618 Making Key Strategic Decisions as of De cember 31, 2000, on an as-if-freely-traded basis. Since this amount is based on rates of return of freely traded marketable securities, Victoria will take a valuation discount for lack of liquidity at the end of her analysis. Because Victoria made adjustments to the 2000 pro forma income state- ment (see the pro forma column in Exhibit 18.5) for discretionary items (offi- cers’ compensation and rent expense) and income tax expense, the 2000 pro forma earnings and resulting value of $31.7 million represents a value for a control (rather than a minority) equity interest. In summary, the discounted cash flow methodology determines ACME’s value today, which represents an owner’s perceived future benefits discounted to the present value. The DCF method forecasts ACME’s cash flows into the future and discounts them to their present value. In addition, this method as- sumes that the owner will sell the company at some point in the future and re- ceive the sale price. The estimated future sale price is also discounted back to present value. The present values of future earnings and future sale price are added together to determine the value of ACME. MARKET APPROACH: PUBLICLY TRADED GUIDELINE—COMPANIES METHOD Bob asks Victoria to explain the market approach to determining value. She says the market approach is a general way of determining a value by comparing the asset to similar assets that have been sold. In business valuation, this can be done by looking for any prior arm’s-length sales of the company’s stock, sales of other companies, or prices of shares in publicly traded companies. In the latter two instances, careful analysis of the other companies must be done to deter- mine if they would properly serve as guidelines under this approach. The American Society of Appraisers describes guideline companies as those “com- panies that provide a reasonable basis for comparison to the investment char- acteristics of the company being valued. Ideal guideline companies are in the same industry as the company being valued; but if there is insufficient transac- tion evidence available in the same industry it may be necessary to select com- panies with an underlying similarity of relevant investment characteristics (risks) such as markets, products, growth, cyclical variability and other salient factors.” 2 In ACME’s case, there have never been any prior sales of corporate stock. In addition, Victoria is unable to find any sales of guideline companies in which adequate information is available. However, she is able to identify five publicly traded companies that could potentially serve as guidelines under the market approach. Having identified the list of potential public companies through database searches, Victoria performs a qualitative and quantitative analyses on the com- panies to determine whether they should serve as guideline companies. This analysis results in the selection of five companies. Business Valuation 619 Victoria’s analysis looks at the public companies’ balance sheets and in- come statements over several years, growth rates, margins, returns on assets and equity, and financial ratios. She also analyzes various share price multiples of the public companies such as: • Market value of invested capital to sales. • Market value of invested capital to earnings before interest, taxes, depre- ciation, and amortization (EBITDA). • Market value of invested capital to earnings before interest and taxes (EBIT). • Market value of equity to pretax income. • Market value of equity to net income. • Market value of equity to cash flow. • Market value of equity to book value. Based on her detailed analyses of the guideline companies and comparing them to ACME, Victoria determines that the following price multiples of the public companies appear to be most correlated and relevant for application to ACME: market value of invested capital to sales, market value of invested cap- ital to EBITDA, market value of invested capital to EBIT, and market value of equity to pretax income. The median price multiples for the five public companies are: Then Victoria applies the median price multiples to ACME. See Ex- hibit 18.12 for her calculations. Her analysis indicates a value of ACME’s eq- uity at December 31, 2000, of $35.2 million on an as-if-freely-traded basis. Since Victoria made adjustments to the 2000 income statement (see the resulting pro forma column in Exhibit 18.5) for discretionary items (officers’ compensation and rent expense), she explains that the 2000 earnings and re- sulting value of $35.2 million represents a value to an owner of a control eq- uity interest. Thus, Victoria concludes that there is no need to add a control premium. A control premium is an upward adjustment to the value that re- flects the power of control as compared to the value of a noncontrol equity in- terest. (However, many analysts believe that a control premium would be necessary simply because of the use of public minority share multiples even though the income was adjusted upward to reflect the discretionary expenses of a control owner. Many of these people, however, would not use the median multiple of the public companies as Victoria did but adjust it [usually down] Median Price Multiple Market value of invested capital to sales 0.54 Market value of invested capital to EBITDA 5.80 Market value of invested capital to EBIT 7.26 Market value of equity to pre-tax income 6.72 620 EXHIBIT 18.12 ACME Manufacturing Inc.: Public ly Traded Guideline Co. method of valuation. ACME ($m illion) Median Market Value Multiple of Pro Forma of Invested Market Value Weighted Price Multiple Guidelines Amounts a Capital Less: Debt of Equity Weight Avera ge Market value of invested capital to sales 0.54 Sales $50.29 $27.16 $10.41 $16.75 25% $ 4.19 Market value of invested capital to EBITDA 5.80 EBITDA 8.21 47.62 10.41 37.21 25% 9.30 Market value of invested capital to EBIT 7.26 EBIT 7.21 52.34 10.41 41.93 25% 10.48 Market value of equity to pretax income 6.72 Pretax income 6.66 N/A N/A 44.76 25% 11.19 Value of Equity $35.16 a See Exhibit 18.5 for 2000 pro forma amounts after valuat ion adjustments were made. Business Valuation 621 for funda mental differences between the selected public companies and the private business. Thus, if these analysts first adjust the price multiple down- ward as a fundamental adjustment and then apply an upward control premium, the result may be similar to Victoria’s valuation conclusion.) However, since the $35.2 million value is based on freely traded mar- ketable securities, Victoria will take a valuation discount for lack of liquidity at the end of her analysis. RECONCILIATION OF VALUATION METHODS The results of Victoria’s valuation analysis are: Method Value Income approach $31.7 million Market approach 35.2 million Average 33.5 million Victoria chooses to weigh each method equally resulting in an average value of $33.5 million. This value represents 100% of the common stock of ACME at December 31, 2000, on an as-if-freely-traded and control basis. DISCOUNT FOR LACK OF LIQUIDITY A freely traded basis means an investment can be sold and converted to cash within several days. When shares of stock are sold on a public exchange, the seller will usually receive cash within a few days making them freely traded in- vestments. Under the income approach, Victoria used rates of returns from publicly traded securities. Under the market approach, she used price multi- ples of publicly traded shares. Thus, the values under both of Victoria’s ap- proaches result in as-if-freely-traded values. Because it would likely take Bob (or any other owner of the business) several months or longer to sell ACME and receive cash, the liquidity of an investment in ACME’s shares is significantly different than the liquidity of publicly traded shares of stock. Therefore, Vic- toria takes a discount from the as-if-freely-traded value of $33.5 million for ACME’s equity. The preceding provides the rationale for applying a discount for lack of liquidity. However, the amount of the discount must be quantified. The closest empirical evidence to quantify the discount comes from studies of restricted public stock prices and studies of share prices just prior to companies’ initial public offerings. These studies indicate discounts for lack of marketability of 35% to 45% on average. Since these studies relate to minority equity positions in the companies instead of control positions, Victoria uses a discount below the averages of the studies. Based on her analysis and judgment, she applies a 10% lack of liquidity discount to the as-if-freely-traded $33.5 million equity 622 Making Key Strategic Decisions value. This represents the discount an investor would require for buying shares in ACME instead of an investment that is freely traded. VALUATION CONCLUSION FOR ACME Victoria concludes that the fair market value of the common stock of ACME as of December 31, 2000, was $30,150,000 ($33.5 million less 10% discount for lack of liquidity). VALUING MINORITY INTERESTS The preceding ACME case study valued 100% of the equity (stock) in the business. Had Bob owned only, say, 25% of the common stock, Victoria would have to apply some additional analysis to value his minority interest. With a 25% interest, Bob would no longer have the ability to control the company. A minority interest is a business ownership of less than 50% of the voting shares. The owner of a minority interest in most private businesses cannot con- trol the company. A control interest in a company has the power to direct man- agement and policies of a business usually through ownership of enough shares to influence voting and other decisions. Intuitively, someone would rather own a control interest in a private business (51%) instead of a minority interest (49%) because of the power to control the company. Buyers would typically pay a significantly different price when comparing a 51% interest to a 49% interest. This phenomenon is called a discount for lack of control (or minority discount). The second area of additional analysis for Victoria would be for the typi- cal difficulty in selling a minority interest in a closely held business. Mar- ketability is the ability to quickly convert property (an investment) to cash at minimal cost. Hypothetically, if Bob owns only 25% of ACME’s stock and someone else owns the other 75%, the number of buyers interested in buying Bob’s shares is significantly less than if he owns 100%. Since Bob actually owns the entire company, he has several ways to sell it. For example, he can sell the company through an investment banker or business broker. He can also take the company public. If Bob hypothetically only owns 25% of ACME’s stock, these options are not realistically available to him. Therefore, his minor- ity interest is less marketable. Intuitively, investors prefer owning marketable investments over nonmarketable ones. Therefore, buyers of minority interests in private companies typically pay less since the shares are not marketable. This is called a discount for lack of marketability. In valuing a minority interest, a major consideration is the timing and amount of the anticipated future economic benefits flowing directly to the mi- nority owner. This consists of the company’s periodic distributions to the mi- nority owner and the estimated holding period for owning the equity interest Business Valuation 623 until it is sold and the sales proceeds are received. We saw through the DCF model that the value of the asset is the present value of the expected future benefits. In valuing a minority interest, the emphasis shifts toward the future benefits flowing to the minority shareholder as opposed to the business overall. For example, if a minority owner expects not to receive any distributions from the business for 10 years even though the business is profitable, this is signifi- cantly different from a business that makes annual shareholder distributions of the profits. The values in these two situations would be considerably different. BUSINESS VALUATION STANDARDS Professional business appraisers follow certain standards when doing business valuations. Business valuation standards include the following: Uniform Standards for Professional Appraisal Practice—The Appraisal Foundation. Standards issued by various membership organizations such as American Society of Appraisers, Institute of Business Appraisers, and National As- sociation of Certified Valuation Analysts. VALUE ENGINEER ING Just as the CEO of a public company tries to enhance the value of the shares, management of a private company can work on increasing the value of the business in anticipation of a future sale. Certain factors can have a significant effect on the value of a typical closely held business. Management can focus on these factors to potentially increase the future value of the business. Some of the factors are obvious, while some are not. They include the following: • Decrease expenses (increases cash flow/income). • Increase revenues (increases cash flow/income). • Significantly increase the earnings growth rate (may increase earnings projections, lower capitalization rate due to growth factor). • Eliminate the owners’ personal expenses and perquisites (increases cash flow/ income, lowers buyer risk of inaccurate financial statements). • Report all income on the financial statements and tax return (increases cash flow/income). • Develop the management team for the possibility that the current owner(s) may leave the business upon a sale (lowers buyer risk of earn- ings volatility). • Plan for the current owner-managers’ continuing employment under the new owner for a fixed period (lowers buyer risk of earnings volatility and loss of customers, employees, and vendors). 624 Making Key Strategic Decisions • Have annual financial statements audited or reviewed by a certified pub- lic accountant and improve interim financial reporting (lowers buyer risk of inaccurate financial statements). • Develop a list of potential synergistic buyers and identify the ones with the most to gain from an acquisition of the subject company (search for the highest synergistic value to be paid). • Decrease dependency on major customers and vendors (lowers buyer risk of earnings volatility in the event of the loss of any of these customers or vendors). • Begin assembly of key business information for potential buyers (lowers buyer risk of perceptions of potential earnings volatility without having such knowledge). • Improve any existing poor financial statistics or ratios (lowers buyer fi- nancial risk). Public companies report earnings and performance on a quarterly basis and the share prices frequently react quickly. On the other hand, private com- pany values generally react more slowly to changes. Thus, management may need to work on value improvement factors one to two years in advance of mar- keting a business. SUMMARY The fair market value of a private business is essentially an estimate of the price that a willing buyer would pay and a willing seller would accept. Buyers have different motives for buying a business. Financial buyers are looking for a return on their investment. Strategic buyers are usually looking to integrate their company with the business for unique strategic reasons. Financial buyers pay fair market value while strategic buyers usually pay a price reflective of the unique strategic advantages to the specific buyer. Often, strategic buyers pay more than fair market value. Although it is possible to conduct a business valuation that is not overly complex, the question remains whether the result- ing value is accurate. Many variables go into a valuation analysis. A business valuation is both a quantitative and qualitative process that is focused on as- sessing investment risk and investment return. It is largely an assessment of the risks a buyer is taking in acquiring and owning the company. In addition, a val- uation attempts to project the earnings an owner of the business can expect in the future as a return on investment. Author’s Note. This chapter is not intended to be a complete text on business valuation. It is meant to illustrate through examples many of the fundamentals of business valuation and their application. The proper application of valuation theory depends on the actual facts and circumstances of the investment being valued. Business Valuation 625 FOR FURTHER READING Desmond, G. and J. Marcell, Handbook of Small Business Valuation Formulas and Rules of Thumb, 3rd ed. (Los Angeles: Valuation Press, 1993). Pratt, S., R. Reilly, and R. Schweihs, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 4th ed. (New York: McGraw-Hill, 2000). Pratt, S., R. Reilly, and R. Schweihs, Valuing Small Businesses and Professional Prac- tices, 3rd ed. (New York: McGraw-Hill, 1998). Reilly, R. and R. Schweihs, Valuing Intangible Assets (New York: McGraw-Hill, 1998). Smith, G. and R. Parr, Valuation of Intellectual Property and Intangible Assets (New York: John Wiley, 2000). Trugman, G., Understanding Business Valuation: A Practical Guide to Valuing Small- to Medium-Sized Businesses (New York: AICPA, 1998). , Handbook of Business Valuation, 2nd ed. T. West and J. Jones, Eds. (New York: John Wiley, 1999). , Stocks, Bonds, Bills, and Inflation Yearbook Valuation Edition (Chicago: Ibbotson Associates, published annually). INTER NET LINKS www.aicpa.org American Institute of Certified Public Accountants www.appraisers.org American Society of Appraisers www.appraisalfoundation.org Appraisal Foundation www.gofcg.org Financial Consulting Group www.ibbotson.com Ibbotson Associates www.instbusapp.org Institute of Business Appraisers www.nacva.com National Association of Certified Valuation Analysts NOTES 1. International Glossary of Business Valuation Terms, jointly published by the American Institute of Certified Public Accountants, American Society of Appraisers, Canadian Institute of Chartered Business Valuators, National Association of Certi- fied Valuation Analysts, and Institute of Business Appraisers. Further terminology from this jointly published international glossary is included in glossary at the end of this book. 2. American Society of Appraisers, Statement on Business Valuation Standards 1. 626 Glossary Accounting exposure: Increases or decreases in assets and liabilities resulting from exchange rate movements, which may not be associated with either current or prospective cash inflows or outflows. Accounting exposure is distinguished from economic exposure where cash inflows and outflows are expected to be associated with exchange rate movements. Accrual accounting: An accounting method that recognizes revenues as they are earned and expenses as they are incurred. The timing of revenue and expense recognition is not tied to the timing of the inflow and outflow of cash. Accrual ac- counting is seen as essential in order to develop reliable measures of periodic finan- cial performance. Acquisition: The purchase—not necessarily for cash—of a controlling interest in a firm. Activity-based costing: A process of identifying the different activities that gener- ate costs. Adapter: Typically, a small circuit board inside a computer that lets the computer work with hardware external to the computer. Examples: A network adapter allows a computer to be hooked into a network; a display adapter allows a computer to drive (display text, graphics) a computer monitor. AICPA: The American Institute of Certified Public Accountants. This is the na- tional professional association of certified public accountants (CPAs). All-current method: A method of translating foreign-currency financial state- ments whereby all assets and liabilities are translated at the current (balance sheet date) exchange rate, contributed capital accounts are translated at historical ex- change rates (rates in existence when the account balances first arose), and all rev- enues and expenses are translated at the average exchange rate in existence during the reporting period. Translation adjustments resulting from fluctuating exchange rates are accumulated and reported with accumulated other comprehensive income in shareholders’ equity. Amortization: the periodic, noncash charge used to reduce an intangible asset. Application Service Providers (ASP): Companies that rent out applications and process data for other companies, similar to service bureaus in the 1960s and 1970s. Glossary 627 Asset (asset-based) approach: A general way of determining a value indication of a business, business ownership interest, or security by using one or more methods based on the value of the assets of that business net of liabilities. Asset acquisition: an acquisition executed by purchasing the assets of the target firm. Asymmetric risk: An exposure that results in profits or losses only if the underlying price or economic variable moves in one direction. At-the-money: The condition of a call or put option when the strike price equals the stock price. Some economists define at-the-money as being the case when the stock price equals the present value of the strike price. B2C e-commerce: The sale of goods and services between a company and a con- sumer over the Internet. Balanced scorecard: A comprehensive set of performance measures intended to capture a more balanced picture of management’s success in achieving goals than can be captured by financial measures only. Bearish: Pessimistic. Anticipating a decrease in an asset value. Best efforts underwriting: An agency arrangement by which underwriters agree to use best efforts to sell all, or a certain minimum number of, shares of a public offering. Beta: A measure of systematic risk of a security; the tendency of a security’s returns to correlate with swings in the broad market. Bidder: The firm that initiates a merger or acquisition; the bidder usually retains control of the surviving firm. Bit: The smallest gradation of data stored in a computer. Technically, a bit is either a 1 or a 0. Computers use groups of bits, called bytes, to represent character data. Blue-sky laws: State laws regulating securities that provide for licensing brokers/dealers and registering new securities issuances. Budget: A comprehensive, quantitative plan for utilizing the resources of an entity for some specified period of time—showing planned revenues, expenses, and result- ing earnings—together with a planned balance sheet and cash flow statement. If bud- gets adjust for volume they are called flexible; otherwise, they are static. Budget entity: Any accounting entity, such as a firm, division, department, or project, for which a budget is prepared. Budget performance report: An internal accounting report that shows the differ- ence between actual results and expected performance planned in a budget. Budget review process: The process of evaluating budget proposals and arriving at the master budget. Budget variance: The difference between the budgeted data and actual results. Bullish: Optimistic. Anticipating an increase in an asset value. Business valuation: The act or process of determining the value of a business en- terprise or ownership interest therein. Byte: Typically, eight bits in a computer, which as a unit, represent one character of data. A computer diskette can store 1,400,000 bytes of data, or 1,400,000 characters of data. This represents about 500 pages of single-spaced text. . flexible; otherwise, they are static. Budget entity: Any accounting entity, such as a firm, division, department, or project, for which a budget is prepared. Budget performance report: An internal accounting