business valuation: where should i start and what should i know brian a. reed, cpa, cva partner,...

Business Valuation: Where Should I start and what should I know

Brian A. Reed, CPA, CVAPartner, Transaction Advisory Services

Weaver

Overview

• Identify the events and reasons when an independent business valuation may be needed

• Understand the key factors involved in the valuation of a privately held business

• Describe a typical valuation engagement, process and report• Discuss discounts and premiums• Court case updates

Reasons to perform a business valuation analysis

• Gift and estate tax purposes • Marital disputes• Minority shareholder

disputes• Buy-sell agreements• Employee stock ownership

plans (ESOPs)• Management buyouts

• Lost profit analyses

• Mergers and acquisitions• Purchase price allocations• Goodwill impairment analysis• Stock option valuation

Standards and Premise of value

• Standards of value– Fair market value – Fair value – Investment value

• Premise of value– Going concern value – Orderly liquidation value – Forced liquidation

Standards of value

• Revenue ruling 59-60 defines fair market value as:– “ … in effect, it is the price at which the property would change hands

between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”

• ASC Topic 820, Fair Value Measurements and Disclosures (ASC 820) (formerly FASB Statement No. 157, Fair Value Measurements) defines fair value as:– “[T]he price that would be received to sell an asset or paid to transfer a

liability in an orderly transaction between market participants at the measurement date."

Standards of value

• Revenue ruling 59-60 outlines approaches, methods and factors to consider in valuing shares of closely held corporations– It was meant to apply to valuations for estate and gift tax

purposes– Has been accepted in the valuation community as a basis

for all valuations of interests in closely held businesses without a public market

– Establishes the factors that should be considered as part of a valuation analysis

• Nature of the business and the history of the Company

Standards of value

• Industry outlook• Book value of the stock and the financial condition of

the Company• Earnings capacity of the Company• Dividend paying capacity• Assessment of whether the Company has goodwill or

other intangible value• Sales of the stock and the size of the block of stock to be

valued• Market price of stocks of corporations engaged in the

same or similar line of business

Standards of value

• Fair value as defined by ASC 820 includes the following components:– Exit price– Market participants– Orderly transaction– Principal or most advantageous market– Highest and best use

Standards of value

Valuation Purpose Applicable standard of valueGift and estate tax FMVESOPs FMVFinancial acquisitions FMVDissenting stockholders actions Legal fair value (in most states)

Minority oppression statutes Legal fair value (in most states)

Strategic acquisitions Investment valueBuy-sell agreements Anything parties agree onMarital dissolution No standard of value specified in

most states – court specific

Financial reporting value Accounting fair value as defined by ASC 820

Valuation MethodologiesValuation

methodologies

Publicly traded comparable companies

Comparable transactions

analysisIncome approach Other

• “Public market valuation”

• Value based on market trading multiples of comparable companies

• Applied using historical and prospective multiples

• Does not include a control premium

• “Private market valuation”

• Value based on multiples paid for comparable companies in sale transactions

• Generally includes a control premium

• Present value of projected free cash flows

• Incorporates short-term and long-term expected performance

• Risk in cash flows and capital structure captured in discount rate

• Adjusted book value (Cost approach)

• Dividend discount model

• Liquidation analysis

• Break-up analysis

Valuation Methodologies

• Publicly traded comparable companies or guideline publicly traded company analysis – Revenue Ruling 59-60 indicates that the market approach should at

least be considered– There are rarely, if ever, companies that are exactly like the subject

company– The common issues surrounding the use of comparable company

information includes the following:• Are the public companies selected by the valuation analyst

sufficiently "comparable" to the subject company?• What specific factors make two companies similar? • What adjustments are appropriate, if any, to the chosen market

multiple? • Which market multiple is most appropriate?


• Publicly traded comparable companies or guideline publicly traded company analysis – Steps to be considered under the guideline company method:

• Step 1 – Obtain financial statements for the subject company

• Step 2 – Analyze and adjust financial statements of the subject company as needed

• Step 3 – Adjust tax expense accordingly, given the other adjustments that were made

• Step 4 – Perform a search for and select publicly traded guideline companies


• Step 5 – Obtain appropriate financial information for a representative period of time for the guideline public companies

• Step 6 – Consider adjusting or normalizing guideline public company financial data for the following

• Step 7 – Analyze the differences between the public companies and the subject company including the following:

– Business description– Company operations– Financial condition– Other qualitative and quantitative considerations


• Step 8 – Select appropriate valuation multiple for guideline public companies

• Step 9 – Calculation of valuation multiples• Step 10 – Selection of valuation multiple• Step 11 – Application of selected multiple to subject

company• Step 12 – Consider whether any discounts or premiums

should be applied to the conclusion of value

Valuation MethodologiesGuideline publicly traded company analysis example

Industry CompsAverage BEV / Rev 1.1xAverage BEV / EBITDA 10.0xMedian BEV / Rev 0.7xMedian BEV / EBITDA 8.0xLower quartile BEV / Rev 0.5xLower quartile BEV / EBITDA 6.8x `

Currency: $US actual ABC CompanyTTM revenue 27,564,712TTM EBITDA 1,173,016

Selected multiple BEV/Rev 0.7xBEV/EBITDA 8.0x

Indicated BEV Cash BEV Weighting Weighted BEVBEV/Rev 18,305,725 1,726,820 20,032,545 50% 10,016,273BEV/EBITDA 9,426,061 1,726,820 11,152,881 50% 5,576,440

BEV, non-controlling, marketable basis 15,592,713Control premium 15.0%BEV, on a controlling, marketable basis 17,931,620Marketability discount 10.0%BEV, on a controlling, non-marketable basis 16,138,458


Guideline publicly traded company analysis example Currency: $US in thousands, except per share amounts Average Median Lower quartile Upper quartile ABC CompanyOperating PerformanceTotal revenue $3,348,403 $2,417,042 $701,799 $4,994,000 $27,565Average days sales outstanding (DSO) 53.90 48.15 38.20 58.50 66.85 Average days payables outstanding (DPO) 40.51 30.54 22.19 64.71 22.87 Cost of revenue 84.22% 84.39% 88.23% 80.17% 86.58%Gross margin 15.78% 15.61% 11.77% 19.83% 13.42%EBITDA margin 9.52% 7.64% 5.28% 13.82% 4.26%Current ratio 2.04 1.95 1.63 2.24 1.87 Effective tax rate 76.49% 32.84% 24.37% 36.41% 0.00%Return on assets 4.28% 3.79% 1.45% 6.53% 10.18%Return on equity 6.64% 9.54% 3.34% 18.42% 18.48%CapEx as % of revenue 3.90% 2.94% 0.87% 5.79% 0.18%Working capital (3) $449,501 $300,384 $111,312 $691,000 $4,115Net working capital (4) $210,573 $96,850 $35,555 $380,981 $4,485Working capital as % of revenue 15.93% 15.48% 11.01% 19.54% 14.93%Net working capital as % of revenue 10.15% 9.03% 4.55% 14.35% 16.27%Depreciation exp as % of revenue 4.09% 3.16% 0.94% 6.44% 0.28%


• Comparable transaction analysis– The theory behind this method is that prices paid in the

acquisition of entire companies that are similar to the subject business that have sold in the marketplace can provide a reasonable approximation of the value of the subject company.

– The value generally obtained under the direct market data method is a control value.

– Adjustments could be necessary if the value to be calculated is that of a minority interest.


• Comparable transaction analysis– Common transaction multiples include price or MVIC to the

following:• Revenues• EBIT• EBITDA

– Sources include• BIZCOMPS®• Business Brokers• Pratt's Stats™• Thomson Financial Securities • Institute of Business Appraisers Market Database


Comparable transaction analysis example Target SIC code Country

Effective Date

Mergerstat Control

Premium

Implied Minority

Discount Net Sales EBITDA EBITMVIC (BEV)

EBIT Margin

Net Income Margin

EBITDA Margin

MVIC/Sales

MVIC/EBITDA

MVIC/ EBIT

1541 Denmark 11/30/2000 117.4% 54.00% 224.6$ 8.1$ 4.8$ 36.7$ 2.12% 1.30% 3.58% 0.16 4.56 7.691542 England 12/27/2000 74.6% 42.7% 733.8$ 53.8$ 47.1$ 135.9$ 6.41% 4.09% 7.34% 0.19 2.52 2.891541 Greece 8/26/2002 -39.1% -64.3% 21.7$ 1.5$ 1.5$ 10.1$ 6.72% 1.24% 6.72% 0.47 6.94 6.941542 Greece 9/9/2002 -41.2% -69.9% 20.9$ 1.9$ 1.9$ 16.3$ 9.06% 2.64% 9.06% 0.78 8.62 8.621542 Hong Kong 12/27/2002 42.9% 30.0% 685.2$ 31.4$ 21.0$ 386.0$ 3.06% 1.45% 4.58% 0.56 12.30 18.411752 Canada 5/13/2005 82.5% 45.2% 5.9$ 0.6$ 0.5$ 2.6$ 8.01% 5.75% 10.17% 0.45 4.39 5.571731 United States 8/30/2007 27.1% 21.3% 992.3$ 77.4$ 50.8$ 191.4$ 5.12% 2.77% 7.80% 0.19 2.47 3.771542 Greece 9/12/2007 -2.9% -3.0% 204.9$ 11.5$ 1.7$ 119.8$ 0.83% 0.31% 5.62% 0.58 10.39 70.011541 Malaysia 10/31/2007 52.2% 34.30% 155.4$ 15.5$ 15.3$ 40.7$ 9.82% 7.16% 10.00% 0.26 2.62 2.671521 United States 9/1/2009 23.3% 18.9% 135.0$ 7.3$ 5.3$ 52.8$ 3.93% 3.74% 5.44% 0.39 7.19 9.941796 Japan 10/1/2009 45.9% 31.5% 283.4$ 7.7$ 6.5$ 47.2$ 2.29% 0.95% 2.73% 0.17 6.10 7.291541 Canada 7/13/2010 17.8% 15.1% 564.5$ 39.2$ 34.6$ 99.5$ 6.13% 4.19% 6.95% 0.18 2.54 2.881542 Malaysia 8/18/2011 15.6% 13.5% 686.5$ 55.1$ 55.1$ 256.9$ 8.03% 4.93% 8.03% 0.37 4.66 4.66

Lower quartile 15.6% 13.5% 135.0$ 7.3$ 1.9$ 36.7$ 3.06% 1.30% 5.44% 0.19 2.62 3.77Median 27.1% 21.3% 224.6$ 11.5$ 6.5$ 52.8$ 6.13% 2.77% 6.95% 0.37 4.66 6.94Mean 32.0% 13.0% 362.6$ 23.9$ 18.9$ 107.4$ 5.50% 3.12% 6.77% 0.37 5.79 11.64Upper quartile 52.2% 34.3% 685.2$ 39.2$ 34.6$ 135.9$ 8.01% 4.19% 8.03% 0.47 7.19 8.62


Comparable transaction analysis example ABC CompanyTTM revenue (in $US actual) 27,564,712 TTM Adjusted EBITDA (in $US actual) 1,173,016

Selected multiple BEV/Rev 0.5xBEV/EBITDA 7.2x

Indicated BEV WeightingBEV/Rev 12,850,002 50.0% 6,425,001BEV/EBITDA 8,434,623 50.0% 4,217,311

BEV on a controlling, non-marketable basis (in $US actual) 10,642,312 Discount for lack of control 13.5%BEV on a non-controlling, non-marketable basis 9,205,600


• Income approach – There are two methods that can be used to value direct

equity or invested capital:• Discounted cash flow (DCF)

– Multi-period– Present value of expected future cash flows– Erratic or unstable net cash flows– Discount by use of a discount rate

• Cost of equity capital• WACC


– Utilizes residual period after stabilization of cash flow• Capitalization of future net cash flows• CF0(1 + g) / (Discount rate - g)

• Capitalization cash flow method– Single period– Stable net cash flows– Shortcut of DCF method– Discount using capitalization rate


• Income approach – There are two primary models to determine the appropriate

cash flow:• Direct equity

– Direct valuation of common equity– Often used when valuing minority interests because a

minority interest holder has no ability to influence the capital structure

– PV = [NCFe(1))/(1 + ke)] + [NCFe(2))/(1 + ke)2] + ... + [NCFe(n))/(1 + ke)n]


• Invested capital– Enterprise valuation– Often used when the capital structure is expected to

change and/or control value, especially when the enterprise has little to no debt or too much debt, and an optimal amount of debt would enhance entity value

– Based on net cash flow to invested capital– PV = [NCF(1))/(1 + WACC)] + [NCF(2))/(1 + WACC)2] + ... +

[NCF(n)/(1 + WACC)n]


Income approach: Net cash flow to equity:Net income after tax

Plus: Non-cash charges (typically depreciation, amortization and deferred taxes)

Less: Incremental working capital to support growth

Less: Anticipated capital expenditures (typically property, plant and equipment)

Plus: New debt principal in (borrowings)

Less: Debt principal out (repayments)

Equals: Net cash flow to equity


Income approach: Net cash flow to invested capital:Net income after tax

Plus: Interest expense (tax-effected)

Less: Non-cash charges (typically depreciation, amortization, and deferred taxes)

Less: Incremental working capital (excluding interest bearing debt obligations) to support growth

Plus: Anticipated capital expenditures (typically property, plant, and equipment)

Equals: Net cash flow to invested capital


• Income approach – Cost of capital

• The expected rate of return that the market requires to attract funds to a particular investment

• Referred to as the discount rate• Should represent the perceived risk of the investment• “Forward looking" expected rate of return (or required

rate of return)


– Cost of capital (continued)• Commonly used approaches for calculating the return on

common equity– Capital asset pricing model (CAPM)

• CAPM = Rf + (Rp x β)– Modified CAPM

• CAPM = Rf + (Rp x β) + Size risk + Specific company risk

– Build-up method• Ke = Rf + Rp + Size risk + Specific company risk


Currency: $US in millionsAssumptions

Tax Rate 30.0%Risk-Free Rate of Return (Rf)(1) 3.34%Market Risk Premium (Rm - Rf) 6.0%Size Premium 4.1%Company Specific Risk Premium 3.0%Industry D/(D+P+E) 22.0%Industry D/E 28.5%Industry P/E 1.1%Industry Cost of Debt (Rd) 5.3%Industry Cost of Preferred (Rp) 0.0%Industry Tax Rate 30.0%

Income approach – Cost of capital example


Income approach – Cost of capital example

Market Risk Premium (Rm - Rf) 9.45%Multiplied by: Industry Levered Beta 1.26 Adjusted Market Risk Premium 11.88%Add: Risk-Free Rate of Return (Rf) 3.3%Add: Size Premium 3.9%Add: Company Specific Risk Premium 3.0%Cost of Equity 22.1%Multiplied by: Industry E/(D+P+E) 76.6%Cost of Equity Portion 16.93%

Industry Cost of Debt (Rd) 5.3%Industry Tax Rate 0.0%After-Tax Cost of Debt 5.3%Multiplied by: Industry D/(D+P+E) 23.4%Cost of Debt Portion 1.24%

Industry Cost of Preferred (Rp) 0.0%Multiplied by: Industry P/(D+P+E) 0.0%Cost of Preferred Portion 0.0%

WACC 18.2%


Income approach – Discounted cash flow exampleCurrency: $US actual 2012F (6) 2013F 2014F 2015F 2016F 2017F ResidualNet income 2,684,263 4,008,093 4,408,902 3,423,383 3,594,552 3,774,280 3,962,994 Add: interest expense (income) 31,580 47,154 51,869 57,056 59,909 62,905 66,050 Add: depreciation and amortization 126,318 188,616 207,478 228,226 239,637 251,619 264,200 Less: capital expenditures (157,898) (235,770) (259,347) (285,282) (299,546) (314,523) (330,249) Add/Less: incremental working capital (1,831,383) (864,491) (778,042) (855,846) (470,715) (494,251) (518,963) Net Cash Flow 852,880 3,143,602 3,630,861 2,567,537 3,123,837 3,280,029 3,444,030 Discount period (years) 0.38 1.25 2.25 3.25 4.25 5.25 Present value (PV) factor: 18.2% 0.9390 0.8112 0.6864 0.5808 0.4915 0.4159PV of cash flow 800,883 2,549,941 2,492,257 1,491,354 1,535,440 1,364,278 Residual growth rate 5.0%Multiple 7.59Residual net cash flow 3,444,030 Future value of residual 26,144,047 Discount period (years) 5.75 Discount factor 0.3826PV of residual value 10,003,188

Sum of PV of cash flow 10,234,152 PV residual value 10,003,188 Business enterprise value on a controlling, marketable basis 20,237,339Discount for lack of control 13.5%Business enterprise value on a non-controlling, marketable basis 17,505,299Less: discount for lack of marketability 25.0%Business enterprise value on non-controlling, non-marketable basis 13,128,974

Types of Reports

• Detailed report– Only for valuation engagements

• Summary report– Cannot restrict valuation approaches that are applicable– No difference in relation to economic and industry

background research between a summary and a detailed report

– No changes in the due diligence measures taken with a summary report versus a detailed report

• Calculation report – Requires fewer procedures than a detailed report

Discounts and premiums

• Discount for Lack of Control– A controlling interest

• Is an interest in a business enterprise where the necessary elements of control are active and tied to the interest

– A minority interest lacks potentially valuable rights that a controlling shareholder or group enjoys.

– Necessary to evaluate the facts and circumstances surrounding the situation to determine whether effective control exists.


• Discount for Lack of Marketability– The principal economic factor causing a lack of marketability (“LOM”) discount is

the increase in risk caused by the inability to quickly and efficiently return the investment to a cash position

– There are two types of empirical studies used to quantify valuation adjustments associated with the lack of marketability of noncontrolling ownership interests in closely held businesses:

• Restricted Stock Studies– Studies that measure the difference between the private price of a

restricted and the publicly traded stock price of the security the same company

• Pre-IPO Studies– Studies based on the difference between the initial pubic offering (IPO)

price of a company and transactions in the same company’s stock prior to the IPO.


Discount for Lack of MarketabilityStudy Type of study Mean MedianSEC Institutional Investor Study (for NYSE companies) Restricted stock 25.8%SEC Institutional Investor Study (for non-reporting entities) Restricted stock 32.6%Gelman Study Restricted stock 33.0% 33.0%Moroney Study Restricted stock 35.6% 32.8%Maher Study (unadjusted) Restricted stock 35.4%Trout Study Restricted stock 33.5%Pittock/Stryker (Standard Research Consultants) Study Restricted stock 45.0%Willamette Management Associates, Inc. Study Restricted stock 31.2%Silber Study Restricted stock 33.8%Hall/Polacek (FMV Opinions) Study Restricted stock 25.2% 22.1%Management Planning, Inc. Study Restricted stock 27.7% 28.9%John Emory Study (1997-2000) Pre-IPO 50.0% 52.0%John Emory Study (1995-1997) Pre-IPO 43.0% 42.0%John Emory Study (1994-1995) Pre-IPO 45.0% 45.0%John Emory Study (1992-1993) Pre-IPO 45.0% 44.0%John Emory Study (1990-1992) Pre-IPO 42.0% 40.0%John Emory Study (1989-1990) Pre-IPO 45.0% 40.0%John Emory Study (1987-1989) Pre-IPO 45.0% 45.0%John Emory Study (1985-1986) Pre-IPO 43.0% 43.0%John Emory Study (1980-1981) Pre-IPO 60.0% 66.0%Minimum 25.2% 22.1%25th percentile 33.1% 32.9%Average 38.9% 40.7%Median 38.8% 42.0%75th percentile 45.0% 45.0%Maximum 60.0% 66.0%


Discount for Lack of Marketability

InputsDiscount for lack of

marketability (DLOM)

S0 = $1.00 Ghaidarov method (1) 35.70%K = $1.00 Chaffee method (2) 49.17%rf = 1.24% Finnerty method (3) 61.41%

Dividend yield (7) q = 0.00% Longstaff method (4) 181.51%Cumulative yield r = 1.24%PV of dividend PV(Div) = 0Adjusted So Adj So = $1.00

Time in Months 60 MonthsT = 5.000σ = 65.7%

Price of underlying stock (5)Strike price (5)Risk-free rate (6)

Option time in yearsVolatility (8)


Discount for Lack of Marketability

Case Court Date DLOM

Estate of William G. Adams v. Commissioner

U.S. Tax Court March 28, 2002 35.0%

Jane Z. Astleford v. Commissioner U.S. Tax Court May 5, 2008 21.23%

Estate of Dunn v. Commissioner U.S. Tax Court August 1, 2002 22.5%

Gross v. Commissioner U.S. Tax Court July 29, 1999 25.0%

Kelly v. Commissioner US. Tax Court October 11, 2005 23.0%

Court Case Updates

• Malik v. Falcon Holdings, LLC, 2012 U.S. App. LEXIS 5336 (March 14, 2012)– Actual transaction is the “gold standard” of valuation– “The value of a thing [asset] is what people will pay.”

• Gearreald v. Just Care, Inc., 2012 Del. Ch. LEXIS 91 (April 30, 2012)– Delaware Court accepts supply-side equity risk premium– Court rejects liquidity argument for lesser size premium

• Holber v. M&T Bank (In re Scheffler), 2012 Bankr. LEXIS (June 5, 2012)– Cost method inappropriate method to value technology

Disclaimer of Liability

Weaver provides the information in this presentation for general guidance only, and it does not constitute the provision of legal advice, tax advice, accounting services, investment advice or professional consulting of any kind. The information included herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation. Tax information is not intended to be used and cannot be used by any taxpayer for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided "as is," with no assurance or guarantee of completeness, accuracy or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability and fitness for a particular purpose.

Presenter Biography

Brian A. Reed, CPA, CVAPartner, Transaction Advisory Services

Brian Reed has more than 12 years of diversified financial advisory experience ranging from acquisition due diligence and valuation services to ligation support and fraud investigations. He has worked with a wide range of clients including both private equity and corporate clients. In addition, he has provided financial support services to attorneys.

Brian has participated in acquisition due diligence engagements ranging from $1 million to over $500 million. Additionally, he has performed a significant number of valuation engagements related to purchase price allocations, goodwill impairment analysis, gift and estate taxes and litigation consulting engagements. His experience includes engagements in the manufacturing, retail, software, distribution, professional services and oil and gas industries.

He received his Bachelor of Arts degree at the University of Texas at Austin and a Master of Business Administration degree in finance and accounting from Tulane University.

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business valuation: where should i start and what should i know brian a. reed, cpa, cva partner,...

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