Is It Time To Go Beyond Cookbook Valuations?
First, let’s address the professional bias that distinguishes those
whose backgrounds are primarily in accounting from those in finance or
economics. Then let’s acknowledge the influence of a hands-on,
operational background versus an academic or advisory one. As a great
fan of Dr. Burton Gordon Malkiel, I believe he “gets it” to the chagrin
of many of his detractors.
Way too many perform and expect cookbook valuations. A cookbook valuation is when the cook [analyst] follows the instructions about the required ingredients, preparation, cooking time and temperature. However, the difference between a cook and a chef is the chef has a masterful comprehension of why certain ingredients and quantities were used as well as how changes to any step produces differing results.
In this article, we’ll cover some issues involving the income and market approaches as well as adjustments for impairments associated with illiquidity. Finally, we’ll wrap up with current thinking involved in marital dissolution valuation theories and practice.
The Income Approach. Follow the steps of the build-up method applying Ibbotson data when developing the capitalization/discount rate. Roger Grabowski and many others are to be commended in making this process uniform and easily repeated. What influence do global market economies have on the dollar and how does this impact the principles that are the basis of the initial build-up building block – the risk free rate? They don’t.
Then as the theory goes we examine the 80+ year history of the largest companies’ (S&P or NYSE) market performance to reflect the long-term returns premise. The argument for applying this measure is that it smoothes the peaks and valleys of major historical events like WWII and stagflation. Okay, let’s agree to disagree. Here are a few thoughts.
The U.S. market clearly no longer operates in a domestic vacuum. Ask any employee who has seen his position downsized, outsourced or otherwise shipped overseas since the late 1970’s and early 1980’s. What other arguably permanent market changes have occurred? Manufacturing companies like US Steel and General Motors are no longer national and global powerhouses. These companies had paid considerably more in taxes before they began to offshore operations. They now have lobbyists influencing tariffs and regulations. Their capitalization was significantly influenced by the amount of inventory, plant and equipment they possessed as well as the size of their labor forces.
Many of the largest companies by capitalization are now those possessing significant intellectual property. A growing amount of their revenues are global in nature, as is their competition. What of officer compensations that have grown out of proportion to line personnel salaries or actual performance of the companies they manage. Can performance assumptions on their returns be compared to that of yester-year’s companies? Unlikely.
The various measures of size are broken down into deciles. In the top deciles, there are a few dozen companies whose capitalization influences the entire group. This is also true for using industry specific (“beta”) adjustments. What of the premise of an informed buyer and seller under the fair market value standard? Is this realistic when there’s an absence of transparency even when SEC 10K’s and 10Q’s are filed? Enron come to mind? And how does one accurately tax-affect an “S” corporation when, through off-shoring, many public companies report little to no taxable income while stating profits in their annual reports?
And who are these investors? Half or more are institutional investors like CALPERS (the retirement fund of California state employees). Many of these entities trade in hundreds and millions of dollars. They influence market values by simply threatening to transfer funds. Most have armies of Ivy League MBA/PhD analytical types who have direct access to executive management. And some require a board seat. And what of the analysts who have upper management authorizing their AAA ratings of subprime loans? Are these the investors under the fair market standard when they create short- and longer-term volatility?
Now as one drills down to examine the smaller public companies within their industries, one finds many are more indicative of closely held’s management’s ability to leverage their strengths and minimize weaknesses, while acting nimbly in their markets. Which public market analysts are evaluating their performance and what is creating their P/E results?
Whether reading the Wall Street Journal, Barron’s or perusing through Hoovers, how many companies would one invest in if they anticipated annual growth of 3.0%? Yet, this is oft applied. But the equity market is not typically static. A paltry $10,000 invested in the S&P index in 1980 is now worth $270,000 proves this point.
A reasonable inquiry is “Is the company scalable?” In other words, with a capital infusion, how large and quickly could the company grow? With public companies, their boards and shareholders are expecting the company to expand through acquisition and new products and/or services. Even a change in inventory, such as raw materials (metals) where pricing would increase by 50% due to supply shortages would result in increased finished goods pricing. The point is, when the business valuation analyst opines a “sustained” growth of 3%, in essence, the business is operationally stagnant. And does the analyst discuss the Subject company may be at a size plateau where earnings decline until momentum builds?
Then there’s the investor holding period. It’s interesting that in real estate appraisal reports the appraiser is expected to express the likely marketing period prior to an actual consummated transfer. There’s an implied holding period. What standard requires the business analyst to express the likely holding period of the investment or, for that matter, what the reasonable return ought to be under present market conditions when considering alternative investments? This point is raised as part of total return with the capital appreciation reflected in the opined growth rate. We’ll discuss this concept further when discussing quantifying the levels of discounts for lack of marketability.
And from where are the 1%, 3% and 7% company specific adjustments coming? Duff and Phelps has helped. But, if the overall cap rate is 17% and the company specific adjustment is 4% versus 2%, this is a 23.5% versus an 11.8% portion of the overall rate. It seems something more rigorous than “in my professional opinion” ought to be expressed to defend these figures. This is especially true, if the majority of business value is intangible.
Now some bright business valuation practitioners are beginning to ask the right questions concerning the optimal returns on capital assets and levered debt. The point of raising the above questions is that simply following the build up methodology without exploring issues such as these fails to raise the level of inquiry expected of a chef.
The Market Approach. Valuation giants like Ray Miles, Shannon Pratt and the Trugmans (Gary and Linda) have added a great deal to this issue.
Let’s assume an apples-to-apples comparison and the analyst understands the difference between Sellers’ Discretionary Earnings, Net Income, EBITDA and Free Cash Flow. It could be argued that if the depth of inquiry was performed under the Income Approach locating comparable smaller publicly traded companies for the buildup method, then issues such as growth and debt/equity mix and return (ROA/ROE) could help filter the best selections prior to adjustments for liquidity and control, as might be required.
When say seven comparables are selected from a closely held database and three have low earnings and two have no earnings, the application of the P/E multiple seems to be put in doubt without some serious explanation by the analyst. When two business comps where the sales are similar, but one has a 2% profit margin and the other 5% (2.5x greater), but the sales price is maybe 20% greater on the more profitable one; what does that do to the P/E multiple of the lower margin comparable? It makes it high and potentially skews the valuator to a higher result in the absence of really examining what’s going on. So should the analyst create quadrants of least, best, median and mean to reflect what the likely price buyers and sellers would agree?
Toby Tatum did a wonderful job raising the bar on questions an analyst ought to be asking about the data that could influence the multiples selected and their adjustment.
One should examine the duration the sales comparables were listed and the difference between asking and sales price (bid-ask spread). This may be helpful in considering whether listings can be another useful source of comparable data. Similar to the real estate appraisal market, these are the comparables of last resort, but I’d argue when there’s been a fair amount of time between when comparables have sold and current market conditions, then the use of listings might make a great deal of sense as would discussion of why there are as many or as few businesses in a given industry currently for sale. I believe Tom West (Business Reference Guide author and long-time business broker) might have much to impart as to the likelihood of certain businesses ever selling based upon industry, revenue size and profitability.
And what about the influencing of financing terms on comparables.
Certainly, when 10% is put down and 90% is financed for ten years at 8%, when no lending institution is likely to do so at a 12% or 15% interest rate, would suggest a need to consider whether this is a cash equivalent comparable for multiple selection under the fair market standard unless many transactions are found to be financed in this matter.
And there are clearly industries with nominal change to price to revenues multiples whether the company reports $1 million or $100 million in annual revenues. Many a valuation cook has given way too much weight to this multiple without the depth of inquiry that ought to exist prior to doing so. Even in public data there are often two P/R multiples provided, reflecting the enterprise and the equity values. Woe to the analyst who has not captured the influence of debt on value.
The DLOM. There are some really bright folks out there like Judge Laro, Lance Hall, Chris Mercer and Jay Abrams who have raised the bar on our thinking about quantifying the level of adjustment for the impairments associated with [discount for] lack of marketability and illiquidity.
Regardless of whether one is examining the level of discount for an asset holding or an operating company, there ought to be the following questions raised:
Holding period: This is a critical area for an analyst who might be arguing for a greater adjustment. Any valuator worth their salt is aware of the IRS’ position that unless one can demonstrate that the sale of the asset or company is imminent, then the potential embedded gain liability is not a rightful proxy for the level of discount. Given recent capital gains tax levels, who could argue?! Seriously, this is wonderful, if you have full appreciation of the position. In essence, the Service is stating a position on the likely holding [prolonged] period. So agree with them for goodness sake!
Every industry study reflects the longer the holding period, the greater the level of uncertainty. The greater uncertainty, the greater the discount. Many conferences which discuss the DLOM levels were lowering because restricted stock holding periods had dropped from two to one year. This doesn’t mean the discount one can argue ought to go down. If anything, it gives further evidence to the underlying principle that longer holding periods result in higher adjustments.
Now the area that often does not receive the rightful level of focus is the proper use of restricted stock and IPO studies. Assuming we can separate the potential influence that parties involved in these transactions have on these stock prices, most will agree certain industries are more volatile than others, have historically higher levels of profitability, are more mature and/or have the potential for hyper-growth. The point is when one eliminates blue sky influences, there’s still ample data to examine.
What ought to be examined is Finance 101. What is the total near and long-term return the investor could expect? When a company is putting off distributions of 12%, 15% and higher yields and then the analyst states a DLOM of 35% is justified is looking for trouble.
That would provide a 23% adjusted yield assuming a pre-discounted 15% yield. But what is the total return for the interest holder taking into consideration capital growth and current total return expected on alternative investments as of the date of the valuation? When the analyst is not tying the valuation to the date of value and return, then predictably the level of discounts seems to be the same with “cookbook” support.
Just a final thought on this issue. There are three companies all with the same value with the first having a 12% yield, the second a 6% yield and the third no distribution history. The first has no or nominal growth anticipated for the next five years. The second has a 6% growth history and the third has a 15% average growth. If one held a 10% interest in each company, would the DLOM be the same, and if not, why and which is likely to have the highest and lowest adjustments? This is the point where the rubber meets the road for practitioner theory and practice discussion. The cookbook just won’t get you there.
Marital Dissolution Values. There’s a lot written about the distinction between the fair market value and the fair value standards, so we won’t dwell on this issue. What ought to be discussed in the analyst’s report is the sole and separate property and date of marriage.
Most would agree what was owned by the spouse prior to the marriage often remains the sole property of that spouse. The question ought to be “Is the economic benefit passive versus active?” Does the non-operating spouse have rights to a company’s growth that is passive? If the operating spouse infuses $100,000 of sole property into covering a struggling business and then assigns a $100,000 shareholder loan, how does that impact the allocation of value?
What if inventory costs double and that causes revenues to double? This would certainly have some impact on fixed and variable costs as well as result in a likely increase in profitability even if no changes occurred in staff size or capital equipment. If the industry growth rate was 10% annually, and this is how much the business’ revenues increased, is this a benefit to be shared with the “out-spouse”? If the operating spouse has historically worked only 30 hours weekly, but could work more, does the fact that s/he chose not to have a bearing on the valuation?
Certainly, statutes have tried to oversimplify issues that valuators have and will face. Bad facts and bad statutes create bad results. It seems manifest that the analyst has a duty to the industry and the client to educate the trier of fact, as best as s/he can.
There are really two things that the analyst is being paid to opine: the level of risk (uncertainty/volatility) and the likely level of future economic benefit to the investor. We have the opportunity to bring the theory and practice to a higher nexus.
Carl L. Sheeler, PhD, CBA, AVA is the managing partner of the nationwide business valuation, advisory and litigation support firm, Allison Appraisals & Assessments, Inc. Since 1954, the company has provided 1,000’s of business valuations and reviews as well as economic loss reports for purposes ranging from Estate Planning/Gifting/Taxes, Commercial Damages, Condemnation, Dissenting Shareholder/Disassociation Actions to Marital Dissolutions. Dr. Sheeler has been involved in litigation support with national entities including Exxon, Ernest & Young, Bank of America, Amtrak and American Honda as well as a myriad of municipalities and insurers. He has successfully prepared reports allowing for value adjustments as great as 65% of the interests’ value for estate related purposes. Designated an expert witness, he has provided testimony in deposition as well as in Federal and State Courts on over one hundred occasions. He has authored a plethora of articles and presented on the above topics for legal and finance journals in the US and the PRC. He is an instructor for a national business valuation association.