Monthly updates to the equity risk premium from Damodaran
“It has been an interesting year, watching the market recover from the current crisis—a little too fast for my taste,” writes Professor Aswath Damodaran in his latest e-alert, Damodaran Online. “The equity risk premium in the S&P 500, which was 6.43% at the start of the year, is now back down below 5%,” he says. Because the ERP is far more dynamic now than it ever has been, Aswath has monthly updates to website. For example, the equity risk premium at the end of October was 4.97%. Damodaran’s updated background on ERPs is available here.
Other updates: Damodaran also posted several papers to his site on "difficult to value" companies, including: 1) Cyclical and Commodity companies; 2) Distressed companies; and 3) Young and Start-up companies. “You are welcome to take whatever you can out of them,” he writes, with his typical generosity to the greater appraisal and academic community, “and your comments are always welcome.”
Quality of valuations for financial reporting is up—and so is competition, litigation
The quality of valuation reports from specialists has improved dramatically over the last few years, according to a panel of “Big 4” auditors at the ASA Fair Value Summit, held November 13th in the San Francisco offices of KMPG. The days of “rogue/cowboy” valuations are over, says Josh Cashman (Arcstone Partners), who provided a special report on the event to BVWire, highlighting the following points:
- Fair value regulation? The panelists foresee continued self-regulation for the BV industry, driven primarily by the Big 4 firms, without any formal standards in the near future.
- Increased litigation. Expect a wave of fair value litigation in the next two to five years, focusing on 141R—in particular the fair value measurements made today on the basis of contingent consideration (earn-outs, etc.) that play out differently in the future. Although the first round of lawsuits may not target valuation specialists, look for the “losers” to turn around and try to recoup damages from valuation providers.
- International challenges. Without a single, SEC-like agency to regulate business valuation on an international scale, valuation analysts should continue to track the subtle but meaningful ways in which auditors from various countries handle reviews. (A good source? The BVWire routinely reports on international activities—as in our last issue.)
Finally, the auditors’ panel cautioned attendees to prepare for sensitivity analyses. To avoid litigation, companies will demand a range of values and some sort of confidence interval. “In other words—the secret is out, and BV professionals aren’t expected to arrive at a single number; rather, our work should provide a reasonable range of values, supported by a confidence interval,” Cashman says. “Auditors are now asking: What is the tightness of the range, and what is the sensitivity?” While companies cannot express a range of values in their balance sheet, a possible solution could be to include the confidence intervals in the footnotes, to satisfy investor disclosure needs.
Don’t miss FV Summit in New York. If you missed the one-day ASA overview, be sure to sign up for BVR's 3rd Annual Summit on Fair Value for Financial Reporting in New York City on February 1-2, 2010. For the first time, registrants can attend both days in person—or view any or all sessions via live webcast, right from their desktops. To get the complete agenda and a podcast from Chair Neil Beaton describing the Summit, click here.
Hitchner offers hints for using Pratt’s Stats
For the past fifteen years, the users of Pratt’s Stats® and other private databases (such as BIZCOMPS®, etc.) have provided an informal peer review of applying the transactions data in the market approach. At the AICPA’S National BV Conference in San Francisco two weeks ago, Jim Hitchner (Financial Valuation Advisors) added to the peer-acceptance process, first by pointing out that all BV professional standards, including the AICPA’s SSVS-1, require the appraiser to investigate guideline transactions data and make any necessary adjustments to minimize the differences in accounting treatments between the subject company and the comparables.
Hitch then examined nine copyrighted transactions and footnotes from Pratt’s Stats to illustrate typical adjustments and highlight potential red flags to varying deal structures, such as:
- Does the purchase price include working capital (excepting inventory)? This could influence MVIC multiples when averaged with transactions that treat this asset differently.
- Does it include other assets and/or liabilities? Purchase price allocation information available in Pratt’s Stats can help highlight non-standard transactions (those that include more than cash paid, notes, or interest-bearing liabilities).
- Were contingent earn-outs included? Contingent payments are normally excluded from MVIC, requiring adjustments to transactions that include these elements.
- Is the income statement concurrent with closing? Many of the proprietary deal documents collected by Pratt’s Stats analysts include statements generated as part of the offering memo or last period available, and the resulting multiples should adjust for any material changes.
- Does the purchase price allocation apply value to the non-compete, if any? Since CPAs are often lax in this accounting practice for small business transactions, business appraisers may have to use their own judgment to derive this value from comps.
Of course, all these points and more are made in The Comprehensive Guide to the Use and Application of the Transactions Databases by Nancy Fannon and Heidi Walker, who have continually warned about the errors appraisers can make by simply averaging comparables, for the obvious reason that not all sellers and buyers structure deals with similar terms. To view the table of contents and order the new Guide, click here.
Try our new, no-cost Risk-Free Rate Lookup tool
Who knew the risk-free rate would be getting so much attention these days? (See, for example, BVWire #85-4 and the report on Professor Damodaran’s address at the most recent ASA national BV conference.) Likewise, in their session at the AICPA BV conference in San Francisco, presenters Stacy Collins, Jim Harrington, and Don DeGrazia agreed that appraisers should look to the actual, historical rates to calculate a risk-free rate for use in current engagements.
Just in time: Try the new Risk-Free Rate Lookup™ tool, now available at BVR. Using the latest data from the Federal Reserve Board, BVR’s Risk-Free Rate Lookup provides nine risk-free rates commonly used to develop a discount rate. To retrieve the risk-free rates for a specific day, simply enter the “As of” date and then click on Get Rates—it’s that fast, and it’s free.
More free resources: report on the state of healthcare economy
Congress may never come to any consensus on healthcare reform—but at least business appraisers can get current on the state of the economy as it concerns healthcare, by registering for “Healthcare Valuation,” part 3 of 3 in BVR’s Teleconference Series. The series concludes with a special look at hospitals, co-management agreements, and joint ventures. Featuring Don Barbo, Jim Lloyd, and Greg Anderson—all expert contributors to BVR’s Guide to Healthcare Valuation—this final installment will discuss how new regulations and proposed reforms will affect valuations. It all begins at 10:00 am PT/1:00 pm ET. Two CPE credits are available. To learn more or to register, click here. As a bonus, our “Report on the Healthcare Economy,” by Mark Dietrich is available as a free excerpt from the newly updated Healthcare Guide—by clicking here.
Two new studies support higher DLOM
Perhaps nothing in business valuation is more controversial than the discount for lack of marketability (DLOM).This one adjustment can have a sizable impact on clients' tax obligations. So, naturally, one question frequently lingers in attorneys' minds at the end of estate-planning engagements: Did the business appraiser select an appropriate discount?
. . . We offer a way to calculate DLOM using a unique empirical approach that directly compares privately held companies to publicly traded counterparts.
So begins a new article, “The Matched Pairs Approach,” by Pepperdine University professors Maretno Agus Harjoto and John K. Paglia in a recent issue of Trust and Estates (Oct. 2009, copy available to subscribers only). In their study, the authors first considered “matched pairs” of data, linking private firm sale transactions in Pratt’s Stats® with a similar-sized public comparables from the Compustat database for the same year and industry. They also matched each selected Pratt’s Stats transaction with an industry average based on year and three-digit NAICS code. Ultimately, they conclude that “DLOMs for private companies should be dramatically larger than what's currently being claimed.”
In fact, the Matched Firm study resulted in an average discount of nearly 70% in 1999 to a high of almost 81% in 2005, according to Dr. Stanley Pollock, whose analysis of the article appears in the latest Business Valuation Notes (Nov. 2009) from the Minnesota Business Valuation Group. “The studies display discounts which fluctuate with economic changes, but the discounts are consistently larger than obtained using other methods,” Pollack observes. “The research demonstrates that not only is the potential discount larger for private companies when compared to public company than appraisers have been applying, but that the discount research also supports the notion that a DLOM is relevant for controlling interest values.”
Interestingly, the October 2009 Trust and Estates contains a second article, “The Holy Grail of a Valid DLOM,” by Hans P. Schroeder, describing a “real world” regression analysis based on selected data from the FMV Opinions Restricted Stock Study™ that is “simple to use and, in… testing so far, give sensible results. It remains to be seen how the approach will stand up in court,” Schroeder concludes, “but I believe its chances are good.”
New Fair Value Forum tackles DLOM and other challenges
Conceived by a small and committed group of valuation professionals, the newly created Fair Value Forum (FVF) addresses fair value accounting and “its significant role in changing the standards of practice within the business valuation industry.” Based in Silicon Valley, CA but with a membership that spans the country, the Fair Value Forum gathers 10 times a year to:
- Discuss relevant issues;
- Engage the regulatory community (the IRS and SEC);
- Publish white papers; and, ultimately,
- Elevate the practice of business valuation.
“Through its collective efforts and wisdom, the FVF plays a vital role in developing and disseminating best practices among the growing population of valuation practitioners,” say the founders at the FVF website. For instance, a new article by members Annika Reinemann and Joe Orlando takes a closer look at implied Discounts for Lack of Marketability, examining not only two existing approaches, but proposing a third. To view the complete article, click here.
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