Business Valuation and Taxes Procedure Law and Perspective phần 5 ppt

Assessment of Risk Risk can be defined as the degree of certainty (or lack thereof) of achieving future expecta- tions at the times and in the amounts expected. One of the most important products of financial statement analysis is to provide an objec- tive basis for assessment of risk relative to industry average risk and/or risk of specific guide- line companies. Risk analysis is of critical importance because, other things being equal, the higher the risk, the lower the fair market value of the company. In the income approach, the higher the risk, the higher the market’s required rate of expected return on investment. The market’s required rate of return on investment is called the discount rate, the rate at which projected cash flows are discounted back to a present fair market value. The discount rate represents the total expected rate of return on the value of the investment, including both cash distributions and capital appreciation, whether realized or unrealized. The higher the risk, the higher the dis- count rate, and thus the lower the value of the company or interest in the company (see Chapter 14). In the market approach, risk is reflected in valuation multiples. The higher the risk, the lower the valuation multiples, and thus the lower the fair market value of the company or in- terest in the company (see Chapter 15). Risk also affects the discount for lack of marketability. Other things being equal, the higher the risk, the higher the discount for lack of marketability (see Chapter 18). Assessment of Growth Prospects Another purpose of financial statement analysis is to provide a basis for assessing the prospects for growth. The higher the company’s prospective growth in net cash flows (or earn- ings, or some other measure of benefit to shareholders), all else being equal, the higher the present fair market value of the company. In the discounted cash flow method within the income approach, growth is reflected directly in the projections. Financial statement analysis can provide a basis for evaluat- ing the reasonableness of the projections. The discounted cash flow method, discussed in Chapter 14, requires that all projected future benefits to the owners be discounted back to a present value at a discount rate that reflects the risk of realizing the benefits projected. In the capitalization method within the income approach, growth is reflected by sub- tracting the rate of expected long-term growth from the discount rate to arrive at the capital- ization rate (see Chapter 14). Financial statement analysis can help to evaluate the reasonableness of the estimate of the long-term growth rate. The capitalization method dis- cussed in Chapter 14 consists of dividing some measure of benefit by a capitalization rate, which is either the discount rate minus the expected long-term growth rate or a rate ob- served from comparative companies. In the market approach, expected growth is reflected in the valuation multiples. Financial statement analysis can be helpful in evaluating the reasonableness of the multiples applied to the subject company’s fundamentals. 160 COMPARATIVE FINANCIAL STATEMENT ANALYSIS COMPARABLE RATIO ANALYSIS For convenient analytical purposes, ratios can be arbitrarily classified into half a dozen categories: 1. Activity ratios 2. Performance ratios 3. Return-on-investment ratios 4. Leverage ratios 5. Liquidity ratios 6. Other risk-analysis ratios The following list of financial statement ratios is not all-inclusive, but presents those most commonly used. Activity Ratios (sometimes also called Asset Utilization Ratios) Activity ratios relate an income statement variable to a balance sheet variable. Ideally, the bal- ance sheet variable would represent the average of the line item for the year, or at least the av- erage of the beginning and ending values for the line item. However, many sources of comparative industry ratios are based only on year-end data. For the ratios to have compara- tive meaning, it is imperative that they be computed from the subject company on the same ba- sis as the average or individual company ratios with which they are being compared. It also should be noted that many ratios can be distorted significantly by seasonality, so it may be im- portant to match comparative time periods. Accounts receivable turnover: The higher the accounts receivable turnover, the better the company is doing in collecting its receivables. Inventory turnover: The higher the inventory turnover, the more efficiently the company is using its inventory. Note: Some people use sales instead of cost of goods sold in this ratio. This method inflates the ratio, since it does not really reflect the physical turnover of the goods. Cost of goods sold Inventory Sales Accounts receivable Comparable Ratio Analysis 161 Sales to net working capital: The higher the sales to net working capital, the more efficiently the company is using its net working capital. However, too high a sales-to-working-capital ratio could indicate the risk of inadequate working capital. Sales to net fixed assets: Sales to total assets: Generally speaking, activity ratios are a measure of how efficiently a company is utilizing var- ious balance sheet components. Performance Ratios (Income Statement) The four most common measures of operating performance are: Gross profit as a percentage of sales: Operating profit (earnings before interest and taxes [EBIT]) as a percentage of sales: Pretax income as a percentage of sales: Net profit as a percentage of sales: Net profit Sales Pretax income Sales EBIT Sales Gross profit Sales Sales Total assets Sales Net fixed assets (Cost Accumulated depreciation)− Sales Net working capital (Current assets – Current liabilities) 162 COMPARATIVE FINANCIAL STATEMENT ANALYSIS All four measures can be read directly from the common size income statements, which are discussed in the following section. A higher performance ratio means that a higher price- to-sales multiple can be justified. Return-on-Investment Ratios Like activity ratios, return-on-investment ratios relate an income statement variable to a bal- ance sheet variable. Ideally, the balance sheet variable would represent the average of the line item for the year, or at least the average of the beginning and ending values for the line item. Unlike activity ratios, return-on-investment ratios sometimes are computed on the basis of the balance sheet line item at the beginning of the year. However, many sources of comparative ratios are based only on year-end data. For the ratios to have comparative meaning, it is im- perative that they be computed for the subject company on the same basis as the average or in- dividual company ratios with which they are being compared. Return on equity: Note: The preceding ratio normally is computed based on book value of equity. It also may be enlightening to compute it based on market value of equity. Return on investment: Return on total assets: Note: These ratios are normally computed based on book values. Each measure of investment returns provides a different perspective on financial perfor- mance. In valuation, return on equity influences the price-to-book-value multiple, and return on investment influences the market-value-of-invested-capital (MVIC)-to-EBIT multiple. A higher return on various balance sheet components justifies a higher value multiple relative to those components. Leverage Ratios The general purpose of balance sheet leverage ratios (capital structure ratios) is to aid in quantifiable assessment of the long-term solvency of the business and its ability to deal Net income + [(Interest)(1– Tax rate)] Total assets Net income + [(Interest)(1– Tax rate)] Equity + Long - term debt Net income Equity Comparable Ratio Analysis 163 with financial problems and opportunities as they arise. Balance sheet leverage ratios are important in assessing the risk of the individual components of the capital structure. Above-average levels of debt may increase both the cost of debt and the company-specific equity risk factor in a build-up model for estimating a discount or capitalization rate. Al- ternatively, above-average debt may increase the levered beta in the capital asset pricing model (CAPM). The CAPM, discussed in Chapter 14, is a procedure for developing a dis- count rate applicable to equity. Total debt to total assets: Equity to total assets: Long-term debt to total capital: Equity to total capital: Fixed assets to equity: Debt to intangible equity: Note: The preceding ratio sometimes is computed using total equity minus intangible assets in the denominator. Leverage ratios are a measure of the overall financial risk of the business. Total liabilities Total equity Net fixed assets Total equity Total equity Long-term debt + Equity Long - term debt Long - term debt + Equity Total equity Total assets Total liabilities Total assets 164 COMPARATIVE FINANCIAL STATEMENT ANALYSIS Liquidity Ratios Liquidity ratios are indications of the company’s ability to meet its obligations as they come due—in this sense, they are factors that may be considered in assessing the com- pany-specific risk. Current ratio: Quick (acid test) ratio: times interest earned: a. or b. Note: Depreciation in the preceding formula is usually construed to include amortization and other noncash charges, sometimes expressed by the acronym EBITDA (earnings before inter- est, taxes, depreciation, and amortization). Coverage of fixed charges: Other Risk-Analysis Ratios Business risk (variability of return over time): Standard deviation of net income Mean of net income Earnings before interest, taxes, and lease payments Interest + Current portion of long-term debt + Lease payments EBDIT Interest expense EBIT Interest expense Cash + Cash equivalents + Short-term investments + Receivables Current liabilities Current assets Current liabilities Comparable Ratio Analysis 165 Business risk measures volatility of operating results over time. The higher the historical business risk, the less predictable future results are likely to be. Variability of past re- sults is a better predictor of variability of future results (risk) than a past upward or downward trend is of a future upward or downward trend. Note: This measure is called the coefficient of variation. It can be applied to any measure of income, including sales, EBITDA, EBIT, gross profit, pretax profit, or net cash flow. Degree of operating leverage: Note: This is really another measure of business risk. The numerator could be any of the mea- sures of income listed earlier. Financial risk (degree of financial leverage): COMMON SIZE STATEMENTS A common size statement is a balance sheet that expresses each line item as a percentage of to- tal assets or an income statement that expresses each line item as a percentage of revenue. When several years of financial statements are available for a company, common size statements can be used to compare the company against itself over time. This is called trend analysis. The Chapter 15 appendix section contains two examples, one being five years of common size balance sheets, and the other, five years of common size income statements for Optimum Devices. Note that five years of statements produce only four years of year-to-year changes and thus a four-year compound rate of growth, or decline, in each line item. When a number of years’ worth of common size statements are used, the volatility of each line item can be measured using the standard deviation of the year-to-year changes. When a comparable number of years of common size statements are available for industry averages or specific guideline companies, the relative volatility of each line item can be com- pared. Higher volatility is indicative of higher risk. A single year’s common size statements can be used to compare subject company to in- dustry averages or to specific guideline companies. Exhibit 15.10 is an example of a subject company’s common size statements relative to industry averages; Exhibit 15.13 is an example of a subject company’s common size statements compared with specific guideline companies. (See Chapter 15.) Percentage change in income to common equity Percentage change in EBIT Percentage change in operating earnings Percentage change in sales 166 COMPARATIVE FINANCIAL STATEMENT ANALYSIS TYING THE FINANCIAL STATEMENT ANALYSIS TO THE VALUE CONCLUSION The implications of the financial statement analysis for the conclusion of value should be identified in the financial statement analysis section, the valuation section, or both. Some re- ports have an extensive financial analysis section with no mention of implications for value either in the analysis or valuation section. To be convincing, the report should be cohesive; the report should hang together, with each section lending support for the value conclusion. The connection should be explained, not leaving the reader to guess. Many readers will not be fi- nancial experts, and a connection that might be apparent to a financial analyst might not be obvious to a less sophisticated reader. CONCLUSION The primary objectives of financial statement analysis are to identify trends and to identify the strengths and weaknesses of the subject company relative to its peers. Perhaps the most impor- tant outgrowth of financial statement analysis is objective evidence of the subject company’s risk relative to its peers. This relative riskiness plays a part in the discount and capitalization rates in the income approach, and in the valuation multiples in the market approach. Conclusion 167 Chapter 12 Economic and Industry Analysis Summary Objective of Economic and Industry Analysis National Economic Analysis Regional and Local Economic Analysis Industry Analysis General Industry Conditions and Outlook Comparative Industry Financial Statistics Management Compensation Information Conclusion Partial Bibliography of Sources for Economic and Industry Analysis National Economic Information Regional Economic Information Industry Information Management Compensation Sources SUMMARY Almost every company is affected to some extent by economic conditions and by conditions in the industry in which it operates. No discussion of business valuation would be complete without at least a brief discussion of external factors. Various economic and industry factors affect each company differently, and the key to effective economic and industry analysis is to show how each factor impacts the subject company. Some companies are affected by certain aspects of the national economy. Others are af- fected primarily by regional and local economic factors. Some are affected more heavily than others by conditions in the industry in which they operate. Economic and industry analysis identifies those factors that affect the subject company. OBJECTIVE OF ECONOMIC AND INDUSTRY ANALYSIS The objective of economic and industry analysis is to provide relevant data on the context within which the company is operating. The key word here is relevant. No company operates in a vacuum. All companies are impacted to a greater or lesser ex- 168 tent by external conditions. These could be national, regional, or local economic conditions and/or conditions in the industry in which the company operates. The extent to which various economic and industry conditions affect differing companies varies widely from company to company. It is the appraiser’s job to identify what aspects of economic and/or industry conditions tend to affect the subject company, to identify how those conditions are expected to change in the future, and to assess the impact of those changes on the subject company. “It is essential for the appraiser to relate economic indicators and outlook to the specific circumstances of the subject company and valuation engagement.” 1 A great deal of economic and industry data are available online. The most comprehensive source of economic and industry data available online is Best Websites for Financial Profes- sionals, Business Appraisers, and Accountants, 2nd ed. 2 (referred to in subsequent sections of this chapter as Best Websites). NATIONAL ECONOMIC ANALYSIS Companies in some industries are heavily impacted by certain aspects of the U.S. economy. In some cases those aspects of the national economy have little or no relevance. Major components of national economic analysis include the following: • General economic conditions: • Gross domestic product (GDP) • Consumer spending • Government spending • Business investments • Inventories (increases or decreases) • Trade deficit • Consumer prices and inflation rates • Interest rates • Unemployment • Consumer confidence • Stock markets • Construction • Manufacturing The analyst should identify which of these economic variables affects the subject com- pany, and should concentrate the economic analysis on those variables. Long-term outlooks National Economic Analysis 169 1 Shannon Pratt in Economic Outlook Update 4Q 2002 (Portland, OR: Business Valuation Resources, LLC, pub- lished quarterly). 2 Eva M. Lang and Jan Davis Tudor, Best Websites for Financial Professionals, Business Appraisers, and Accoun- tants, 2nd ed. (Hoboken, N.J.: John Wiley & Sons, Inc., 2003). [...]... × 8 = 5. 6) Size premiumd Industry adjustmente 5. 4% 7.0% 5. 4% 7.0% 3 .5% –3.6% 3 .5% — 5. 6% 3 .5% — Estimated Equity Discount Rate 12.3% 15. 9% 14 .5% 5. 4% a 20-year U.S Treasury bond yield to maturity as of the valuation date, July 31, 2003 1926–2002 arithmetic average of excess return on S&P 50 0 stocks over 20-year U.S Treasury bonds per Ibbotson Associates, Stocks, Bonds, Bill and Inflation, 2003 Valuation. .. end of this chapter 3 Business Valuation Data, Publications, and Internet Directory (Portland, OR: Business Valuation Resources, LLC, published annually) 4 See note 2, Chapter 3, pp 37 56 5 Shannon P Pratt, Robert F Reilly, Robert P Schweihs, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 4th ed (New York: McGraw-Hill, 2000) 6 See note 2, Chapter 4, pp 57 –73 Industry Analysis... Appendix: An Illustration of the Income Approach to Valuation SUMMARY OF APPROACHES, METHODS, AND PROCEDURES In the hierarchy of widely used business valuation terminology, there are approaches, methods, and procedures In business valuation, as in real estate appraisal, there are three generally recognized approaches: income, market (sales comparison), and asset-based (cost) Within these approaches, there... median figures, with upper and lower quartiles Covers over 800 lines of business, broken down into three size ranges by net worth for each SIC (www.dnb.ca/products/indnorm.html) Industry Valuation Update Portland, Ore.: Business Valuation Resources, LLC The Industry Valuation Update is a six-volume series on industry valuation topics Each volume includes seven general business valuation chapters, two... of its equipment, the advantages and disadvantages of its location, the quality of its management, and its general and specific strengths and weaknesses MANAGEMENT INTERVIEWS Management interviews can be helpful in understanding the history of the business, compensation policy, dividend policy, markets and marketing policies and plans, labor relations, regu- 1 Rev Rul 59 -60 178 Interviews with Persons... comprised of abstracts and fulltext records from more than 1,000 of the world’s important business publications, including trade journals, local newspapers and regional business publications, national and international business newspapers, trade and business newsletters, research studies, S1 SEC registration statements, investment analysts’ reports, corporate news releases, and corporate annual reports... Year 3 $1,200 $1 ,50 0 $1,700 Expected long-term growth rate following year 3 = 5% Using the Gordon Growth Model to estimate the terminal value, these assumptions would result in the following calculations: $1, 200 $1, 50 0 $1, 700 PV = + + 2 + (1 + 20) (1 + 20) (1 + 20)3 $1, 700 × (1 + 05) 20 − 05 (1 + 20)3 $1, 7 85 $1, 200 $1, 50 0 $1, 700 = + + + 15 1.20 1.44 1.728 (1 + 20)3 $1, 200 $1, 50 0 $1, 700 $11,... annual reports RMA Annual Statement Studies Philadelphia: Risk Management Association, annual Standard & Poor’s Analyst’s Handbook New York: Standard & Poor’s Corporation, Inc., annual (www.standardandpoors.com) Standard & Poor’s Industry Surveys New York: Standard & Poor’s Corporation, Inc., biannual (www.standardandpoors.com) University of Michigan Documents Center: Ann Arbor, Mich This Web site from the... end of 2 years, and so forth $9 25. 93 × 1.08 = $1,000 $ 857 .34 × 1.08 × 1.08 = $1,000 $793.83 × 1.08 × 1.08 × 1.08 = $1,000 Source: Shannon P Pratt, The Lawyer’s Business Valuation Handbook (Chicago: American Bar Association, 2000): 108 All rights reserved Used with permission 188 THE INCOME APPROACH The terminal value may be estimated either by the Gordon Growth Model or by market valuation multiples... migration, top employers, business/ living costs, and more Subscriptions include current report and two updates Samples are available for each report Industry Forecast Reports include five-year forecasts for up to 50 financial variables, current and forecasted trends, risk factors, and so on Each report also includes data on macroeconomic conditions, trends, and outlooks Reports are four pages and updated three . ECONOMIC AND INDUSTRY ANALYSIS 3 Business Valuation Data, Publications, and Internet Directory (Portland, OR: Business Valuation Resources, LLC, published annually). 4 See note 2, Chapter 3, pp. 37 56 . 5 Shannon. publications, including trade journals, local newspapers and regional business publications, national and international business newspapers, trade and business newsletters, research studies, S1 SEC registration. Corporation, Inc., annual. (www.standardandpoors.com) Standard & Poor’s Industry Surveys. New York: Standard & Poor’s Corporation, Inc., biannual. (www.standardandpoors.com) University of Michigan