| EXECUTIVE SUMMARY | |
|
|
| FRANK C. EVANS, CPA/ABV, CBA, ASA, is a principal in the Pittsburgh office of American Business Appraisers, a national network of business valuation firms. He serves as editor of Business Appraisal Practice, a journal published by the Institute of Business Appraisers, and an assistant professor, business administration, Pennsylvania State University. He also is a member of the IBA’s College of Fellows. | |
ost experienced valuation service providers will tell
you that applying appraisal theory to real-world practice can be
extremely confusing. However, as with any emerging high-growth
service, it is vital that CPAs maintain their characteristic
performance standards. The profession’s boom in business valuation
(BV) services in the past decade means more CPAs in public practice
and in business and industry have to know BV to stay on top.
| Which return on investment would you prefer, 20% or 40%? The choice isn’t as easy as you think! In fact, it will depend on the definitions of “return” and “investment.” |
Different valuation methods, literally hundreds of sources of financial and strategic information, and various state and federal valuation regulations make this a complex occupation. As daunting as this all sounds, there are a number of basic tenets of business appraisal that will help CPAs implement BV application with a high level of quality control and skill.
UNDERSTAND THE APPRAISAL ASSIGNMENT
First and foremost, you must fully understand the nature of the assignment to ensure it is the right fit for you. As Gary Trugman, CPA, notes in his book, Understanding Business Valuation, appraisers can’t take on every engagement that comes their way. It is therefore very important that each aspect of a BV assignment be clearly stated in the engagement letter. These points will form the basis of the final valuation report.
“The appraiser must be crystal clear about what he or she is appraising, both in the engagement letter and in the valuation report,” says Nancy Fannon, CPA, ABV, CBA, BVAL, partner in the American Business Appraisers division of Baker, Newman and Noyes in Portland, Maine, and member of the AICPA’s BV committee. “A misunderstanding early in the engagement often leads to an unsatisfied client. Spelling it all out in the engagement letter ensures that everybody understands what’s being appraised and the standard of value the CPA is using.”
COMPLY WITH COMPETENCY AND INDEPENDENCE STANDARDS
Business valuation is more than just review and analysis of financial statements. CPAs in public practice offering BV as a client service must conform with several standards on professional competence; due professional care; planning and supervision; and communication with clients, including the AICPA Statement on Standards for Consulting Services (SSCS). The Uniform Standards of Professional Appraisal Practice (USPAP) of the Appraisal Standards Board define the minimum independence and competence standards necessary for reporting to federal regulatory agencies. Although AICPA members are not required to follow USPAP, these standards strengthen the quality of BV services. Business appraisers should review USPAP and pay particular attention to Standard Rule 9-4, which includes guidelines that are similar to those found in the widely recognized IRS Revenue Ruling 59-60 (on valuations).
Valuations prepared for estate and gift taxes, divorce and shareholder disputes often require the testimony of expert witnesses. CPAs who provide such testimony will likely face tough challenges to their credentials and conclusions from opposing attorneys. Steven F. Schroeder, JD, CBA, of Economic and Valuation Services of Marysville, California, says the need for thorough and impartial work cannot be overemphasized: “The successful demonstration by the expert witness of competence and credentials in the event of a challenge is essential to protecting the admissibility of the opinion in court.”
WATCH THE MARKET
Because business valuation involves financial calculations, accountants naturally want to begin the process by analyzing a target’s financial statements. Wise appraisers use spreadsheets, but they do not start their analysis with them, nor are they slaves to them. What happened to the business in the past may not accurately indicate what it will do in the future.
Financial statements show the results of a company’s operations but not their underlying causes. Begin an analysis by thoroughly studying the industry in which the company operates. Identify trends and “risk and value drivers,” the factors that affect quality, productivity, costs, technology, distribution, pricing and sales. These influence the financial performance and, ultimately, the value of the business.
“Seeing a company on paper compared to actually understanding where the company ranks in the industry can result in two drastically different pictures,” says Kristin Tessier, a business unit controller with the Syracuse, New York, medical products manufacturer Welch Allyn. She advises the appraiser to get answers to the following
- What makes the company tick?
- In M&As, does the seller know something about the market that the buyer doesn’t?
- Will the products or services be as valuable in the future as they are today?
- How much investment will it take to sustain continued growth?
“It’s easy to assume that once the company is purchased, any problems it is experiencing today will go away. The trick is to understand what the problems are, how they will be fixed and how much it will cost in both time and capital,” Tessier adds.
Some appraisers overlook market factors because they are inexperienced or they assume that there is very little “relevant” data out there—a dangerous assumption. Studying the market yields information on operating ratios, such as P/E ratios, of private or public company transactions in a particular industry. Annual reports, 10-K reports, and analysis from Value Line Investment Survey, S&P Stock Reports and analysts’ and brokers’ observations reveal investor preferences and concerns and identify key value drivers and performance measures in an industry. Collated, such details form a picture of why certain companies achieve high multiples while others do not.
KNOW THE DIFFERENCE BETWEEN FAIR MARKET AND INVESTMENT VALUE
Four standards of value commonly are used in business valuation: fair market, fair, investment and intrinsic value. CPAs in public practice who prepare valuations for estate and gift or divorce purposes often use fair market value, and those in industry often use investment value which is the strategic value to a specific buyer. Fair value is defined statutorily and generally is used in shareholder lawsuits. Intrinsic value is the theoretical value at which an analyst thinks a stock should be trading.
Appraisers must make a distinction between each standard and understand how each best applies to an assignment. In a merger or acquisition, appraisers for the purchasing company often begin their analysis of the target company by projecting what the target will be worth after they own it. These buyers look at synergies, such as increased sales opportunities or duplicated expenses that can be eliminated. These synergies determine the investment or strategic value of the target to that specific buyer, and this value should represent the buyer’s maximum price.
Buyers must recognize, however, that a target company wishing to be bought may try to inflate its value. Andrzej Kasperek, director of business development for the Visteon Automotive Systems Division of Ford Motor Co., says: “when acquiring companies, private or public, we must ensure our stockholders benefit from new synergies brought by us to the combined business.”
“The buying company often enjoys synergies that were the result of a previous investment,” says Tessier. “M&As are intended to make the company stronger, not to merely grow in size without depth.”
The buyer should base its initial offer therefore on the target’s fair market value on a stand-alone basis, rather than on a higher investment value resulting from the combination. This is an important reason to appraise both the fair market and investment values of the business.
Prudent buyers determine in advance the maximum price they can pay for the target and still increase shareholder value. To pay above this amount destroys value because the price paid exceeds the discounted future returns purchased. “One needs to clearly define a walk-away price prior to the point when emotions become a factor,” says Kasperek.
Informed sellers should consider fair market value as the floor in negotiations, because they want to share in the value the merger would create. When several buyers express interest, the target will most likely be worth a different amount to each because of variations in company economies, production or warehouse capacities, products, customers or sales territories.
Sellers also must consider—early in the process—the potential synergies in the marketplace. Steven Bishop, vice-president of finance of Hester Industries, a Virginia poultry processor, had prepared for a sale of the company years before it took place. “To determine what was strategic in our business, we continuously analyzed the market by reading trade journals and talking to customers,” says Bishop. “We hired independent business appraisers to critique our business and identify what was truly important to a buyer. By laying the proper groundwork and being ready to sell at a time when the market was demanding what our company could offer, we were able to sell at a premium price to a large public company.”
KNOW WHEN TO USE THE INVESTED CAPITAL VS. EQUITY MODEL
Your engagement may require you to value a whole company or just its specific assets and equity interests. For example, in appraisals for gift tax purposes, you most commonly are estimating the value of a minority equity interest that is gifted. To appraise the complete enterprise, develop the valuation on an invested capital basis—the market value of the total capital invested in the company, including interest-bearing debt and equity capital (see exhibit 1, below).
The invested capital model is chiefly used to appraise a controlling interest in a company—an ownership interest of more than 50% of the common stock of the company that allows the owner to determine the company’s mix of debt and equity capital. This model—with the capital structure based on debt and equity at market rather than book value—prevents distortions of value that may result when a company’s level of debt differs widely from the industry average. This invested capital model also can be used to value equity, particularly when the company has an unusual capital structure. After you determine the invested capital value, subtract the interest-bearing debt from the invested capital value to determine the value of equity. Of course, equity can be valued directly, so the equity model most often is used to value equity interests for estate and gift or divorce engagements.
|
|
DON’T LET RATES OF RETURN DISTORT VALUE
Which return on investment would you prefer, 20% or 40%? The choice may depend on the definitions of “return” and “investment.” Return is the benefit to the investor and is usually some measure of income or cash flow. Investment generally is common stock equity, invested capital, specific assets or another security such as preferred stock or a stock option. To avoid error, the appraiser must correctly match the return with the rate of return (see exhibit 2, above).
Watch out for distortions. For example, using the single-period capitalization calculation and the 20% equity cap rate in exhibit 2, $10,000,000/20% yields a $50,000,000 equity value, while $12,000,000/20% yields a $60,000,000 equity value, and $20,000,000/20% yields a $100,000,000 equity value. The $50,000,000 equity value is the only correct choice. The other values result from matching a capitalization rate of return that applies to net cash flow with different returns. Remember, it is imperative that appraisers match the return with the correct rate of return.
The appraiser must exercise the same care when using the invested capital model. Because invested capital includes debt and equity, the appraiser must employ a return to debt and equity (invested capital). The “benefit streams” shown in exhibit 3, below, include earnings before interest, taxes, depreciation and amortization (EBITDA); earnings before interest and taxes (EBIT); or net cash flow to invested capital. These returns to debt and equity must be discounted or capitalized by a cost of debt and equity, which is a weighted average cost of capital. When appraisers develop rates and returns correctly, the equity and invested capital models should yield approximately the same equity value. Assuming the company in exhibit 3 had interest-bearing debt of $25,000,000, it could be subtracted from the $75,000,000 invested capital value to yield an equity value of $50,000,000.
|
|
BEWARE OF EARNINGS MEASURES—CASH IS KING
Brokers and investment bankers usually cite multiples of EBITDA or EBIT as their basis for establishing a very high value for their client’s business. Investors, however, spend cash—not earnings—and they must understand that the potential cash available to them is usually far less than EBITDA or EBIT. Consider the data in exhibit 4, above, which shows various income, expense and similar operating measures.
The equation below computes net cash flow to invested capital, which recognizes the cash that is available to interest-bearing creditors and investors after allowing for the company’s annual need for cash to fund capital expenditures and working capital and pay income taxes. EBITDA and EBIT are popular with sellers and their agents because they yield impressively high numbers, but the key to finding value is to follow the cash.
| Computing Net Cash Flow to Invested Capital | |
| Net
income after taxes + Tax-adjusted interest expense (2.5M 3 [1240%]) + Noncash expense – Capital expenditures +/– Change in working capital = Net cash flow to invested capital |
$12,000,000 1,500,000 2,500,000 (3,000,000) (1,800,000) $11,200,000 |
The computation of net cash flow to equity is illustrated in the adjacent column. Appraisers consider it the proxy for dividends and capital appreciation to common stockholders—their net cash return—and it is usually a small fraction (in this case 40%) of the highly promoted “EBITDA cash.”
| Computing Net Cash Flow to Equity | |
| Net income
after taxes + Noncash expense – Forecasted annual capital expenditures +/– Forecasted annual change in working capital +/– Forecasted annual change in long-term debt = Net cash flow to equity |
$12,000,000 2,500,000 (3,000,000) (1,800,000) 300,000 $10,000,000 |
When appraisers calculate the net cash flow in a capitalization—using either the single-period capitalization method or calculating the terminal value in the multi-period discounting method—the calculation is based on an assumption that annual cash flows will grow to infinity at an implied rate. For such a calculation to be realistic, the capital expenditures, change in working capital and change in long-term debt must reflect levels that a perpetual model can sustain. Reduce the cash flow under change in working capital to reflect that the company’s growth will require ongoing working capital outlay. Similarly, for a growing company, capital expenditures should exceed depreciated write-offs, and borrowing will provide cash over the long term.
VERIFY ALL RATES OF RETURN
Many litigation experts, brokers and investment bankers prefer to use EBITDA or EBIT rather than net cash flow to determine value, especially if they are trying to manipulate a company’s value. Net cash flow rates of return, derived from the capital asset pricing model (CAPM) or the build-up method—the primary methods appraisers use to calculate the cost of equity—are easily verified and are a good basis for gauging risk.
Anecdotal evidence and limited statistics are often all that support EBITDA or EBIT multiples, and appraisers often derive them from transactions that are inappropriate for comparative purposes. Appraisers should question whether such rates are reasonable for the risks associated with the investment being considered. Be similarly cautious of rates of return quoted from net income. They often are based on historical data—nobody invests to buy last year’s return.
Appraisers also can be confused by high price-earnings ratios (P/Es), such as 25 to 1. They conclude that 1/25 yields a discount rate of 4%, which is inconsistent with the much higher rates, such as 25%, derived from the CAPM or build-up methods. Appraisers should be able to reconcile the 4% vs. the 25% rates of return, and explain how they reflect different levels of risk in the market.
Exhibit 5, below, illustrates an adjustment process for a large public company P/E ratio when it is used to derive a discount rate for a closely held company—appraisers sometimes use this comparison when searching for market evidence to verify the discount rates for equity in a particular industry. True numbers would vary by engagement and date. Remember, large public companies usually possess advantages in size, market share, access to capital, depth of management and breadth of product lines that far exceed those of a privately held business. Appraisers therefore must reduce the ratios to reflect a smaller, closely held target’s additional risk characteristics.
Price/earnings ratios are derived by dividing the stock price by the earnings per share (EPS). Because they are based on the earnings of a single year, the multiple reflects the market’s expectation for growth on those earnings. For this reason, they are the reciprocal of a cap rate, which is a denominator applied to a single year’s return. Thus, cap rates are discount rates that have been reduced by the anticipated long-term growth rate, as shown below.
| Converting a Discount Rate to a Capitalization Rate | |
| Discount rate – Long-term growth rate = Capitalization rate |
The commonly quoted P/E is a ratio of stock price to last year’s net earnings affected by the market’s short-term growth expectation, whereas cap rates derived from the CAPM or build-up methods are rates that apply to next year’s net cash flow. It’s another reason to be very careful when matching rates and returns. Exhibit 5 reconciles the P/E ratio of 25 times last year’s EPS with the discount rate of 25% for next year’s net cash flow to equity.
Cap rates derived from very high P/E ratios signal the appraiser that the company is expected to achieve and sustain long-term rapid growth. If the competitive analysis of the industry and the target company suggest this is not possible, then a cap rate based on these multiples is inappropriate. When returns vary substantially from year to year, use the multi-period discounting method rather than the single-period capitalization, because it requires a forecast that can better reflect variations in the returns.
| Exhibit 5: Conversion Adjustment | ||||||||||||||||||||||
Conversion of
a large public company P/E ratio of 25 to a discount rate for
net cash flow to equity of 25% for a closely held company
|
ALWAYS CHALLENGE LONG-TERM GROWTH RATES
The cap-rate growth factor—the difference between the discount rate and the cap rate—often is used to inflate the value of a company.
When a company has achieved 20% or 30% compound growth for several years, appraisers should not assume that this rate of growth can be maintained indefinitely. Growth usually attracts competition, changing a company’s strategic advantages. Even in unusual circumstances where high growth is expected for the foreseeable future, appraisers must remember that the capitalization process is based on an assumption that returns extend to infinity. Appraisers therefore should portray the high growth in a forecast in the multi-period discount method, but then compute the terminal value using a long-term growth rate that reflects the growth of that industry (and, to a lesser extent, the general economy).
“Fooling yourself that the prospective company has a higher terminal value than can be supported will result in paying too much for an acquisition,” says Tessier. “Why add more risk to the equation, when five years down the road the picture could be drastically different—especially in an ever-changing market full of new technologies.”
This is one reason why the very high P/E ratios of many high-tech or Internet companies may be meaningless. Rapid growth for such companies is anticipated; but the growth is not expected to be indefinite. Therefore, the single-period capitalization rate, and its inverse, the P/E ratio, cannot accurately portray the low start-up income, rapid short-term growth and slower long-term growth of these companies.
CHALLENGE PREMIUMS OR DISCOUNTS
A final estimate of value may include the appraiser’s adjustments to reflect the degree of marketability and control, or lack of control, of the equity interest being appraised. Such adjustments often affect value more than any other consideration.
Premiums and discounts are dependent upon the degree of control and marketability implicit in the appraiser’s initial estimated value. That is, you must know whether the value initially determined reflects control or lack of control and marketability or lack of it. When appraisers use the single-period capitalization or the multi-period discounting methods, most or all of the difference in control vs. lack-of-control value is reflected in the choice of a control or lack-of-control return.
The shareholder who owns a controlling interest can determine what portion of the company’s income he or she takes as compensation or fringe benefit—vs. what the company reports as income. Lacking control, the minority shareholder gets whatever return the controlling shareholder chooses to pay to the minority owners. Thus, the controlling shareholder can manipulate the company’s value in varying degrees. For this reason, appraisers generally should reflect differences in value related to levels of control by adjusting the company’s return to be capitalized or discounted. Appraisers who attempt to portray these distinctions through premiums or discounts that are derived from market data often will distort value.
Industry CPAs should note that buyers usually purchase controlling interests in M&A transactions where the single-period capitalization or multi-period discounting methods are most commonly used to compute value. When the buyer’s control returns are chosen, adjustments for control are not needed. The lack of marketability discount is usually small or zero because possession of control gives the owner the option to sell the business to liquefy the investment.
The number of shareholders, composition of ownership, provisions in the corporate bylaws, and laws that vary by state will influence degrees of control. CPAs must carefully assess these to determine the degree of control or lack of it.
Remember, the controlling shareholder in a closely held corporation generally has far greater liquidity than the minority owner, because he or she controls the company’s cash flow and the decision whether to sell the company. For this reason, the discount for lack of marketability may be low, or even zero, when the CPA is appraising a controlling interest.
Finally, apply premiums and discounts only to equity value, not to invested capital, because debt is not affected by control or marketability.
HAVE PRIDE IN YOUR REPORT
Reports must comply with professional standards and be effectively written. Review your work to assure it is well organized, comprehensive and thoroughly documented. According to Donna Walker, ASA, of Columbia Financial Advisors, Inc. in Portland, Oregon, who has served for many years as a report reviewer for the American Society of Appraisers, appraisal reports demonstrate the quality and professionalism of the appraiser.
The valuation report should provide a reader who may know nothing about the valued company a thorough explanation of the economic environment and industry in which the company operates; details of its personnel, operations, policies and performance; and an opinion of value the reader can understand and follow to a convincing conclusion.
Although there are no shortcuts to writing the valuation report, there are several things to do before you consider a job finished:
- Begin with the appropriate reporting standards. Determine if your report complies with criteria enumerated in revenue ruling 59-60 and fulfills all eight components.
- Search the valuation literature—including books, journals and conference proceedings—for explanations, discussions and illustrations.
Have someone who is not versed in business valuation, but who has strong writing skills, review your report. His or her questions and comments may expose gaps a judge or business executive would notice and give you a chance to make corrections before your report goes public.
TAKE A COLD HARD LOOK
Be honest with yourself. CPAs in both industry and public practice should assess their current level of BV knowledge. If the topics discussed in this article are confusing or unclear, you may need more professional education before you say yes to a valuation assignment. A key point to remember in your self-assessment is that it is best to have the harshest scrutiny of your appraisal work occur as you do it, not later in a negotiation or, worse, under challenge by an opposing expert during litigation.
| Suggested Reading
Books the BV professional should have at hand. The Balanced Scorecard. Robert S. Kaplan and David P. Norton. Harvard Business School Press, Boston. 1996. Basic Business Appraisal. Raymond C. Miles. John Wiley & Sons, Inc., New York and Toronto. 1984. Business Valuation Body of Knowledge. Shannon T. Pratt. John Wiley & Sons, Inc., New York and Toronto. 1998. Competitive Strategy: Techniques for Analyzing Industries and Competitors. Michael E. Porter. The Free Press, New York. 1980. Cost of Capital: Estimation and Applications. Shannon P. Pratt. John Wiley & Sons, Inc., New York and Toronto. 1998. Creating Shareholder Value. Alfred Rappaport. The Free Press, New York. 1998. Guide to Business Valuations. Jay E. Fishman, Shannon P. Pratt, J. Clifford Griffith and D. Keith Wilson. Practitioners Publishing Co., Fort Worth, Texas. 1999. Quantifying Marketability Discounts: Developing and Supporting Marketability Discounts in the Appraisal of Closely Held Business Interests. Z. Christopher Mercer. Peabody Publishing, LP, Memphis, Tennessee. 1997. The Synergy Trap. Mark L. Sirower. The Free Press, New York. 1997. Understanding Business Valuation: A Practical Guide to Valuing Small to Medium-Sized Businesses. Gary R. Trugman. American Institute of Certified Public Accountants, Inc., New York. 1998. Valuation of the Closely Held Business: Advanced Theory and Applications. David M. Bishop. The Institute of Business Appraisers. 1997. Valuing a Business: The Analysis and Appraisal of Closely Held Companies, third edition. Shannon P. Pratt, Robert F. Reilly and Robert P. Schweihs, Richard D. Irwin. Professional Publications, Chicago. 1995. |
