Drawing Value and Perspective from a Business Valuation

1. Drawing Value and Perspective from a Business Valuation Presented By: Robert Vance, CPA/ABV/CFF, CVA, CFP rvance@forensicval.com

2. The Concept of Value • Oldest known appraisal—Genesis 23, Verse 15 • “The land is worth 400 shekels” • First Century B.C.—Publius • “Everything is worth what its purchaser will pay for it” • Modern Valuation Theory—ARM 34—1920 • A result of the 18th Amendment (Prohibition) • First attempt at valuing goodwill associated with breweries and distilleries

3. What Is Value? • According to Merriam-Webster’s Dictionary: • A fair return or equivalent in goods, services, or money for something exchanged; • The monetary worth of something: marketable price; • Relative worth, utility, or importance; • A numerical quantity that is assigned or is determined by calculation or measurement

4. Financial Value • “The value of any financial asset is the net present value of all future cash flows discounted at the appropriate rate of return.” • Brealey & Meyers—Principles of Corporate Finance

5. Price Does Not Equal Value • Price is what you pay; value is what you hope to receive • The value of a business interest depends on an estimate of the future benefits and the rate of return used to discount those benefits into today’s dollars

6. Principal of Substitution • A prudent buyer will pay no more for property than it would cost to acquire an equally desirable substitute with the same utility.

7. Types (Standards) of Value • Fair market value • Fair value • Intrinsic value • Investment value • Book value • Replacement value • Value in place • Insured value • Loan value • Social value • Moral value • Ethical value • Religious value • Sentimental value

8. Fair Market Value • “The price at which a property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell and both parties have reasonable knowledge of the relevant facts.” • Revenue Ruling 59-60

9. Fair Value • A statutory standard of value determined by State Law • Applies in: • Dissenting shareholder actions and forced corporate dissolution • Financial Reporting Standards (Goodwill Impairment Testing)

10. Fair Value • According to the Uniform Business Corporation Act • “Fair value,” with respect to a dissenter’s shares, means the value of the shares immediately before the effectuation of the corporate action to which the dissenter objects, excluding any appreciation or depreciation in anticipation of the corporate action unless exclusion would be inequitable.

11. Book Value • Book value of assets less book value of liabilities • Accounting Value— • the retained earnings or partner capital balance you might find on a business tax return or balance sheet • NOT market value

12. Premise of Value • Going concern • Assumes the business will continue into the future • Liquidation value • Forced liquidation • Orderly liquidation

13. Drawing Value and Perspective from a Business Valuation THE VALUATION PROCESS

14. Normalization • Normalizing adjustments • “Typical” non-control adjustments • Unusual and/or extraordinary items • Non-recurring and/or one-time items • Non-operating assets • Real estate, excess cash, obsolete inventory etc. • Control adjustments • Owner’s compensation and perks • Excessive distributions • Non-operating assets • Cars, airplanes, vacation homes, yachts etc.

15. Drawing Value and Perspective from a Business Valuation VALUATION APPROACHES AND METHODS

16. Common Approaches to Valuation • Asset Approach • Market Approach • Income Approach

17. Market Approach • Guideline publicly traded company method • Based on similar and relevant comparable entities • Adjustments are often necessary to make the comparables more similar • Guideline merged and acquired company method • Based on actual transactions of similar entities • Bizcomps, Done Deals and Pratt’s Stats • Industry source and business brokers

18. Market Approach • Apply a multiple to derive a value • Price to earnings (P/E ratio) • Price to gross revenues • Price to seller’s discretionary cash flow • Price to EBIT or EBITDA • Price to book value

19. Market Example

20. Income Approach • Discounted earnings method • Capitalization of earnings method • Excess earnings method

21. Central Concept: Present Value

22. What Is the Discount Rate? • The rate of return, or cost of capital, necessary to convert a monetary sum, payable or receivable in the future, into present value • Cost of capital • The expected rate of return an investor requires in order to attract funds to a particular investment

23. How Do We Develop a Discount Rate? • Build-up Approach • Weighted Average Cost of Capital (WACC) • Capital Asset Pricing Model (CAPM) • Published industry standards

24. Example of a Build-Up Approach

25. Discounted Earnings Method vs. Capitalization Method • Discounted Earnings Method is applied • Future performance is not expected to be consistent and/or stable • Capitalization Method is applied • Company performance is expected to be stable or grow at a stable rate

26. Discounted Earnings Method • Converts a stream of projected earnings or other benefit stream into present value by applying a discount rate • The earnings from each period are discounted to present value and then a “terminal” value is added to arrive at the total value

27. Capitalization Method • Converts a single period of historical earnings or other benefit stream into present value by applying a capitalization rate

28. Capitalization Example Historical Normalized Net Cash Flow ÷ Divided by: Capitalization Rate = Equals: FMV of Equity (100%) × Times: Percentage Ownership = Indicated Value

29. Rules of Thumb Method • May use a multiple or a combination of approaches—Market/Income/Asset • Common in some industries • Do not take into consideration the unique characteristics of the subject—uses “average” • Sometimes used to support other approaches

30. Drawing Value and Perspective from a Business Valuation LEVELS OF VALUE

31. Levels of Value

32. Discounts & Premiums • They depend on the interest to be valued and the techniques used to establish the value conclusion • Discount for lack of control • Premium for control • Discount for lack of marketability • Key person discount

33. Discount for Lack of Control • A/K/A Minority Interest • Lack of control in a closely held company implies you are at the mercy of the controlling owner(s) • Substantial discounts may be necessary to attract an investor to purchase a minority interest in a closely held company

34. Discount for Lack of Marketability • The time required to convert an ownership interest to cash affects the level of marketability • Factors that affect marketability • Distributions of earnings • Active market or industry roll-up • Key person • Number and profile of owners e.g., family owned • Restrictions on transfer of stock

35. Key Person Discount • “An amount or percentage deducted from the value of an ownership interest to reflect the reduction in value resulting from the actual or potential loss of a key person in a business enterprise.” • International Glossary of Business Valuation Terms

36. Putting It All Together Historical Normalized Net Cash Flow ÷ Divided by: Capitalization Rate = Equals: FMV of Equity (100%) × Times: Percentage Ownership - Disc. for Lack of Marketability (“DLOM”), and/or - Disc. for Lack of Control (“DLOC”)

37. Putting It All Together Net Cash Flow $1,000,000 ÷ Capitalization Rate 20% = FMV of 100% of Equity $5,000,000 × Percentage Ownership 40% = Pre-discount Value $2,000,000 - DLOM 25% = Non-Marketable Value $1,500,000 - DLOC 15% = Minority Value $1,275,000