Friday, November 2, 2012

Business Valuation Techniques: Best Comparable Transaction Analysis

Selecting Comparable Companies/Transactions

Many appraisers prefer the guideline company method because of the quantity and quality of data available about the selected company or companies.  Some appraisers will review hundreds of companies searching for the one most comparable to the subject company.  This, however, is also the problem.  We are lured by the data to over rely on one or a few comparable companies.  

It is impossible to know all of the factors contributing to one company’s value as of a given date by reviewing its financial data.  Circumstances involving key personnel, large customers, proprietary technology, and the condition of equipment all may have influenced the share price or transaction value.  Was the transaction hostile, or for the benefit of upper management?  Did the transaction incorporate synergistic value which allowed the buyer to pay a premium to fair market value?  Perhaps the most significant question would be: what were the short and long term growth rates of earnings expected by the investors? Far too many factors are unknown to pin an estimate of value to a single comparable.  Valuing a company is not like valuing a residence or a piece of real estate.  We can’t just walk through the place and have a look at the kitchen floor.

The risk of arriving at an erroneous conclusion of value (or, a highly erroneous conclusion, given there is no ‘right answer’ in valuation work) is increased due to information affecting transactions that is unknown to the appraiser.  Therefore, the probability of unknown information skewing an estimate of value derived from the Market Approach increases as the number of companies compared to (‘the group’ of comparable companies) decreases.  The unknown factors present in individual companies are diminished or ‘washed-out’ as the size of the group increases, just as a diversified portfolio of securities reduces the unsystematic risk associated with each security in that portfolio.  This principle is true when applying either the guideline company method or the transactional data method. 

We cannot claim to know all factors pertaining to an individual company, but we can reasonably assess the conditions present in an average company given the industry.  We can more reliably estimate the expected growth rate of earnings of an average company in an industry than we can estimate the expectations of investors for a specific company when limited information about that company is available.  Today, due to expanding databases, we can select a large group of companies with many factors similar to our subject company; industry, size, profitability, etc.    

Ten to twenty companies is a sufficient size to substantially reduce the risk of an individual transaction skewing the result.  It should be comprised of the most comparable companies identifiable.  The subset of companies should be limited to those in a reasonable size range and in a similar profitability percentage as your subject company.  Transaction date is less significant than industrial similarity and size.  According to Ibbotson’s Stocks, Bonds, Bills, & Inflation, historic equity returns do not indicate clear patterns or trends over their 80+ year period of data collected, and are better characterized as a ‘random walk’ from year to year.  For this reason, date range does not need to be limited to transactions within a few years of the valuation date.  Depending on the industry, ten years is a reasonable maximum.  Industry conditions may change substantially in more than a decade.  Those changes could impact investors’ long-term perceptions of risk for that industry.    

Geographic limitations should be applied judiciously based on the nature of the subject company.  If a company’s customers, suppliers, and competitors are nation-wide, then geographic limitations may not have an impact on the operation of the business.  Unnecessarily restricting a search to a geographic region could limit the number of companies in the resulting sample. This may cause the acceptance of a broader criterion of search characteristics (thereby reducing the similarity of the comparable companies in your group to your subject company) to achieve a reasonable group size. 

Using the Data

Many experts will calculate key ratios or multiples (Price to Sales, Price to Earnings, Price to Gross Margin) for each comparable company, and find the medians and means of those ratios.  Medians are often preferred to means because medians are not skewed by outliers.  Means are also useful because they allow for the calculation of the average deviation percentage of the mean.  This is a useful measure of the dispersion of the data in the group. 

The less divergent the data is within the group, the more consistent and reliable the median or mean produced.  An average deviation percentage less than 20% indicates highly consistent data, and above 50% is highly divergent.  The degree of consistency in the data is a measure of how reliable the estimate of value arrived at using the Market Approach will be, and may indicate to the appraiser the degree to which they may rely upon this approach in their final conclusion of value.

The median and mean ratios are applied to data from the subject company to arrive at a transactional value.  Problem: valuing the subject company based on an earnings multiple derived from the group, effectively applies the group’s expected growth rate of earnings to the subject company.

Applying a median multiple to the subject company may be applicable if the company’s performance is comparable to the median company in the group.  If this technique is used, adjustments to the resulting value should be made for capital structure and excess assets to arrive at an equity value comparable to other approaches.  If the subject company has a short or long term expected growth rate that is substantially different from the group, then applying the median Price to Operating Income ratio of the group to the expected operating income of the subject company may not produce a reasonable estimate of value. 

A comparison which allows the appraiser to factor out growth can be derived by taking the analysis of the median/mean comparable company a step further.  In the following example, median/mean data of the group was used to calculate a discount rate applied to the median/mean company earnings.  This discount rate can be directly compared to the discount rate determined in the Income Approach as a measure of reasonableness for both approaches.  The company can then be valued using the income approach formulae, except the discount rate applied to the future expected earnings would come from the median or mean company data of the comparable group.  This technique allows for variable rates of increasing or declining earnings to be accounted for within the Market Approach.  This is not a blending of approaches, because the discount rate arrived at in the Market Approach is completely independent of any other approach.


In the table below, two ‘companies’ are created from the group, one representing the median of the group, and the other the mean.  Acquisition debt was estimated at one third the purchase price.  The anticipated growth rate of net cash flows was estimated to be 4%, showing little growth above long term inflation.  Cost of debt was estimated to be 7%.  Using the Single Period Capitalization Method, the Return on Investment (ROI) of the median company is 25.7%, and is 17.2% for the mean company. 

Return on Investment Analysis
Operating Income
Op Inc/Sales
Price/Op Inc
Est Aquisition Debt
Estimated Growth Rate
Estimated Cost of Debt

Given the large range in size of the companies in the group, the largest companies can have a significant impact on the group mean (company #18’s purchase price is larger than the total of companies #1-12).  Further, the largest three companies’ ratios are all substantially higher than the group averages.  For these reasons, the median company is a better representation of the group overall.

Based on the estimated return on investment of the median company in the 18 company group of 25.7%, the 28.23% required return on investment for equity capital in XYZ, Co. stock derived from the Income Approach appears to be a reasonable basis for valuing earnings.

Brian Murray CPA/ABV, CVA specializes in business valuations and merger and acquisition consulting, and has served as an expert witness in court.  Please call (920) 225-6436 to find out more or visit our website, and click on the BUSINESS VALUATION link.  Go to now for a fast and affordable business valuation report prepared by Brian Murray.

Wednesday, October 3, 2012

Corporate Tax & Company Value: Tax Affecting

Are Valuation Experts Tax Affecting The Wrong Earnings?

Recently NYU professor and noted valuation authority Aswath Damodaran posted a blog article (The dividend 'tax cliff' approaches: Implications for stocks) about the potential devaluation of dividend paying stocks if the preferred dividend tax rate were to climb back up to the ordinary rate.  If equities would be devalued due to an increase in the dividend tax rate, then the rate of return required by investors for equities was lower during the period the preferential rate was in effect than before or after the preferential rate existed.  Investors recognize the preferential tax rates available to them for long-term capital gains and qualifying dividends, and require a lower rate of return from assets producing tax-preferred income.  This could inspire valuation experts to make a tax adjustment reducing untaxed PTE (Pass Through Entity) income to equate it with corporately taxed income that qualifies for tax preference at the shareholder level.  Before making this tax adjustment, the valuation expert should consider the following:

1.      If the build-up method is used in the income approach, and Ibbotson data is used to arrive at the discount rate, the 80+ year return averages used were derived from a period where capital gains and dividends where predominantly not tax preferred.  Non-preferred PTE earnings may be more comparable to the historic discount rate than the recently tax preferred corporate earnings.
2.      If a transactional data method is used in the market approach, many of the comparable companies (depending on the size of the subject company) will also be PTEs.  Given that the investors acquiring those companies have factored the entity status into their decision, it would not be appropriate to convert PTE income to tax preferred income when comparing to other PTEs.
3.      Investors offset the benefit of tax preferred dividends against the absence of a preferential long-term capital gains tax rate applied to C corp assets. The degree of the offset is dependent upon: the tax circumstances of the investor, the probability of the investment being liquidated in an asset sale, and the potential capital gains resulting from such a sale.

While it is clear that investors would prefer lower taxed C corp dividend income to ordinarily taxed PTE income (all else being equal) perhaps valuation experts are adjusting the wrong income.  Instead of reducing PTE earnings to make them equivalent to C corp earnings, then valuing the reduced earnings using historic equity returns (which are derived predominantly from non-tax preferred periods), perhaps the PTE earnings should not be reduced at all.  Instead, when valuing a C corp, the required rate of return by investors should be adjusted to factor in the relatively recent tax law preferring them.  Making an adjustment to lower the required rate of return for C corp earnings to reflect the temporary tax preference given them would effectively increase the value of those earnings to the investor.  This could be applied for the time period that the beneficial tax rate is expected to be present.  This rate adjustment could also be moderated based the potential of an asset based sale causing capital gains to be taxed at the corporate level. Making this adjustment would properly account for the potential decrease in value postulated by Professor Damodaran.

Brian Murray CPA/ABV, CVA specializes in business valuations and merger and acquisition consulting, and has served as an expert witness in court.  Please call Murray & Roberts CPA Firm SC at (920) 225-6436 to find out more or visit our website, and click on the BUSINESS VALUATION link.  Go to now for a fast and affordable business valuation report prepared by Brian Murray.

Tuesday, October 2, 2012

Due Diligence - a terrific article

Article about Due Diligence Process for Sellers found in Exit Planning Review

Well worth reading if you're preparing to sell your business!

Brian Murray CPA/ABV, CVA
Murray & Roberts CPA Firm SC

Brian Murray CPA/ABV, CVA specializes in business valuations and merger and acquisition consulting, and has served as an expert witness in court.  Please call Murray & Roberts CPA Firm SC at (920) 225-6436 to find out more or visit our website, and click on the BUSINESS VALUATION link.  Go to now for a fast and affordable business valuation report prepared by Brian Murray.

Buying or Selling a Business? Here's What to Look For in a Business Valuation

Are you considering selling your company or buying a company?  Do you need to value a business for an estate, divorce, or for estate planning?  An expertly prepared business valuation report may prove to be a very valuable investment.  

GET VALUE  It is essential that your valuation expert has significant experience in business purchase and sale transactions. No amount of study can replace real world experience.  We have been valuing businesses for ten years, and providing business consulting to our clients interested in buying or selling businesses for twelve years.  Brian Murray is an expert in business valuation, has been recognized as a Certified Valuation Analyst (CVA) by the National Association of Certified Valuation Analysts, and has given expert witness testimony in depositions and court.

WEALTH DRIVERS  In addition to revealing the value of your business as of a certain date, a valuation report can expose key drivers of value that may help you maximize your company's worth.    

For example, one company's key driver of value may be the consistency of its earnings stream and the strength of its balance sheet.  If management should decide to make an aggressive investment in advertising in an attempt to grow the company shortly before the sale, the company value may actually be reduced by the interruption of cash flows if the benefits of the advertising have not yet materialized.

In another case, a valuation report exposed that a company's value was deminished due to increased risk caused by a substantial amount of their sales being derived from a single customer.  Company management responded by aggressively diversifying their customer base.  Even though the sales to the new customers were made at slightly lower margins than those to the larger customer, the company's value was greatly increased due to the reduction of risk perceived by investors.

After analyzing another company we found its key driver of value was consistent annual growth in sales and cash flows.  After learning this we advised management to maintain this growth rate.  As a result, the company management chose not to sell business units which would have caused total company revenues to fall. Ultimately this company was sold at a price that was principally based upon the company's consistent growth rate.

GET MORE THAN FAIR  Often a company may have value to a particular investor, or type of investor, that is higher than fair market value.  This additional value is called synergistic value, or strategic value.  Our experience in merger and acquisition transactions and contacts with corporate buyers and private equity groups helps us identify those strategic opportunities.  After those strategic opportunities are identified, we develop a profile of the ideal strategic buyer, estimate the cash flows they would derive from the acquisition, and determine the strategic value based on those additional cash flows. This information can prove to be very valuable in negotiation.

Brian Murray CPA/ABV, CVA specializes in business valuations and merger and acquisition consulting, and has served as an expert witness in court.  Please call Murray & Roberts CPA Firm SC at (920) 225-6436 to find out more or visit our website, and click on the BUSINESS VALUATION link.  Go to now for a fast and affordable business valuation report prepared by Brian Murray.

Tax Affecting S Corp Earnings, Bernier II; Implications on Business Value

Bernier Heading Back to Trial Regarding How Tax Affecting S Corp Earnings Can Substantially Reduce Value

Unlike traditional corporations (C corporations), subchapter S corporations do not pay federal or state income taxes.  However the earnings of S corporations are taxed to the shareholders at the full ordinary rate, instead of the 15% corporate dividend rate (preferred rate) enjoyed by shareholders of C corporations.  To account for this difference, some valuation professionals feel the S corp earnings should be ‘tax affected,’ presuming that a rational investor would prefer C corp earnings to S corp earnings, all else being equal.

The adjustments can be substantial.  In Delaware Open MRI Radiology v. Kessler, the court settled on a 29.4% adjustment.  However, very convincing arguments can be made for both applying and not applying the adjustment, and courts have ruled in both directions (Gross, Gallagher, Giustina, Bernier, Kessler).  The IRS (see Gross) has historically taken the position that tax affecting is inappropriate.  Now, Bernier v. Bernier – a key divorce case supporting tax affecting - is headed back to trial.

The impact of tax affecting the S corp earnings will, in most cases, cause a reduction in value near or equivalent to the discount percentage.

Regardless of whether tax affecting S corp earnings will benefit your client’s position or not, your valuation expert should address their logic for applying or not applying the discount in their valuation report.  Failure to do so may result in the court discounting or disregarding your expert’s testimony (see judicial commentary in Bernier I and Kessler).

Brian Murray CPA/ABV, CVA specializes in business valuations and merger and acquisition consulting, and has served as an expert witness in court.  Please call Murray & Roberts CPA Firm SC at (920) 225-6436 to find out more or visit our website, and click on the BUSINESS VALUATION link.  Go to now for a fast and affordable business valuation report prepared by Brian Murray.