“There is no place to hide from country risk,” says Prof. Aswath Damodaran (NYU Stern School of Business) in his latest biannual update that includes free spreadsheets on country risk premiums, sovereign CDS (credit default swap) spreads, corruption scores, political risk scores, and more. In the past, this has been Damodaran’s most popular download.
Big picture: Investors are “delusional” if they think they can avoid dealing with risk in other countries by investing in just U.S. stocks, he says. A company’s exposure to country risk should not be determined by where it is incorporated and traded but rather from where it gets its revenue, he says. In 2015, the companies in the S&P 500 derived approximately 44% of revenues from foreign markets, he points out. When valuing companies with substantial foreign operations, the country-specific input can be critical. A country risk premium must be used, by either adjusting the cash flows or changing the discount rate. What’s more, it’s not just emerging countries you have to worry about.
Damodaran also updated his related paper on SSRN, and he has a YouTube video that summarizes his latest findings and talks about how to incorporate country risk into valuation.
Compromised projections compel Chancery to ‘defer’ to deal price
A recent statutory appraisal decision from the Delaware Court of Chancery offered a familiar valuation contest between the discounted cash flow analysis and the merger price. Shareholders opposed to the going-private merger of PetSmart claimed that their discounted cash flow analysis was the best indicator of fair value. The company advocated in favor of the merger price. The court’s decision zeroed in on the management projections.
The significance of the projections wasn’t lost on the parties, both of which retained projections experts as well as valuation experts. The petitioners’ projections expert said the forecasts met industry standards and reliably predicted the company’s future cash flows. The company’s projections expert dismissed them as being “overly optimistic and wholly unreliable.” The forecasts were the product of a management team that had no experience creating long-term projections and that could not draw on past examples for guidance because the company never created long-term projections in the ordinary course of business, this expert noted.
The petitioners’ valuation expert developed a WACC-based DCF analysis that yielded a fair value of $128.78 per share. The company’s expert allowed that financial analysts (and courts) often consider the DCF analysis the “gold standard.” But for a sound analysis, “one must use the ‘expected’ (as opposed to ‘hoped for’) future cash flows of the business,” he said. Here, the management projections were “entirely unreliable.” He concluded the sales price, $83 per share, represented fair value.
‘Telltale indicators of unreliability’: There was a “vast delta between the valuations generated by the parties’ proffered methodologies,” the court noted. It said it would resist the temptation to conclude neither outcome reflected the company’s fair value or to strike a balance between the two results. The appraisal process was adversarial and required it to consider the facts presented, the court pointed out.
There were two key questions: (1) whether the sales process leading to the merger was “fair, well-functioning and free of structural impediments to achieving fair value for the Company”; and (2) whether there was a reliable foundation for the DCF analysis. As to the sales process, the court found the auction “came close to perfection to produce a reliable indicator of PetSmart’s fair value.” The final price was higher than PetSmart stock had ever traded, the court observed. In terms of the DCF, the court stated that the “first key to a reliable DCF analysis is the availability of reliable projections of future expected cash flows.” Here, the projections underlying the petitioners’ DCF analysis were “saddled with nearly all of [the] telltale indicators of unreliability.”
Using the price the petitioners’ expert determined “would be tantamount to declaring a massive market failure occurred here that caused PetSmart to leave nearly $4.5 billion on the table,” the court said. It declined to go there, instead opting to “defer” to the deal price, “because that is what the evidence presented in this case requires.”
A digest of In re PetSmart, Inc., 2017 Del. Ch. LEXIS 89 (May 26, 2017), and the court’s opinion, will be available soon at BVLaw.
Comments are due August 7 on IRS Notice 2017-28, which targets for reform the controversial proposed Section 2704 regs designed to curb estate valuation discounts for minority interests. In last week’s coverage, we reported that these regs are among eight proposals identified by the Treasury as candidates for modification or withdrawal. The business valuation community banded together with attorneys and estate planners to derail these regs, and their appearance in the new notice is good news. But, in the immortal words of Yogi Berra, “it ain’t over till it’s over,” so submit your comments to Notice 2017-28 by August 7 (how-to instructions are in the notice).
How can two highly qualified credentialed experts come up with such different numbers? That question was on the very first slide of a presentation by a panel of judges at the recent annual conference of the National Association of Certified Valuators and Analysts (NACVA) in Chicago. This question reflects a perception that valuation experts are hired guns. Why else would the two sides be so far apart?
Two reasons: “Assumptions and advocacy,” says Michael Kaplan (Kaplan Forensics), who moderated the session. Of course, different legitimate assumptions about the many variables and inputs in a business valuation can affect the opinion of value. The problem is when experts fall into the trap of becoming an advocate. One of the circumstances that encourages advocacy is the “belief that there is no truth—there is merely perception,” Kaplan notes. Sometimes, the attorney on the case will “reshape truth into advocacy” by selecting an expert who can be “led astray” or by withholding important evidence or providing unreasonable assumptions. Experts need to challenge the evidence and assumptions and must approach the valuation from a purely objective standpoint, Kaplan says.
The panel consisted of Judge Christopher Yates (Circuit Court; Kent County, Mich.) and Judge Steven I. Platt (retired full-time Circuit Court judge in Maryland). The session was titled, “Experts Sabotaging Themselves in Court—The Judges Tell All.” But Judge Platt noted that they would not exactly be telling all, otherwise they’d have to assert their Fifth Amendment rights, he quipped.
Deferred revenue gets a haircut under ASC 805, but how much?
In accounting terms, deferred revenue is simply the cash received in advance of recognizing revenue because the seller still needs to fulfill on the deal, such as deliver the goods or perform some service. It’s a liability—common examples are prepaid subscriptions, license agreements, gift cards, and the like. Under ASC 805, acquired liabilities are measured at fair value in a business combination. Typically, the fair value of deferred revenue is less than its book (accounting) value—but how much less? Is there a common range of percentage reductions? That was one of the questions asked of the speaker during a recent BVR webinar on valuing deferred revenue.
Do your homework: “The haircuts are all over the board,” says Ray Rath (Globalview Advisors), and the reduction depends on the facts and circumstances in each case, so he urges valuation analysts to examine what makes up deferred revenue, in terms of types of revenue, terms, clients and other factors. Rath did mention that a firm that had deferred revenue on gift cards reduced book value by 50%, because many people don’t cash them in. Of course, there are items of deferred revenue that are much more complex, such as customer contracts with multiple elements and performance obligations.
In the supplemental reading material for the webinar, an article on the IT industry states that reductions between 40% and 70% are not uncommon. In some acquisitions, Oracle had reported the fair value of deferred revenue at a 60% reduction to book value. The article is “Deferred Revenue in the IT Industry,” from the August 2012 issue of Business Valuation Update.
During the webinar, Valuing Deferred Revenue, Rath also discussed the new revenue recognition rules, the methods of valuing deferred revenue (he prefers the bottom-up approach), and the published guidance on the topic.
Fairness opinion provider rankings for first half 2017
Thomson Reuters’s Mergers & Acquisitions Review – First Half 2017 contains rankings for worldwide providers of fairness opinions. Here are the top five providers (based on the number of transactions) of announced fairness opinions rendered in the United States:
1. Duff & Phelps
2. Prairie Capital Advisors Inc.
3. Evercore Partners
4. (tie) Sandler O'Neill Partners
4. (tie) Bank of America Merrill Lynch
Worldwide, the top five providers of announced fairness opinions are:
1. Gram Capital
2. Duff & Phelps
3. China Merchants Securities Co.
5. China Securities Co Ltd
Expert says new book pulls back curtain on BV for court
The Business Valuation Bench Book, a new volume by William J. Morrison (WithumSmith+Brown) and Jay E. Fishman (Financial Research Associates), is designed to give judges and attorneys a reference guide of fundamental business valuation concepts. “The authors do an excellent job of ‘pulling back the curtain’ on business valuations, showing judges where they need to spend time querying experts on their appraisals,” says Steve Bravo, a business appraiser and financial expert with Apogee Business Valuations. “This book will prove to be extremely handy and helpful to judges trying to sort out opposing experts’ conclusions of value. It can be equally beneficial to attorneys and experts in their case preparation.”
The book says you can expect some tough questions such as these: Do you have a thorough understanding of the subject business, and have you considered the eight factors of Revenue Ruling 59-60? Why do you believe your determination of the normalized income to capitalize best represents the expected future performance of the company? Under your DCF method, can revenues realistically grow at the projected rates, and do the expenses support the revenues?
In connection with the post-implementation review of IFRS 3, the European Financial Reporting Advisory Group (EFRAG) has been conducting research into a number of potential amendments to the goodwill impairment test with a view to enhancing its application and effectiveness and reducing complexity. EFRAG has issued a discussion paper, “Goodwill Impairment Test: Can It Be Improved?”.
The scope of the publication is limited to impairment testing, and it does not seek to address broader topics such as identification and measurement of acquired intangible assets in a business combination. Nor does it address the extent to which these assets should be separated from or subsumed into goodwill. Ideas presented in the paper focus on how to allocate goodwill to cash-generating units (CGUs), when to determine the recoverable amount, and how to determine the recoverable amount.
EFRAG asks for comments on the advantages and disadvantages of the potential amendments presented in this context. The deadline for comments is December 31.
Comments published re: OECD draft on hard-to-value intangibles
The Organization for Economic Co-operation and Development (OECD) discussion draft BEPS Action 8 Implementation Guidance on Hard-to-Value Intangibles (HTVI) “provides guidance on the approach to pricing transfers of hard-to-value intangibles described in Chapter VI of the Transfer Pricing Guidelines.” The OECD has published the comments it received from the Big Four, Duff & Phelps, BDO, RSM, ktMINE, and others. A number of commenters suggest providing more comprehensive examples and not confining the examples to the pharmaceutical industry, as the draft does. The comment letter from ktMINE, which maintains a royalty rate database, focused on the availability of timely data and its ability to limit “information asymmetry” between taxpayers and tax administrations.
People: KPMG announced the hires of Mark Martin and Mark Horowitz as principals and Tracy Gomes as managing director, all in the firm’s Economic & Valuation Services Tax Practice. Martin will also serve as national leader in Transfer Pricing Dispute Resolution ... Matthew Nadeau has been promoted to manager at Concord, N.H., firm Nathan Wechsler & Co ... Weaver announced the promotion of Aracely Rios to partner in its Dallas office ... Ben Sheppard is now a principal at Green Hasson Janks in Los Angeles and will lead the expert witness and litigation support line.
Firms: Brown Schultz Sheridan Fritz received a 2017 “When Work Works” award, highlighting the Camp Hill, Pa.-based firm’s workplace flexibility ... Haskell & White was named one of the “Best Places to Work in Orange County” for the sixth year in a row by the Orange County Business Journal ... Chicago-based Mueller was admitted as a member firm of PKF International ... Rosen Sapperstein & Friedlander announced the relocation of its headquarters from Owings Mills, Md., to Towson, Md., opening at the new site in December
Fairness opinions continue to play a prominent role in M&A transactions, and these knowledgeable preparers explain their opinion process. Plus, get a look at BVR’s new Fairness Opinion Research Service in a bonus segment.
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