Is it time to dust off the ‘H Model’ for measuring growth?
An e-question during BVR's teleconference on Goodwill Impairment in a Troubled Economy dealt with the interaction of discount rates and cash flow forecasts. “When the first five years [of cash flow projections] are negative,” the attendee asked, “how might this affect your discount rates and debt-equity ratio? Would they then vary from one year to the next? Consider that applying a higher discount rate to negative cash flows results in a lower negative present value amount.”
“There’s a fairly good argument as to why that makes sense,” commented Edward Morris Jr. (Clifton Gunderson, LLP). “For different points in time and considering the company’s projections going forward, there will be different risks in the marketplace. The risk may be higher particularly for the negative years.” There could very well be different cost of capital calculations and ratios done on an annual basis for a period of time until you reach what you consider a stable “go-forward” earnings in cash flow.
“There is also the ‘H Model',” said moderator Jim Alerding (Clifton Gunderson), “which says if you have discrete periods of time where you do have different impacts on your cash flows for either business or economic reasons, that you stage your rates and perhaps your ratios of debt to equity.” Where can you find more information? Why, at Professor Aswath Damodaran’s richly populated website—in particular, “Dividend Discount Models,” Chapter 13 of Damodaran on Valuation: Security Analysis for Investment and Corporate Finance (Wiley, 2d Ed. 2006):
The H model is a two-stage model for growth, but unlike the classical two-stage model, the growth rate in the initial growth phase is not constant but declines linearly over time to reach the stable growth rate in steady stage….The model is based upon the assumption that the earnings growth rate starts at a high initial rate…and declines linearly over the extraordinary growth period…to a stable growth rate….It also assumes that the dividend payout and cost of equity are constant over time and are not affected by the shifting growth rates.
The Professor (NYU Stern School of Business) addresses the limitations of the model as well as its best applications. For more of the chapter’s discussion of the H Model (p. 21) as well the Gordon Growth and Dividend Discount models, click here. Another source: Alerding also noted that an H Model summary is available in the appendix to Financial Valuation Applications and Models, by Jim Hitchner (Wiley, 2d Ed., 2006).
Latest Daubert decision: Don’t ignore critical data
An otherwise “supremely qualified expert cannot waltz into the courtroom and render opinions unless those opinions are based on some recognized scientific method and are reliable and relevant under the test set forth by the Supreme Court in Daubert,” said the federal district court (S.D. Indiana), in the latest decision to consider a financial expert under the by-now familiar standard. The first strike: the expert “cherry-picked” his data, relying solely on information fed to him by the attorney.
“When an expert ignores critical data in forming his opinions, he fails to satisfy Daubert,” the court ruled. In addition, the expert also: 1) failed to independently verify the data; 2) ignored the one-year termination clause in the parties’ contract; 3) excluded reasonable business expenses in his calculation of lost profits; and 4) used an incorrect markup on sales. The final blow: Although the expert spent years valuing public companies, he admitted no experience in valuing closely held businesses. Faced with all these factors, the court could not “conclude with any confidence that he qualifies as an expert.”
For the complete case abstract of MDG International v. Australian Gold, Inc., 2009 WL 1916728 (June 29, 2009), see the September 2009 Business Valuation Update™. The full-text court opinion will be available to subscribers at BVLaw™.
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FASB-IASB financial crisis group issues final report
Continuing our coverage on convergence (or lack thereof) by the international and U.S. financial accounting standards boards—spurred to greater intensity by the current economic climate—last week the FASB-IASB Financial Crisis Advisory Group (FCAG) published its recommendations and final report. “I urge policymakers around the world to study the report and to take note of its conclusions, especially the importance of broadly accepted accounting standards that are the result of a thorough due process,” says FCAG co-chair, Hans Hoogervorst, in a release. “The report highlights the importance but also the limits of financial reporting. Accounting was not a root cause of the financial crisis, but it has an important role to play in its resolution.”
One financial executive’s perspective. “I think there can be a positive benefit in FCAG's reminder that there are inherent limitations on financial reporting, because if people (including, but not limited to, auditors and the plaintiff's bar) were not (subconsciously, if not consciously) in search of the 'one correct number' for, e.g., the fair value of a non-traded or thinly traded instrument… then I think there'd be less pressure and more room for professional judgment (or for those who prefer the term: reasonable judgment), recognizing accounting is more of an art than a science,” comments Edith Orenstein, Director of Accounting Policy Analysis and Communications at Financial Executives International (FEI), in a recent FEI post.
However, I wonder if some of the emphasis on inherent limitations—and more significantly, the emphasis on external limitations on the reliability of financial reporting (such as weakness in clearing mechanisms and market infrastructure, which FCAG encourages the 'appropriate authorities' (presumably government, regulators) and 'business entities' to address—may place too much of the onus or 'blame' on those external parties for fair value information that is not reliable or not relevant, rather than allowing for the idea that perhaps some of the fundamental underpinnings of the fair value model established in FAS 157 should be given further consideration, such as the emphasis on the 'market participants' (aka 'exit value') model, and the prioritization ('level 1' of the 3 level hierarchy) on observable market values, and other wording in the original standard which ring fenced the area in which FASB's further guidance…could operate. (Emphasis added)
The report makes 23 recommendations in four major areas: 1) effective financial reporting; 2) limitations of financial reporting; 3) convergence of accounting standards; and 4) standard-setter’s independence and accountability. The full FCAG report is available at http://go.iasb.org/fcag, or here.
Restaurant valuations give ‘food for thought’
Restaurant valuations have long been the “bread and butter” of many appraisers, offering a smorgasbord of data and opportunities to consider a rich assortment of inputs and assumptions—including whether “rules of thumb” can ever form the basis for a conclusion or are merely “icing on the cake.” Another easy mis-assumption to make: Similar restaurants in the same town run by the same management can serve as good comparables. For instance, in Shalley v. Borough of Sea Bright, 2009 WL 1324024 (May 15 2009), the New Jersey Court of Appeals considered a restaurant owner’s proof of lost profits for a proposed restaurant based on his prior operations. Among other differences, however, the proffered comparables didn’t share the same menu, suppliers, financing schemes, locations, or size, and the court dismissed the evidence as “pure speculation.”
To separate fact from fiction in the food world, join experts Ed Moran, Kevin Yeanoplos, and John Hall (McDonald’s Corp.) in “Valuing Restaurants,” the next in BVR’s Industry Spotlight Series teleconferences, taking place tomorrow, August 6th. For more information, including a special discount on the teleconference and Moran’s Guide to Valuing Restaurants, click here.
PCAOB proposes new engagement quality review standard
The Public Company Accounting Oversight Board (PCAOB) adopted Auditing Standard No. 7, Engagement Quality Review (EQR) last week. “The EQR standard provides a framework for the engagement quality reviewer to evaluate objectively the significant judgments made and related conclusions reached by the engagement team in forming an overall conclusion about the engagement,” says a PCAOB release.
“At the same time, the EQR is not intended to become a second audit,” observed Chair Mark Olson, in a statement to the Board last week. “[Its] approach appropriately focuses the review procedures on the areas of a particular audit that are more likely to have significant engagement deficiencies. The reviewer is required to evaluate the significant judgments made and related conclusions reached by the engagement team and to evaluate the engagement team’s assessment of and responses to significant risk, including fraud risk.” The standard also takes into account smaller firms with limited resources. “In particular, the standard allows firms the flexibility to use a qualified reviewer from outside the firm.” Once the SEC approves, the standard will be effective for both the EQR of audits and interim reviews for fiscal years beginning on or after December 15, 2009.
Another release and invitation to apply. Also last week, the PCAOB issued its Concept Release on Requiring the Engagement Auditor to Sign the Audit Report, and its invitation to apply to an Investor Advisory Group. The Group will “represent a broad spectrum of the investment community and consist of individuals who have a demonstrated history of commitment to investor protection.” Any person or firm may submit nominations to InvestorAdvisoryGroup@pcaobus.org, including the nominee’s name, a short biography, and contact information. The deadline is August 17, 2009, with appointments announced by September 17th and terms beginning in October.
Predicted litigation boom may focus more on audit firms
“Federal class action securities filings began to surge in 2007 with the subprime lending collapse,” begins a new report titled Recent Trends in Securities Class Litigation: A 2009 Mid-year Update, by NERA Economic Consulting. “As the subprime lending meltdown grew into a full-blown credit crisis, the number of filings related to the credit crisis also grew, both in absolute number and as a fraction of all filings. In 2008, driven by this crisis, filings reached a peak of 259 cases, the highest level since 2002. In the first half of 2009, filings have come in at a similar rate, with 127 filed by June 30, on pace for over 250 for the full year.”
Predictably, in the post-Madoff world, 20% of the year-to-date filings contain Ponzi scheme allegations. Given the credit crisis, litigation has also focused on defendants in the finance sector. Nearly two-thirds (67%) of the 2009 filings name at least one financial institution defendant, compared to approximately 25% of the cases filed four years ago. “The percentage of cases naming an accounting firm as a co-defendant also increased in the first half of 2009, rising to 17%, the highest percentage in the past five years,” according to NERA. Historically, settlements in securities cases have been higher when the defendant admitted accounting irregularities.
Three new resources compare FAS 157 to internat'l standard
The International Accounting Standards Board (IASB) just published three new resources that compare its exposure draft on Fair Value Measurement (issued May 2009) to FASB Statement No. 157, Fair Value Measurements, including:
- A marked-up version of the text that shows the wording differences between the exposure draft and FAS 157;
- A table that cross-references paragraphs in FAS 157 to source paragraphs in the IASB exposure draft; and
- An FAQ based on preliminary feedback to the IASB exposure draft.
Comments on the exposure draft are due Sept. 28, 2009, after which the IASB plans to hold round-table discussions (dates and locations to be announced). Ultimately, the IASB expects to publish its fair value measurement standard in 2010.
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