such as a fee based on a percentage of the value. Each organization requires valuators to warrant in the report that their fee arrangement is not based on the finding of value.
Limiting Conditions All reports must set forth key assumptions, conditions, and restrictions chat impact the value estimate. Thus, a reader is informed of key assumptions. For example, a common limiting condition in valuation reporcs is the statement chat the valuator has not independently verified or audited any of the financial or other information provided by the company being valued. Or, suppose a company has a lawsuit out- standing, which is a material factor that could negatively impact the business, but whose impact cannot be fully known or foreseen. The valuator would clearly want to state in the report chat chis uncertainty exists and that its impact is unknown.
Professionals Participating in the Assignment All individuals materially participating in the valuation assignment must be disclosed and must sign the report, including a certification regarding their independence, fee arrangement, and ocher factors required
17-35 BUSINESS VALUATION S
in each specific society’s standards, as well as chose required by USPAP. If a p~rticipant disagrees wi_th the valuation findings in che report, chis disagreement must also be stated, along with the nature of the dissent.
Information Sources Used Valuation reports should be able to be replicated by the reader. Therefore, a sound business appraisal needs
co include all key sources relied upon.
Report Content Although each society’s standards requirements differ, all e~se~cially require chat a valuation report be fully documented to include detailed discussions of the followmg items.
Purpose and Scope of t he Assignment .
Valuation requirements and methodologies can differ depending upon the pu:pose (e.g., ~state tax, gift planning, buy-sell agreement, purchase or sale). A v~uatio~ of a ~eal estate holdmg corporanon, for estate tax purposes, might be required to ignore crapped-m capital gams taxe~ that would be due by the cor- poration if it sold its real property. By contrast, in a valuation for a possible ~urchase of chose _shares,_an adjustment downward in value for crapped-in capital ga!ns taxes wo~ld be an important fa~to: 1mpactmg value. Therefore, a valuation is only designed to be valid for a specific purpose. Any rescncnons on the use of the report should be included in the narrative.
Standard of Value Used The appropriate standard of value used must be clearly set forth and defined, such as fair market value,
fair value, or investment value.
Identification of the Specific Interest Being Valued
The report must clearly delineate the interest chat is being valued (e.g., 100_ common shares in ABC Corporation, representing 10 percent of che 1,000-total issued and outstandmg common sharest 1?e appraiser cannot just state he or she is valuing a “minority interest in the shares _of ABC Com~anr, 1?1f- ferent share holdings, even of minority interests, can have different values depe~dmg upon the d1scnbunon of a company’s ownership, che potential for swing block attributes, and the impact of relevant state law
and shareholders’ agreements.
Specific Valuation Date Used . The value of any asset is only valid as of a given date because market conditions, the investment cl1m~te, and ocher factors change from one day to the next . As an example, for property settlement purposes m a divorce a company might be valued as of che dace of the couple’s separation. At that time, the comp~ny might have a value of $8 million. Six months lacer, the company _m_ighc los~ a major custo~er accountmg for 50 percent of its revenues, causing its value co drop to $4 million. This example exp lams why valua-
tions must carry a specific date.
Relevant State Law Governing the Entity
Scace statutes affect elements of valuations. For example, if a company is incorporated in Ma~la~d, chis fact is important, because Maryland state law may impact the rights of the interest holder, its mcome
taxation, and other factors.
Scope of the Valuation Report The valuation report should outline che scope of the procedures u~d~rtaken in the valuation, and the report also should disclose any way in which the procedures are limited. Note cha~ v~luators s~o~ld carefully read USPAP concerning che scope of a valuation assignment and the rescncnons pertammg
to limited scope valuations.
Data Collection and Analysis
Nature and History of the Bu siness A valuation must consider both che nature and the history of a business. Understan~i_ng how_ a business started and has evolved over rime provides a great deal about the risks and opport~mnes_ that impact the company and its value. Additionally, one must consider the mana~eme~t of the busmess, its ~trengths an~ weaknesses, products and services offered, customers, supply relanonsh1ps, sales and mark~nn~, ~~mpen- cion, credit relationships, contractual arrangements, facilities, the location of the company s acnvmes, and
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a variety of other factors that impact the business. The reader of a valuation report should come away with a clear grasp of the who, what, when, where, why, and how of a company’s business. This clarity places the valuation findings in context and allows readers to draw their own independent conclusions about whether they believe the valuation findings are reasonable.
By contrast, poorly written reports with little detail leave users knowing little more about the company than when they started reviewing the report. Lack of details leaves the reader with no basis on which to judge the report’s validity.
Historical Financial Information on the Business
Historical financial results and performance provide a great deal about the investment attributes of a company, the quality of its management, and its risks and opportunities. This history also serves as a clue to the company’s possible future outlook. All business appraisals should include a full summary of historic financial results of the business, including income statements and balance sheets for prior years. Business valuation standards are silent on the number of years to be included; however, a commonly held view is that five years is a minimum if the business has been in business that long. However, in cyclical companies, a five-year snapshot may not capture the full view of an industry cycle. Thus, valuators may conclude that more years of information should to be included to give an accurate representation of the business.
Financial Analysis
Reports must undertake a thorough financial analysis of the business, including an examination of historic financial trends and key factors impacting results, and compare financial performance and financial statement ratios with industry performance measures (if available). This process also should include common-sized income statements (items shown as a percentage of net company revenues) and balance sheets (items shown as a percentage of total company assets). Financial statement ratios typically include measures of profitability, liquidity, working capital, leverage, debt service coverage, asset utilization, and return on equity. See Chapter 4.
Industry and Economic Conditions, Outlook, and Impact on the Subject Company
Each company is subject to unique industry and economic trends and forces, often over which the busi- ness has little or no control, but which can heavily impact future financial and investment performance and value. The valuation report should include a discussion of these key factors and how they impact the company. For example, an industry might face a worsening outlook due to a tight supply of a key raw material, which would lead to higher prices and lower demand for the resulting end product. Alternatively, a government agency may be preparing to deregulate the industry, leading to potentially greater competition and downward pressure on prices as new competitors enter the business. From an economic perspective, local, regional, and national economies can impact a company and should be discussed.
Current Investment Climate and Rates of Return for Similar Investments
The investment climate at the valuation date is relevant because it impacts the rates of return buyers require for investing in different types of assets. Similarly, historic rates of return on investments such as the company being valued may provide indications as to its current value. Any valuation should consider and discuss these elements, and define and discuss the specific data used, and why. For example, in using the capitalization of income method (an income valuation approach), the valuation may depend upon a capitalization rate developed by using data based on long-run returns from investing in public companies. Any report should clearly document the development of the capitalization rate and the specific resources used to develop the rate of return.
Past Transactions in Company Shares and Acquisition or Sale Factors
Past transactions in the shares of a company itself, if they have occurred, can sometimes serve as an in- dicator of the company’s present worth. Such transactions need to be discussed, when they are relevant indicators of present value, and why or why not. Also, plans by the company for a sale or merger, or any past solicitations by potential outside acquirers, could be highly relevant in how an investor might view the present value of the shares. These situations, if present, should be discussed, and their relevance to the value detailed. The valuator should place him- or herself in the shoes of a shareholder who is considering selling shares, and who bases the asking price for the shares in large part on his or her consideration of the valuation report. Suppose four weeks before the valuation dace the company entered into preliminary dis- cussions with a possible buyer for a purchase of the whole company, and discussions were continuing. This activity would certainly be relevant information for the prospective seller and reader of the report to know.
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Methodology
Methods Considered and Reasons for Selecting the Ones Used
All business valuations should include consideration of the income, cost, and market approaches to valu- ation. A report should include a discussion of the methodologies considered, which ones were employed, and why. Equally important is a discussion of why certain methods were not employed.
Implementation of the Methods
A valuation report should fully discuss all the steps used in implementing each valuation method, and any adjustments made to financial statements and why. The reader should be able to fully replicate the process chat the valuator went through and understand how the valuator arrived at each finding.
Reconciliation of Findings of Value A reconciliation is a section of the business valuation that summarizes the findings by each of the respec- tive valuation methods, then gives the rationale for how each was considered, and why, in arriving at a final estimate of value. This reconciliation might be accomplished through an explanation of why various weightings were attached to each method. Alternatively, if mathematical weightings were not employed, the narrative should explain the basis of what led the business appraiser to the ultimate value and why.
Adjustments to Valuation Findings The report should discuss and consider any possible adjustments to the value chat might be relevant. These might include premiums for control, along with minority, lack of marketability, key persons, and other discounts. If the business or entity has nonoperating or excess assets (e.g., excess cash, investment property, and marketable securities) not needed in the day-to-day business, adjustments to the value should be made and supported. The rationale for these adjustments must be clearly specified. If studies are used as a basis, they should be cited. Many valuation reports fall miserably short in chis area, particularly about discounts for lack of marketability. The report spends 40 to 60 pages analyzing the company to arrive at a sound and supported preliminary value. Then, with no supporting rationale, the valuation analyst arbitrarily, and with- out any stated basis or support, reduces the value by a discount for lack of marketability, often in the 30- to 40-percent range. Readers must have a clear indication of adjustments, their basis, and the valuator’s rationale.
Conclusion of Value This element is straightforward and involves a clear statement of the findings of value.
Business Valuation Reports
ORGANIZATION OF A VALUATION REPORT55
The greatest analysis is of little value if a client cannot understand it. A valuation report must make the analysis undertaken and ultimate results derived easy to understand. A well-organized report helps anyone, even its author, who can refer to it in the future, long after the facts of the company have faded from memory. A well-organized report is also helpful in court or with an IRS agent when explaining the valuation methods used and the conclusions reached. Attempting to explain the valuation work with a weak report can lead to confusion on the witness stand or with the IRS agent and, ultimately, can detract from the presentation.
PAY ATTENTION TO MECHANICS 56
A well-organized report is also easier to check for mathematical errors because it carefully shows the step- by-step calculations. Nothing is more embarrassing or casts doubt on a valuator’s professional capabilities than a simple math error that is discovered, especially during a trial or in negotiations with the IRS. The implication the other side will argue is that if the “expert” cannot even add, subtract, multiply, or divide, how is he or she qualified to understand and apply advanced business valuation techniques? Professionals should not allow themselves to be put in such a position.
Also, the valuation report should be spell-checked and read at every stage and examined to make sure that tables are not broken by page, the numbering of sections is sequential, and the format and type makes the information easy to read.
17-38
1] 17,291
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FORENSIC AND INVESTIGATIVE ACCOUNTING
MAIN SECTIONS OF THE VALUATION REPORT57
Seven main sections help to organize the report. Tabbed pages dividing the sections give the reader quick and accurate access to the information.
1. Front Pages The first section, immediately following the report’s cover, consists of:
1. Cover sheet (with company name and the valuation date), 2. Transmittal letter, and 3. Table of contents.
2. Introduction This second section provides explanations of the purpose of the appraisal, the summary of the findings, the independence and qualifications of the valuator, the information used in the report, and any legal precedents followed in the report (e.g., Rev. Ru!. 59-60).
3. Company Information Under a tab labeled “Company Information” is an overview that addresses key issues at the company-the history and nature of the business, ownership, management, customers, suppliers, competitors, banking relationships, related-parry transactions, legal issues, material factors affecting the company, etc. Also , included in the Company Information section are analyses of the company’s industry as well as the eco- nomic and population outlook.
4. Financial Condition Under a tab labeled “Financial Condition,” source data for comparative financial information is given as well as a thorough financial analysis of the company, both from balance sheet and income statement perspectives.
5. Valuation Methodology Following a “Valuation Methodology” tab is an explanation of the various valuation approaches consid- ered in the report and chose ultimately used. Each approach’s effect on value is explained in detail, both mathematically as well as in real-world terms. Seep-by-step calculations of each approach used in the report are shown from an objective perspective, leaving nothing out or subject to question (except the reasonable differences of a subjective nature).
6. Valuation Conclusion Under a tab labeled “Valuation Conclusion,” the preliminary values from the prior section are assimilated into one table and then analyzed for the ultimate selection and/or weighting of one or more methodolo- gies. This section also contains the analysis of the application of any minority discount, control premium, discount for lack of marketability, or adjustment for nonoperating or nonessential assets or liabilities. This section concludes with the final estimate of value.
7. Exhibits The final tab can contain at least six exhibits:
1. Limiting conditions 2. Definitions of valuation terms (as promulgated by the ASA) 3. Qualifications of the valuation professionals who worked on the report 4. Common size balance sheets of the company 5. Common size income statements of the company 6. Ratio analysis of the company
Additional exhibits are added as necessary to support the valuation analysis. Examples of additional exhibits normally included are the following:
■ Discounted cash flow analysis with supporting assumptions ■ Information on publicly traded comparable companies ■ Information on private transactions of similar businesses
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BUSINESS VALUATIONS 17-39
The forensic accountant decides where it is best to show financial statement adjustments or spreadsheets based on their complexity and size. Whether these items end up in the body of the report or in the exhibits, a good goal for each report is to show as much information as possible in the body without interrupting the reader with large and complex pages of data. Large charts, such as the additional exhibits mentioned above, may be too large to effectively include in the body of the report and, thus, they should be shown as an exhibit. When tabbed pages are used in the report, the reader can easily flip to the exhibit section.
Preparing to Testify
STRATEGIES FOR EFFECTIVE TESTIMONY
Many of the strategies that are effective for expert witnesses in other types of cases also work well in valua- tion cases. The following is a short discussion of many key issues an expert should consider when preparing to testify. One useful approach is to review a checklist of items that should be addressed before testifying. In the Journal of Accountancy, “Expert Testimony Guidelines for CPA Valuation Analysts,” the author provides a checklist of issues char typically would be useful in preparing for testifying in a valuation case. 58
The following guidelines will assist in preparing to testify in a valuation case:
1. Review and update your resume. 2. Know and understand the faces of che case. 3. Anticipate and prepare answers for expected difficult questions at deposition and cross examination. 4. Understand all information and calculations in che expert report. 5. Carefully prepare for deposition testimony. 6. Be certain there are no conflicts of interest.
The expert muse testify so that the court can clearly understand che issues in che expert’s testimony. Experts should review and update their resume regularly. A forensic accountant should never provide a
potential client with a resume chat indicates chat the expert’s resume is not current or completely accurate. Often a favorite strategy of opposing counsel is to scrutinize the resume of an expert looking for items that are not current or not completely accurate. Even if the opposing attorney finds only very minor errors or exaggerations on a resume, the attorney may use the questionable items on the resume to characterize the opposing expert’s testimony as questionable or even untrue. An expert can jeopardize his/her entire testimony by minor errors or blatant exaggerations on the expert’s resume.
One of the authors of this textbook was hired as an expert for a business damages case. He carefully reviewed the opposing expert’s resume and noted that the opposing expert listed “Certified Forensic Accountant” as one of his professional credentials. To verify this statement, the issuing organization was contacted, but had no record of the opposing expert having earned it. Deposition questions were then prepared to ask about the credential. The answers provided by the opposing expert while being deposed were hesitant and evasive. He changed his answer a few times, and he could not remember how he earned the credential, nor the name of the organization that issued it to him. He finally stated that he was not a member of the association that “issued” it. It was very apparent that he was not a “certified forensic accountant.” Listing false credentials, as in this case, can cause an expert’s entire work product to be called into question.
Mose disputes have many issues and facts related co the case. Although many of the facts may nor re- late directly co the analyses made by the forensic accountants, the expert should know as much about all the issues in che case as possible. Forensic accountants testify about accounting/financial issues chat the court might otherwise not understand, but che expert muse demonstrate an understanding of the faces and issues in the case and how they relate co che technical issues about which the expert testified. If the expert is uninformed about key issues in the case, the technical opinions in the expert’s testimony may be discounted or ignored by the court.
Deposition testimony and cross examination testimony require an expert co be able co answer questions from the opposing attorney. Many of those questions might be challenging co answer in a manner chat supports the expert’s opinions. If the expert prepares for testimony by anticipating the difficult questions and framing an answer co chose questions before testifying, often the expert’s testimony is much more
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17-40
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I
FORENSIC AND INVE STIGATI VE ACC OUNTING
effective. Typically, an expert knows his/her case-related weak points far better than the opposition. The expert should use this knowledge in advance of testifying to prepare for the tough questioning of the op- posing attorney. The attorney for the expert’s side in the case usually will have some advice and thoughts about questions relating to challenging issues in the case.
An expert must be well versed in all components of the expert report. To students this may sound self- evident, but in large forensic practices, testifying experts typically have a team of support staff that works on all aspects of the expert report. Although the testifying expert manages the analysis team, the expert usually does not make all the calculations and does not assemble all of the relevant materials in the report. Therefore, the testifying expert should carefully review the expert report and as many details as poss ible. The report should identify all the information that was received and reviewed in forming the opinions expressed in the report. The expert does not need to describe the specific impact of each item that was used in forming the opinions in the report, but if there were essential documents or other information that was critical to forming the opinions, the expert should be able to discuss them. If others were involved in malcing calculations or in other ways supporting the expert report, the expert must be certain that he/she clearly understands all parts of the report.
Effective expercs carefully prepare for deposition testimony. Most attorneys work with their experts to be sure the expert is ready for the deposition. For relatively new expercs, the attorney will explain the nature, purpose, process, and expectations of depositions. The expert’s attorney will probably provide whatever information is required relating to the questioning style and other characteristics of the depos- ing attorney. Because experts are usually deposed late in the discovery process, the deposing attorney will probably have taken a number of depositions in the case from other witnesses, as well as the plaintiff and defendant. Likely the expert’s attorney will provide the expert with copies of some of the deposing attor- ney’s prior depositions. The expert must read the depositions to see the nature and style of the attorney’s questions. Usually the foundation of much of the expert’s deposition will be the expert report. The expert should expect to be asked about everything that is in the report, including the opinions and how they were developed. Near the end of the deposition, the expert probably will be asked if, at trial, he or she expects to render any opinions that are not included in the expert report and what, if any, additional work will be performed between now and the trial.
The expert must be certain that there are no conflicts of interest relating to the case. Experts that are in demand have many opportunities to participate in a wide variety of cases. It is easy to overlook some seemingly innocent relationships with current or former clients or other relationships that might render an expert ineligible for a case because of a conflict of interest. The expert must remain diligent about avoiding potential conflict of interest problems.
Perhaps the final item on the expert’s checklist is to be certain that the opinions that will be presented at trial are simplified so that lay members of a jury will be able to understand the issues presented by the expert. Many accounting/financial concepts in disputes are complex and comprehensive. Often the is- sues are difficult even for professionals, which may be why the case arose initially. When these complex technical issues are presented to others who have little or no knowledge of accounting/financial concepts, the court can be confused. Even judges typically have limited knowledge of accounting issues. Therefo re, an expert should develop and present the opinions in the expert report in a way that enhances the court’s understanding and appreciation of the accounting/financial issues presented in the expert’s testimony.
No single checklist can serve as an effective guideline for every dispute in which a valuation analyst might testify, but there are many articles, books , and practice guides that provide a wealth of informatio n to guide experts in pursuing their career objectives. One excellent source for practitioners is the “Califor- nia Society of CPAs Litigation Sections Practice Aid” that is issued by the California Society of Certified Public Accountants. 59 This document is a non-authoritative practice aid designed to assist members in complying with the AICPA’s Statement on Standards for Valuation Services No. 1 (SSVS No. 1). The practice aid does not attempt to interpret SSVS No. 1, but instead offers a series of detailed checklists to assist practitioners in the field.
CONCLUSION Business valuations are difficult to prepare well. Understanding the different approaches to valuation and the standards of value are critical starting points. This chapter goes well beyond the concepts and demonstrated much of the real-world processes involved. Valuations may be more art than science, but a great deal of accounting, financial analysis , and even legal discipline must be built into the process or the valuation will not hold up in court. Although there are at present four standards-setting bodies, they generally agree on the important standards involved in the process. A business valuation report requires
BU SINE SS VALUATION S 17-41
rigors of its own. Even if the right data has been gathered and all the right calculations and interpretations have been made, the report must be properly constructed to demonstrate that an objective supportable valuation has been performed. This chapter describes proper report construction as well.
For the accounting student who has a penchant for forensic accounting and an interest in finance, business valuation is one area that merits career consideration. For more information on business valuation see the CCH Business Valuation Guide. 60
ENDNOTES 1 G.S. Gaffen, “Guidance for the CPA Entering
the Business Valuation Profession,” THE OHIO CPAJouRNAL (July-September 2002), p. 22 .
2 Discussion in this section is adapted from George Hawkins and Michael Paschall, CCH 2017 BUSINESS VALUATION GUIDE, WOLTERS KLUWER (Riverwoods, IL: CCH INCORPORATED, 2016) , ISBN 978-0-8080-4535 -9.
3 American Society of Appraisers website (http://www.appraisers.org!credentials!ceiv- certification) , on 02/10/17.
4 Ibid. 5 Discussion in this section is adapted from
George Hawkins and Michael Paschall, CCH 2017 BUSINESS VALUATION GUIDE, WOLTERS KLUWER (Riverwoods, IL: CCH INCORPORATED, 2016), ISBN 978-0-8080-4535-9.
6 Ibid. 7 Michael Bolotsky, p xxi , foreword-Business
Valuation Discounts and Premiums, Shannon Pratt, 2001 .
8 AICPA, Statement on Standards for Valuation Services No. 1, VS Section 100, “Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset,” June 2007, Section .40.
9 Cross v. Comm ., T.C. Memo 1999-254, aff’d 272 F.3d 333 (CA-6, 2001) . See also Estate of John E. Wall v. Comm., T.C. Memo 2001-75.
10 See E. J. Barr, Valuing Pass-Through Entities, Hoboken, J.J., John Wiley and Sons, 2014, 272 pp.
11 Discount for Lack of /11arketability, Job Aid for IRS Valuation Professionals, Internal Revenue Service (Sept. 25 , 2009), p. 4.
12 Rev. Rul. 59-60, 1959-1 CB 237, Sec. 4.02(g) . 13 Chapter Seven, Valuation Discounts and
Premiums, Fundamentals, Techniques, & Theory, National Association of Certified Valuators and Analysts (2012) , p. 9 (http:! I edu. nacva. com!preread/2012B VTC/2012v1_ FTT_Chapter_Seven .pdf) on 02/12/2017.
14 The 9th Circuit Court of Appeals did, however, find that in one instance voting and nonvoting shares should be valued the same. Estate of Simplotv. Commissioner, 249 F.3d 1191 (2001), rev ‘g 112 T.C. 130 (1999) .
15 Valuation of Non-Controlling Interests in Business Entities Electing to Be Treated as S Corporations for Federal Ta x Purposes, A Job Aid for IRS Valuation Analysts, Internal Revenue Service (Oct. 29, 2014), p. 13 .
16 Chapter Seven , Valuation Discounts and Premiums, Fundamentals, Techniques, & Theory, National Association of Certified Valuators and Analysts (2012) , p. 13 (http:! I edu.nacva.comlpreread/ 2012BVTC/2012v1_ FTT_Chapter_Seven.pdf) on 02/12/2017.
17 Statement on Standards for Valuation Services No. 1, VS 100, American Institute of Certified Public Accountants (June 2007), Appendix B.
18 /11andelbaum v. Commissioner, T.C. Memo 1995-255, 69TCM 2852 , at 2867 (1995) .
19 Discount for Lack of /11arketability, Job Aid for IRS Valuation Professionals, Internal Revenue Service (Sept. 25 , 2009) , pp. 6&7.
20 /11andelbaum v. Commissioner, T.C. Memo 1995-255, 69TCM 2852 , at 2866 (1995) .
21 Valuation Training for Appeals Officers (Coursebook), Department ofTreasury, Internal Revenue Service, Training 6126-002 (Rev. 05-97), TPDS 87221R, p. 101.
22 Rev. Rul. 59-60, 1959-1 CB 237, at Sec. 4.02(b) .
23 Estate of /11itchell v. Commissioner, T.C. Memo 1997-461, 74 TCM 872 (1997), aff’d in part, vacated in part 250 F.3d 696 (9th Cir. 2001) .
24 The discussion in this section is adapted from George Hawkins and Michael Paschall, CCH 2017 Business Valuation Guide, Wolters Kluwer (Riverwoods, IL: CCH Incorporated, 2016), ISBN 978-0-8080-4535-9
25 Rev. Rul. 59-60, 1959-1 CB 237, amplified by Rev. Ruis. 83-120, 80-213 , 77-287, 65 -193, and 65-192 .
26 Ibid., at Sec. 3.01. 27 Steve Worrall, “Buried Treasure: Looking
for Hidden Assets in a Divorce,” Georgia Family Law, Feb. 24, 2007. georgiafamilylaw. com/2007/02/24/buried_treasure/.
28 The discussion in this section is adapted from George Hawkins and Michael Paschall, CCH 2017 BUSINESS VALUATION GUIDE, WOLTERS KLUWER (Riverwoods, IL: CCH INCORPORATED, 2016), ISBN 978-0-8080-4535-9 .
29 Gordon developed two models using dividends as the income measure of value. The first is a “single stage” model where the anticipated dividends per share for the coming year are divided by a capitalization rate. The second model is a multi-stage dividend valuation approach that works like the discounted cash flow method, with the only difference being that actual anticipated dividends, not free cash flow, is the income measure . See Myron J. Gordon, THE INVESTMENT, FINANCING, AND VALUATION OF THE CORPORATION (Homewood, Illinois: Richard D. Irwin, 1962).
30 The discussion in this section is adapted from George Hawkins and Michael Paschall, CCH 2017 BUSINESS VALUATION GUIDE, WOLTERS KLUWER (Riverwoods, IL: CCH INCORPORATED, 2016) , ISBN 978-0-8080-4535-9.
31 Ibid. ” Ibid. 33 Ibid. 34 Ibid. 35 Ibid. 36 Ibid. 37 Ibid.
38 Ibid. 39 Information on purchasing Annual Statement
Studies, as well as RMA’s other publications can be obtained at the following address: Risk Management Association, 1801 Market Street, Suite 300, Philadelphia, PA 19103-1628, 800- 677-7621 , [email protected], Internet – www.rmahq.org/ContactUs.
40 The discussion in this section is adapted from George Hawkins and Michael Paschall, CCH 2017 BUSINESS VALUATION GUIDE, WOLTERS KLUWER (Riverwoods, IL: CCH INCORPORATED, 2016) , ISBN 978-0-8080-4535-9.
41 Ibid. 42 Ibid. 43 Ibid. 44 Ibid. 45 Ibid. 46 Rev. Rul. 59-60, 1959-1 CB 237, amplified by
Rev. Ruis. 83-120, 80-213, 77-287, 65-193, and 65-192 .
47 Copeland, Koller, and Murrin, VALUATION: MEASURING AND MANAGING THE VALUE OF COMPANIES (New York: John Wiley & Sons Inc., 2000}, p. 134.
48 See John Mills, Lynn Bible, and Richard Mason, “Defining Free Cash Flow,” THE CPA JOURNAL (January 2002).
49 Palepu, Healy, and Bernard , Bus1NESS ANALYSIS & VALUATION USING FINANCIAL STATEMENTS, 2d ed . (South-Western : 2000), p. 11-16.
so AICPA, Valuation of a Closely Held Business, Small Business Consulting Practice Aid 8; Management Advisory Services Practice Aids (New York: AICPA, 1987), p. 12.
51 Glen Desmond, HANDBOOK OF SMALL BUSINESS VALUATION FORMULAS AND RULES OF THUMB, 3d ed . (Camden, Maine: Valuation Press, 1993).
52 The discussion in this section is adapted from George Hawkins and Michael Paschall, CCH 2017 BUSINESS VALUATION GUIDE, WOLTERS KLUWER (Riverwoods, IL: CCH INCORPORATED, 2016), ISBN 978-0-8080-4535-9.
53 Ibid. 54 Ibid. 55 Ibid. 56 Ibid. 57 Ibid. 58 Robert Reilly, “Expert Testimony Guidelines
for CPA Valuation Analysts,” JOURNAL OF ACCOUNTANCY (November 2010), p. 20 .
59 CalCPA’s Litigation Sections, “California Society of CPAs Litigation Sections Practice Aid,” California Society of Certified Public Accountants (January 18, 2008), v. 1.01.
60 George Hawkins and Michael Paschall, CCH 2017 BUSINESS VALUATION GUIDE, WOLTERS KLUWER (Riverwoods, IL: CCH INCORPORATED, 2016) , ISBN 978-0-8080-4535-9 .
17-42 FO REN S IC AND IN VESTI GAT IVE ACCO UNTIN G
EXERCISES
1. Why would a forensic accountant need to perform a business valuation? Can people not just look up the value at a particular date on the appropriate stock exchange? Explain .
2. Do you agree that there really are many situations in which closely held companies need to be valued because of a desired or required sale of some por- tion of the ownership? Explain .
3. If a stock is traded publicly, is there ever a need to secure the services of a forensic accountant to per- form a business valuation of the company? Explain.
4. Given the same financial and other relevant infor- mation about a particular company, is it not logical that any informed business valuation professional would come to similar valuations? Explain .
5. Describe some situations giving rise to the need for valuations.
6. Valuation methods can be broken into what three types?
7. Group these valuation approaches into asset-based, income approach, and market approach types: a. Adjusted book value method b. Capitalization of earnings method c. Discounted future earnings method d. Guideline public company method e. Merger and acquisition method f. Rules of thumb approach
8. Define these terms: a. Historical cost b. Replacement cost c. Intrinsic value d. Fair market value e. Discounted future earnings method f. Capitalization of earnings method g. Capital asset pricing model (CAPM)
9. Identify and describe the most common measure of value used in business valuations.
10 . What are the most commonly used methods of business valuation? Are there any reasons to use business valuation methods other than the common ones? Explain.
11. If a forensic accountant decides to use an ea rnings model to perform a business valuation, shou ld all earnings data be treated in the same way? Explain .
12 . Search the Internet for premiums and discoun ts as- sociated with valuing closely held companies. What kinds of information did you find? Do you thin k the use of such base valuation adjustments is clear and easy to apply to specific valuation assignme nts? Identify at least three premiums/discounts.
13. Search the Internet for information about “flow- through” business entities. What is an example of a flow through organization? What if anyth ing is the impact of being a flow-through company on the valuation of the business?
14. Search the web to find out what appears to be the position of the IRS/U.S. Tax Court as it relates to any adjustment that should be made to a business’s val- uation if it is a flow-through company. Why wo uld the IRS care about this issue?
15. Search the web for IRS Revenue Ruling 59-60 and see what experts and professionals have to say about this ruling that was first issued in 1959.
16. Business valuations can be adversarial or non-adver- sarial in nature. If the heart of a dispute is the value of a major asset such as a business, the lines are clearly drawn . But many business valuations have some form of dispute associated with it. Search the web for business valuation disputes and prepare a list of some common types of disputes associated with business valuations.
17. The XYZ Company is a closely held family man u- facturing business. During the last five years, the company has experienced earnings of $700, $75 0, $400, $800, and $950 (all amounts in $1,000) . The valuation expert has determined that the most ap- propriate approach is to use the income method with weighted average income as the most logi cal basis for measuring earnings . The expert weights t he income so that the most recent years of earnings are the most important. Also, assume that considering the small size of the business relative to its competi- tors, the most appropriate price-earnings ratio is 9. Also, assume that the purpose of this valuation is
BU SINE SS VALUATI ONS
to determine the value of the 12 percent equity in the business owned by the firm’s long-time direc- tor of R&D and manufacturing who has decided to retire from the business. After careful analysis the valuation expert has determined that the loss of this key employee discount is 10 percent, and the minority interest discount is 30 percent. Determine the value of the 12 percent interest of the retiring employee.
18. Refer to the information in Exercise 17-17 but use the average income approach to find the base valu- ation rather than the weighted average method . De- termine the value of the 12 percent interest of the retiring employee.
19. Two partners, Jones and Smith, owned and oper- ated a successful dairy business together for 15 years. The business processed dairy products and operated a popular retail ice cream store. During the past year, the two partners have had an increasing number of serious arguments about how to operate the business and about planned future expansion of the business. Both partners have agreed that they no longer can operate the business together. Either partner is willing to sell his share of the business to someone else and to get out of the dairy business altogether. An independent appraiser has valued the total value of the business at $1.5 million . Partner Jones owns 49 percent of the business, and Partner Smith owns 51 percent of the business. What is the value of each partner’s share of the business? What was the basis for your evaluation of the partners’ share of the business?
20. What would be the effect on free cash flows of each of the following items: a. Purchase of $400,000 of fixed assets b. Sale of $220,000 of book value fixed assets for
a loss of $50,000 c. A $90,000 increase in net working capital d. Issuance of $600 ,000 of first mortgage bonds
21. E&K Company has a net book value of $250,000. The company has a 10 percent cost of capital. The firm expects to have profits of $45,000, $40,000, and $55,000 respectively for the next three years. The company pays no dividends and depreciation is five percent per year of book value . a. Using the excess earnings model, should the firm
be valued at more or less than its book value?
17- 43
b. What, if anything, are the company’s abnormal earnings for the next three years?
c. What is your best estimate of the firm’s value using the excess earn ings model?
22. Earnings valuation models. Bayview Real Estate Development is a company that owns and operates a number of real estate ventures. The company also engages in real estate acquisitions and sales of prop- erties, some of which are properties the company no longer wishes to operate. Similar real estate firms earn a 15-percent rate of return . Bayview reported the following earnings over the last five years:
Gain (Loss) Operating on Sale of
Year Income Assets Net Income
$1,500,000 $800,000 $2,300,000
1,700, 000 700,000 2,40 0,000
1,900,0 00 200,000 2,1 00,00 0
4 1,800,000 (300, 000) 1,500,000
5 2,2 00,000 (400,000) 1,800,000
Prepare a business valuation for the Bayview Real Estate Development Company using an earnings model: a. Prepare your analysis giving equal weights to
the five years of earnings data . b. Prepare your analysis giving greater weight to
the more recent earning periods (where five is more recent) .
c. What assumptions or adjustments did you make in your analysis with respect to nonoper- ating income?
23 . Discounted cash flows valuation model. Smooth- tone Products manufactures sound systems. The company’s weighted average cost of capital is 12 percent. The company forecasted the following free cash flows for the next 20 years .
Year Free Cash Flows
1 $10 ,000,000 2 15,000,000
20,000,000
4 23,000,000
25 ,000,000
6-10 20,000,000 per yea r
11-20 17,000,000 per year
Use the discounted cash flow approach to value the Smoothtone Products Company.
I
1 1
17-44 FORENSI C AND INVE STIGATIVE A CCOUNTING
24. Business valuation. The Branson Trucking Company was started by three brothers in Columbus, Ohio in 1987. In 1992, Dave James came into the company pri- marily for marketing and growth purposes. Soon Dave showed that he was effective at increasing business and making deals that caused the company to grow signifi- cantly. Within 10 years, Branson trucking was one of the major regional carriers in the central Midwest.
Over the years, the Branson brothers gave stock options to Dave James to keep him happy with the firm and to reflect his contributions to the firm’s growth and general success. Dave exercised these options over time, and by 2005, the three Branson brothers and Dave James each owned 25 percent of the stock of the Branson Trucking Company.
A few years ago, however, two of the Branson brothers wanted to bring their children and spouses into the trucking company. The role that these family members would play in the business created signifi- cant discussions and some strife. Dave James in par- ticular was opposed to bringing in additional family members. Dave threatened to leave the company, and some of the Bransons thought this was a good idea. After several months of negotiations, it was agreed that Dave James would receive one year’s severance pay, and the three Branson brothers would buy his stock in the company at its fair value. At the end of 2017, Dave James resigned from the trucking compa- ny.
Branson Trucking Company is a closely held com- pany that does not trade in any market. The only stock sales have been directly from the company to the original holders of the stock. Below are income statements and retained earnings statements for the Branson Trucking Company for the years 2013-2017. The Branson Trucking Company financial statements are prepared by the Black & Blue CPA Group directly from Branson’s accounting data. This accounting firm also prepares all of the Branson Trucking Company’s tax returns. The financial statements are prepared di- rectly from Branson Trucking’s accounting data and are not audited by any accounting firm.
Dave James received severance pay of $150,000. He is currently employed in a similar marketing po- sition with another company earning $175,000 a
year. During the 2013-2017 time period, the average price earnings ratio for similar trucking firms th at were traded in open markets were 8, 12, 15, 11, and 14, respectively, for the five-year period. After Dave James left the company, Branson Trucking’s net in- come for the years 2018 and 2019 was $650,000 and $890,000, respectively. Below is an appraisal report of the Branson Trucking Company’s assets as of December 31, 2017. At that time the firm’s total liabilities were $5,100,000 .
Required: You are hired as a forensic accounting expert to prepare a business valuation. More sp e- cifically, you are to determine the fair value of Dave James’s 25 percent ownership interest in the Bra n- son Trucking Company at the time of his departure. Prepare the valuation report using the assumption of either (a) or (b) below:
[Note: Ask your instructor which assumption yo u are to use; do not use both (a) and (b). Ideally, one – half of the class should use assumption (a) and th e other should use assumption (b), and then compa re the valuations.]
a. Assume you have been hired by Dave James to prepare the valuation report.
b. Assume you have been hired by the three Bran – son brothers to prepare the valuation report.
Additional requirements: Explain the reasoning fo r applying any premiums or discounts you use in the valuation, and why you used a specific percentage amount. Also, explain why you did not use certain premiums or discounts that other business valuators might use. Discuss limitations, if any, in your report about your valuation of this business.
Appraiser Report: Dan Willens, Appraiser 4610 E. Washington Street Columbus, Ohio 43218
At your request, I have appraised the assets of the Branson Trucking Company as of December 31, 2017. In arriving at my valuations of these assets, I used in- dustry trade data, accepted valuation methods, and other sources of information, as I deemed appropri- ate under the circumstances. Below is a summary of the results:
BU SINESS VALUATIONS
Branson Trucking Company Fair Market Value of Assets
December 31, 2017
Current Assets:
Cash & Cash Equivalents
Accounts Receivable (net)
Inventory, Parts, and Supplies
Prepaid Expenses
Fixed assets:
Land
Buildings & Fixtures
Rolling Stock
Long-Term Investments:
$324,000
230,000
365,000 141 000
750,000
2,920,000
4,730,000
340,000
$1,060,000
8,400,000
Bonds of other firms
Common Stock of other firms 700 000 1,040 000
Total Assets at Fair Market Value
$10,500,000
UNAUDITED Branson Trucking Company
Income Statement
For the Year Ended December 31, 2013
Sales
Less Sales Allowances
Net Sales
Cost of Sales
Gross Profit
Operating Expenses
Operating Income (Loss)
Other Income:
Gain (Loss) on Sale of Assets
Income {Loss) Before Taxes
Income Taxes
Net Income (Loss)
$17,281,000
562,000
Branson Trucking Company Statement of Retained Earnings
For the Year Ended December 31, 2013
$16,719,000
12 617,000 4,102,000
4,886,000 (784,000)
588,000
{196,000)
0
$(196,000)
Beginning Retained Earnings
Net Income for the year
Retained Earnings
$1,456,000
(196,000)
$1,260,000
UNAUDITED Branson Trucking Company
Income Statement
17-45
For the Year Ended December 31, 2014
Sales
Less Sales Allowances
Net Sales
Cost of Sales
Gross Profit
Operating Expenses
Operating Income (Loss)
Other Income: Gain (Loss) on Sale of Assets
Income {Loss) Before Taxes
Income Taxes
Net Income (Loss)
$20 ,321 ,000
768 000 $19 ,553 ,000
12 977000
6,576,000
6 894 000
(318,000)
____fil1QQ_Q
353,000
_____Th_QQQ
$338,000
Branson Trucking Company Statement of Retained Earnings
For the Year Ended December 31, 2014
Retained Earnings Net Income
Less Dividends Retained Earnings
UNAUDITED Branson Trucking Company
Income Statement
$1,260,000 338 000
1,598,000 120,000
$1,478,000
For the Year Ended December 31, 2015
Sales
Less Sales Allowances
Net Sales Cost of Sales
Gross Profit
Operating Expense
Operating Income (Loss)
Other Income: Gain (Loss) on Sale of Assets *
Income {Loss) Before Taxes
Income Taxes
Net Income (Loss)
$22,149,000
883 000
* Switched from ACR (tax) depreciation to straight-line depreciation .
$21 ,266,000
14122 000
7,144,000
6 452 000
692,000
254 000
946,000
286 000
$660,000
Branson Trucking Company Statement of Retained Earnings
For the Year Ended December 31, 2015
Retained Earnings Net Income
Less Dividends Retained Earnings
$1,478,000 660,000
2,138,000 400,000
$1,738,000
17-46 FORENSIC AND INVESTIGATIVE ACCOUNTING
UNAUDITED Branson Trucking Company
Income Statement For the Year Ended December 31, 2016
Sales
Less Sales Allowances
Net Sales
Cost of Sales
Gross Profit
Operating Expenses
Operating Income (Loss)
Other Income:
Gain (Loss) on Sale of Assets
Income (Loss) Before Taxes
Income Taxes
Net Income (Loss)
$29,258,000
1186 000
Branson Trucking Company Statement of Retained Earnings
For the Year Ended December 31, 2016
$28,072,000
20 346 000
7,726,000
6 488 000
1,238,000
254 000
1,492,000
665 000
$827,000
Retained Earnings $1,738,000 Net Income 827,000
2,565,000 Less Dividends 500,000 Retained Earnings $2,065,000
UNAUDITED Branson Trucking Company
Income Statement For the Year Ended December 31, 2017
Sales
Less Sales Allowances
Net Sales
Cost of Sales
Gross Profit
Operating Expenses
Operating Income (Loss)
$34,610,000
2 407000
$32,203,000
21 677000
10,526,000
8 738 000
1,788,000
Other Income:
Gain (Loss) on Sale of Assets
Income (Loss) Before Taxes
Income Taxes
Net Income (Loss)
344 ooo 2,132,000
960 000 $1,172,000
Branson Trucking Company Statement of Retained Earnings
For the Year Ended December 31, 2017
Retained Earnings Net Income
Less Dividends Retained Earnings
$2,065,000 1,172,000 3,237000 800,000
$2,437,000
25. You are asked to value an S corporation that had be – fore tax income of $100,000, with a tax rate of 40 percent. Calculate the value using the IRS’s approach and the non-IRS approach, and assume a capitaliza – tion rate of 20 percent. What is the premium for the pass-through entity?
26. Search the Internet and find the Alaska Supreme Court case involving the valuation of the Trans-Alas- ka Pipeline. What was the Court’s opinion?
27. Describe these discounts and premiums:
a. Loss of a key person discount. b. Lack of marketability discount. c. Minority interest discount. d. Control premium.
28. Below are the partial unaudited financial statements for L&B Enterprises, Inc.
a.
BUSINESS VALUATIONS 17-47
For the Years Ended
Income Statements 12/31/2015 12/31/2016 12/31/2017 12/31/2018 12/31/2019
Sales $7,500,000 $7,700,000 $7,200,000 $8,100,000 $8,400,000
Cost of Goods Sold (4,575,000) (4,620,000) (4,248,000) (4,779,000) (4,872,000)
Gross Profit 2,925,000 3,080,000 2,952,000 3,321,000 3,528,000
Operating Expenses (1,755 ,000) (1,830,000) (1,925,000) (2,140,000) (2,210,000)
Operating Income 1,170,000 1,250,000 1,027,000 1,181,000 1,318,000
Nonoperating Income (Loss)
Investment Income (Loss) 5,000 5,500 (25,000) 1,000 (3,000)
Gain (Loss) on Fixed Assets 80,000 (60,000) (120,000) 55,000 70,000
Interest Expense (95,000) (74,000) (73,000) (86,000) (85,000)
Income Before Taxes 1,160,000 1,121,500 809,000 1,151,000 1,300,000
Income Tax Expense (348,000) {336,450) (242,700) (345,300) {390,000)
Net Income $812,000 $785,050 $566,300 $805,700 $910,000
Retained Earnings Statements
Beg. Bal. in Retained Earnings $3,500,000 $4,212,000 $4,897,050 $5,313,350 $5,969,050
Net Income 812,000 785,050 566,300 805,700 910,000
Cash Dividends {100,000) {100,000) (150,000) (150,000) {150,000)
End. Bal. in Retained Earnings $4,212,000 $4,897,050 $5,313,350 $5,969,050 $6,729,050
Other Information
Cash Flow, Operating Activities: $950,000 $1,100,000 $640,000 $980,000 $1,200,000
P/E Ratio for Industry: 11 10 13 12
Income tax rate is 30%
Compute the value of a 75 percent interest in L&B Enterprises allowing for these assumptions:
Assumption
Minority interest discount
Control premium
Lack of marketability discount
Loss of a key person discount
Five-year weighted average earnings with most recent years weighted heaviest, using net income
Five-year unweighted average P/E ratio for earnings capitalization
Amount
-0-
15%
20%
-0-
b. Compute the value of a 35 percent interest in L&B Enterprises allowing for these assumptions:
Assumption
Minority interest discount
Control premium
Lack of marketability discount
Loss of a key person discount
Five-year unweighted average earnings, using net income
Five-year unweighted average P/E ratio for earnings capitalization
Amount
10%
-0-
30%
-0-
17- 48 FORE N SI C A N D IN V ESTI GATI V E A CCO UNTI N G
29 .
30 .
31.
32.
33 .
C. Compute the value of a 45 percent interest in L&B Enterprises allowing for these assumptions:
Assumption
Minority interest disco unt
Control premium
La ck of marketability discount
Loss of a key person discount
Amount
5%
-0-
25%
13%
Fi ve-year w eighted average earnings w ith m ost recent y ears weighted heav iest , using operating in co me
Most recent P/ E ratio for earnings capitalization
Which is not a certification for valuation experts? 34. Which Item is not a significant strategy for effective expert witness testimony?
a. ASA. b. MAFF. a. A correct, up-to-date resume .
C. CBA. b. Inform counsel of any conflicts of interest.
d. ABV. C. Understand all relevant facts Involving th e
e. All of these are valuation certifications. issue(s) . d. Do not lie.
Which Is not one of the six standards of value? e. All the above are significant strategies .
a. Fair market value. 35 . Compute the weighted average cost of capital given b. Fair value. the following information. C. Investment value. d. Intrinsic value. Cost of debt: 7%
e. All of them are standards of value . Cost of equity: 14%
Which would not be considered an income valua- Tax rate: 25% tion approach?
Capitalization of income method. Debt in the capital structure at market value :
a. $1,700,000 b. Discounted future income method . C. Discounted cash flow method . Equity in the capital structure at market value:
d. Capitalization of excess earnings method . $800,000 e. All the above are income valuation approaches.
36. Define “weighted average cost of capital.”
Which is not a market valuation approach? 37. Explain the concept of present value and why it may
a. Guideline public company method . be used in business valuations.
b. Market data method . 38 . What circumstances would make someone a “key
C. Past transaction method. person” in the area of business valuations?
d. Book value . e. All the above are market approaches . 39 . Why is Rev. Rul. 59-60, which was issued in 1959,
List at least six items where fair value measures are still relevant today?
required or permitted. 40 . What is the essential difference between the dis- counted future cash flow method and the discount- ed future income method?
BU SI N ESS VAL UATI O N S
41 . Visit the website of the National Association of Cer- tified Valuators and Analysts and list three items of interest that you learned.
42 . Explain the difference between “active” and “pas- sive” appreciation of a business as it relates to the owner.
43 . What is a buy-sell agreement? Provide an example .
44. Does a 51 – percent ownership interest always repre- sent “control” of the business? Explain.
45 . What is the difference between “gross profit” and “operating profit” of a business?
46. Why do professionals operating with the same busi – ness information not arrive at similar dollar valua- tion for the business?
47. Go to this website and explain why medical prac- tices have become hot investments: https:I !www. marketwatch. com! story I doctors-are-being-bought- up-by-priva te-eq u ity-a nd-its-you r-hea l th-on- the- line-2078-06-08 .
17- 49
48 . What are angel investors and what do they typically ask for when contributing capital to a company?
49 . Search the Internet for a recent business sale. De- scribe the valuation process the purchaser used .
50 . If a cost method approach to valuation is appropriate- ate, _____ provides a much more accurate method of valuation .
a. fair market value
b. adjusted book value
c. net present value
d. market value
e. Some other answer.
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