The Market Approach to Valuing Businesses (Second Edition)

Transcription

1 BV: Case Analysis Completed Transaction & Guideline Public Comparable MARKET APPROACH The Market Approach to Valuing Businesses (Second Edition) Shannon P. Pratt Reprinted with permission. For permission to reuse copyrighted content from The Market Approach to Valuing Businesses (Second Edition), please go to or contact Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, telephone , fax by National Association of Certified Valuators and Analysts (NACVA). All rights reserved. Market Chapters 1 Used by Institute of Business Appraisers with permission of NACVA for limited purpose of collaborative training v1

2 MARKET APPROACH BV: Case Analysis Completed Transaction & Guideline Public Comparable 2 Market Chapters by National Association of Certified Valuators and Analysts (NACVA). All rights reserved v1 Used by Institute of Business Appraisers with permission of NACVA for limited purpose of collaborative training.

3 Common Errors in Implementing the Market Approach Chapter 17 Inadequate Selection of Guideline Companies Defining Too Narrow a Population Guideline Public Companies Guideline Merged and Acquired Companies Guideline Limited Partnerships Inadequate Comparative Analysis Indiscriminate Use of Average (or Median) Multiples Failing to Consider Guideline Company Financial Statement Adjustments Failure to Conduct a Site Visit and Management Interviews Making Inappropriate or Unsupported Financial Statement Adjustments Inappropriate Adjustments Inadequately Supported Adjustments Applying Multiples to Inconsistently Defined Data Failure to Match Time Periods Failure to Match Historical Time Periods Applying a Multiple Derived from Average Data to a Single Period s Data Applying a Multiple from Historical Data to Forecast Data Reliance on Rules of Thumb Failure to Account for Excess or Deficient Cash Failure to Adjust for Differences in Deal Terms and Structure Differences in Deal Terms Differences in Property Transacted Assets Plus... Rules Failing to Apply Appropriate Discounts and Premiums Summary If the analyst implements market approach methodology using the procedures described in this book, the errors discussed in this chapter should not occur. 263

4 264 The Market Approach to Valuing Businesses Nevertheless, reading this chapter, which is somewhat in the nature of review, may help the analyst to avoid falling into any of these frequently encountered traps. Moreover, the chapter may prove useful in a disputed valuation setting when any of these errors is encountered in a report by an opposing valuation analyst.the chapter provides concrete material for getting errors corrected, which may help to facilitate settlement. In the context of litigation, the chapter offers a basis for deposition questions, cross-examination questions, rebuttal testimony, and lawyers briefs critiquing an opposing expert s testimony or report methodology. INADEQUATE SELECTION OF GUIDELINE COMPANIES Probably the most common shortcoming in implementation of the market approach is one that takes place near the beginning of the exercise: poor selection of guideline companies. Defining Too Narrow a Population The problem of defining too narrow a population of guideline companies from which to choose can occur with either the guideline public company method or the guideline merged and acquired company method. Guideline Public Companies. There are over 15,000 public companies reporting to the Securities and Exchange Commission (SEC), not to mention as many more that are public but fall below the SEC reporting requirement as measured by either asset size or number of stockholders. However, none of the major secondary services covers every one of the reporting companies, and services such as Value Line cover only a small subset of the largest companies. Consequently, analysts often overlook some of the smaller guideline public companies that are likely to be most comparable to the subject being valued. Guideline Merged and Acquired Companies. Getting a comprehensive list of guideline merged and acquired companies can be even more difficult than getting a good list of guideline public companies because there is no single comprehensive source. Appendix B should help the analyst in this respect. Also, for smaller companies, the emergence and expansion of the four private company databases discussed in this book should make the company selection more comprehensive for small and midsize companies (mom-and-pop businesses up to those valued under $100 million). Guideline Limited Partnerships. The Partnership Profiles database contains over 315 real estate related limited partnerships. The publicly registered limited partnerships include commercial, apartments, insured mortgages, leases, parking lot, and retail real estate properties. It is common to find guideline limited partnerships that are similar in size, leverage, and profitability to family limited partnerships.

5 Common Errors in Implementing the Market Approach 265 Inadequate Comparative Analysis Many times in court, one analyst s market approach has been accepted and another s rejected because of the relative degree of comparability of the guideline companies selected. After the initial selection, comparative analysis of both the nature of operations and the financial characteristics should be undertaken to reach a final group of guideline companies. On occasion, the initial selection criteria may even be widened to allow one or a few more companies with investment characteristics similar to the subject. INDISCRIMINATE USE OF AVERAGE (OR MEDIAN) MULTIPLES One of the most common errors in implementation of the market approach is naively applying either mean or median guideline company multiples to subject company data with little or even no comparative analysis. Once in a while, the subject company will have characteristics almost identical to the average of the guideline companies, but not often. Even if it does, the analyst should point out analysis that leads to the conclusion of this similarity. But more often, differences between the guideline and subject companies would lead to applying multiples that are not identical to the guideline averages. That is why we do comparative financial analysis and conduct site visits and management interviews. As discussed in Chapter 10 on selecting and weighting multiples, one might choose the multiples of the most comparable subset of guideline companies; might increase or decrease multiples by a percentage; might choose a point in the observed range, such as upper or lower quartile or quintile; or possibly (but rarely) even justify multiples outside the observed range. A related error is unexplained adjustments, such as blindly adjusting all multiples by exactly the same percentage or in exactly the same manner. It may be appropriate to adjust some multiples differently from others. The most obvious example would be a company that had a high return on sales but a low return on equity relative to the guideline companies. This situation would suggest a price/sales ratio above the guideline averages, but a price/book value ratio below the guideline averages. FAILING TO CONSIDER GUIDELINE COMPANY FINANCIAL STATEMENT ADJUSTMENTS A common error in implementing the guideline public company method (or the guideline merger and acquisition method using acquired public companies) is to make proper adjustments to the subject company financial statements but ignore possible comparable adjustments to the guideline company statements. Many types of adjustments should be made for valuation purposes that would

6 266 The Market Approach to Valuing Businesses not be classified as extraordinary under generally accepted accounting principles (GAAP). Some of these would include Nonrecurring items, which should be eliminated to get comparable, normalized operating results Major gains or losses on the sale of assets Effect of strikes Effect of lawsuits Results of discontinued operations Also, if some companies are on last in, first out (LIFO) inventory accounting and some on first in, first out (FIFO), all should be adjusted to FIFO to put them on a comparable basis. None of these factors will show up if the analyst relies on secondary sources to compile financial data for the guideline companies. This is one important reason why it is desirable to use original company documents, such as 10-Ks and 10-Qs, if this level of detail is required. FAILURE TO CONDUCT A SITE VISIT AND MANAGEMENT INTERVIEWS If possible, site visits and management interviews are equally important for the income approach and the market approach and, in many instances, even for the asset approach. There are, of course, situations where the site visit and management interviews cannot be conducted due to the restrictions of time or hostility of the parties. The analyst has the responsibility of selecting the guideline companies. Seeing the operations and interviewing management should help guide the analyst s judgment as to which potential guideline companies are satisfactorily comparable. Also, management may have some suggestions as to guideline companies that the analyst may have overlooked or may have some valid reasons to consider rejecting certain guideline companies that the analyst was considering. Furthermore, the analyst must exercise judgment to decide on the types and levels of market multiples to apply to the subject company relative to the multiples observed for the guideline public or merged and acquired companies. The analyst almost inevitably gains some insight on the subject company s strengths and weaknesses relative to its peers by observing the premises and operations and interviewing the management (and sometimes even customers and other related outside parties, such as suppliers, bankers, accountants, attorneys, and competitors). These insights, along with the comparative financial analysis, should guide the analyst s judgment in choosing the types and levels of market multiples to apply to the subject company relative to the peer group guideline companies selected.

7 Common Errors in Implementing the Market Approach 267 Most of us like to do the first pass at the financial statement adjustments and the comparative financial analysis (described in Chapters 7 and 8) before the site visit and management interview. This exercise usually results in questions to ask management to gain greater insight about observed data and the implications for future changes. (After all, valuation is to assess the present value of the future benefits of investing in the company, and a study of the past is really to help assess that future.) The visit and interviews also may result in some revisions to or additions to (or even elimination of) some preliminary financial statement adjustments. Site visits and management interviews are especially important if there is actual or possible litigation. Courts tend to accord considerably more credibility to an analyst who has visited the premises and operations and interviewed management than to one who has not. There are instances, of course, when site visits are not possible or practical. We suggest that, in such cases, the analyst should disclose it in the report and note the reason for omitting the site visit. MAKING INAPPROPRIATE OR UNSUPPORTED FINANCIAL STATEMENT ADJUSTMENTS The standard of value and the assumed ownership characteristics often dictate whether certain financial statement adjustments are warranted in a particular situation. In any case, if adjustments are made (or might potentially be made but are rejected), the analyst should provide adequate support for the reason and amount of the adjustment. Inappropriate Adjustments When valuing a minority interest under the standard of fair market value, many analysts would consider it an error to make financial statement adjustments that only a control owner can make.the most common example is excess compensation. For example, if the control owner is taking excess compensation and will continue to do so, that money will not be available to minority stockholders; therefore, the analyst would take the position that the statements should not be adjusted as if it would be. One argument in favor of a compensation adjustment when using the public guideline company method is to put the subject company on a basis that is comparable to the guideline companies. If that is done when there is excess compensation, then there should be a minority interest discount, even though the public companies are minority interests, to reflect the distribution of the excess compensation to the control owner. If the standard of value is fair value, and if case law indicates that a pro rata

8 268 The Market Approach to Valuing Businesses portion of control value is appropriate, then there would be justification for an adjustment for things like excess compensation even though the shares that are being valued are minority shares. Inadequately Supported Adjustments It is important that the magnitude of any financial statement adjustments be supported, using the best empirical data available. Again, an adjustment for reasonable compensation is both the most common and the most controversial. There are many sources of compensation data, and the analyst should try to choose the source most germane. 1 APPLYING MULTIPLES TO INCONSISTENTLY DEFINED DATA There are many levels of the income statement and balance sheet from which data for market value multiples may be drawn. Furthermore, each of the variables may be before or after possible adjustments as discussed in Chapter 7. The possible mismatches between the variable as defined for the guideline companies and the variable as defined for the subject company are too numerous to catalog in this book, but it is essential to be on the lookout for possible mismatches. FAILURE TO MATCH TIME PERIODS Measuring financial variables over different time periods for the guideline companies from the subject company can lead to very distorted results. This can be especially true with cyclical or seasonal companies, and especially true if the effective valuation date is near the turning point in a cycle. Failure to Match Historical Time Periods Public companies report operating results quarterly. About half of them have calendar fiscal years, while the other half have fiscal years somewhat scattered throughout the calendar. The analyst usually uses subject company data as near as possible to the effective valuation date. If public company fiscal quarters coincide with the date of the subject company data, that data should be used, not the public company s prior fiscal year data. If the fiscal quarters do not coincide, then it is usually best to use data from the closest available date. In some situations, being off by only a single quarter distorted results to the point of being meaningless at a turning point in a cyclical industry. Some analysts also use only the public companies latest full-year data when more recent quarterly data are available.

9 Common Errors in Implementing the Market Approach 269 When using merger and acquisition data, dates necessarily will not coincide: An adjustment for changes in industry conditions may be needed. Applying a Multiple Derived from Average Data to a Single Period s Data If, for example, the analyst creates a multiple based on a current stock price times the average of five years past earnings for each guideline company, common sense would dictate that the multiple should be applied to the last five years average earnings for the subject company. Yet sometimes such a multiple is applied to a single year s earnings (or some other variable) for the subject company. If there is any kind of a trend or cyclicality for either the guideline company or subject companies earnings (which is usually true), this mismatch will result in a distorted indication of value. Applying a Multiple from Historical Data to Forecast Data The price/earnings (P/E) multiple, as it is published for thousands of companies in the national and world financial press, represents the current price times the latest reported 12 months trailing earnings. Some analysts, however, take those reported P/Es and apply them to their subject company s coming-year projected earnings. Assuming that the industry is expecting growing earnings, this produces an upwardly biased indication of value. If the financial variable to be used for the subject company is next year s projected earnings, then this must be matched with guideline company multiples consisting of the valuation date price times the projected earnings for each respective guideline company. (Sources for such forecasts are included in Appendix B.) RELIANCE ON RULES OF THUMB If there is a widely used rule of thumb for valuation in an industry, it should be considered. However, it should not be relied on as the only method. Rather, it is more appropriately used as a sanity check on the value as determined using other appropriate valuation methods. In his book on valuation formulas for small businesses, Glenn Desmond emphasizes this point: Formulas and rule-of-thumb multiplier ranges change because of new forms of competition, influences from regional or national inflation or recession, changes in popularity and marketability of businesses, and refinements in valuation methodology and data sources. Since the 1988 edition of this handbook, there has been a general decline in the value of small businesses. As of late 1992, declines of 25% to 30% are common.... 2

10 270 The Market Approach to Valuing Businesses [F]ormula valuations are not substitutes for careful consideration of other appropriate valuation methods that are applicable to the business being appraised. 3 Nobody knows how most rules of thumb were derived. We have included them in this book on the market approach because some people think that they represent a consensus of actual market activity. However, it may be more accurate to say that they may represent what business brokers anticipate or owners hope to realize on a sale versus what owners in the industry typically realize on a sale. The author has conducted two major tests of rules of thumb, one for the property management industry and the other for the car rental franchise industry. In each case, a valuation rule of thumb was developed by an extensive survey of business owners in the industry. Then an extended study of actual transactions of sales of the companies in the industry was made. In the case of the property management companies, the actual transactions were at an average of about 65% of the value that the consensus rule of thumb indicated. In the case of the car rental franchises, the actual transactions were at an average of about 50% of the values that the consensus rule of thumb indicated. Based on this limited anecdotal evidence, one might conclude that rules of thumb tend to be upwardly biased, and this could be so. Many people are interested in this question, so the author has planned a lengthy series of empirical tests. Recently and over the next several years, we have and will test published valuation rules of thumb against actual transactions, using Pratt s Stats and other private transaction databases, and publish the results. 4 FAILURE TO ACCOUNT FOR EXCESS OR DEFICIENT CASH Market multiples based on financial operating results (e.g., price/earnings, market value of invested capital/earnings before interest, taxes, depreciation, and amortization [MVIC/EBITDA]) do not directly reflect differences in the cash positions from one company to another. A common error is failure to make any adjustment when the subject company has significantly more or less cash or cash equivalents than the guideline companies. There are at least three ways to handle significant cash differences: 1. Adjust multiples up or down to reflect greater or less financial strength. 2. Add or subtract a specific dollar amount for an estimate of excess or deficient cash. 3. Subtract out all the cash of both guideline and subject companies before the comparative analysis, and then add the subject company s cash back at the end: the investment banker s method.

11 Common Errors in Implementing the Market Approach 271 FAILURE TO ADJUST FOR DIFFERENCES IN DEAL TERMS AND STRUCTURE All too often, we find that the prices at which the guideline merger and acquisition transactions took place are not adjusted for differences in transaction terms or for differences in the property being transferred. Differences in Deal Terms Most small businesses are not sold for cash. The seller often accepts a note from the buyer, and the interest on the note usually is at rates below those that would be available in an arm s-length commercial loan. The price of such a deal should be adjusted by computing the present value of the seller s note using a market rate of interest. Both Pratt s Stats and BIZCOMPS provide the transaction terms necessary to make this adjustment. The analyst must make an estimate as to what a market rate of interest would be. Failure to make such an adjustment, where appropriate, usually results in overstatement of the value of the guideline transaction, thus resulting in overstated multiples. A related problem arises when the terms of the guideline transaction contain contingencies. The most common contingency is retention of existing clients, commonly found in sales of professional practices, such as accounting practices. If enough information is available, the analyst should adjust the transaction price to the present value of the best estimate of the expected proceeds. If such an estimate cannot be made, the analyst might consider dropping the transaction from the guideline list. Differences in Property Transacted The different middle-market and small-company databases have different policies about what is assumed to be included in the transaction price, as discussed in Chapter 6. This is especially true with respect to current assets and current liabilities transferred or assumed. It is important to compare what is assumed to be included in the subject transaction and adjust for the value of any differences between it and what was included in the guideline transaction. One of the most commonly overlooked differences is noncompete and employment contracts. In most cases, the property that the analyst is appraising does not include either a noncompete or an employment agreement. However, the transaction prices for a significant portion of small businesses and professional practice sales do include noncompete and/or employment agreements. If the guideline transactions do include such agreements and the subject property does not, the value of such agreements should be subtracted from the guideline

12 272 The Market Approach to Valuing Businesses company transaction prices and the multiples recomputed before applying the multiples to the subject property. Failure to make this adjustment results in overstatement of the value of the subject property. Most Pratt s Stats and BIZCOMPS transactions include the information necessary to make these adjustments. Failure to make these adjustments is a common problem in valuations for divorces. Noncompete and employment agreements are regarded as personal rather than marital property in most states. Nevertheless, we often see valuations of businesses and practices that are based on guideline transactions without any reduction in price for the inclusion of those valuable intangible assets. ASSETS PLUS... RULES The chapter section Reliance on Rules of Thumb noted that some rules are in the form of assets plus a multiple of some operating variable. Such rules never address a value less than the net asset value, and they usually assume (at least loosely) that the asset values are somewhere near current replacement value. Many businesses are worth much less than the replacement value of their assets, all the way down to liquidation value. A business is worth something more than the value of its assets only to the extent that it can earn more than a reasonable return on the asset value. That is the concept of the excess earnings method, where the capitalized value of earnings over a reasonable return on assets is added to the asset value. But we never hear anyone speak of the deficient earnings method, where one might subtract the capitalized value of an earnings deficiency from the value of the assets. Goodwill is not only a function of continuing patronage, but also is dependent on being able to make a return on that patronage over and above a reasonable return on tangible assets. Many small business owners with established patronage but poor returns do not understand why they cannot sell their businesses for the current value of their assets plus some blue sky for the customer base. One very highly regarded small women s clothing chain, however, wisely chose to liquidate when it realized that its competition was strong enough that it could not even earn a reasonable profit relative to the liquidation value of its assets. FAILING TO APPLY APPROPRIATE DISCOUNTS AND PREMIUMS We sometimes see a failure to adjust, or make proper adjustments, to get from the level of value indicated by the market approach results to the level of value required in the assignment. Often the nature of the adjustment is perfectly appropriate, but there is no, or inadequate, data presented to support the magnitude of the adjustment. Chapters 11 and 12 on discounts and premiums should help the analyst avoid this important category of errors.

13 Common Errors in Implementing the Market Approach 273 SUMMARY The opportunities to go awry in the implementation of the market approach are legion. Sometimes the toughest ones to spot are errors of omission, such as failing to consider the full population of potentially useful guideline companies, failure to make certain adjustments, or failure to use all of the best data available to support certain adjustments, such as reasonable compensation or a discount for lack of marketability. Some of the most common errors are Inadequate guideline company selection Failure to analyze and adjust guideline company data Failure to conduct site visit and management interviews Making inappropriate or unsupported financial statement adjustments Applying multiples to inconsistently defined data Failure to match time periods Reliance on rules of thumb Failure to account for excess or deficient cash Using an assets plus rule when the company s returns are not even adequate to support the assets employed Applying improper (or not applying proper) discounts and premiums, or not adequately supporting the amounts of the discounts or premiums applied We hope that this chapter will help the analyst avoid any of these shortcomings. Moreover, we hope that this chapter will help spot errors in opposing valuations and have them corrected or convincingly brought to the attention of the decision maker or court. Notes 1. Many general and specialized sources of compensation data are included regularly in Where to Find It: Business Valuation Data Directory, published as a supplement to Shannon Pratt s Business Valuation Update. 2. Glenn Desmond, Handbook of Small Business Valuation Formulas and Rules of Thumb, 3rd ed. (Camden, ME:Valuation Press, 1993), 4. Reprinted with permission of Marshall & Swift, LP. 3. Id. at Results have been published in Shannon Pratt s Business Valuation Update.

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