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BUSINESS VALUATION

INTERNATIONAL VALUATION STANDARDS COMMITTEE

INTRODUCTION A. What is being appraised? B. Definitions of Value. – "Fair Market Value" usually the standard of value in the United St at esofAmer i c a.I ti swel ldef i ned.“ Mar ket Val ue” ,asdef i nedi nr ealpr oper t yandbyI VSC,i st hesameasFair Market Value in business appraisal. • Fair market value is considered to represent a value at which a willing buyer and a willing seller, both being informed of the relevant facts about the business, could reasonably conduct a transaction, neither person acting under the compulsion to do so. • Although not stated in the definition, it assumes: 1) a cash value; 2) both parties can perform (buyer has financing and seller has clear title and can deliver); 3) a reasonable time for exposure in the market; and 4) normal s will be signed. • Unusual factors must be explained if not valued.

C. Who Performs Business Valuations – – – – –

Chartered Financial Analyst (CFA) of the Institute of Chartered Financial Analysts Accredited Senior Appraiser (ASA) of American Society of Appraisers in Business Valuation Certified Business Appraiser (CBA) of the Institute of Business Appraisers Accredited in Business Valuation (ABV) of the American Institute of Certified Public ants. Chartered Business Valuator (CBV) of the Canadian Institute of Chartered Business Valuators.

BUSINESS APPRAISAL STANDARDS A. International Valuation Standards –2003, Guidance Note 6. B. Uniform Standards of Professional Appraisal Practice (USPAP) Standards 9 and 10 as well as the Preamble – Standard 9: In developing a business appraisal, an appraiser must be aware of, understand and correctly employ those recognized methods and techniques that are necessary to produce a credible appraisal. – Standard 10: In reporting the results of a business appraisal, an appraiser must communicate each analysis, opinion and conclusion in a manner that is not misleading.

C. American Society of Appraisers Business Valuation Standards D. Institute of Business Appraisers Business Valuation Standards

BUSINESS VALUATION THEORY A.The value of a business arises from: –Assets, either Tangible or Intangible; and –Cash Flow (different definitions of income)

B.The Phases of Business Value –Orderly Liquidation is often the least value if the owner has ability to sell the assets –As cash flow increases, the value of the business increases from the liquidating value of tangible assets to the going concern value of tangible assets –As cash flow increases further, the value of the business increases to include the value of specific, identifiable and non-identifiable intangible assets

VALUE=ƒ(INCOME,ASSETS) Re lations hip of Value , Income and As s e ts Inc o me Le ve l Va lue

10 9 8

V a l u e

Co mp a ny Va lue

7

Go o dwill

6 5

Va lue in Us e

4 3 2

Liquida tio n Va lue

1 0 0

1

2

3

4

5

Income

6

7

8

9

The Three Basic Approaches to Value 1. Cost – Is a balance sheet focused approach (also called Adjusted Balance Sheet) – Based on the premise that a prudent buyer will pay no more for a property than it would cost to replace with a substitute property with the same utility -- the principal of substitution – Concept: Value all the assets of a company, subtract the liabilities, to arrive at the value of FMV stockholders' equity – Value of each asset may be derived by using any of the three approaches for valuing those individual assets – Assets and company may be valued as a going concern or in a liquidation scenario

COST APPROACH FAIR MARKET VALUE BALANCE SHEET CURRENT ASSETS

CURRENT LIABILITIES

WORKING CAPITAL LONG TERM DEBT

FIXED ASSETS EQUITY GOODWILL

ASSETS

LIABILITIES + EQUITY

The Three Basic Approaches to Value - Continued 2. Market a) Again, principle of substitution. b) Comparison between subject property and similar properties which have recently sold. Normally either publicly traded shares of similar companies or acquisitions of similar companies. c) May be either balance sheet or income statement focused d) Value the equity or invested capital of a company through comparison with the pricing of investment in companies (often as traded in the stock market) e) Generally, is a going concern assumption, not liquidation

The Three Basic Approaches to Value - Continued 3. Income –Based on theory that the value of any asset is the present value of expected future benefits to be derived by the ownership of that asset –Income statement focused –Value the equity or invested capital of a company by deriving the present value of the expected flow of future economic benefits –Generally, is a going concern assumption, not liquidation –Generally, may take two forms •Discounted cash flow •Capitalization of cash flow

Basic Variables Affecting Value 1. Economic conditions 2. Industry Conditions 3. Business Background and Conditions •Earnings history of the firm •Future earning capacity •Balance sheet •Qualitative factors

4. Risk Assessment •Risk free rates of return •General equity risk •Industry specific risk •Company specific risk

Revenue Ruling 59-60 a) The nature of the business and history of the enterprise b) The economic outlook in general and condition and outlook of the specific industry in particular c) The book value of the stock and the financial condition of the business d) The earnings capacity of the company e) The dividend-paying capacity f) Whether or not the enterprise has goodwill or other intangible value g) Sales of stock and the size of the block to be valued h) The market prices of stocks of corporations engaged in the same or similar lines of business whose stocks are actively traded in a free and open market, either on an exchange or over-the-counter

FINANCIAL STATEMENT ANALYSIS What is the goal of financial analysis? –Identify unusual items –Identify what happened and why it happened –Identify trends and what caused them –Identify how the company departs from the industry norm and why –Comparison with comparable companies to assist in selection of appropriate valuation multiples

Adjusted Book Value 1.

Purpose - To replace cost of assets and liabilities with current economic value

2.

Typical balance sheet adjustments – – – – – – – – – – – –

Non-operating assets and liabilities such as excess cash and securities, excess investment property and related obligations Uncollectible receivables LIFO or current replacement cost inventory adjustments Marketable securities Unmarketable securities Accelerated depreciation Real property per appraisal Machinery & equipment per appraisal Intangible assets like goodwill, non-compete agreement Advantageous on debt Contingencies such as lawsuit or pension obligations Deferred taxes

Liquidation Value 1. Orderly or forced liquidation 2. Consult management, auctioneer, P&M appraiser, and/or real estate appraiser concerning appropriate liquidating discounts 3. Consider liquidation costs –Auctioneer's fees and commissions –Continued fixed cost and istrative costs during liquidation period –Legal, ing and other professional fees –Taxes payable by the corporation

Market Based Asset Approaches 1. Price/book value - where do similar companies stocks sell relative to book value 2. Price/adjusted book value – Conceptually the best asset approach – Most applicable when assets consist primarily of: •Inventory - LIFO adjustments to market data •Real Property - Publicly traded Real Estate Investment Trusts (REITs) for market data •Securities - Publicly traded investment companies

– Advantages - Uses adjusted company data and market data – Disadvantages - Difficult or impossible to get adjusted asset data for similar companies. Cannot make valid comparisons.

ADJUSTMENTS TO INCOME GOAL: REACH NORMALIZED OPERATING INCOME A. Non-operating Items - Remove effect on income statement of non-operating assets. Examples include: – Excess real property - adjust for rental income, property taxes, depreciation, debt service – Excess cash and securities - adjust for interest income, gain (loss) on securities

B. Varying ing Treatments – LIFO/FIFO inventory – Depreciation (tax lives vs. economic lives) – Capital versus operating lease – Pension ing

Non-recurring Items 1. Gain (loss) on sale of assets 2. Bad debts 3. Professional fees 4. Unusual production costs - labor or materials 5. Start-up costs 6. Discontinued operations 7. Unusual revenues - price or volume

CAPITALIZATION OF INCOME Var i at i onsof" I ncome“ – Net income after income tax – Income before income tax (EBT) – Operating income or earnings before interest and taxes (EBIT) – Earnings before interest, taxes, depreciation and amortization (EBITDA) – Cash flow = Net income plus non-cash charges such as depreciation and amortization – Invested Capital methods – Which measure is most appropriate will depend on the specific situation

Capitalization Rate • A rate to translate income (or expected income) into value • Definition: Capitalization rate = required rate of return (discount rate) minus expected long term growth • Capitalization Rate = Required Rate of Return - Growth (For All Non-Zero Growth Rates) • Capitalization Rate = Required Rate of Return Only If Growth Rate is Zero • Value = Expected Income/Capitalization Rate • Value = Expected Income . Required Rate of Return less Growth Rate

MARKET DATA APPROACHES A.

Conceptual Basis - Principle of substitution

B.

Get "market" multiples for similar companies that have recently sold or whose shares are actively traded. Multiple based on : – – – – – –

C. D.

Current earnings and/or cash flow Historical average earnings and/or cash flow Projected future earnings and/or cash flow Revenues - key on comparative profit margins Volume (revenue) Equity or adjusted equity - key on comparative return on equity

Make qualitative and quantitative comparisons between subject company and market data. Assess comparative growth and risk characteristics. Should pricing multiples for subject company be above, below or similar to the market norms?

MARKET DATA APPROACHES E. Sources of Market Data – Similar publicly traded companies – Similar acquired companies – Industry rules of thumb – Make sure the comparisons are accurate, i.e., make the same adjustments to the market data that were made to the subject company

F. Summary – Do proper company analysis and adjustments – Adjust data of comparables, if appropriate – Determine appropriate norms for market multiples – Determine how the company's multiples should differ from the market norms

OTHER CONSIDERATIONS •Buy/Sell Agreements •History of Past Transactions or Offers to Buy •Discounts for Minority Interest (or Lack of Control) and Lack of Marketability • for Control •Special Attributes of Control •Control or Minority Assignment can largely dictate appraisal methodology •Special rights or privileges, i.e., put options, preferred stock conversion or redemption features

VALUATION CONCLUSION • Briefly review all source documents to see if any important factors were missed • Re-read the appraisal assignment • Summarize and compare the conclusions of the various approaches • Recheck methods that give extreme values • Determine the relevance of the various approaches or the particular assignment • Arrive at a single point estimate, by either quantitative or qualitative techniques. Better to round than to imply a false sense of precision • Check the final conclusion against adjusted income or adjusted equity. Does the answer make sense?