Valuing and Selling Your Business: A Quick Guide to Cashing In (2014)
Chapter 3. Valuation Approaches
How the Sausage Is Made
Valuations for divorce cases and shareholder disputes are the closest we get to hand-to-hand combat in the accounting profession. Two valuation experts battle on the witness stand. We fight over future cash flows and what the expected rate of return should be on the cash flows. We have reams of paper to support our positions and hope that the attorney on our side asks the right questions and that the opposing attorney asks the wrong ones. However, many times none of this matters. The ultimate decision makers are the judges who probably neither have a business background nor enjoy listening to number nerds debate high-dollar issues. Sometimes their decisions are well thought out and make sense with the facts of the case. Other times, it is clear they did not really understand valuation theory, or they may have had an alternative motive with their decision. Going to trial on valuation issues is litigation roulette because it is hard to predict where the answer will land.
I have testified over two dozen times, including in front of a sleeping, snoring judge as well as before a plaintiff and defendant making obscene gestures at each other during my testimony. What follows are two real-life combat stories that will show you some difficulties in preparing a business valuation.
Hand-to-Hand Combat
The first case is called “a tweak here and a tweak there make a big difference.” A few years ago, I was hired to provide two valuations of a manufacturing company for a domestic case. The owner started the business before he was married; therefore, I had to value the company at the date of the marriage and at the date of the divorce. The spouse was entitled to 50% of the growth in the value of the company between those two dates. In my opinion, the growth in value between the two dates was $2 million. At the last minute, the business owner’s spouse hired a valuation expert, and he had very little time to produce a report. He decided to use my reports and just slightly change my cash flow assumption and my expected rate of return on the cash flow for both valuations. By only changing two assumptions, he concluded that the growth in value between the marriage and divorce date was $6 million—a huge difference created by only a couple of tweaks of my report. We provided testimony for over a week telling the judge why the other valuator was wrong and why our analysis was superior. Afterward, we shook hands and asked each other about our families since we were friends. The judge selected an amount that was in between our conclusions.
The second case, I call “the 30-minute clock cleaning,” shows the difficulty of using and supporting the market approach to value. I was hired by a divorce court to provide a valuation for both parties of a small retail store. No big deal, I thought. It turned out to be a very difficult case. The husband accused the wife of fraud, and it was difficult to obtain financial data. I felt that I could not rely on the income approach since the reported financial data was suspect. However, I was able to locate many transactions of similar type stores that could be used to determine the value of the company based on reported revenues and adding an amount for unreported cash. Since the court had hired me, I had expected to walk into court and give about an hour of testimony, have everyone be impressed with my wisdom, and then thank me as I walked out of the courtroom. The husband’s attorney asked the court for a 30-minute recess to examine my file. When the recess was over, he proceeded to discredit my market method in the eyes of the judge. How could I compare a retail store located in a small city in Ohio to one that was located in Albany, New York or in Cleveland, Ohio? This went on for another 30 minutes. I attempted to explain why this approach was valid, but I have to admit that he did a great job of raising serious questions about the validity of the market data with only a 30-minute review of my file.
The point of telling you about these two cases is twofold. First of all, small changes in the assumptions will make a big difference in value. Second, I believe that the income approach is superior to the market approach since it is so difficult to find comparable companies that have sold that are similar to yours. As I explained in the previous chapter, there are only three recognized approaches in determining the value of a business. Under each approach, there are several different methods that can be deployed to determine value. Both the market approach and the asset approach have their places, but in the real world, the income approach is what is used to buy and sell businesses. Therefore, we will focus on the income approach in this chapter and provide limited insight on the market and asset approaches to value.
The Income Approach to Value
This approach values your business like any other investment. When using this approach, I pretend that I am buying the business and determine how much I am willing to pay for it. The amount I am willing to pay depends on my assumptions about the future cash flow and how much risk is related to that cash flow. The keys to this approach are answering the questions that were introduced in the last chapter:
· How much cash will I put into my pocket from buying this business? (This is the sustainable cash flow.)
· How sure am I that it will go into my pocket? (This is the required rate of return related to the sustainable cash flow.)
Once those questions are answered, the valuator is able to determine the enterprise value.
There are two primary methods that valuators use when applying the income approach. Sometimes both methods are used, but most of the time the valuator chooses between one of the two:
· Single-stream capitalization method: This method is used when the future cash flow is anticipated to be relatively stable and has a constant rate of long-term growth. The sustainable cash flow is determined and then reduced to a single unchangeable amount that is expected to continue indefinitely. The required rate of return using this method is called the capitalization rate (discount rate less a long-term sustainable growth rate). The sustainable cash flow is divided by the capitalization rate to determine the present value of the future cash flows, which is the enterprise value.
· Discounted cash flow method: This method is used when a company’s future cash flows are not expected to be stable and cannot be reduced to a single number. This method projects the future revenues, profits, and cash flows over a number of years (projection period). Beyond a certain point of time, it is assumed that the company will continue to grow cash flow at a constant rate. A mathematical formula determines the “terminal value” of a company at the end of the projection period. This terminal value is the present value of the future cash flows after the projection period. The present value of the future cash flows from the projection period plus the terminal value equals the enterprise value.
Under each method, it is important to estimate the expected future revenues and cash flows based on fully understanding the business and its prospects for the future. This is done through financial, industry, and economic analysis and discussions with management. After performing this analysis, the valuator will decide whether to use the single-stream capitalization or discounted cash flow method. The method selected depends on whether the expected future cash flow can be reduced to a single amount. The following are situations when the discounted cash flow method is preferred over the single-stream capitalization method:
· The company’s growth rate is expected to be very high, inconsistent, or negative.
· Management knows that future results will be variable due to known factors. This could include the loss of a major customer or the introduction of a new product line.
· The company will wind down operations due to a known event.
We will focus on the single-stream capitalization method in this chapter, which is much easier to understand and apply. This will allow you to understand the basic theory behind the income approach.
Let’s now turn our attention to how the sustainable cash flow is determined.
How Much Cash Will I Put into My Pocket?
No matter what method is used, it is critical that the valuator understand the historical financial trends and be able to determine what the true historical earnings have been. Financial statements may not tell the real story. A business may appear to be unprofitable, but in reality is very profitable and vice versa. Business owners manage their bottom line to provide themselves with the highest after-tax proceeds (from the combination of wages and profits). Also, certain events happen to a business that impact the reported profit levels, but they may not be recurring or normal for the business operations. It is important that the valuator normalize the historical numbers in order to understand what the true historical earnings have been.
The Normalization Process
The starting point in determining the sustainable cash flow is to normalize the historical financial statements. The normalization process restates the financial statements to exclude items that are not part of the normal business operations.
The first step in the normalization process is to summarize the historical earnings levels. I like to use EBITDA (earnings before interest, taxes, depreciation, and amortization) in my analysis. I usually summarize at least five years of the historical EBITDA amounts and also add back owner’s compensation. From this amount, I make adjustments to the historical earnings to normalize the earnings and make them comparable with others in the industry. The following are adjustments that are made to normalize historical earnings:
· Extraordinary or nonrecurring income and expense items
· Expenses that are not standard in the industry
· Owner’s compensation that is either higher or lower than fair market wages
· Income or expense items relating to nonoperating assets
The best way for you to understand the normalization process is to go through a scenario. We will continue with the Fantastic Footballs, Inc. scenario that was presented in Chapter 2. The following chart summarizes Fantastic Footballs’ five-year revenue and EBITDA trends:
The historical EBITDA has ranged from $80,000 to $600,000. Is this a true reflection of Fantastic Footballs’ historical earnings?
Owner’s compensation is an area where there is a great deal of discretion and differences between businesses. Business owners pay themselves differently depending on the business entity type (C-Corporation, S-Corporation, LLC, etc.), their financial needs, and the health of the business. They do not compensate themselves the same way they compensate their employees. Employees are paid based on their roles, skills, and value to the business. Properly normalizing owner’s compensation is very important. Because of this, we add back owner’s compensation in the analysis prior to making any normalization adjustments to isolate the owner’s compensation issue. The following is the same analysis, but showing the historical EBITDA before owner’s compensation (EBITDAOC):
Once the EBITDAOC is determined, it is time to make the adjustments to normalize the EBITDA. Let’s assume that Fantastic Footballs had a product liability suit in 2010. The cost to defend and settle the lawsuit was $250,000, and management indicated that lawsuits like this are rare. It was a one-time event that depressed the 2010 earnings, so we will add back to the EBITDA level the expenses related to this litigation. The next adjustment is for the way in which Fantastic Footballs records its inventory. The inventory is recorded by using a last-in, first-out (LIFO) method because it provides the company with a tax advantage. However, the first-in, first-out (FIFO) inventory method provides a truer picture of the actual value of the inventory and the cost of goods sold. Therefore, we will make an adjustment to convert the Fantastic Footballs’ inventory from LIFO to FIFO.
The last adjustment is for owner’s compensation. Charlie, the owner of Fantastic Footballs, is the CEO and receives a salary and a bonus based on the annual profits. To understand the true earnings capacity of Fantastic Footballs, we need to determine what Charlie’s wages would be in the marketplace for the services he performs. This adjustment is made by understanding the number of hours that he works and services that he provides. Once we understand this, we examine various salary surveys to determine what it would cost to replace Charlie at fair market wages. The following is the normalized EBITDA calculation after making the previously mentioned adjustments:
You can see that there is quite a difference between the historical EBITDA and the normalized EBITDA levels. In 2010, the reported EBITDA was $80,000 and the normalized EBITDA was $500,000. That is a big difference! This is mainly due to the lawsuit expense and LIFO inventory depressing the net income and the fact that Charlie’s compensation was higher than the fair market wages.
Important It is critical that you normalize the historical earnings. You will not be able to determine the future sustainable cash flows without preparing this analysis.
Determining the Sustainable Cash Flow
Now that the historical EBITDA has been normalized, we can begin the process of determining what the sustainable cash flow level should be for Fantastic Footballs. This is a two-step process. For the single-stream capitalization method, we must decide on a single amount that will represent Fantastic Footballs’ future sustainable EBITDA. It is important that a great deal of effort is placed in determining this amount since a bad assumption will lead to a wrong valuation conclusion.
The normalized EBITDA has ranged between $150,000 and $850,000 during the past five years. The five-year average is $600,000. After hitting a low in 2009, the normalized EBITDA has increased each year. What EBITDA amount should we use? The latest year results of $850,000? The five-year average of $600,000? As you will see later in this chapter, there will be a big difference in the enterprise value depending on which EBITDA level is chosen.
The EBITDA level to use is dependent on understanding the historical trends, industry forecasts, and management’s plausible forecast of the future. Perhaps the recent history will continue because Fantastic Footballs recently obtained a few new large customers. Maybe industry studies have shown that football has gained in popularity and that the future is bright for football manufacturers. If our analysis led us to believe that the positive trends would continue, then our chosen sustainable EBITDA level would be based on recent history.
Alternatively, we might have learned that the football industry is cyclical and that every five years Fantastic Footballs has some good years and some bad years. Management may have told us that they do not believe that the positive trends that started in 2010 will continue into the future. If this is true, then we may choose the five-year average of $600,000 as our sustainable EBITDA level.
Once we decide on the sustainable EBITDA level, we need to determine the sustainable cash flow. Business owners cannot put the EBITDA amounts into their pockets. Before this can happen, they must do the following:
· Pay income taxes.
· Buy new equipment to sustain operations.
· Be able to fund their working capital needs.
Let’s continue on with our scenario. Let’s assume that we selected $800,000 as the sustainable EBITDA level. This is because management believes that the most recent trends will continue for the foreseeable future. The bad results in 2009 were impacted by the recession and the issue surrounding the lawsuit. Management believes that future results will be slightly lower than the 2012 levels due to pricing pressures from the competition. After much analysis and discussion with management, we have decided that the sustainable EBITDA level is $800,000.
In order to convert the EBITDA level to cash, we must take account of income taxes, make an allowance for future capital expenditures, and determine future working capital needs. You have to pay taxes on your profits. You also have to make capital improvements (equipment, machinery, and building improvements) and have cash available to fund your growth (working capital needs) to sustain operations. The amount needed for working capital is a function of expected growth rate and the current working capital level.
In order to convert the sustainable EBITDA level to a sustainable cash flow level for Fantastic Footballs, we made the following adjustments:
· The taxable income is equal to the EBIT (earnings before interest and taxes). For this scenario, there is no interest expense. The taxable income is EBITDA less depreciation. The corporate income tax amount is based on a tax analysis.
· We have assumed that the future capital expenditure will average $100,000 a year. This is the amount needed to buy new equipment and make building improvements on an annual basis.
· The amount of cash that is needed to be retained to fund the growth in inventory and accounts receivable is $20,000.
The calculated sustainable cash flow is as follows:
Based on this analysis, the buyer of Fantastic Footballs can expect to put $450,000 on an annual basis in his pockets. This assumes that the buyer pays fair market wages for CEO services and that there are no unusual or nonrecurring items. In other words, the $450,000 is the amount that he can do with as he wants since there is no need to retain this amount in the business. How much are investors willing to pay for a $450,000 cash flow stream? It depends on how confident they are that the $450,000 will go into their pocket.
How Sure Am I That It Will Go into My Pocket?
Now that the sustainable cash flow has been determined, it is time to develop the appropriate rate of return needed to entice a buyer to invest in Fantastic Footballs. This rate is developed by understanding Fantastic Footballs’ individual risk profile and its prospects for future growth. In addition, it is important for the valuator to have a basic understanding of investment theory and the rate of returns available on alternative investments.
There are two important concepts behind the development of the required rate of return. The first is risk, and the second is the time value of money. We have previously mentioned the direct relationship between risk and the rate of return. The higher the risk associated with an investment, the higher the rate of return that is required to entice an investor. The concept of time value of money is that a dollar now is worth more than a dollar received in the future. The value of a company is the present value of the future cash flows. You must account for both risk and the time value of money when valuing a company.
There are three important terms that valuators use when determining the rate of return required by the investor in a business:
· Discount rate: This is the rate required by investors to entice them to invest in a particular business. It is also called the cost of equity. The discount rate incorporates both the time value of money and the risk related to the company.
· Capitalization rate: This is the discount rate less the long-term growth rate of the company’s cash flows.
· Weighted average cost of capital (WACC): This is a company’s capital structure consisting of equity (investors) and debt (creditors). The enterprise value is determined based on the cash flow that is available to both equity owners and creditors. Therefore, the rate of return that is applied to the future cash flows is a blend of cost of the equity and debt.
Determining the Required Rate of Return
The first step in developing the rate of return is to determine the discount rate. This is the rate of return that an equity investor needs in order to invest in your business. There are two popular ways that valuation professionals use in determining the discount rate: the “build-up” approach and the capital asset pricing model (CAPM). The build-up approach is based on the premise that a company’s discount rate is composed of a number of identifiable return factors that are added together, or “built up,” into a total required rate of return. CAPM theory holds that the cost of equity is equal to the risk-free rate of return, plus a risk analysis based on similar companies that are publicly traded. The major difference between the two approaches is that the CAPM adds an analysis of public market data to the discount rate calculation. Each approach includes a risk premium component that reflects the fact that investors must be paid to take any risk above that of a “risk-free” investment. The difference between the risk-free rate of return and the total return from an equity investment is called a risk premium.
The rest of this section will be devoted to the build-up approach in developing a discount rate. The CAPM is too complex for the purposes of this book and usually is applied in the valuation of very large companies.
The build-up approach follows this step-by-step process:
1. First, we determine what a risk-free investment is. In the valuation profession, long-term US Treasury bonds are considered to be risk-free investments. I prefer to use the 20-year US Treasury bond rate, as of the valuation date, for my risk-free rate.
2. The next step is to add an “equity risk premium.” This is the premium that equity investors received in the US public markets over and above the risk-free return. We use the Duff & Phelps LLC Risk Premium Report to determine this equity risk premium. Recently, the equity risk premium has been in the 8% to 14% range. The level of the premium depends on the size of the business being valued. For companies with revenues of less than $100 million, the equity risk premium is at the high end of the range.
3. After applying an equity risk premium, we must decide whether to make an adjustment for industry risks. The risk profile for each industry is different, and the industry may be more risky or less risky than the general equity market. The Duff & Phelps LLC Risk Premium Report also provides industry risk profiles.
4. The final risk adjustment is called the specific company risk premium. This premium is determined by the individual characteristics of each business. Some businesses have large risk premiums while others have none or small premiums. This is one of the most subjective adjustments that valuators make and where most valuation battles are fought in conflict valuations. Some of the most popular adjustments are made for the following:
· Customer concentration issues
· Thin or inexperienced management team
· Reliance on one or two key employees
· Pending lawsuits
· Violation of governmental regulations
· Inconsistency of historical earnings
· Competitive factors
· Limited access to raw materials and employees
· Life cycle of products or services
Let’s return to the Fantastic Footballs scenario. The risk-free rate is based on the 20-year US Treasury Bond rate as of the valuation date. The equity risk and industry risk premium are based on the Duff & Phelps LLC Risk Premium Report. The final step is to determine the specific company risk premium. This is solely based on the valuator’s subjective analysis. For Fantastic Footballs, it is a concern that one customer accounts for 25% of the total revenues. Also, the business is dependent on Charlie’s relationships with his customers and the fact that he has not developed a sales force or a second line of executives. If something happened to Charlie, the customers may go elsewhere. The following is an example of determining the discount rate by using the build-up approach:
Once a discount rate is developed, it is important to compare it with the returns of alternative investments. The source I like best for this step is the “Pepperdine Private Capital Markets Project—Survey Report 2014.”1 This survey provides the required rate of returns required by angel, venture capital, private equity and mezzanine investors. I make a comparison of my developed discount rate to the required returns of mezzanine investors and private equity groups (PEGs). Mezzanine investors provide debt (and sometimes equity) financing to businesses. The debt is usually not fully secured and is subordinate to other creditors. Per the Pepperdine survey, the typical return required by a mezzanine investor (up to $10 million investment) is in the 14% to 21% range and for PEGs (up to $10 million) is in the 23% to 28% range. This survey is an excellent gauge to use as a reasonableness test of the calculated discount rate. The rate of return required for very risky investments in a business could exceed 30%.
The WACC is based on the business’s optimal capital structure. This is done by analyzing the debt structures of other companies in the industry and the company’s debt capacity. To calculate the WACC, we multiply the returns required for each component of capital (equity and debt) by its contribution to the total capital. The debt component is the cost of debt financing for the company on an after-tax basis. This is determined by using the company’s current market interest rate for debt financing and reducing that rate for the tax benefit of paying interest. For Fantastic Footballs, let’s assume that optimal capital structure is 70% equity and 30% debt and the market interest rate for its debt financing is 6.0% with an income tax rate of 33.0%. The required equity return is 24% as developed previously and the after-tax return of debt financing is 4%. Therefore, the WACC would be calculated this way:
The calculation of the capitalization rate is a very simple calculation. It is the WACC less the long-term growth rate for the business. When I say long-term, I mean forever. One of the biggest mistakes that I see in other valuation reports is that the long-term growth rate is too high. I have been able to discredit another valuator by showing the court that the business being valued will be larger than Microsoft in 30 years based on the other valuator’s growth rate. The growth rate should not be significantly higher than the overall growth rate for the industry and the U.S economy. It rarely is above 4.0%. If a business expects very high growth for the next few years, the discounted cash flow method should be used.
For Fantastic Footballs, we will use a 3.0% long-term growth rate and thus, the capitalization rate is 15.0% (WACC of 18% less the 3.0% growth rate).
Calculating the Enterprise Value
In the last chapter, I mentioned that the enterprise value is the price that you can sell your business operations for. To calculate the enterprise value of Fantastic Footballs by using the income approach, we simply divide the future sustainable cash flow by the developed required rate of return. The following is the enterprise value of the company by using the assumptions developed in this chapter:
Remember the case in the beginning of this chapter—a tweak here and a tweak there makes a big difference? Let’s make a tweak here and there and see if this is true. Let’s assume that another valuator prepared a valuation of Fantastic Footballs. He disagrees with me on only two assumptions. First, he believes that the future sustainable EBITDA should be the five-year average of $600,000 and that the sustainable cash flow is $300,000. Second, he disagrees with the 15.0% required return that I developed and believes it should be 20%. These changes do not seem large, but they make a significant difference in value as shown here:
Only two changes were made in the assumptions, but they made a huge difference. The changes don’t appear to be major, but the valuation under the second example is one half of the original example. You can see why there are valuation battles in the courtroom and with the IRS. Who is right? We may never know since Fantasy Footballs, Inc. is not for sale.
The development of the sustainable cash flows and the required rate of return require many judgment calls by the valuator. Little changes mean big differences in value. This is why it is important for you to understand and be involved in the valuation process. Just as the income approach requires many subjective factors, so does the market approach.
The Market Approach to Value
You may be familiar with the market approach to value. Most of you have bought a house or have refinanced your mortgage. As part of the process, the bank requires an appraisal of your home. Appraisers locate homes in your neighborhood that have recently sold. They then compare the homes that have sold that are similar in size and location to your home. They may make some adjustments for square footage, a finished basement, and other items to the homes that have sold. With this data, appraisers make an estimate of the value of your home.
This is very effective. What better evidence of value than recent actual transactions of a similar type of investment?
Valuators attempt to do a similar process in valuing a business under the market approach. There is a search for similar types of companies (guideline companies) that have actually been sold or are publically traded. They make adjustments to the data obtained from the guideline companies. They then apply this information to the business being valued to determine a value under the market approach. However, meaningful and ample data from similar companies is a challenge to obtain. Many times, it is difficult to make the right conclusion. For this reason, I usually place less reliance on the market approach and use it to support the valuation conclusion arrived from the income approach.
The following are the two valuation methods that are used under the market approach when valuing a company:
· The Guideline Public Company Method
· The Guideline Transaction (Merger and Acquisition) Method
The Guideline Public Company Method uses the market data and share prices of publicly traded companies to derive a value. Valuators look for companies that are publicly traded and similar to the business being valued to serve as a benchmark in the valuation. Typically, I only use this method for companies with revenues in excess of $50 million. An exception is when I am valuing a community bank. There are hundreds of small community banks that are publicly traded.
This method is misapplied frequently. I have seen a valuation analyst try to use this method to value a small software company with $5 million in sales. The comparable companies used included Microsoft and Oracle, which is ridiculous. The only thing that Microsoft and a small software company have in common is that they develop and sell software. This is like comparing an NFL team to a middle school flag football team. They both play football, but that is all they have in common.
If guideline companies are located, the value of a company is based on multiples derived from publicly traded companies and ongoing earnings (e.g., net income and EBITDA).
The Guideline Transaction Method locates companies that have sold in the marketplace as a benchmark in valuing a company. Several databases are available that provide the actual sale transactions of closely held companies. These databases are populated by business brokers who self-report their transactions. For a business like McDonald’s, this method can be used with confidence. Each McDonald’s operates in a similar fashion, and there are a lot of transactions data to analyze. What about a football manufacturer? How about your business? How many businesses are like yours for which transaction data can be reviewed?
How do valuators prepare a market approach to value if they cannot find comparable companies or the data received is not reliable? What I do is use generic surveys (like the Pepperdine study) and other sources that provide transactional data by broad industries and size of business. The Pepperdine study provides the average EBITDA multipliers for different industries by size of business. This information comes from investment bankers and business brokers, and it is helpful in determining the reasonableness of the income approach conclusion.
In Chapter 2, we prepared a value of the enterprise value of Fantastic Footballs based on the market approach. Here is that calculation again:
There is one more approach that is used to value a business—the asset approach.
The Asset Approach to Value
This approach is effective for an asset holding company (real estate and liquid investments) and for companies that are worth more dead than alive. These companies have a significant amount of physical assets (inventory, equipment, and receivables) but minimal or no profits.
If the value under the asset approach is higher than the values calculated under the income approach and market approach, then the valuator should consider the value under an orderly liquidation. The liquidation method assumes that a company is worth more under a liquidation premise than a going-concern entity.
The asset approach values the individual assets and liabilities of the business. Under this approach, the fair market value of the assets less the company’s total obligations is the value of the company.
This approach is usually not used in the valuation of a going concern. A company’s value is determined by its ability to generate cash flow, not by the value of its assets individually. It generally carries little or no weight in comparison to the income and market approaches; therefore, we will not provide any further analysis on this approach.
Determining Equity Value
The equity value is another name for the value of the company’s stock. This is what is valued and reported to the IRS when you make a gift to a child and the value that is used to divide assets in a divorce. As stated in Chapter 2, the equity value is determined by adding to the enterprise value the value of the nonoperating assets and subtracting out the obligations that are not typically assumed by a buyer of the business. Here is the formula of the equity value again:
Equity Value = Enterprise Value + Nonoperating Assets – Liabilities Not Assumed
The first step in determining the equity value is concluding what the enterprise value is. For Fantastic Footballs, Inc., we have prepared a value based on the income approach and the market approach. Let’s assume under the asset approach that the value of Fantasy Footballs is $1.5 million. The following is a summary of the calculated values:
What should our enterprise value conclusion be? Is it a simple average of the three approaches? Absolutely not! The asset approach should not be a factor for Fantastic Footballs since it is a going concern that has a nice profit level. Should the market approach be considered? It depends on how confident valuators feel about the comparable companies. Typically, more weight is placed on the income approach, and in this case we will conclude an enterprise value of $3.2 million.
Let’s assume during our financial analysis that we discovered that Fantastic Footballs owns a large life insurance policy on Charlie. It has a death benefit of $5 million and a cash surrender value of $500,000. Tomorrow, the company could cash in the policy to the insurance company and receive $500,000. Even though the insurance policy is important, it is not necessary to operate the business. Nonoperating assets are items that are owned by the business that are not necessary for the day-to-day operations.
We will assume that Fantasy Footballs has a normal working capital level and a long-term bank note of $1.2 million. This note is a liability that would not be assumed in a typical business transaction and needs to be deducted to determine the equity value.
The following is the equity value of Fantasy Footballs with the previously mentioned assumptions:
Value per Share
Our valuation conclusion usually includes a value-per-share amount. This should be a simple calculation, right? Take the equity value divided by the number of shares outstanding. Many times it is this simple, but other times it is not. If the business has stock options or other synthetic equity, additional calculations need to be made to determine the value per share.
There is a difference in the value per share between a controlling interest and one that does not have control. Why? If you own one out of 100 shares in a company, what can you do with that? Can you set your salary, declare a dividend, or force a sale of the company? The answers are no, no, and no. Only a majority shareholder can do those things. What rights does a minority shareholder have? It depends on your state and the language of your shareholder agreement (if you have one).
Because of the limitations associated with a minority interest, discounts are applied when valuators are asked to value a minority interest. The exception is if there is an agreement that says valuators should not apply the discounts in the valuation.
There are two discounts that valuators apply to a minority interest. The first is a lack of control discount (or minority interest discount), and the second is a marketability discount.
Valuators are often asked to prepare the valuation of a minority interest. Most requests are related to the gift of a company’s stock from a parent to a child. The other situation is the exit of a shareholder from a business. This exit could be by choice or by force. Should a discount be applied in this situation? At times, there is disagreement among shareholders about whether these discounts apply. If you are a shareholder who has a minority interest, make sure that you have a buy-sell or shareholder agreement that specifies whether your interest should be reduced by the lack of control and a marketability discount.
There are many studies and court cases that can be examined to determine the appropriate discount level for a minority interest. I will not bore you with these studies or court cases. It is important for you know that the value per share for a minority interest is lower than the value per share for a controlling interest. Included next is the value-per-share calculation for Fantastic Footballs. Let’s assume that there are 100 common shares outstanding and that the appropriate discount for the lack of control discount is 12% and the lack of marketability discount is 25%. The value of a minority nonmarketable common share is calculated as follows:
The value of minority shareholder’s’ share of stock is 34% less than the value of a controlling interest. In the real world of valuation, a minority interest usually has a 20% to 50% reduction in value when compared with a controlling interest. The level of the discount depends on the company’s dividend policy, written shareholder agreements, and whether there will be a liquidating event in the future (sale, public offering, or liquidation).
Summary
After reading this and the previous chapters, I hope you have a better understanding of the entire valuation process. It is not a very clean process, but it’s not as messy as making sausage.
So if you call me and ask for a formula to value your business or ask for something quick and dirty, you will understand why I will say that I am not interested in assisting you. Valuation is so much more than a formula or putting numbers in a spreadsheet. The valuator has to really understand the business in order to develop the sustainable cash flow and to develop the appropriate rate of return.
Most valuators rely heavily on the income approach to value. This approach is the same mindset that someone buying your business will have. The market approach may apply to your situation depending on whether the valuator can locate comparable companies that have sold or are publicly traded. The asset approach is rarely used for a going concern. The exception is when the business owner can achieve more proceeds by liquidating the business than through continued operations.
Now that you have a good understanding of the entire valuation process, it is time to discuss ways to make your business more valuable. In the next chapter, we will discuss the various strategies you can implement to grow the value of your business.
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1Pepperdine University, “Pepperdine Private Capital Markets Project—Survey Report 2014,” http://bschool.pepperdine.edu/appliedresearch/research/pcmsurvey/. This survey is free to anyone who requests it.