The current economic environment has presented unprecedented circumstances for members of the business valuation profession. Those who perform valuations for financial reporting are grappling with issues surrounding impairment, market capitalization versus fair value determinations, reasonable rates of return, and active versus distressed and inactive markets, to name a few.
The JofA hosted a virtual round-table discussion with valuation professionals from the financial reporting sector to gauge how they are handling such issues in today’s climate and what their outlook is for the near future.
Dave Dufendach, CPA/ABV, ASA, is a partner in Grant Thornton’s Seattle valuation practice. His primary focus is fair value for financial reporting: performing reviews for audit purposes in addition to valuations for nonaudit clients.
Walter McNairy, CPA, is a Raleigh, N.C.-based member in charge of Dixon Hughes PLLC’s public company practice.
Mike Morhaus, CPA/ABV/CFF, CVA, ASA, is a senior manager in the Forensic and Valuation Services department of Anders Minkler & Diehl in St. Louis. He specializes in the valuation of closely held business and other financial assets and has testified in the courts of Missouri and Illinois on a variety of business valuation and forensic accounting issues.
Bernard Pump, CPA/ABV/CFF, is a partner in Deloitte’s Chicago location, specializing full time in the valuation of closely held businesses.
Carolyn Worth, CPA/ABV, is a partner with KPMG LLP in the San Francisco office. She has been doing valuations for about 30 years, dealing mostly with public companies and fair value accounting.
Kevin R. Yeanoplos, CPA/ABV/CFF, ASA, is the director of valuation services for Brueggeman and Johnson Yeanoplos PC of Tucson, Ariz. He is currently a commissioner on the AICPA’s National Accreditation Commission and the immediate past chair of the ABV Credential Committee.
JofA: Have you ever faced a similar environment, and if so, what kind of lessons did you learn from it?
Carolyn Worth: A lot of economists are making comparisons to the Japanese banking crisis of 1990. I see similarities with a lack of understanding by the investor on the risks that the banks were taking in a very difficult credit environment. Now a lot of companies are relying more heavily on the income approach and ignoring the market approach, because they’re seeing dislocation between the two methodologies. If you ignore the market approach, then you’re ignoring other investors’ understanding of what they think the future economic benefits of the cash flow will be from these companies. The best thing to do is try to reconcile the two.
Bernard Pump: There’s an interesting parallel to the tech boom when we couldn’t explain the market pricing of companies. Through valuation techniques, you couldn’t get as high as the market with some of these tech stocks. The situation is similar today where in many industries, especially financial services, you can’t force the valuations low enough to replicate the market pricing of some of these companies.
Dave Dufendach: Another difference between that environment and today is we didn’t have FAS 157 (FASB Statement no. 157, Fair Value Measurements) back then with its laser-focus on market observations, so that adds a new element to the current situation.
Pump: It’s a wonderful thing that we have companies embracing income approaches under the FASB guidance because you can see the potential for that downward spiral if you are relying exclusively on the market approaches. Many of my clients are private-equity firms that have always used a market multiple in pricing their securities under FAS 157. Now they’re looking to the income approach, and I find it somewhat amusing that they’ve fully embraced the income approach as opposed to the market approach.
When pricing multiples drop significantly, challenges arise on how to perform services in light of not having a normal, usual market to turn to for comparability. The market is valuing companies at an all-time low, resulting in market approach valuations that are lower than the income approach valuations. The market approach uses pricing multiples of similar public companies as a benchmark to value the subject company, while the income approach tends to rely on a discounted cash flow methodology. Generally, when the market is “properly” priced, these two methods should result in a similar estimate of value for the subject company, assuming all factors are held equal.
However, in today’s environment, valuation analysts are seeing a wide spread between these two estimates of value that cannot be easily reconciled. As one panelist suggests, the intrinsic value of the subject company is greater than the indication under the market value, causing problems for the valuation analyst, particularly with respect to impairment testing under FASB Statement no. 142, Goodwill and Other Intangible Assets, since intrinsic value is not fair value.
JofA: Are you able to reconcile values or is it impossible to get back to reconciliation between the market method and an income approach?
Pump: We’re performing FAS 142 impairment tests. The SEC requests that you reconcile the market capitalization of the company to the summed-up value of the business reporting units, the business as a whole. The difference between those is called an implied control premium with the market value usually being a little bit less than the overall value through the other methods. And that number’s been in the range of 10% to 20% historically. Right now it’s not uncommon to see 100% implied control premium (acquisition premium). It’s a real challenge, because even after you’ve drilled down on the projections and put as much risk premium as you can into the discount rate, you can’t get very close to the publicly traded stock price.
Walter McNairy: When our clients are ready to write down goodwill impairment, they want to write it down to their market cap versus some interim valuation between market cap and book value. Getting clients to realize that they may have impairment and that the market cap is significantly less than book value has been a difficult task.
Pump: I’ve got clients that are trading below their liquidation value, yet some of them are currently profitable. So it’s a challenge to understand how the market is pricing some of these businesses.
Kevin Yeanoplos: It becomes even more problematic when you’re trying to reconcile the values with a privately held company, because there tends to be more disjointedness between the market approach and the private companies. Every one of these issues that we’ve discussed for public companies becomes even more problematic with the private ones.
Dufendach: With a private company that has multiple reporting units, you don’t have that market cap sitting out there to observe and reconcile to. We often see in place of that an overall value for 123(R) purposes (FASB Statement no. 123(R), Share-Based Payment). We try to diligently ensure that what we’re looking at for impairment is appropriately reconciled with whatever other indications of value might be out there for the overall company.
JofA: Are there any other common problems that you are seeing in valuations for financial reporting purposes?
Yeanoplos: One of the key issues that we are all facing is valuing a company, as of a particular date. Let’s say it was Sept. 30, 2008, a date on which there were significant market issues. Do we address it in terms of liquidity or of risks associated with a future economic benefit?
Dufendach: Related to that is the question of whether or not a triggering event has occurred. Is a drop in the market, whether you’re public or private, sufficient to require an impairment test other than the scheduled date?
The guidance in FAS 142 doesn’t talk about value of reporting units in terms of temporary or other than temporary, leaving it to professional judgment. The seven explicit items in 142 that indicate there might be a triggering event are not all-inclusive, and we have to consider whether a big drop in the market (below carrying value) may fall under the guidance of suggesting an impairment test needs to be performed.
JofA: Do you look at the last year, or do you look at the last 10 years? What kind of experience are you having with that?
Mike Morhaus: Along the lines of the smaller companies, we’re going back more than the traditional three to five years. For some of the construction companies we’re going back 10 years so we can get a better handle on the business cycles to answer the question: Is this low we’re in right now typical for the company? Typically, the DCFs and the single-period models are based on a five-year history, and that’s not sufficient for us anymore.
Worth: One analysis that we’ve added to our review of the financials is to look at actual vs. forecast for the last year, for the last quarters. We’re testing the reliability of management’s historical forecasting capabilities (their ability to forecast in prior periods).
Dufendach: There’s always been a focus on “vetting the forecast,” getting comfortable with the key assumptions, but it’s become even more important. When evaluating an income approach based on a five-year forecast, we are putting a renewed focus on the key assumptions that are embedded in that.
Worth: A lot of valuation professionals are dissatisfied with the equity risk premium, the historical equity risk premium. For the first time I’m seeing a lot of specific company risk adjustments in the weighted average cost of capital (WACC) and the discount rates to try to accommodate the recognition that sees the debt markets are more active, they’re showing more confidence in what the risk is. We are taking the active debt markets as a better indicator of what’s going on in overall risk than some other historical data that we have.
Dufendach: It’s very difficult to know how much we can rely on historical information in this environment. All the key assumptions need to be carefully reviewed.
Pump: Over the past few years, valuation professionals have made a lot of adjustments to the equity risk premium because volatility was very low for a number of years. There were a lot of explanations why equity risk premiums were as high as they were and speculation they need to be adjusted downward. I think that whole philosophy will be re-evaluated under the current market circumstances.
People like Aswath Damodaran, professor of finance at New York University, are talking about looking at forward-estimated equity risk premiums, as opposed to long-term historicals. And the equity risk premiums may fluctuate over time, depending on the markets. For lack of a better road map, many appraisers are putting an adjustment to the equity risk premium in as a specific company risk premium, because there’s no better way to do it right now.
JofA: Some have alleged that the implementation of fair value accounting is the reason for the financial decline. Do you agree or disagree?
Yeanoplos: Fair value may have simply uncovered conditions that already existed. Confusion still exists as to what fair value is or isn’t and understanding the implementation. The confusion is creating some of the market unrest, but I am still uncomfortable saying that fair value caused this. I believe that it’s necessary and is moving us in the right direction.
Pump: Not wanting to recognize the values that might be on the balance sheet—real values— is problematic. The markets tend to focus on short-term results, and to some extent these results may exacerbate the problem in a short-term manner, but I think the market sees past these noncash adjustments.
Worth: A lot of companies are fighting the fair value adjustments because of the violation of debt covenants. It may be that the debt covenant shouldn’t have been tied to the fair value of the assets, but rather, the realization of the assets.
Dufendach: I think that mark-to-market and FAS 157 has been very good in terms of transparency and getting more information to investors. Some of the criticisms of it may come not from the standard itself, but from some of the early applications of it, where perhaps distressed values were observed and taken for fair value and caused some write-downs that might not have been required under a better interpretation of FAS 157. I believe both the FASB and the SEC have made moves to try to clarify those issues.
JofA: The fallout of the economic crisis has had significant impact in many valuation areas other than just determining fair value for financial reporting. Differing levels of value and different standards of value (definitions of value) are involved in valuations prepared for other purposes. For example, estate and gift valuations focus on “fair market value” rather than “fair value.” Given the severe stress and chaos in the financial markets because of illiquidity, excessive leverage and financial mismanagement, how responsive will government agencies such as the IRS be to large valuation discounts assumed in estate valuations, real estate valuations and business valuations?
Pump: In the short run the SEC may be more flexible regarding discounts, simply as a matter of necessity, especially concerning public companies. In the long run I expect that the IRS and the SEC are going to return to the trend that we’ve seen for the past few years, which is requiring more support for the discounts. The SEC has encouraged us to use put option valuations as measures for lack of marketability, and the IRS has pushed for more detailed support for discounts for lack of marketability and control. I don’t see that going away, other than maybe on a temporary basis. On a temporary basis, I don’t think the IRS is going to back down on their discounts.
Yeanoplos: The one thing that’s important to remember with the IRS valuations is that there is definitely a requirement to look at factors that exist as of a particular date.
JofA: If you were talking with a director of a company, would you give them any suggestions on additional due diligence that they should be doing at this point in terms of valuations for financial reporting?
Worth: I wouldn’t hire the company that’s getting a commission on the transactions to do the fairness opinion. There’s an inherent conflict in there. If the SEC wanted to do anything, they should make sure it’s an independent party that provides advice to the board of directors. I believe the advisers should be equally independent of the company or the outcome of the transaction in order to provide unbiased advice.
Yeanoplos: I think that the board of directors should understand the technical aspects of fair value reporting much better, because whether they fully understand fair value or not, they definitely understand that it does have a significant impact on the value of the company. That’s one piece of advice I’d give the directors. If they don’t know it backwards and forwards now, they definitely should.
Dufendach: Awareness of how any transaction will be viewed from a FAS 142 perspective is important to the extent that a big premium is being paid in an acquisition. For example, will that be supportable six, nine, 12 months later, when all the assumptions have to switch over to a market participant standard and a real look at risk premiums and other factors going on in the market? I think that boards of directors would certainly be well-advised to keep in mind how this is going to look from a FAS 142 perspective.
JofA: Is there anything that you want JofA readers, specifically CPAs who are outside of the BV arena, to understand about valuations and the current climate?
Dufendach: The proper focus of valuation is and always should be the long term. We’re all facing the difficulties of assessing what the length of the recession is going to be and the impact it’s going to have on companies’ values. The market is signaling something to us: that the world has gotten much riskier.
Also see sidebars:
Concerns From an Auditor's Standpoint, by Walter McNairy
FASB Updates Fair Value Guidance
Additional Comments From the Virtual Round Table
Virtual Valuation Round Table: Definitions
Editor's note: The JofA would like to thank Gary Trugman, CPA/ABV, MCBA, ASA, MVS, and Robin Taylor, CPA/ABV, CFE, CVA, CBA, for their contributions to this article. Trugman, president of Trugman Valuation Associates Inc., serves on the AICPA’s ABV Examination Committee, is chairman of the Ethics Committee of the Institute of Business Appraisers Inc., and is an editorial adviser to the JofA. Taylor is a member of Dixon Hughes PLLC in Birmingham, Ala., and is chairman of the AICPA’s Business Valuation Committee.