Common Mistakes in Applying the Market Approach. Presented by: Linda B. Trugman CPA/ABV, MCBA, ASA, MBA

Transcription

1 Common Mistakes in Applying the Market Approach Presented by: Linda B. Trugman CPA/ABV, MCBA, ASA, MBA

2 Why Consider Guideline Public Companies or Transactions? Code Section 2031 states: In the case of stock and securities of a corporation the value of which, by reason of their not being listed on an exchange and by reason of the absence of sales thereof, cannot be determined with reference to bid and asked prices or with reference to sales prices or with reference to sales prices, the value thereof shall be determined by taking into consideration, in addition to all other factors, the value of stock or securities of corporations engaged in the same or similar line of business which are listed on an exchange (emphasis added)

3 Why Consider Guideline Public Companies or Transactions? Revenue Ruling states that the analyst should consider: The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter RR also states: Although the only restrictive requirement as to comparable corporations specified in the statute is that their lines of business be the same or similar, yet it is obvious that consideration must be given to other relevant factors in order that the most valid comparison possible will be obtained (emphasis added)

4 Why Consider Guideline Public Companies or Transactions? ASA BV Standard II.A states: Transactions involving the sale, merger or acquisition of business, business ownership interests, securities and intangible assets can provide objective, empirical data for developing valuation ratios for use in business valuation ASA BV Standard II.B states: The development of valuation ratios from guideline transactions of significant interest in companies should be considered in the valuation of businesses, business ownership interests to the extent that sufficient and relevant information is available

5 Issues with the Guideline Public Company Method

6 Known or Knowable Different interpretations of known or knowable As of date of death (July 5, 2004), what financial information is available? (Estate of Gallagher) Subject Company Financial Data Guideline Public Company Financial Data IRS June 27, 2004 June 30, 2004 Taxpayer May 30, 2004 March 28, 2004

7 Known or Knowable IRS argument June financial data more accurate than earlier information Taxpayer argument June financial data for subject and guideline public companies not likely to be closed and published at valuation date Court decision: Financial data as of June 30, 2004 Even though this information was not publicly available as of the valuation date, that is not to say that our hypothetical actors could not make inquiries of [the company] or of the guideline companies (or of financial analysts), which would have elicited non-publicly available information as to end-of June conditions

8 How Do You Define Same or Similar? Amount of investment in plant and equipment Amount of investment in inventory Level of technology employed Level of skill required to perform the operation Size Financial position Liquidity Years in business Financial market environment Quality of earnings Marketability of shares Operating efficiency Geographical diversification Past growth of sales and earnings Rate of return on invested capital Stability of past earnings Dividend rate and record Quality of management Nature and prospects of the industry Competitive position and individual prospects of the company Basic nature of the activity General types of goods or services produced Relative amounts of labor and capital employed Extent of materials conversion

9 Estate of Joyce C. Hall (92 TC 312) Filed Feb. 14, 1989 Hallmark Greeting Cards, Inc. Date of death Oct. 29, 1982 One publicly-traded company in industry American Greetings IRS appraiser only used one guideline company American Greetings

10 Estate of Joyce C. Hall (92 TC 312) Taxpayer s expert - The First Boston Corporation GPC selection criteria Produced brand name consumer goods Leading companies in their industries Publicly traded Business and financial characteristics similar to Hallmark

11 Estate of Joyce C. Hall (92 TC 312) Taxpayer s expert Shearson Lehman Hutton Inc. Selection Criteria Sold low cost, consumer, nondurable goods through channels similar to those used by greeting card companies Stable, high-profile quality reputation with the consumer and a leading brand name Differentiable products from its competitors Products involved some element of social expression Leaders in their industries

12 Estate of Joyce C. Hall (92 TC 312) First Boston Companies American Greetings A.T. Cross Company Avon Products, Inc. The Coca-Cola Company Lenox, Incorporation Papercraft Corporation Shearson Lehman Hutton McDonald s Anheuser Busch IBM Coca-Cola 15 companies in total but only these four were individually listed in decision

13 Estate of Joyce C. Hall (92 TC 312) Moreover, it is inconceivable to us that a potential buyer of Hallmark stock would consider only one alternative comparable, i.e., American Greetings stock. Respondent s argument too narrowly construes the concept of comparability and ignores the use of similar as well as same in section 2031(b). PCA s market comparison analysis is thus defective in that it relied on only one comparable company with sales in a different market channel.

14 Estate of Joyce C. Hall (92 TC 312) In contrast to PCA, petitioner s experts acted reasonably in selecting comparable companies in the similar business of consumer nondurable goods, in drawing conclusions based upon careful comparisons of Hallmark with individual comparables, and in relying primarily upon the price-to-earnings method of valuation to test the reasonableness of Hallmark s adjusted book value formula.

15 Estate of Gallagher (TC Memo ) Filed June 28, 2011 Paxton Media Group, LLC Date of death July 5, 2004 Taxpayer s expert used GPCM as a sanity check

16 Estate of Gallagher (TC Memo ) IRS s expert located 13 companies and used four that Expert believed were most similar based on size He believed those companies to be the most comparable to PMG because their underlying price multiples generally reflect an investor s assessment of both current and future earnings prospects as well as the business and financial risks, inherent in the Company s business as of the valuation date.

17 Estate of Gallagher (TC Memo ) Judge disregarded the market approach because of differences between the GPCs and PMG: Size (PMG was one-third the median revenue and one-fourth the median total assets of the GPCs) Product mix (PMG had few specialty publications and no internet component) Historical growth Liquidity Leverage We find that [the IRS s expert] improperly relied on the guideline public company method because the four guideline companies alone were not similar enough to PMG to warrant its application

18 Estate of Giustina (TC Memo ) Filed June 22, 2011 Giustina Land & Timber Co. LP Date of death Aug. 13, 2015 Both experts used a GPCM

19 Estate of Giustina (TC Memo ) Taxpayer Plum Creek Timber Co., Inc. Pope Resources, LP IRS Plum Creek Timber Co., Inc. Pope Resources, LP Deltic Timber Corp. Potlatch Corp.

20 Estate of Giustina (TC Memo ) Descriptions of GPCs Plum Creek REIT (52% of revenues from timber sales) Pope Resources partnership (81% of revenues from timber) Deltic and Potlatch substantial revenues from other than owning timberland and selling timber The Court In our view, neither expert appropriately considered that the other companies have assets other than timberland assets and that they earn income from sources other than timber sales. Because of this failure, and because other methods are available, we accord no weight to the guideline publicly traded company method.

21 Fundamental or Mathematical Adjustments? Size and growth adjustments can be quantified Michael Mattson, Don Shannon and Don M. Drysdale, Adjusting Guideline Multiples for Size, Valuation Strategies (WG&L), Sep/Oct 2001 Alina Niculita, CFA, Adjusting Public Multiples: A Summary of Theories and Methodologies, BVUpdate TM (Business Valuation Resources), January 2007

22 Problems with Adjusting Multiples Do the quantification methods consider all subject company risk? Do you still need to add a fundamental adjustment? Do the size adjustments reduce the multiples so much that the companies are no longer same or similar? Guideline company is decile one while subject company is in decile 10? Can you quantify a growth adjustment? Subject company growth represents perpetual growth while guideline company growth estimates are generally short term (one to two years)

23 Problems with Adjusting Multiples Starting with average or median multiples Financial analysis indicates that subject company is stronger or weaker than guideline companies Not considering that subject company is more similar to one or two guideline companies

24 Why Are My Income and GPCM Values So Different? Using a size or specific company risk premium in your discount rate but not adjusting your multiple for the same risk factors Adjusting guideline public company multiples for shortterm growth (1-2 years) while considering perpetual growth rate in income approach (terminal value)

25 Issues with the Guideline Public Transaction Method

26 Data - IBA 33,000+ transactions 10 data points SIC code, business type, annual gross sales, owner s compensation (not available for all transactions), annual earnings (not available for all transactions), year and month of sale, sales price, geographic information, sales price to gross sales, sales price to annual earnings

27 Data- BIZCOMPS 13,000+ transactions 21 data points SIC and NAICS codes, business type, annual gross sales, sale data, seller s discretionary earnings (SDE), sale price, ask price, SDE to gross sales, sale price to gross sales, sale price to SDE, percent down, terms, inventory, fixed assets (without real estate), real estate, rent to gross sales, location, days on market, franchise royalty, number of employees

28 Data Pratt s Stats 23,000+ transactions 80+ data points Six multiples 13 financial ratios

29 Mixing Databases Each database defines sales price differently: Bizcomps: Actual sale price (does not include inventory or real estate) IBA: Total consideration including cash, notes, liabilities assumed by buyer and other consideration such as employment contracts or noncompete agreements Pratt s Stats: Market value of invested capital (includes cash, notes plus any interest-bearing debt assumed. Also includes non-compete agreements but excludes real estate, earnouts and employment/consulting agreements

30 Mixing Databases What was sold? Bizcomps: Fixed assets and intangible value IBA: Can be inventory, fixed assets (exclusive of real estate) and intangible value Pratt s Stats: Asset sale: Includes inventory, fixed assets (exclusive of real estate) and intangible value (intermediary should be providing the assets included) Stock sale: All operating assets and liabilities

31 Mixing Databases How are earnings defined? Bizcomps: Seller s discretionary earnings=normalized EBITDA plus one owner s salary plus perqs IBA: Annual earnings=normalized EBIT plus own owner s salary plus perqs Pratt s Stats: Seller s discretionary earnings=normalized EBITDA plus one owner s salary plus perqs

32 Date of Transaction How old is too old? Ray Miles stated that as sales prices grow in an industry, so do revenues therefore multiples increase proportionately Has the industry undergone consolidation? If so, are the multiples indicative of fair market value? Has the industry undergone fundamental changes that makes old multiples less or not relevant? Medical

33 Other Miscellaneous Problems/Errors Not having enough information about the target companies Not knowing whether earnings are normalized Not knowing what assets and liabilities are included in the transaction Not knowing if the transaction is financial or strategic

34 Problems With Both Methods

35 How Many GPCs/Transactions Are Enough? Estate of Hall one is NOT enough Estate of Kaufman A proper valuation report must contain enough data on each similar corporation to allow the Court to make an informed, independent decision as to whether the corporations are sufficiently similar to the subject corporation to perform a proper analysis Financial Valuation (Jim Hitchner) A larger group of comparables will reduce the importance on any single guideline company. Since at least one company in any group may be anomalous, having a larger group reduces the effect of this potential anomaly. Having a larger group of comparables increases the likelihood that more of the subject s characteristics can be captured.

36 Use of Statistics/Regression Analysis Lack of understanding of statistics leads to nonsensical results Regression analysis does not work with only a few observations Regression analysis is not meant to be predictive Not every financial analysis leads to use of average or median multiple Not considering the difference between median and average

37 Lack of Analysis Leads to Nonsensical Results Must analyze the subject company, guideline companies and transaction targets (to the extent possible). Failure to perform this analysis potentially leads to the following: Pick an average or median multiple when the subject company is better or worse than the average Select a multiple from one or two companies/transactions that are really not similar to the subject Failure to adjust the multiples for differences between the subject and the target

38 CONCLUSION: Thorough understanding and analysis of all of the data leads to better, supportable results! THANK YOU FOR ATTENDING! QUESTIONS???