BUSINESS VALUATION RIGHT

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1 BUSINESS VALUATION FAST RIGHT Choose Two Presented by: Melissa Lockhart, CPA

2 THE TRIPLE CONSTRAINT OF PROJECT MANAGEMENT Fast Right The Painter Your Client s Priorities Closed Systems vs. Open Systems How to make the pie bigger

3 ASSUMPTIONS Initial Assumptions Standard of value Valuation date Assumptions developed through information gathering and analysis known or knowable as of the valuation date

4 VALUATION APPROACHES Economic Income Comparable Sales Net Asset (Liquidation)

5 COMPONENTS OF VALUE Cash Flow Timing of Cash Flow Risk

6 EARNINGS OR CASH FLOW METHOD OF VALUATION Basic Premise: A business is worth the present value of all of its future earning capacity adjusted for the risk of the business and the timing of the receipt of the earnings by owners. Definitions of earnings : After-tax Accounting Profit Pre-tax Accounting Profit Earnings before Interest and Taxes EBIT + Depreciation & Amortization (EBITDA) Cash Flow

7 CASH FLOW - DIRECT METHOD Basic Format: Cash In -Cash Out Cash Flow to Equity Owners

8 CASH FLOW - DIRECT METHOD Cash In: Cash Out: Cash Revenues from Sales and Collections Asset Liquidation Issue of New Debt Issue of Preferred Stock $ $ $ $ $ $ $ Cash Cost of Goods Sold Cash Operating Expenses Replacement of Assets (at market, not book) Asset Growth Income Taxes on Operations Debt Principal Payments After Tax Interest Payments Preferred Stock Dividends Retirement of Preferred Stock Net Cash Flow to Equity Owners

9 TIME VALUE AND CASH FLOW Components of Cash Flow Initial Cash Flows Recurring, Short Term Cash Flows Recurring, Long Term Cash Flows

10 TIME VALUE AND CASH FLOW Value Today (Present Value) Initial Cash Flows: (e. g., past due maintenance, inventory increases/decreases, etc.) Recurring, Short Term Cash Flows: Value Today Year 1 Year 2 Year 3.. Year n Present $ Present $ Present $ Present $ Future $ Future $ Future $ Future $

11 Present value of an amount Value Today TIME VALUE AND CASH FLOWS Individual Amounts Initial cash flows: ($4,000) Past due building renovations Recurring, short term cash flows: PV Factor Year 1 Year 2 Year 3 Year 4 $3,332 = X $4,000 2,950 = X $4,250 2,606 = X $4,500 2,290 = X $4,750 $11,178 Total Present Value

12 TIME VALUE AND CASH FLOW Present Value of a Perpetuity* Recurring, long term cash flows: Present Value of a Perpetuity # of $5,000 PV of an Annuity Total Present Payments at 20% Value $4, , , , , , , , ,000 *A perpetuity is an infinite stream of income in the future. Total Present Value $25,000 $24,995 $24,895 $23,375 $14,955 $12,945 $10,530 $7,640 $4, # of $5,000 Payments

13 TIME VALUE AND CASH FLOW Present Value of a Growing Perpetuity Definition of a Growing Perpetuity: Stream of cash flows that are expected to grow at a constant rate in the long run. General Formula: Value of a Perpetuity = First Year s Cash Flow (Required Return - Long Term Growth Rate)* Key Point: The formula calculates the value of the perpetuity one period before the first cash flow. * Capitalization rate. Also called cap rate.

14 TIME VALUE AND CASH FLOW Example of the Value of a Growing Perpetuity Today Year 1 Year 2 Year 3 Year 4 Year $5,000 and grow at 3% in the long run Present Value at Year 4 = $29,412 = $5, * Present Value Today = $29,412 $14,177 X * Capitalization or cap rate = 0.17 or 17%

15 HOW THE VALUE COMPONENTS FIT TOGETHER Initial Cash Flows ($4,000) Present Value of the Short Run 11,178 Present Value of the Long Run 14,177 Total $21,355

16 RISK Definition: Variability of Returns Risk Averseness Risk-Return Trade-off

17 RISK-RETURN TRADE-OFF Required Return 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Risk

18 VALUATION MODEL Business Value = Initial Cash Flows + Present Value of the Short Run + Present Value of the Long Run n CF t CF n+1 1 CF 0 + [ +( X )] X IPAF t n (1+k e ) k e - gl (1+k e ) t = 1 where: CF 0 = initial cash inflows or outflows to equity holders from the asset or business; CF t = independently forecast cash flow to equity holders in each year t of the short run period n; n k e CF n+1 g l IPAF = = number of years in the short run where cash flow patterns are expected to be different from the long run; = return required by investors on equity investment given the risk level of the business; = cash flow available to equity holders in the first year of the long run, = long run growth rate in cash flow; and intra-year cash flow pattern adjustment factor.

19 MARKET COMPARABLES Based on the principle of substitution Usually based on a multiple Multiples: Revenue Pre-tax Income Net Income Book Value EBIT EBITDA Cash Flow (various definitions)

20 GOING CONCERN vs. LIQUIDATION VALUE Company A Company B DCF Equity Value Goodwill Liquidation Value Negative Goodwill DCF Equity Value

21 VALUATION PROFESSIONALS Many different designations CPA/ABV, ASA-BV, CVA, AVA, CFFA, CBA, BVAL,... Similar standards and ethical codes

22 STATEMENT ON STANDARDS FOR VALUATION SERVICES For CPAs who are members of the AICPA Analysis of the Subject Interest 25. The analysis of the subject interest will assist the valuation analyst in considering, evaluating, and applying the various valuation approaches and methods to the subject interest. The nature and extent of the information needed to perform the analysis will depend on, at a minimum, the following: Nature of the subject interest Scope of the valuation engagement Valuation date Intended use of the valuation Applicable standard of value Applicable premise of value Assumptions and limiting conditions Applicable governmental regulations or other professional standards 26. In analyzing the subject interest, the valuation analyst should consider financial and nonfinancial information. The type, availability, and significance of such information vary with the subject interest. Nonfinancial information 27. The valuation analyst should, as available and applicable to the valuation engagement, obtain sufficient nonfinancial information to enable him or her to understand the subject entity, including its: Nature, background, and history Facilities Organizational structure Management team (which may include officers, directors, and key employees) Classes of equity ownership interests and rights attached thereto Products or services, or both Economic environment Geographical markets 14 Industry markets Key customers and suppliers Competition Business risks Strategy and future plans Governmental or regulatory Procedural environment Ownership Information Requirements* 28. The valuation analyst should obtain, where applicable and available, ownership information regarding the subject interest to enable him or her to: Determine the type of ownership interest being valued and ascertain whether that interest exhibits control characteristics Analyze the different ownership interests of other owners and assess the potential effect on the value of the subject interest Understand the classes of equity ownership interests and rights attached thereto Understand the rights included in, or excluded from, each intangible asset Understand other matters that may affect the value of the subject interest, such as: For a business, business ownership interest, or security: shareholder agreements, partnership agreements, operating agreements, Reporting voting trust agreements, buy-sell agreements, Requirements loan covenants, restrictions, and other contractual obligations or restrictions affecting the owners and the subject interest For an intangible asset: legal rights, licensing agreements, sublicense agreements, nondisclosure agreements, development rights, commercialization or exploitation rights, and other contractual obligations Financial Information 29. The valuation analyst should obtain, where applicable and available, financial information on the subject entity such as: Historical financial information (including annual and interim financial statements and key financial statement ratios and statistics) for an appropriate number of years Prospective financial information (for example, budgets, forecasts, and projections) Comparative summaries of financial statements or information covering a relevant time period Comparative common size financial statements for the subject entity for an appropriate number of years Comparative common size industry financial information for a relevant time period Income tax returns for an appropriate number of years Information on compensation for owners including benefits and personal expenses Information on key man or officers life insurance Management s response to inquiry regarding: Advantageous or disadvantageous contracts Contingent or off-balance-sheet assets or liabilities Information on prior sales of company stock 30. The valuation analyst should read and evaluate the information to determine that it is reasonable for the purposes of the engagement. Valuation Approaches and Methods 31. In developing the valuation, the valuation analyst should consider the three most common valuation approaches: Income (Income-based) approach Asset (Asset-based) approach (used for businesses, business ownership interests, and securities) or cost approach (used for intangible assets) Market (Market-based) approach 32. The valuation analyst should use the valuation approaches and methods that are appropriate for the valuation engagement. General guidance on the use of approaches and methods appears in paragraphs 33 41, but detailed guidance on specific valuation approaches and methods and their applicability is outside the scope of this Statement. 33. Income Approach. Two frequently used valuation methods under the income approach include the capitalization of benefits method (for example, earnings or cash flows) and the discounted future benefits method (for example, earnings or cash flows). When applying these methods, the valuation analyst should consider a variety of factors, including but not limited to, the following: a. Capitalization of benefits (for example, earnings or cash flows) method. The valuation analyst should consider the following: Normalization adjustments Nonrecurring revenue and expense items Taxes Capital structure and financing costs Appropriate capital investments Noncash items Qualitative judgments for risks used to compute discount and capitalization rates Expected changes (growth or decline) in future benefits (for example, earnings or cash flows) b. Discounted future benefits method (for example, earnings or cash flows). In addition to the items in item a above, the valuation analyst should consider: Forecast/projection assumptions Forecast/projected earnings or cash flows Terminal value c. For an intangible asset, the valuation analyst should also consider, when relevant: Remaining useful life Current and anticipated future use of the intangible asset Rights attributable to the intangible asset Position of intangible asset in its life cycle Appropriate discount rate for the intangible asset Appropriate capital or contributory asset charge, if any Research and development or marketing expense needed to support the intangible asset in its existing state Allocation of income (for example, incremental income, residual income, or profit split income) to intangible asset Whether any tax amortization benefit would be included in the analysis Discounted multi-year excess earnings Market royalties Relief from royalty Asset Approach and Cost Approach 34. A frequently used method under the asset approach is the adjusted net asset method. When using the adjusted net asset method in valuing a business, business ownership interest, or security, the valuation analyst should consider, as appropriate, the following information related to the premise of value: Identification of the assets and liabilities Value of the assets and liabilities (individually or in the aggregate) Liquidation costs (if applicable) 35. When using methods under the cost approach to value intangible assets, the valuation analyst should consider the type of cost to be used (for example, reproduction cost or replacement cost), and, where applicable, the appropriate forms of depreciation and obsolescence and the remaining useful life of the intangible asset. Market Approach 36. Three frequently used valuation methods under the market approach for valuing a business, business ownership interest, or security are: Guideline public company method *scope Guideline company transactions limitation method Guideline sales of interests in the subject entity, such as business ownership interests or securities Three frequently used market approach valuation methods for intangible assets are: Comparable uncontrolled transactions method (which is based on arm s-length sales or licenses of guideline intangible assets) Comparable profit margin method (which is based on comparison of the profit margin earned by the subject entity that owns or operates the intangible asset to profit margins earned by guideline companies) Relief from royalty method (which is based on the royalty rate, often expressed as a percentage of revenue that the subject entity that owns or operates the intangible asset would be obligated to pay to a hypothetical third-party licensor for the use of that intangible asset) For the methods involving guideline intangible assets (for example, the comparable profit margin method), the valuation analyst should consider the subject intangible asset s remaining useful life relative to the remaining useful life of the guideline intangible assets, if available. 37. In applying the methods listed in paragraph 36 or other methods to determine valuation pricing multiples or metrics, the valuation analyst should consider: Qualitative and quantitative comparisons Arm s-length

23 Improving Efficiency Things that make the process less efficient Multiple entities to be valued Changing valuation dates Poor accounting systems Incomplete or conflicting information Information provided in a disorganized manner Clients who are unavailable or unresponsive to requests for information or clarification

24 Improving Speed, Strength, and Economic Efficiency Things that make the process more efficient Invite us to your initial meeting. We can help the client understand the process and set expectations for the work. Establish and stick to valuation date. Provide all of the documents requested in our questionnaires and the completed questionnaires at the same time. Provide internal historical financial statements in excel format with income statements on one tab and balance sheets on another. Many accounting programs allow financial statements to be exported in this manner. Determine who the valuation professional may work with to obtain additional information and establishing effective communications channels.

25 THE OFFER Saturday morning seminars More about the approaches and methods More about present value calculations More about risk Valuation reports

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