Valuing Closely Held Businesses

1. Valuing Closely Held Businesses Chapter 15

2. Valuation Principles • Recall Ch. 15: Economic models that value financial assets are based on concept of value as discounted present value of future cash flows. • Valuing real assets (e.g. real estate, closely held businesses) is based on same general principles as valuing financial assets. • “Closely held” refers to business that is privately owned and does not issue publicly traded stocks or bonds.

3. Revenue Ruling 59-60 • IRS’s Revenue Ruling 59-60 • Commonly used source of conceptual guidance for valuing closely held companies • Fair market (classic definition): price at which property would change hands between willing buyer and willing seller when former is seller under no compulsion to sell, with both parties having reasonable knowledge of facts • In valuation of closely held corporations or valuation of stock of corporations for which market quotations are unknown or unreliable, all available financial data and all relevant factors affecting fair market value should be considered.

4. Revenue Ruling 59-60 • 8 fundamental factors that require careful analysis: • Nature and history of business • Company and industry economic outlook • Financial condition of business including book value of stock • Earning capacity • Dividend payment capacity • Whether company has goodwill or other intangible assets • Prior sales of stocks in company and size of block to be offered • Market prices of stocks of corporations engaged in same or similar businesses that have stocks actively traded in free and open markets

5. Revenue Ruling 59-60 • Most basic approach to valuing company: Calculate book value of company (assets minus liabilities) • Assets on balance sheet are based on historical cost (less depreciation for fixed assets) • Calculation of liquidation value overcomes problems of relying on historical cost. • Liquidation value: estimated current market value of all assets minus all liabilities • Indicates amount that could be obtained by selling off all company’s assets and paying off all liabilities

6. Revenue Ruling 59-60 • Using rules of thumb or benchmarks to determine value at which business is sold • Examples • Management training companies sell for 1-1½ times current year’s revenue • Small investment advisory practices sell for 3-4 times current year’s revenue • Broad rules of thumb, such as 10-15 times earnings • Rules of thumb are based on many years of experience in particular industry and are related to what is considered reasonable rate of return on invested capital in that industry

7. Revenue Ruling 59-60 • Use some variation of capitalization of income method • Capitalization of income requires calculation of discounted present value of some future income stream • Present value of constant income stream expected to be paid in perpetuity equals dollar amount of income divided by discount rate • Ex. Present value of dollar per year paid in perpetuity at 20% discount rate is $5.00 since $1/.20 = $5.00. • 20% discount rate translates into 5 times income stream.

8. Revenue Ruling 59-60 • Difficulty of any discounted cash flow approach is selection of appropriate discount rate. • Closely held businesses usually select discount rates as function of perceived riskiness of business. • Common guideline: Select discount rate in terms of percentage rate added to current ninety-day Treasury bill interest rate, assuming T-bill rate reflects current cost of money for short-term, risk-free loan • No hard-and-fast rule!

9. Revenue Ruling 59-60 • Valuation for growing income stream is complicated. • Common example of valuing growing income stream is that of valuing share of common stock using dividend discount valuation model (recall Ch. 14) .

10. Case Analysis: Valuing Home Medical Care, Inc. • Home Medical Care, Inc.: closely held home medical services company • See Exhibit 15.1: HMC’s income statement • Approximately 60% of revenue comes from oxygen equipment rental and oxygen sales • Approximately 40% of revenue comes from product sales • See Exhibit 15.2: HMC’s balance sheet • See Exhibit 15.3: HMC’s key financial ratios and industry standards

11. Case Analysis: Valuing Home Medical Care, Inc. • Exhibits 15.1-15.3 provide information about nature of business, book value of stock, financial conditions of business, earning and dividend paying capacity of company • See Exhibit 15.4: HMC’s 5-year pro-forma income statement • Provides information to help judge future financial condition of business

12. Case Analysis: Valuing Home Medical Care, Inc. Profitability • Based on all three measures of profitability, HMC is significantly more profitable than average company of comparable size in industry. In 2008: • ROS of 6.4% is 1.8% above industry median of 4.6%. • ROI of 11.6% is more than 3% above industry median of 8.4%. • ROE of 23.8% is more than 3% above industry median of 20.6%.

13. Case Analysis: Valuing Home Medical Care, Inc. Liquidity • Current ratio of 2.2 and quick ratio of 1.8 are adequate and in line with industry medians of 2.4 and 1.9, respectively. • Days sales in receivables at 83 days is in line with industry median of 87 days. • Days sales in inventory at 62 days is in line with industry average of 55 days.

14. Case Analysis: Valuing Home Medical Care, Inc. Operating Efficiency • Sales to total assets of 1.8 compared to industry average of 1.9 (HMC is in line with industry) • Industry is capital-intensive • Additional investment of $1.00 in assets is needed to support each additional $1.80 of sales that HMC generates as company grows • Compared to sales to assets ratio of 3.8 for retail drugstores, which indicates that $1.00 in additional assets supports sales growth of $3.80

15. Case Analysis: Valuing Home Medical Care, Inc. Leverage • HMC’s leverage position is relatively high, but in line with industry • HMC’s total debt as percent of total assets is 51.4% compared to industry figure of 51.7% • Median value of debt as percent of total assets across 21 broad industry groups is 31.2% • HMC’s long-term debt as percent of total assets is 22.9% compared to industry median of 15.6%. • Despite heavy debt use, HMC’s times interest earned is a healthy 6.5 compared to industry ratio of 6.8.

16. Case Analysis: Valuing Home Medical Care, Inc. Overall Evaluation • Despite high leverage (characteristic of industry), HMC is an efficiently managed, profitable, and solvent company. • Above-average profitability and normal debt use of industry  rate of return on equity capital exceeds common rule of thumb of “about 20% return on equity capital” • Return to capital is very good, but company is riskier than average closely held corporation due to heavy debt use.

17. Case Analysis: Valuing Home Medical Care, Inc. Applications of Valuation Model to Home Medical Care • Exhibit 15 shows forecast of expected future sales growth and profitability • Revenues and earnings are expected to grow at 20% per year for next 5 years • Suppose we expect earnings to grow at 10% per year for all years after 2008. What is reasonable value for HMC based on its future income stream?

18. Case Analysis: Valuing Home Medical Care, Inc. Applications of Valuation Model to Home Medical Care • Selecting appropriate capitalization rate • 90-day T-bill rate: approximately 5.5% • HMC is a small company with much uncertainty as to whether its high growth expectations can be achieved  rate of at least 16% above risk-free rate is appropriate • Discount rate: 21.5% (= 5.5% + 16%) • What is future value of HMC’s income stream at 22% discount rate?

19. Case Analysis: Valuing Home Medical Care, Inc. Applications of Valuation Model to Home Medical Care • Base value on discounted present value of expected future earnings • Apply dividend discount model as of end of 2008 • Value of HMC equals sum of present value of earnings from 2009 through 2013, plus present value of company at end of 2013 as determined by value of all future earnings growing at 10% per year indefinitely

20. Case Analysis: Valuing Home Medical Care, Inc. Application of Valuation Method to Home Medical Care • Present value of next 5 years’ earnings using 22% discount rate: PV of 5 years’ earnings = $277,000/1.22 + $332,400/1.222 + $398,800/1.223 + $478,600/1.224 + $574,300/1.225 • At end of year 5 (calendar year 2013), value of company should be present value of all future earnings growing at 10% per year: V5 = ($574,300 × 1.10)/(0.22 − 0.10) V5 = $5,264,417

21. Case Analysis: Valuing Home Medical Care, Inc. Application of Valuation Method to Home Medical Care • Present value of V5 discounted back to year one at 22% discount rate: PV of V5 in year 1 = $5,264,417/1.225 PV of V5 in year 1 = $1,947,830 • Total value of HMC is sum of present value of next 5 years’ earnings plus present value of V5: Value of HMC = $1,098,529 + $1,947,830 = $3,046,359

22. Case Analysis: Valuing Home Medical Care, Inc. Application of Valuation Method to Home Medical Care • This valuation approach gives HMC fairly high value: • HMC is assuming company will grow at rate of 20% for next 5 years. • At end of 5-year period, V5 of $5,264,417 is approximately 9.2 times earnings in 2008 (capitalization rate of 10.9%). • Unless growth prospects documented, it is unlikely that potential buyer would pay as much as $3.1 million for HMC • Value of $3.1 million is approximately 13.4 times 2008 earnings of $230,800 (well above common rule of thumb of 10 times earnings for small businesses)

23. Case Analysis: Valuing Home Medical Care, Inc. Application of Valuation Method to Home Medical Care • Substantial value added can be achieved by successfully implementing high-growth strategy • Optimal “exit strategy” for HMC: • Do whatever possible to meet 20% growth targets over next 5 years • Position company for sale at reasonable multiple of earnings in 2013 or 2014