Math for Lawyers: Valuation Theory and Practice 101. December 8, 2011

Transcription

1 Math for Lawyers: Valuation Theory and Practice 101 December 8, 2011

2 Agenda Introduction Presentation Questions and Answers (anonymous) Slides now available on front page of Securities Docket Wrap-up

3 Webcast Series Approximately every other week December 14: SEC Enforcement--Key Developments in 2011

4 Panel Jeff Litvak, CPA/ABV/CFF, ASA Senior Managing Director Forensic and Litigation Consulting, FTI Consulting Ken Mathieu, CPA/CFF/ABV Managing Director Forensic and Litigation Consulting, FTI Consulting

5 Business Valuation (BV) Theory and Principles for Attorneys December 8, 2011 Jeff Litvak, CPA/ABV/CFF, ASA Ken Mathieu, CPA/ABV/CFF, MBA Senior Managing Director Managing Director

6 Business Valuation (BV) Overview Introduction Standards of Value Premises of Value BV Standards BV Approaches / Methodologies Discounts and Premiums Financial Statement Analysis Case Study/Conclusion of Value 6

7 I. Introduction: What is Business Valuation?

8 What is Business Valuation Business Valuation: The act or process of determining the VALUE of a business, business ownership interest, security, or intangible asset. 8

9 What is Value? Is value an absolute or relative measure? Is value inherent in the asset being valued or is it impacted by perception? Can there be more than one value for a certain asset at a particular point in time? If so, why? Is the concept of value time-dependant? 9

10 Concept of Value Due to factors such as opportunity costs and inflation: A dollar today... is worth more than a dollar tomorrow 10

11 Concept of Value (cont.) Value is an economic concept; as such it is an OPINION of the worth of an asset at a given time in accordance with the specific definition of value. Source: Uniform Standards of Professional Appraisal Practice 11

12 What Creates Value? Investors assign value based on the FUTURE ECONOMIC BENEFITS The value of a cash flow stream is a function of: The timing of cash receipts The risk that less cash than expected will be received 12

13 Litigation When is Valuation Needed? Bankruptcy Marital Dissolution Damages caused to business Compliance Determination of Estate & Gift taxes Employee Stock Ownership Plans (ESOPs) Purchase Price Allocation Goodwill Impairment Testing Strategic Purchase/Sale of business or shares Fairness Opinions 13

14 Case Study Subject Company: Dunder Muffler Paper Company Industry: Paper Manufacturing Valuation Date: December 31, 2009 Interest Valued: 40% (Minority) Premise of Value: Going Concern Standard of Value: Fair Value Purpose of Valuation: Shareholder Dispute 14

15 II. Standards of Value

16 Standards of Value 1. Fair Market Value 2. Investment Value 3. Intrinsic Value 4. Fair Value 16

17 Fair Market Value Standards of Value (Cont.) The PRICE, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer a hypothetical willing and able seller acting at arms length knowledge of the relevant facts. 17

18 Investment Value Standards of Value (Cont.) Value to a PARTICULAR INVESTOR based on individual investment requirements and expectations. 18

19 Intrinsic Value Standards of Value (Cont.) The value that a prudent investor considers to be the true or real value that will become the market value. 19

20 Standards of Value (Cont.) Fair Value (Two Types): Fair Value (State Rights) - minority interest (i.e., not a willing seller) Fair Value (Financial Reporting) - SFAS 141R, SFAS 142, and SFAS 157 SFAS 157 defines Fair Value as: The 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. 20

21 III. Premises of Value

22 Premises of Value Premise of value refers to the appropriate CONTEXT or set of circumstances to consider with respect to the valuation, including: Going concern value Liquidation value 22

23 IV. BV Standards

24 BV Standards The U.S. professional associations that publish business valuation standards are: American Institute of Certified Public Accountants (AICPA) American Society of Appraisers (ASA) Institute of Business Appraisers (IBA) National Association of Certified Valuation Analysts (NACVA) The Appraisal Foundation (TAF) 24

25 BV Standards: AICPA SSVS1 Stmt. on Standards for Valuation Services No. 1 AICPA members will be required to follow this standard when they perform engagements to estimate value that culminate in the expression of a conclusion of value or a calculated value. Exception from this Statement: This Statement is not applicable to engagements that are exclusively for the purpose of determining ECONOMIC DAMAGES (for example, lost profits) unless those determinations include an engagement to estimate value. 25

26 IV. BV Standards: ASA I. General Requirements for Developing a Business Valuation II. Financial Statement Adjustments III. Asset-Based Approach to Business Valuation IV. Income Approach to Business Valuation V. Market Approach to Business Valuation VI. Reaching a Conclusion of Value VII. Valuation Discount and Premiums VIII. Comprehensive Written Business Valuation Report IX. Intangible Asset Valuation 26

27 BV Standards: ASA (cont.) SBVS-1 SBVS-2 The guideline company valuation method Merger and acquisition method Advisory Opinions (AO) - Asset-Based Approach to Business Valuation Procedural Guidelines (PG) Litigation support: Role of the independent financial expert 27

28 BV Standards: IBA Standard One Standard Two Standard Three Standard Four Standard Five Standard Six Standard Seven Professional Conduct & Ethics Oral Appraisal Reports Expert Testimony Letter Form Written Appraisal Reports Formal Written Appraisal Reports Preliminary Reports Conducting A Business Appraisal Assignment 28

29 BV Standards: USPAP Standard No. 9 Standard No. 10 Business Appraisal, Development Business Appraisal, Reporting 29

30 BV Standards: Revenue Ruling Nature and history of the business Dividend-paying capacity Economic and industry outlook Intangible value Financial condition Sales of the stock Earning capacity Market price of stocks of comparable corporations 30

31 V. BV Approaches / Methodologies

32 BV Approaches Three basic approaches to determining value: Asset Approach (also, Cost Approach) Market Approach Income Approach Under each approach, there are multiple methods. The use of one or several approaches (or methods) may be appropriate. 32

33 BV Approaches: Asset Approach Primary Method: Adjusted Net Asset Value (NAV) Method The balance sheet is restated from historical cost to market/fair value o NAV = market value of assets LESS market value of liabilities 33

34 BV Approaches: Market Approach Overview: Bases on the principal of SUBSTITUTION A buyer would pay no more than the cost to acquire a substitute property with the same utility Can be used for both control and minority level valuations 34

35 BV Approaches: Market Approach (cont.) Two primary methods: Guideline Public Company Method Based on sales of similar publicly traded company shares May require adjustments for small and medium sized companies due to size, capital structure, and other differences Merger and Acquisition Transaction Data Method Based on acquisition of similar privately held or publicly traded companies Consider aspects of companies involved in the comparable transactions 35

36 BV Approaches: Market Approach (cont.) Example: Dunder Muffler Paper Company Comparable Transaction Database: SIC Filing Date Purchaser Company Name MVIC/EBITDA /6/2000 Smurfit-Stone Container Corporation St. Laurent Paperboard, Inc /27/2000 Nashua Corporation Rittenhouse Paper Company /30/2000 Pechiney SA JPS Packaging Company /6/2000 Cascades, Inc. Wyant Corporation /26/2001 Bowater, Inc. Alliance Forest Products, Inc /27/2001 Tyco International, Ltd. Paragon Trade Brands, Inc /8/2002 Westvaco Corporation Mead Corporation /15/2002 MeadWestvaco Corporation Westvaco Corporation /15/2002 Weyerhaeuser Company Willametter Industries, Inc /23/2002 Alcoa, Inc. Ivex Packaging Corporation /20/2003 Temple-Inland, Inc. Gaylord Container Corporation 8.9 Average 9.2 Median

37 BV Approaches: Market Approach (cont.) Example: Dunder Muffler Paper Company (cont.) Dunder Muffler TTM EBITDA $27.6 million Earnings Multiple x 9.0 Market Approach Value $248.4 million 37

38 BV Approaches: Income Approach Overview: Based on the PRESENT VALUE of expected future benefits Discounted or capitalized cash flow methods Used for both control and minority level valuations 38

39 BV Approaches: Income Approach (cont.) Two primary methods: Discounted Cash Flow (DCF) Method Projects future cash flows for a number of years Terminal value Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Terminal Annual Cash Flow Net Present Value $ $ $ $ $ $$$ Discount to Present Value Capitalized Income Method Estimated future cash flow is capitalized Often used for companies with stable growth rates 39

40 BV Approaches: Income Approach (cont.) Discounted Cash Flow Method Cash flows included in projections Cash flow to equity Cash flow to market value of invested capital (MVIC) Normalized cash flows for terminal value calculation Long-term growth rate Cost of capital 40

41 BV Approaches: Income Approach (cont.) TERMINAL Value = Normalized CF/(WACC g) Capitalization of NORMALIZED cash flows GDP, inflation, or industry long-term expected growth Capitalization Rate = Discount Rate Long-term growth rate 41

42 BV Approaches: Income Approach (cont.) Terminal Value Using Exit Multiple: TERMINAL Value = Normalized CF x Exit Multiple Determine the NORMALIZED EBITDA or EBIT for the final year of the explicit forecast period Apply the appropriate EBITDA or EBIT multiple 42

43 BV Approaches: Income Approach (cont.) Example: Dunder Muffler Paper Company Dunder Muffler Paper Company Cash Flow Projections (in thousands) For the years ended December Terminal Operating income $ 20,887 $ 21,514 $ 22,159 $ 22,824 $ 23,509 Depreciation 11,272 11,272 11,272 11,272 11,272 Amortization EBITDA 32,337 32,964 33,609 34,274 34,959 Income tax expense ($2,048) ($2,109) ($2,172) ($2,238) ($2,305) Capex ($9,000) ($9,000) ($9,000) ($9,000) ($9,000) WC ($3,000) ($3,000) ($3,000) ($3,000) ($3,000) Free Cash Flow $18,290 $18,855 $19,437 $20,037 $20,654 $287,872 Discount Factor Discounted Cash Flow $17,408 $16,256 $15,181 $14,176 $13,238 $175,610 Net Present Value $251,870 43

44 BV Approaches Primary valuation approaches by asset type: Asset Type Asset Approach Market Approach Income Approach Business Real Property Machinery & Equipment Intangible Assets Financial Assets 44

45 VI. Discounts and Premiums

46 Discounts and Premiums Some of the common discounts and premiums are: Control premium An amount by which the pro rata value of a controlling interests exceeds a non-controlling interest. Discount for lack of control (or, minority discount) ( DLOC ) An amount deducted from the pro rata share value of 100% interest to reflect the absence of the power of control. Discount for lack of marketability ( DLOM ) - An amount deducted from the pro rata share value of 100% interest to reflect the relative absence of marketability. Valuation discounts and premiums are supported by empirical market studies. 46

47 VII. Financial Statement Analysis

48 Financial Statement Analysis Basic Analytical Techniques: Growth/Trend analysis Common size analysis Examine Cash Flow from Operations section of items that reconcile financial accounting and cash flow Compare cash flows to income statement 48

49 Financial Statement Analysis (Cont.) Some things to look for in historical financials: Increasing/decreasing profitability Increasing/decreasing financial leverage Increasing/decreasing capital expenditures or R&D Increasing/decreasing net working capital items Increasing/decreasing other assets/liabilities Related income statement and balance sheet items growing at significantly different rates 49

50 Financial Statement Analysis (Cont.) Consider how historical trends will affect the future cash flows : Is revenue growth sustainable? Given operational leverage, how will COGS react to revenue increases? Are SG&A expenses fixed or variable? Is the debt burden manageable? Will debt covenants be met? Is company collecting on its sales? Is the company continuing to invest in growth? How much of revenue increase is lost in increased net working capital? 50

51 Financial Statement Analysis (Cont.) Ratio analysis can allow an analyst to : Spot historical trends Compare one company to another (guideline company benchmarking) Review public analyst reports In Practice: Ratios are commonly used by lenders to determine how much to lend and to set covenants Equity analysts use ratios to predict target stock prices Multiples are nothing more than ratios of value 51

52 Financial Statement Analysis (Cont.) Four major types of ratios : LIQUIDITY ratios measure an entity s short-run ability to pay its maturing obligations ACTIVITY ratios measure how effective the enterprise is using the assets employed PROFITABILITY ratios measure the financial performance of an entity over a period of time LEVERAGE/COVERAGE ratios measure the degree of protection for long-term creditors and investors 52

53 Financial Statement Analysis (Cont.) Examples of LIQUIDITY ratios: LIQUIDITY ratios measure an entity s short-run ability to pay its maturing obligations Current ratio: current assets current liabilities Quick test: cash, marketable securities, AR current liabilities 53

54 Financial Statement Analysis (Cont.) Examples of ACTIVITY ratios: Receivable turnover: net sales average trade receivables Inventory turnover: COGS average inventory Asset turnover: net sales average total assets 54

55 Financial Statement Analysis (Cont.) Examples of PROFITABILITY ratios: EBITDA margin on sales: EBITDA net sales Return on assets: net income average total assets Return on common equity: net income preferred dividends average total assets 55

56 Financial Statement Analysis (Cont.) Examples of LEVERAGE/COVERAGE ratios: Debt to total equity: debt total equity Times interest earned: EBIT interest expense 56

57 Rationale Behind Ratio Analysis Ratio and Financial Analyses Why is it important? Financial analysis tools and techniques can: Isolate trends (positive and negative) Help identify strengths and weaknesses Basic financial analysis tools include: Common size financial statements Ratio analysis Trend analysis of common size statements and ratios 57

58 VIII. Conclusion of Value / Case Study

59 Conclusion of Value Subject Company: Industry: Dunder Muffler Paper Company Paper Manufacturing Valuation Date: December 31, 2009 Interest Valued: Premise of Value: Standard of Value: Purpose of Valuation: 40% (Minority) Going Concern Fair Value Shareholder Dispute 59

60 Conclusion of Value - CASE STUDY In arriving at the conclusion : Reconcile valuation approaches Reliability of the results under the different approaches Determine whether the conclusion of value should reflect the results of: One approach or method or A combination of the results of one or more approaches and methods 60

61 Conclusion of Value CASE STUDY (Cont.) Historical Financial Performance: Dunder Muffler Paper Company Combined Statements of Income (in thousands) For the years ended December Total revenues $ 307,500 $ 293,231 $ 338,615 $ 369,911 $ 397,627 Costs and expenses: Cost of products sold 256, , , , ,470 SG&A 27,843 28,968 30,797 30,871 32,464 Research and development Other expenses ,375 Total costs and expenses 285, , , , ,489 Operating income 22,232 14,299 14,060 18,632 16,138 Interest income Interest expense (169) (296) (233) (215) (238) Income before income taxes 22,136 14,060 13,874 18,518 16,028 Net Income $ 22,095 $ 13,962 $ 13,033 $ 17,241 $ 14,514 61

62 Conclusion of Value CASE STUDY (Cont.) Forecasted Financial Performance: Dunder Muffler Paper Company Combined Statements of Income (in thousands) For the years ended December F 2011F 2012F 2013F 2014F Total revenues $ 409,556 $ 421,842 $ 434,498 $ 447,533 $ 460,959 Costs and expenses: Cost of products sold 352, , , , ,424 SG&A 34,812 35,857 36,932 38,040 39,181 Research and development Other expenses 1,229 1,266 1,303 1,343 1,383 Total costs and expenses 388, , , , ,450 Operating income 20,887 21,514 22,159 22,824 23,509 Interest income Interest expense (410) (422) (434) (448) (461) Income before income taxes 20,610 21,228 21,865 22,521 23,196 Net Income $ 18,562 $ 19,119 $ 19,692 $ 20,283 $ 20,892 62

63 Conclusion of Value CASE STUDY (Cont.) Income Approach: Discount Rate (Build Up Method): Risk Free 4.6% ERP 5.0% Size Premium 4.0% Industry Premium 1.0% Company Specific Risk 2.0% Cost of Equity 16.6% Cost of Debt 7.0% Tax Rate 40.0% After Tax Cost of Debt 4.2% Percent Debt 50.0% Percent Equity 50.0% WACC 10.4% 63

64 Conclusion of Value CASE STUDY (Cont.) Income Approach: Cash Flow Projections Dunder Muffler Paper Company Cash Flow Projections (in thousands) For the years ended December Terminal Operating income $ 20,887 $ 21,514 $ 22,159 $ 22,824 $ 23,509 Depreciation 11,272 11,272 11,272 11,272 11,272 Amortization EBITDA 32,337 32,964 33,609 34,274 34,959 Income tax expense ($2,048) ($2,109) ($2,172) ($2,238) ($2,305) Capex ($9,000) ($9,000) ($9,000) ($9,000) ($9,000) WC ($3,000) ($3,000) ($3,000) ($3,000) ($3,000) Free Cash Flow $18,290 $18,855 $19,437 $20,037 $20,654 $287,872 Discount Factor Discounted Cash Flow $17,408 $16,256 $15,181 $14,176 $13,238 $175,610 Net Present Value $251,870 64

65 Market Approach Conclusion of Value CASE STUDY (Cont.) SIC Filing Date Purchaser Company Name MVIC/EBITDA /6/2000 Smurfit-Stone Container Corporation St. Laurent Paperboard, Inc /27/2000 Nashua Corporation Rittenhouse Paper Company /30/2000 Pechiney SA JPS Packaging Company /6/2000 Cascades, Inc. Wyant Corporation /26/2001 Bowater, Inc. Alliance Forest Products, Inc /27/2001 Tyco International, Ltd. Paragon Trade Brands, Inc /8/2002 Westvaco Corporation Mead Corporation /15/2002 MeadWestvaco Corporation Westvaco Corporation /15/2002 Weyerhaeuser Company Willametter Industries, Inc /23/2002 Alcoa, Inc. Ivex Packaging Corporation /20/2003 Temple-Inland, Inc. Gaylord Container Corporation 8.9 Average 9.2 Median 8.9 $27.6 million EBITDA x 9.0 = $248.4 million 65

66 Conclusion of Value CASE STUDY (Cont.) Conclusion of Value: 40% Interest in Dunder Muffler Value (in millions) Weight Market Approach $ % Income Approach % Invested Capital Value Debt (10.2) Indicated Value of 100% Controlling Interest Fair Value of 40% Minority Equity Interest $

67 Conclusion Basic Valuation Process: Define subject of Valuation Valuation Date Purpose of Valuation Historical Financial Analysis Financial Forecast Comparable Company Analysis Valuation using all three approaches Conclusion of Value 67

68 QUESTIONS?

69 Thank You for Your Time