Oft Forgotten Valuation Principle: Total Return
Few would debate we valuators are purported to reflect the investors’ psychology –primarily motivated by capital appreciation (growth), income (yield) or a combination of the two. In other words – total return. How well do we express this within our reports?
After 15 years of valuing primarily mid-market closely held companies, it seems many valuation practitioners apply a cookbook “check the box” rationale to their businesses and business interests value conclusions. How many provide adequate reasonableness checks when examining the economic benefit of earnings/cash flow and capital appreciation to their final conclusions and then compare this result to alternative investment returns that could be achieved as of the date of value
Chris Mercer, of Mercer Capital - a well respected nationwide business valuation and investment banking firm, recognized the levels of marketability discount were directly tied to the total return expected by an investor. He also was correct at pointing out that the holding period was germane. Perhaps a further dimension is “What market influences were occurring as of the date of value?”
Share pricing bid-ask spreads of actively traded marketable securities reflect the variance in perceived risk-reward among investors among alternative investments at any given point in time. The investor either perceives s/he might want liquidity to invest in something else or expects better performance is yet to come. If we accept this premise, then we accept that value is within a range and reported as a fixed midpoint. We should also expect that motivations and acceptable holding periods likely differ among investors. We should also recognize that given another period – say, two quarters prior or hence, the investors’ motivations might be all together different.
The causes influencing changing motivations may be external market factors, such as sector performance, consumer confidence and/or interest rates. They may also be subject to internal factors such as management, need for diversification or revised risk tolerance.
What makes capturing investor psychology more complicated is that half, if not more, of all proxies of risk are influenced by large institutional investors who often have diversified portfolios and are tracking/shifting investments from day-to-day, if not hour-to-hour with a holding period that is likely to reflect very sophisticated analysts’ quarterly projections.
Institutional investors often hold large blocks of shares, the transfers of which can influence actual stock performance. This is wholly different from a likely less sophisticated individual investor - the subject of our reports. S/he is likely expecting a three- to five-year holding period horizon where performance is unlikely to be influenced by his/her own transfers.
Since many public companies infrequently report positive earnings and fewer still pay regular dividends, then an investor’s performance expectation must be based upon capital appreciation or growth.
Few shareholders would be pleased with a 3% or 5% annual growth rate except perhaps for those operating within the most mature industries. Yet, proxies for sustainable growth in most valuation reports are within this range when developing capitalization rates.
Another issue is the build up method applied in deriving discount rates that makes use of 80+ year market trends reported in Ibbotson’s Stocks, Bonds, Bills and Inflation. Is there anyone who believes that the capital structure of American corporations hasn’t shifted from asset-intensive manufacturers, many of which have outsourced their facilities, to knowledge based businesses? Take Apple Computer, who competed in the ever slimming margins of a PC manufacturer in the early 1980’s to the tech-wunderkid with the iPod and iPhone. The company’s value rests in its intellectual property. What has this trend done to the P/E’s of the U.S. stock market for the past twenty to thirty years?
So, when a value conclusion of a closely held business provides, say a total return of 22%, of which 4% is ascribed to growth and the balance to a proxy of opined distributable earnings, then the question the valuator ought to be able to answer is “as of the date of value what kind of returns was this sector achieving in the public market and how long is it forecasted to remain doing so?” For example, this result in 1999, where publicly traded returns were often north of 20% may be questionably low; whereas, in 2001, it may be quite reasonable.
This is particularly the case when examining levels of discounts for illiquidity and lack of control impairments that often seem to be independent of adequately tying these figures to direct ownership returns as of a particularly point in time. Otherwise a 25% discount would remain constant only if the referenced external market factors remained the same as well, which is unlikely.
Users of our valuation reports can be better educated to examine our conclusions by having an adequate understanding of how well we reflect and support our risk/return determination. This is at the heart of why they retain and pay for these services.
Carl L. Sheeler, PhD, CBA, AVA is the managing partner of the nationwide business valuation 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. Mr. 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 entity 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. He is an instructor for one of the national business valuation associations.