New Concepts, Data, Models and Methods for 2014

Transcription

1 MACPA 2014 Forensic Valuation Conference Baltimore May 16, 2014 New Concepts, Data, Models and Methods for 2014 Jim Hitchner, CPA/ABV/CFF, ASA Jim Hitchner, CPA/ABV/CFF, ASA Managing Director, Financial Valuation Advisors, Inc. CEO, Valuation Products and Services LLC President, Financial Consulting Group LLC Editor in Chief, Financial Valuation and Litigation Expert 34 years in valuation services Inductee in the AICPA BV Hall of Fame Former member of the AICPA task force on BV standards Coauthored over 20 courses; taught over 60 courses Published over 100 articles; made over 200 presentations Editor and/or coauthor of the books: Financial Valuation: Applications and Models, 3rd edition Financial Valuation Workbook, 3rd edition Valuation for Financial Reporting: Fair Value, Business Combinations, Intangible Assets, Goodwill, and Impairment Analysis, 3rd edition PPC s Guide to Business Valuations, 24th edition 2 1

2 Learning Objectives The Participant will: Learn about some of the most important things that happened in 2013/2014 Be updated on the uses of Ibbotson and Duff & Phelps data in the build up model and the modified capital asset pricing model Learn about the Implied Private Company Pricing Line (IPCPL) for cost of capital (based on Pratt s Stats) 3 Learning Objectives The Participant will: Be updated on the Private Cost of Capital Model (PCOC) and the Pepperdine private capital markets project (based on survey data) Learn about new techniques and research in discounts for lack of marketability Gain new insight into the use of calculation engagements and calculation reports including USPAP compliant calculations 4 2

3 Ibbotson and Duff & Phelps* Valuation Products and Financial Valuation and Litigation Expert and various webinars Cost of Capital: Comparisons of Ibbotson and Duff & Phelps Data Inputs in the MCAPM and BUM, Jim Hitchner, FVLE Issue 45, October/November 2013 (Handout) * Morningstar is no longer publishing their Valuation Yearbook. Duff & Phelps is now publishing Ibbotson type data in their new Valuation Handbook. However, the use of the data is the same. 5 Cost of Capital Acknowledgements We would like to thank Morningstar, Inc. for permission to use most of the information on these slides. These slides are only a summary of the material contained in Morningstar s Ibbotson SBBI Valuation Edition 2007, 2008, 2009, 2010, 2011, 2012 and 2013 Yearbooks. Analysts should not use this information on a standalone basis without first reading the Ibbotson book. It is highly recommended that analysts purchase and read each yearly edition of this book. Source: Stocks, Bonds, Bills and Inflation Valuation Edition 2013, 2012, 2011, 2010, 2009, 2008, 2007 Yearbooks. Copyright 2007, 2008, 2009, 2010, 2011, 2012 and 2013 Morningstar, Inc. All rights reserved. Used with permission. To purchase copies of the Valuation Edition, or for more information on other Morningstar publications, please visit global.morningstar.com/datapublications 6 3

4 Cost of Capital Acknowledgements We would like to thank Duff & Phelps, LLC for permission to use most of the information on these slides. These slides are only a summary of the material contained in Duff & Phelps, LLC Risk Premium Report 2007, 2008, 2009, 2010, 2011, 2012 and Analysts should not use this information on a standalone basis without first reading the Duff & Phelps Report. It is highly recommended that analysts purchase and read each yearly Report. Source: Duff & Phelps, LLC Risk Premium Report 2007, 2008, 2009, 2010, 2011, 2012 and Copyright 2007, 2008, 2009, 2010, 2011, 2012, 2013 Duff & Phelps, LLC. All rights reserved. Used with permission. To purchase copies of the Report or for more information please visit 7 Data Chart Assumptions For Comparative Purposes Only Assumptions Can and Will Differ Smaller company where Ibbotson 10 th decile and D&P 25 th category apply Risk free rate (not normalized) as of 8/1/13 and December 31 of each year 2010, 2009 and 2007 Present Ibbotson unadjusted, D&P unadjusted and D&P adjusted Used Ibbotson historical and supply side ERPs Used suggested adjustments in D&P to convert Ibbotson IRP to D&P IRP Only used Ibbotson historical ERP for adjustment Specific company risk is the same for all calculations Betas and IRPs are the same in each period 8 4

5 9 10 5

6 Ibbotson D&P Comparison 8/1/13, 12/31/10, 12/31/09 and 12/31/07 Footnotes 1 Risk premiums over the risk-free rate; total of ERP and size premiums; D&P A Exhibits (25 th category) 2 Converts Ibbotson IRP to D&P IRP; not beta adjusted 3 Converts Ibbotson IRP to D&P IRP; beta adjusted using separately calculated ERP and size premiums; D&P B Exhibits (25 th category) 4 Risk based on operating margin, CV(operating margin) and CV(ROE); D&P D Exhibits 5 Based on assessment that the subject company risk is meaningfully different from the average risk of the companies in the guideline portfolio (more risky or less risky than the average). The company-specific volatility is capturing risk (at least along that one dimension of risk) already

7 13 Recent VPS Polls* August 15, 2013 When valuing a small company, which of the following Ibbotson size premiums do you apply? 74% said 10 th decile June 19, 2013 When valuing a small company, which of the following Ibbotson size premiums do you apply? 67% said 10 th decile February 13, 2013 Which of the following Ibbotson size premium data do you use the most when valuing a small business? 62% said 10 th decile * VALUATION UPDATE: Webinar Poll Results Reveal Common Industry Practices, Financial Valuation and Litigation Expert, FVLE Issue 46, December 2013/January 2014, Valuation Products and,

8 Using Ibbotson Industry Risk Premiums CAPM in a Build Up Wrapper Cannot blindly apply the industry risk premiums (RP i ) as published in Ibbotson s SBBI Valuation Yearbook Use is based on answering several questions: How many observations are there? What s the validity of the SIC Code? Does it make sense? Is it CAPM in a build up wrapper? 15 Using Ibbotson IRPs CAPM in a Build Up Wrapper Does it makes sense? Some RP i s just look strange 2013 Edition: Restaurant industry less risky than the market by 2.66%? 2013 Edition: 1,054 basis point difference between SIC 351 (11 observations), Manufacturing Engines and Turbines IRP of 5.73 SIC 3511 (5 observations), Manufacturing Steam, Gas and Hydraulic Turbines, and Turbine Generator Set Units IRP of

9 Implied Private Company Pricing Line (IPCPL) Business Valuation Resources, LLC Business Valuation Update The Implied Private Company Pricing Line 2.0, Bob Dohmeyer, Pete Butler and Rod Burkert, September 2013 This article updates an initial article published in Business Valuation Review, Spring 2012, The Business Valuation Committee of the American Society of Appraisers BVR webinar PowerPoint slide deck, Bob Dohmeyer and Rod Burkert, November 7, 2013 Draft white paper, The Implied Private Company Pricing Model, Bob Dohmeyer Discussions with Bob Dohmeyer 17 IPCPL 19.8% Pre Tax K o 19.3% 18.8% 18.3% 17.8% 17.3% Ko = FCFF / P+g Pratt s Stats 500 Aggregate K o = 18.1% 16.8% 16.3% $2 $12 $22 $32 $42 $52 $62 $72 $82 $92 $102 BVR Webinar, slides 1 and 4 Revenue $Millions 18 9

10 IPCPL 19 IPCPL 20 10

11 IPCPL 500 transactions/companies from Pratt s Stats 1998 to 2013 Total revenue $4.4 to $10.0 million Total assets (excluding cash) $1.3 to $4.5 million Private buyer of a U.S. company Reported owner s compensation 21 IPCPL Creators state that the models remove the questions over: Specific company risk Risk free rate Equity risk premium Size premium Liquidity Taxes including PTEs Debt capacity 22 11

12 IPCPL Aggregated IRR example (BV Update, September 2013, p. 6) Revenue TTM $3,135.2 Operating Income TTM FMV T o 1,866.5 Operating book capital Aggregate revenue growth 2.36% FCFF 1 = x (590.7 x 2.36%) = K o = FCFF 1 /P + g = 294.0/1, % = 18.1% IRR 23 Private Cost of Capital Model (PCOC) Dr. Craig R. Everett is Director of 2014 Pepperdine Private Capital Market Project 2014 Capital Markets Report obtain free at

13 Private Cost of Capital Model (PCOC) 2014 Capital Markets Report Surveys deployed in October 2013 (pp. 7, 10, 18, 57, 61, 66) Investment bankers (141) Private equity groups (64) Business appraisers (166) Brokers (40) Business owners (951) 25 Private Cost of Capital Model (PCOC) 2014 Capital Markets Report Investment Bankers (p. 13) Metric 0 1M 2 5M 6 10M EBITDA Multiple

14 Private Cost of Capital Model (PCOC) 2014 Capital Markets Report PEGs (pp. 8, 20) Metric 1M 5M 10M 25M EBITDA Multiple Expected Return Required RoR Private Cost of Capital Model (PCOC) 2014 Capital Markets Report Brokers (p. 64) (Midpoint (high low) of six broad industry groups) Metric 100K 500K 1M 5M 5M+ EBITDA Multiple

15 Private Cost of Capital Model (PCOC) 2014 Capital Markets Report Appraisers (p. 58) Averages Risk free rate 3.4% Equity risk premium 6.3% Terminal year growth 3.2% DLOM (minority interest) $1 million revenues 26% $25 million revenues 30% $250 million revenues 33% 29 Private Cost of Capital Model (PCOC) 2014 Capital Markets Report Business Owners (p. 76) 51% less than or equal to $1 million revenue 76% less than or equal to $5 million revenue Cost of equity capital* 55% less than or equal to 12% 20% between 16% and 26% 27% between 0% and 8% *Doesn t look right That s why they hire us 30 15

16 Easy Sanity Check on Long Term Growth Inflation (historical)* 3.0% Inflation (10 year projected)** 2.3% Real GDP (historical)* 3.3% Real GDP (10 year projected)** 2.6% Population (48 year projected)*** 0.6% Nominal GDP (historical) 6.4% Nominal GDP (10 year projected) 5.0% Nominal population and inflation growth ~3% * ( ) ** Livingston Survey, Federal Reserve Bank of Philadelphia, December 2013, p. 4. *** Cohn, D Vera, Census Bureau Lowers U.S. Growth Forecast, Mainly Due to Reduced Immigration and Births, PewResearch Social & Demographic Trends, December 14, 2012, 31 Livingston Survey 10 year Forecast for Nominal GDP Growth From June 2003 to December 2013 High of 6.1% in December 2003 Low of 5.0% in December 2013 Fairly steady decline August 15, 2013 Poll What do you normally see in terms of a long term growth rate? A. 3% or less 37% B. 3% to 5% 53% C. 3% to 6% 10% D. 7% or higher 0% E. Not applicable 1% 32 16

17 An Organized Process for Determining and Supporting Discounts for Lack of Marketability It Is as Hard as You Think but It Can be Done What databases, models and methods work and don t work Levels of reliability and how to reconcile the results Examples and a case study 33 VPS DLOM Guide and Toolkit Currently Under Development All Findings Preliminary and Subject to Change The purpose of this VPS DLOM Toolkit is to provide the valuation analyst with the most complete and comprehensive information on Discounts for Lack of Marketability (DLOMs or DLOM) as well as to provide the analyst with templates for determining the DLOM and suggested report language regarding many of the methodologies A quick peek into some of our (Jim Hitchner, Jim Alerding and Josh Angell) research and preliminary findings Criticisms and input welcome jhitchner@finvaluation.com 34 17

18 New Labels Liquid Marketable illiquid Nonmarketable Examples: Public stock Liquid Control in a private co. Marketable illiquid Minority in a private co. Nonmarketable Real estate Marketable illiquid Machinery & equipment Marketable illiquid 35 Pre IPO Data Inconsistency between how companies value the stock (including discounts) in pre IPO transactions vs. how all the studies/databases determine the discount and thus values Data and calculations based on public SEC reporting documents 36 18

19 Pre IPO Data Management Discussion & Analysis Section Examine the prospectus and/or registration statement materials The factors that management considered in determining the value of their stock on the pre IPO transaction date Includes management s estimates of the DLOM Discounts reported in the prospectus will often differ materially from the discounts reported in several databases and studies Management will often provide information relating to the factors that contributed to the increase in the value of their stock between the transaction date and the IPO date Management may explicitly state that the increase in the fair value of their stock was related to factors unrelated to liquidity, such as improvement in sales or changes in industry conditions 37 Pre IPO Data Facebook IPO and Prior Transactions Pre-IPO Method vs. Reported Discounts Date IPO Trans. Pre IPO Reported Days Price Price DLOM DLOM May 11, 2011 $38 $ % 6.5% 372 July 21, 2011 $38 $ % 6.0% 301 November 11, 2011 $38 $ % 5.5% 188 January 27, 2012 $38 $ % 5.0% 111 May 17, 2012 (IPO) $38 $

20 Pre IPO Data Lifelock, Inc. On March 29, 2012, approximately 6 months prior to the IPO date, LifeLock, Inc. granted options and determined the fair market value of their stock to be $5.20 per share, representing a 42% discount from the IPO price of $9.00 that occurred on October 2, 2012 The initial public offering scenarios assumed that we would conduct an initial public offering in 18 months and were based on our projected EBITDA. We also applied a discount for lack of marketability of 20%, after considering a number of factors, including the probability and time to liquidity for an initial public offering of our common stock. 39 Pre IPO Data Management provided an explicit estimate of its marketability discount of 20% vs. the measured discount of 42% Management explicitly stated that the expected date to IPO was 18 months on the transactions date, which compares to the IPO actually occurring in 6 months Thus, management s 20% estimated discount was for a longer expected holding period as of the date of grant Management indicated that their stock had increased from the prior period due to a reduction in their cost of capital Several material events occurred on this date, including a merger and sales of preferred stock 40 20

21 EPAM Systems, Inc. Pre IPO Data On December 31, 2009, approximately 26 months prior to IPO, EPAM Systems, Inc. granted options and determined the fair market value of its stock to be $5.75 per share Representing a 52% discount from the IPO price of $12.00 per share on February 7, 2012 Based upon a table in the prospectus, management indicated that a 20% discount for lack of marketability as applied only in the Continue Private scenario, suggesting an effective probability weighted DLOM of only 1% vs. the 52% discount reported 41 Pre IPO Data The following illustrates some statements in the EPAM prospectus: We believe the increase in fair value was due to the significant growth in revenues and profitability during 2010, 47.9% and 109.3%, respectively, compared to 2009 We believe the increase in the fair value was due primarily to the significant growth in revenues and profitability we experienced during the first six months of 2011 compared to the first six months of 2010, such growth being 66.3% and 69.8%, respectively... the primary driver behind the fair value increase at June 15, 2011, was magnified by a 30.6% increase in the multiple used in the IPO scenario (8.5x as of November 30, 2010 compared to 11.1x as of June 15, 2011), as market valuations for our industry comparables gradually improved

22 Pre IPO Data Splunk, Inc. Pre IPO option transaction on December 27, 2011 This transaction occurred at a price of $4.82 per share, representing a 72% discount from the $17.00 per share IPO price that occurred on April 20, 2012 The prospectus indicated that this transaction was related to 1,547,500 options granted at an exercise price of $ Pre IPO Data Management further described the following in the prospectus regarding the transaction: Our board of directors considered market conditions, especially for technology companies, our better than anticipated operating performance, our increased revenue forecast, the reduced operating risk in our business, and a shorter time to an expected liquidity event when it determined the fair value of our common stock The board of directors explicitly selected a 13% discount for lack of marketability, which differed significantly from the reported discount of 72% 44 22

23 Pre IPO Data Overall, alternative explanations include changes in: The level of interest rates The forward looking equity risk premium The firm s cost of capital The expected long term expected growth rate The market valuation multiples of comparable publicly traded companies The market valuation multiples of comparable private company transactions National, regional or industry economic conditions Business fundamentals including expansion in sales, profits, margins or cash flows 45 Pre IPO Data Other important factors to consider Profitability Holding period Industry concentration Size Block size Types of securities Cyclicality of the market Number of transactions 46 23

24 Question Can we still rely upon pre IPO studies and databases? 47 Restricted Stock Studies Many different researchers have collected data on restricted stocks and have compared them to their publicly traded counterparts beginning in 1966 The studies conducted have included various time periods for collecting the data and have generated a number of summary statistics to describe the data In applying discounts from restricted stock studies, the analyst must understand the particular study and how it may or may not apply to the subject interest being valued 48 24

25 Restricted Stock Studies Oldies but Goodies? Study Pre 1990 Discount SEC overall average ( ) 26% Gelman ( ) 33 Trout ( ) 33 Moroney ( ) 36 Maher ( ) 35 Stryker and Pittock ( ) 45 Hall and Polacek ( ) 23 Silber ( ) 34 Willamette Management Associates ( ) 31 Pre 1990 mean discount 33% 49 Restricted Stock Studies Oldies but Goodies? Study Post 1990, Pre 2000 Discount FMV Opinions, Inc. ( ) 22% Management Planning ( ) 27 Bajaj, et al. ( ) 22 Johnson ( ) 20 Columbia Financial Advisors ( ) 21 Columbia Financial Advisors ( ) 13 Post 1990 mean discount 21% Overall mean discount 28% 50 25

26 Restricted Stock Studies A Benchmark Study Approach Increasingly critical view of simply beginning with a summary statistic from a group of studies and going from there, either by: Accepting the statistic as is Adjusting it without a believable explanation Attention has turned to getting behind the data and deriving an appropriate discount from the data The IRS DLOM Job Aid drives this home 51 RESTRICTED STOCK STUDIES DID YOU KNOW? The transactions for the FMV Opinions Study, Silber Study, Moroney Study, Stryker & Pittock Study, Trout Study, Willamette Study and Gelman Study are not available in the published data Most of the original studies had small samples and the data is very old There are conflicting conclusions in the various studies on some issues, such as: Block size Rule 144 Industry Market capitalization 52 26

27 Question Can we still rely upon traditional restricted stock benchmark studies? 53 FMV Opinions Restricted Stock Database Many valuation analysts are using the FMV Opinions Restricted Stock Database and suggested methodology ( FMV Opinions Method ) to determine a discount for lack of marketability ( DLOM )* The suggested methodology is a three step process *Espen Robak s Pluris database is also used by many analysts 54 27

28 FMV Opinions Three Step Method (1) The issuing firm s financial and market risk The restricted stock equivalent discount ( RSED ) (2) The level of stock market volatility around the transaction date The market volatility adjustment adjusted restricted stock equivalent discount ( ARSED ) (3) The degree of liquidity of the securities The private equity discount ( PED ) RSED + ARSED + PED = DLOM 55 A New Perspective on the Use of the FMV Opinions Restricted Stock Database Example Draft VPS DLOM Toolkit (under review; subject to change) Developed a relevant sample for the subject company using a quintiles analysis of the FMV Opinions Database (recommended) A quintiles analysis involves matching the subject company to a group of restricted stock transactions in the FMV data with similar fundamental characteristics (i.e., revenue, market value, etc.) as that of the subject The median discount from each quintile is then utilized as a proxy for a discount applicable to the subject company The discounts are further analyzed and adjusted for qualitative differences between the samples and the subject company See the FMV Opinions Companion Guide for additional details 56 28

29 Thoughts on Using the FMV Opinions Database: Recommendations for Quantifying DLOMs Understand the FMV Database Develop a good reference DLOM Isolate transactions with similar characteristics Adjust the reference DLOMs Dividends Illiquidity/Holding Period Risk Other Factors Use other methods QMDM Option Pricing Perform a reasonableness analysis Look at the implied rate of return 57 Question Should we be using restricted stock databases such as FMV Opinions or Pluris? 58 29

30 Company Name: Industry: Revenue: Pre tax Profit After tax Profit Total Assets Total Equity LT Debt Market Value Cost of Capital LT Expected Growth Rate Estimated Volatility: Case Study Facts Salient Characteristic of Company ABC Plastics, Inc. SIC Group 305 Rubber Components $20 million $2 million $1.2 million $5 million $4.5 million None $7.5 million (income approach) 20% (build up method) 4.0% (enterprise level) 58.0% (from public companies) 59 Case Study Facts (cont.) Bill Smith is majority owner (60% of stock) Plans to retire in 5-10 years; sell company Closely held company, small shareholder base No distributions, none expected for foreseeable future FCFE being retained as excess cash Right-of-first refusal (90 days); no offers received Selected Historical Financial Statement Information Year Revenue Norm. Inc. Norm. FCFE Dividends 2009 $18.10 mil. $1.04 mil. $0.95 mil $0.06 mil 2010 $18.50 mil. $1.11 mil. $1.00 mil $0.05 mil 2011 $19.20 mil. $1.15 mil. $1.09 mil $0.11 mil 2012 $19.70 mil. $1.18 mil. $1.06 mil $0.00 mil 2013 $20.00 mil $1.20 mil. $1.14 mil $0.00 mil 2014 (exp.) $22.00 mil. $1.22 mil. $1.20 mil $0.00 mil CAGR (5 Yr.) 3.98% 3.64% 6.01% N/M 60 30

31 METHOD RESTRICTED STOCK STUDIES 61 Restricted Stock Study: Performing a Quintiles Analysis Metric Subject Company ($000) FMV Study Quintile Discount FMV Suggested Weights Market Value $7,500 5 th Quintile 27% 2 Revenue $20,000 3 rd Quintile 16% 1 Total Assets $5,000 5 th Quintile 26% 3 Total Equity $4,500 4 th Quintile 25% 2 MTB Ratio st Quintile 14% 1 Net Profit % 6% 1 st Quintile 14% 1 Volatility 58.0% 2 nd Quintile 14% 0 Wgt. Avg. 22% Average 19% Median 16% 62 31

32 Restricted Stock Study: Performing a Quintiles Analysis Metric Subject Company ($000) FMV Study Quintile Discount FMV Suggested Weights Market Value $7,500 5 th Quintile 27% 2 Revenue $20,000 3 rd Quintile 16% 1 Total Assets $5,000 5 th Quintile 26% 3 Total Equity $4,500 4 th Quintile 25% 2 MTB Ratio st Quintile 14% 1 Net Profit % 6% 1 st Quintile 14% 1 Volatility 58.0% 2 nd Quintile 14% 3 Wgt. Avg. 21% Average 19% Median 16% 63 Restricted Stock Studies: Mandelbaum Factor Analysis Mandelbaum Factor Subject Restricted Stock Impact on DLOM Public vs. private sale of stock No sales Already public Increase Financial Statement Analysis (Risk) Profitable Free cash flow positive Growing steadily No debt Strong balance sheet Negative earnings Negative equity Volatile Decrease Dividend Policy Not distributing Not distributing No effect Nature of the company, its history, industry, position, and economic outlook (Risk) Established since 1980s Stable position Short history Risky industries Decrease Company Management Hoarding excess cash Board of Directors Increase Amount of control transferred in stock Minority transfers Minority transfers No effect Holding Period for the stock Expected 5 10 years Approximately 1.3 yrs. Registration rights Increase Company s Redemption Policy No formal policy No formal policy No effect Costs associated with public offering Expensive Already public Increase Other Factors Copyright 2014 Valuation Products and Less reliable financials Small shareholder base Smith family controls Limited buyer pool None Increase 64 32

33 Restricted Stock Studies: Mandelbaum Factor Analysis Total Adjustment 20%? Indicated Discount (Wgt. Avg.) 42% (i.e., 22% + 20%) Indicated Discount (Low) 34% (i.e., 14% + 20%) Indicated Discount (High) 47% (i.e., 27% + 20%) Indicated Discount (Average) 39% (i.e., 19% + 20%) Indicated Discount (Median) 36% (i.e., 16% + 20%) 65 Restricted Stock Studies: Understanding the Characteristics of the Sample Data Salient Characteristics of Quintiles (Ranked by Volatility) Metric DLOM Vol. % Neg. Profit. %Div. Pay % Reg. Rights Total Assets 26% 108% 86% 0% 22% 1.3 yrs. Market Value 27% 92% 67% 0% 27% 1.3 yrs. Total Equity 25% 87% 79% 0% 36% 1.4 yrs. Market to book 14% 78% 73% 6% 40% 1.1 yrs. Revenue 16% 75% 74% 0% 38% 1.3 yrs. Net Profit Margin 14% 65% 0% 9% 47% 1.4 yrs. Volatility 14% 63% 68% 3% 43% 1.3 yrs. Wgt. Avg. 22% 90% 70% 2% 32% 1.3 yrs. Average 19% 81% 64% 3% 36% 1.3 yrs. Median 16% 78% 73% 0% 38% 1.3 yrs. Subject???? 58% Profitable None N/A 5 10 yrs. Avg. HP 66 33

34 Restricted Stock Studies: Adjusting for Differences in Volatility Shows approx % increase in discounts for each 1% increase in volatility 67 Restricted Stock Studies: Computing Volatility Adjusted Discounts Metric Summary of Sample Statistics for Quintiles Reported DLOM Median Vol. of Quintile Est. Vol. of Subject Diff. in Vol. Vol. Adj. to DLOM DLOM Adj. for Vol. Market Value 27% 92% 58% (34%) (6%) 21% Revenue 16% 75% 58% (17%) (3%) 13% Total Assets 26% 108% 58% (50%) (8%) 18% Total Equity 25% 87% 58% (29%) (5%) 20% Market to book 14% 78% 58% (20%) (3%) 11% Net Profit Margin 14% 65% 58% (7%) (1%) 13% Volatility 14% 63% 58% (5%) (1%) 13% Wgt. Avg. 22% 90% 58% N/M N/M 17% Average 19% 81% 58% N/M N/M 16% Median 16% 78% 58% N/M N/M 13% 68 34

35 Restricted Stock Studies: Adjusting for Differences in the Holding Period Most restrictive 2-year holding period Least restrictive 6-mo. holding period 69 Restricted Stock Studies: Adjusting for Differences in the Holding Period Summary of Sample Statistics for Quintiles Metric Vol. Adj. DLOM HP Adjust. Hp. Adj. DLOM Market Value 21% 15% 36% Revenue 13% 15% 28% Total Assets 18% 15% 33% Total Equity 20% 15% 35% Market to book 11% 15% 26% Net Profit Margin 13% 15% 28% Volatility 13% 15% 28% Wgt. Avg. 17% 15% 32% Average 16% 15% 31% Median 13% 15% 28% 70 35

36 Metric Restricted Stock Studies: Adjusting for Differences in the Holding Period (Option Models) Calculation of Holding Period Adjusted DLOMs Vol. Adj. DLOM % Reg. Rights Avg. HP Wgt. Avg. HP 1 Adj. to DLOM for HP 2 HP Adj. DLOM Market Value 21% 27% 1.3 yrs. 1.0 yrs. 15% 36% Revenue 13% 38% 1.3 yrs. 0.9 yrs. 16% 29% Total Assets 18% 22% 1.3 yrs. 1.1 yrs. 16% 34% Total Equity 20% 36% 1.2 yrs. 0.8 yrs. 17% 37% Market to book 11% 40% 1.1 yrs. 0.7 yrs. 17% 28% Net Profit Margin 13% 47% 1.4 yrs. 0.8 yrs. 17% 30% Volatility 13% 43% 1.3 yrs. 0.9 yrs. 17% 30% Wgt. Avg. 17% 32% 1.3 yrs. 0.9 yrs. N/M 33% Average 16% 36% 1.3 yrs. 0.9 yrs. N/M 32% Median 13% 38% 1.3 yrs. 0.9 yrs. N/M 30% (1) According to FMV Data, the median days to register is 0.17 years. Therefore, the weighted average holding period = % Register*0.17 Years + (1-% Register)*Avg. HP. (2) The holding period adjustment is calculated via an arithmetic average strike put option by examining the increase in discounts as a result of adjusting the holding period from the weighted average holding period to 7.5 years. 71 Restricted Stock Studies: Mandelbaum Factor Analysis Mandelbaum Factor Subject Restricted Stock Impact on DLOM Public vs. private sale of stock No sales Prospect for public sales Increase Financial Statement Analysis (Risk) Profitable Free cash flow positive Growing steadily No debt Strong balance sheet Negative earnings Negative equity Distressed Decrease Dividend Policy Not distributing Not distributing No effect Nature of the company, its history, industry, position, and economic outlook (Risk) Established since 1980s Stable position Short history Risky industries Decrease Company Management Hoarding excess cash Board of Directors Increase Amount of control transferred in Minority transfers Minority transfers No effect stock Holding Period for the stock Expected 5 10 years Approximately 1.3 yrs. Increase Registration rights Company s Redemption Policy No formal policy No formal policy No effect Costs associated with public offering Expensive Already public Increase Other Factors Less reliable financials None Increase Small shareholder base Smith family controls Limited buyer pool Total Adjustment 10%? 72 36

37 Metric Restricted Stock Studies: Summary of Normalized Discounts Reported DLOM Final Normalized /Adjusted DLOMs Vol. Adj. Vol. Adj. DLOM HP Adj. HP Adj. DLOM MBaum Factors Final DLOM Market Value 27% (6%) 21% 15% 36% 10% 46% Revenue 16% (3%) 13% 16% 29% 10% 39% Total Assets 26% (8%) 18% 16% 34% 10% 44% Total Equity 25% (5%) 20% 17% 37% 10% 47% Market to book 14% (3%) 11% 17% 28% 10% 38% Net Profit 14% (1%) 13% 17% 30% 10% 40% Margin Volatility 14% (1%) 13% 17% 30% 10% 40% Wgt. Avg. 22% N/M 17% N/M 33% 10% 43% Average 19% N/M 16% N/M 32% 10% 42% Median 16% N/M 13% N/M 30% 10% 40% 73 METHOD OPTION PRICING MODELS 74 37

38 Option Pricing Models: Arithmetic Average Strike Put Options We utilized an arithmetic average strike put option The model requires the following assumptions: Input Assumption Reasoning Volatility Holding Period Range (48 68%) Based upon volatility estimated from public companies; could also simply evaluate volatilities over a reasonable range 5 10 Years Based upon likely holding period; good to evaluate HP over range Dividend 0% Based upon subject company s history and current policies (see case facts) 75 Finnerty Option Model Holding Period (Years) Implied Marketability Discount 18.0% 4% 6% 7% 8% 9% 10% 11% 11% 12% 13% 15% 17% 19% 21% 28.0% 6% 9% 11% 13% 14% 15% 16% 17% 18% 19% 22% 25% 26% 28% 38.0% 9% 12% 15% 17% 18% 20% 21% 22% 23% 24% 27% 29% 30% 31% Volatility 48.0% 11% 15% 18% 20% 22% 24% 25% 26% 27% 28% 30% 31% 32% 32% 58.0% 13% 18% 21% 23% 25% 27% 28% 29% 30% 30% 32% 32% 32% 32% 68.0% 15% 20% 24% 26% 28% 29% 30% 31% 31% 31% 32% 32% 32% 32% 78.0% 17% 23% 26% 28% 30% 31% 31% 32% 32% 32% 32% 32% 32% 32% 88.0% 19% 25% 28% 30% 31% 31% 32% 32% 32% 32% 32% 32% 32% 32% 98.0% 21% 26% 29% 31% 32% 32% 32% 32% 32% 32% 32% 32% 32% 32% 76 38

39 Questions Should we be using option models in calculating a DLOM? Finnerty Chaffe Longstaff Ghaidarov What s the best way to use option models? 77 METHOD Quantitative Marketability Discount Model (QMDM) 78 39

40 QMDM Used here as a reasonable test Range from 31% to 63% Holding period 5 to 10 years Rate of return 24% to 27% Where and how does QMDM fit in? Primary method? Reasonable test? Other? 79 QMDM Holding Period (Years) Implied Marketability Discount 20.0% 4% 8% 12% 16% 19% 23% 26% 29% 32% 35% 47% 57% 65% 72% 21.0% 5% 10% 14% 18% 22% 26% 30% 33% 37% 40% 53% 64% 72% 78% HP Required Return 22.0% 6% 11% 16% 21% 26% 30% 34% 38% 41% 45% 59% 69% 77% 83% 23.0% 7% 13% 18% 24% 29% 33% 38% 42% 45% 49% 64% 74% 81% 87% 24.0% 7% 14% 20% 26% 31% 36% 41% 45% 49% 53% 68% 78% 85% 90% 25.0% 8% 15% 22% 28% 34% 39% 44% 49% 53% 57% 71% 81% 88% 92% 26.0% 9% 17% 24% 31% 37% 42% 47% 52% 56% 60% 75% 84% 90% 94% 27.0% 9% 18% 26% 33% 39% 45% 50% 55% 59% 63% 77% 86% 92% 95% 28.0% 10% 19% 27% 35% 41% 47% 53% 58% 62% 66% 80% 88% 93% 96% 80 40

41 Conclusions: Application of DLOM Summary of DLOMs Model Min Max Selected QMDM 31% 63% 48% Pre IPO N/A N/A N/A Restricted Stock Basic Quintiles Restricted Stock Normalized Quintiles 34% 38% 47% 46% 40% 42% Option Pricing 22% 31% >22 31% Conclusion 40% Determination of Value of Nonmarketable Interest Indicated Value of Company $7,500,000 Less: Marketability 40% ($3,000,000) Equals: Nonmarketable Minority Value $4,500,000 Multiplied by Interest being valued 20% Indicated value of a 20% Nonmarketable Minority Interest $900, New Insight Into the Use of Calculation Engagements and Calculation Reports Valuation Products and Financial Valuation and Litigation Expert Webinars BV Standards Q&A Real World Solutions to Perplexing Issues, Standards Experts on AICPA, ASA/USPAP and NACVA/IBA, Jim Hitchner, Carla Glass and Bob Grossman, December 9, 2013 Business Valuation Calculations and Calculation Reports Including Two Updated Sample Calculation Reports, Ed Dupke and Jim Alerding, March 28,

42 New Insight Into the Use of Calculation Engagements and Calculation Reports LinkedOut A Response to a Business Valuation Standards Discussion, Financial Valuation and Litigation Expert, FVLE Issue 40, December 2012/ January 2013, Valuation Products and, pp. 1, 3 6. (Handout) Also, ongoing discussions with Ed Dupke, Jim Alerding, Jay Fishman, Carla Glass, Richard Wise, Mark Kucik, Mark Hanson, Bob Grossman and others 83 New Insight Into the Use of Calculation Engagements and Calculation Reports When can I use calculation engagements and reports? What should be the length of calculation reports? How do I adhere to BV reporting standards (AICPA, ASA, IBA, NACVA and USPAP) for calculations? 84 42

43 New Insight Into the Use of Calculation Engagements and Calculation Reports AICPA, ASA, NACVA and the IBA allow calculations As such, they recognize a need in the BV profession to have a lesser work product This need also exists for clients and client representatives such as accountants and attorneys USPAP does not have a calculation or a calculation report ASAs have to follow USPAP, so is an ASA calculation in violation with USPAP? 85 New Insight Into the Use of Calculation Engagements and Calculation Reports Calculations can be used for such services as preliminary estate planning, preliminary mergers and acquisition analyses, and preliminary values for settlement purposes in litigation Note the word preliminary in each example However, there is no requirement to have only preliminary calculations CPAs are free to provide calculations any way they see fit as long as they comply with SSVS 86 43

44 New Insight Into the Use of Calculation Engagements and Calculation Reports The most important limiting language in SSVS for a calculation is as follows: A valuation analyst performs a calculation engagement when (1) the valuation analyst and the client agree on the valuation approaches and methods the valuation analyst will use and the extent of procedures the valuation analyst will perform in the process of calculating the value of a subject interest (these procedures will be more limited than those of a valuation engagement) 87 New Insight Into the Use of Calculation Engagements and Calculation Reports The valuation analyst expresses the results of these procedures as a calculated value (p. 13, 21.b.) (1) a calculation engagement does not include all of the procedures required for a valuation engagement and (2) had a valuation engagement been performed, the results may have been different (p. 34, 76.g.) 88 44

45 New Insight Into the Use of Calculation Engagements and Calculation Reports Some CPAs are providing calculations, calculated values and calculation reports as their only and final value in a litigation setting Some are also offering calculated values as their opinion of value Remember, in a litigation setting an expert opinion must be with reasonable certainty While there is no prohibition against this, from a practical perspective, why would you want to? 89 New Insight into the Use of Calculation Engagements and Calculation Reports If you are admitting that a calculation engagement does not include all of the procedures required for a valuation engagement and had a valuation engagement been performed, the results may have been different (SSVS) or That the objective of a calculation is to provide an approximate indication of value of a business, business ownership interest, security or intangible asset based on the performance of limited procedures agreed upon by the appraiser and the client (ASA) How can this be with reasonable certainty? 90 45

46 New Insight Into the Use of Calculation Engagements and Calculation Reports A calculation is not in conflict with the SSVS to testify That is not a violation of the SSVS The calculation provisions were put into the SSVS to aid the CPA in instances where something less than a full valuation was needed It was wanted by the profession when SSVS was put together and it is a very useful tool in some cases It is not likely to ever be taken out of the SSVS 91 New Insight Into the Use of Calculation Engagements and Calculation Reports **Breaking News** (Handout from FVLE Issue 47) Preparing Calculations under USPAP is Possible Has to do with: What s an opinion? Scope of work Intended use Engagement purpose Other 92 46