©2002-2003 Jones & Roth P

BUSINESS VALUATION

VALUATION CONCEPTUAL STRUCTURE

William V. Mason II, CPA/ABV, ASA

Shareholder, Jones & Roth, P.C.

The value of a business interest depends on the future benefits that will accrue to it. The financial benefits from ownership must come from one of the following sources: first, distribution of cash; second, from the sale of the interest; and, third, distribution from the liquidation of assets. In determining the value of a business interest, one should focus on the benefits the shareholder(s)/ owner(s) may receive with long term ownership of the securities or interest in question from these three sources. In appraisal terminology, these three sources of return correspond to the income, market, and adjusted net asset value approaches, respectively.

INCOME

The income approach relies upon developing a "normalized" earnings/cash flow picture or forecasted discreet periodic cash flow of the target company. Following the determination of normalized or forecasted earnings/cash flows, and a developed reasonable rate of return to an investor, given risks associated with the investment and alternative investment opportunities, a growth rate associated with the cash flow, a fair market value can be determined, by “capitalizing” the anticipated income/cash flows at the appropriate rate of return.

The conceptual basis for this approach comes from the constant growth (Gordon Dividend) model, which is based on the premise that the value of a stream of periodic cash flows, growing at a constant rate, is the present value of all of the cash flows. To apply this model to business valuation, we define "dividends" as either cash flows available to the equity investor, or as debt free cash flow. We define “dividends” as cash flows available to equity investors if we wish to directly value equity. We define “dividends” as debt free cash flow if we intend on valuing total invested capital, because this is the cash pool from which “dividends” could be paid to all invested capital. Invested capital is defined as equity plus interest bearing debt. The definition of “dividends” determines the capitalization rate, which is used to develop value. If “dividends” are defined as cash flow to equity investors, the capitalization rate is developed by referencing the required rate of return of the equity holders, adjusted for anticipated “constant” growth in these dividends, and the resulting value is the equity value. If “dividends” are defined as debt free cash flow, then the capitalization rate is based on the weighted average cost of capital (WACC), adjusted for anticipated “constant” growth in these dividends. The capitalization rate, based on WACC, is developed by “weighting” the rate required for equity capital with the rate required for debt capital, arriving at a blended rate (WACC), based on the amount of debt and the amount of equity associated with the total invested capital. The resulting value is reduced by outstanding debt to estimate the fair market value of equity. The simple assumption used in this model, is that periodic cash flow, “dividends”, will grow at a constant rate in perpetuity (which is why this is referred to as the constant growth model).

The present value of a perpetual stream of “dividends” growing at a constant rate is as follows:

Cash flow to equity holders is defined as net income after taxes, adding back non-cash expenses (e.g. depreciation and amortization) less necessary retained cash (e.g. cash used for purchase of capital equipment or retained due to working capital needs). Debt free cash flow is defined as net income before debt service (interest expense) but after taxes, plus depreciation and amortization, less capital expenditures and less any necessary increase in working capital. The tax analysis (as in “after tax”) is dependent upon the entity type and the level of “tax effecting”.

The discounted cash flows to invested capital method is very similar to the previous method except that it develops first the value of total invested capital. This is developed by capitalizing the cash flows to total invested capital using the weighted average cost of capital (WACC). In developing the blended rate (WACC), the debt rate is adjusted from actual because interest expense (the return to debt investors) is deductible for tax purposes, while the return to equity holders is not adjusted, because dividends are not deductible for tax purposes. When valuing a minority interest, the equity rate and the adjusted debt rate are generally weighted in accordance with the current financial structure to arrive at WACC. When we value a controlling interest, we generally weight the rates in accordance with industry averages, assuming this represents maximum leverage benefits, to arrive at the WACC. The WACC is then adjusted for the anticipated growth rate, much as the equity rate was adjusted for the anticipated long term growth rate

If the cash flows are not assumed to grow in a constant manner, periodic cash flows are developed until it can be assumed that the cash flow will grow at a constant rate. The value of the interest is considered to be the sum of the present values of the discreet cash flow projections (discounted at either the equity rate of return or the WACC depending on the definition of cash flow) plus the “terminal value” discounted to the present. The terminal value is developed by using the constant growth model since the terminal value is developed for the periods in which constant growth is a reasonable assumption. While the growth rate is directly accounted for in the constant growth model, it is incorporated in the projections of the discreet periodic cash flows by developing anticipated revenues and expenses which incorporate sales growth and expense growth. The projected cash flows for these discreet periods have incorporated the growth in the projection, so the present value is developed by referencing just the required rate of return (discount rate) without adjustment for growth.

The second approach, market, is developed differently. The value of the organization can be compared to recent market activity, sales of similar organizations in the same or similar industry. Statistics such as entity sales price to gross revenues, sales price to cash flow, etc. can be developed from the information available regarding these similar organizations that recently sold. Pertinent price ratios can be applied to the target company’s financial results to determine an estimate of fair market value. This is perhaps the most preferable means of developing value for a controlling interest since it is the most objective method. While being preferred, it is difficult or impossible to apply at times. The business entity or interest being valued may not have revenues and/or cash flows to which to apply the observed deal price multiples. Also, because most merger and acquisitions occur in the private market, information necessary to develop deal price multiples may not be available. Minority interest value estimates can be developed from these types of entity multiples, but care must be taken to adjust for the lack of certain control value concepts.

When valuing minority interests, the value of an interest may be compared to recent market activity in equity transactions, reported through public exchanges (e.g. NASDAQ or New York Stock Exchange), in similar organizations in the same or similar industry, or subject to similar risks. Statistics such as price earnings ratios, price to cash flow ratios, price to book value, etc. can be developed from public information regarding these public guideline company transactions. Pertinent price ratios are applied to the target interest to determine an estimate of fair market value. This is the most preferable means of developing the estimate of value for a minority interest since it is objective. Again, while being preferred, it is often difficult or impossible to apply because of lack of comparability of the target interest to any publicly traded interests, due to size, capital structure, product diversification, market area, etc. An entity value, also called enterprise value, may be developed from this information, but care must be taken to insure that adjustments are made, where they are considered necessary, to reflect value associated with a control interest relative to minority interest. Valuations based on per share exchange pricing reflect minority interest transactions, and may need adjustment to reasonably reflect controlling interests.

The third method of developing the fair market value of an entity, adjusted net asset value, may also be used. With a marginally profitable company, or a holding/investment company, the underlying assets would be adjusted to the fair market values, and the resulting "liquidation" value would present a value approach. With profitable operating entities, the whole is assumed to be greater than the sum of its underlying assets. Profitable operating companies are assumed to have either unrecorded intangible assets, or other assets (probably intangible assets) which have maximized values only in association with on-going operations. These are often categorized as goodwill, value of in place management, reputation, etc. Adjusted net asset value approaches, for a going concern, may value these assets in association with continuing operations or on a “piece meal” liquidation basis. Operating entities may be valued using an adjusted net asset value approach by valuing the intangible assets, whether recorded or unrecorded, based on cash flows derived from them and adding the value of the hard assets (cash, accounts receivable, investments, inventory, equipment, etc.) to the result.

Holding and investment companies do not have these intangible assets, and as a result, they are valued by appraising the hard assets of the entity. The appraisal of the “hard” assets of the entity is generally done via some combination of cash flow analysis, if the “hard” asset represents an interest in a going concern, and comparable market transactions. Care must be taken when using the adjusted net asset approach to value a minority interest. In fact, it is generally not applicable to minority interest valuations because a minority interest holder has no ability to force liquidation and access the underlying asset values.

Two concerns which must be resolved in order to appropriately develop fair market value estimates, regardless of valuation methodology applied, relate to the nature of the holding being valued, minority interest versus controlling interest, and the liquidity of the investment (i.e. marketability).

When valuing minority interests, the appraiser must be aware of the basis on which the valuation approach rests. When using earnings or cash flows, are the earnings/cash flows those which a minority interest holder generally has access to, or do they reflect only those available to a controlling interest holder. A controlling interest holder can adjust financial structure, control dividends/distributions with regards to timing and amount, alter operating efficiencies, set compensation amounts, hire and fire employees, etc. A minority interest holder has no ability to control any of these issues, and they have influence on these issues only at the discretion of the controlling interest holder(s). The implication of this “control” issue is that if the entity is being valued based on control data, and/or cash flows associated with entire entity transactions’ multiples, any minority interest valuation based on this “control” basis will need to be adjusted for the loss of value represented by the lack of control associated with a minority interest holder. This adjustment in value is called the minority interest discount. It is applied only to arrive at a minority interest value when the base value was derived from controlling interest assumptions and analyses. The reciprocal of this “minority interest” discount implies that if the value of a control interest is being developed from minority interest base information, a control premium must be applied to minority value base to properly value a controlling interest. For example, if a total entity value is being developed by referencing observed price/earnings multiples reported on publicly held stocks, the base information is minority interest observations. Price/earnings multiples reported on publicly traded stocks reflect per share, minority interest, prices. A share of stock is a minority interest. It is assumed that imbedded in this “market” price is a minority interest discount, and to properly value a controlling interest, a control premium must be applied to reflect control aspects.

The other issue which must be considered in any fair market valuation is liquidity of an investment. When we develop values based on alternative, but freely tradable investments, then we have assumed a level of liquidity to the investment. The investor treasures liquidity. Liquidity, for minority interests, is generally defined as the ability to convert an investment to cash in three days. If you own a share of General Electric, you can call your broker, sell the share and retrieve your cash in a three day period. Liquidity is valued because it offers the investor an opportunity to withdraw from an investment in a timely manner, regardless of the reason. All things being equal, an investment is worth more if it is marketable than if it is not, because investors prefer liquidity over lack of liquidity. Lack of liquidity significantly increases the downside risk.

The Wall Street Journal, November 6, 1998, discussed current public markets suffering from low liquidity, even when an “active” market exists. The example cited concerned a money manager’s inability to market bonds issued by Merrill Lynch & Co. In August 1998, following the onset of the Russian financial crisis, professional money managers began fleeing securities with any risk. U.S. Treasury bonds became the investment of choice. In September 1998, the manager of Colonial Asset Management, attempted to sell $1 million of bonds issued by Merrill Lynch & Co. In a market where ordinarily $80 million of Merrill bonds trade on an average day, almost no market existed without discount. Current market value was, based on bond rating, terms, and face interest rate, anticipated at $104. The best offer was $98. This represents a discount of 5.8%, based purely on liquidity concerns (the basis for marketability discount). Liquidity in even high quality publicly traded securities, whether stocks or bonds, is a concern. Significantly reduced liquidity resulting from no public market is an even greater factor.

When an interest in an entity has no ready market, and its value has been developed by either comparison to freely tradable or even partially tradable interests, then the appraiser must be conscious of the diminution in value resulting from the lack of a ready market. This reduction, or adjustment, in value to reflect the relative illiquidity is called a discount for lack of marketability (DLOM), or just marketability discount. Empirical evidence supporting the existence of this discount and the level of the discount is available through numerous published studies.