March 28, 2012 | Issue #114-4  

Historical ERP: Busting open one of the
biggest BV ‘myths’

In response to last week’s item on the equity risk premium (ERP)—in particular, the recent articles in the EconomistEric Nath (Eric Nath & Associates) alerted us to his article: “The Biggest Valuation Myth,” just-published in the Business Valuation Review (Fall 2011). From the summary abstract:

The traditional Capital Asset Pricing Model and Build-Up Method have failed to reliably quantify the required rates of return for equity holders. This paper discusses how profoundly business appraisers, the courts, investors, auditors and the general public have been misled into thinking that these methods are valid, and suggests a way forward using an on-line survey method (the Pepperdine University Survey).

“One of the biggest business valuation mistakes is confusing historical equity returns with expected or required equity returns,” Nath writes. “More to the point, however, is that while it might be reasonable to assert that past market behavior could influence investors’ expectations, this tells us nothing about how much influence it has, nor does it lead anywhere close to the conclusion that the past is a determinant of investor expectations.” Instead, he suggests several “better ways” of getting to an estimated return on equity; to read the complete article, visit Nath’s web site. (Where, by the way, he’s also posted his myth-busting paper on control premiums.)

Damodaran updates his ERP. “One of my obsessions is the equity risk premium,” Aswath Damodaran (NYU Stern School of Business) admits in this week’s blog. “To me, it is the ‘number’ that drives everything we do.” Two events prompted his new post: the Economist articles as well as the 5th annual update of his paper on ERP. Importantly—and implicitly agreeing with Nath—the Professor states, with emphasis:

If I had to use a historical risk premium, I would go with the 4.10%, since it is long term, a compounded average, and over a long-term risk-free rate. However, I am much more uncomfortable with the assumption of mean reversion in the U.S. market than I used to be since, in my view, the structural shifts that have come out of globalization have changed the rules of the game. As a consequence, I no longer use historical premiums in either valuation or corporate finance.Given the dynamic and shifting price of risk that characterizes markets today, I think it makes sense to compute and use an updated implied equity risk premium in valuation and corporate finance.

Read the complete blog post here; the Professor’s updated paper on ERP is available here.

Growing your BV practice means ‘putting yourself out there’

The good news: Less than a quarter (23.1%) of respondents to our latest online poll saw their BV firms lay off employees during the economic downturn, although one participant admitted, “We cut staff by nearly 50% and required the remaining staff to be more efficient and productive.” Still another said it wasn’t the economy that prompted staff cuts: “They could not do the work.”

The current talent shortage combined with an uncertain economy may have tempered most practitioners’ expansion plans. Roughly half of survey participants (53.3%) plan to hire new employees in 2012, but, “We are replacing only terminated employees,” comments one. Says another, “We do not plan on hiring new employees until we see some stabilization of pricing in the market.” Another is looking for “professionals who want to work.”

During the downturn, more participants focused externally, on business development, than internally, on improving processes (although about a third split their time equally between the two). “You have to treat marketing like a client,” says one respondent. “Keep paying attention to it during the good times and the bad.” In making renewed marketing efforts, nearly 70% of respondents said they were encouraging practitioners to publish, speak, and/or participate in professional events. ”Putting yourself in front of a target audience is the best marketing that one can do,” says one. “No one has time to read the newsletters and firm brochures, and [people] are too busy for lunches.”

As for solid and emerging growth areas, survey participants checked off forensic accounting, consulting services (M&A and succession planning), shareholder disputes, matrimonial, and healthcare. Fair value for financial reporting—in particular, 409(a) work—shows little or no opportunity for growth, they say. Surprisingly, a third of respondents (63.7%) believe that both tax (estate and gift) and bankruptcy work are on the wane. At least one noted that “other related fields, such as personal injury and wrongful death damages calculations, and lost profits calculations,” could be on the rise. “We are seeing more traditional CPAs deciding to offer [BV] because their traditional practices of tax and audits have not grown,” observes one, but “they forget about the ‘damages’ of having a valuation, forensic, and litigation services department in their CPA firms.”

Must-have resource for litigation practices

Thinking about expanding your litigation services—or just maintaining them on the current, cutting edge? Consider BVR’s Online Symposium on Litigation & Economic Damages, which continues on April 3 with part 9: Raw Deal: Purchase Price Disputes. Join experts Jeff Litvak and Kenneth Mathieu (both FTI Consulting) as they examine the unique issues associated with these disputes, including the appropriate measurement of damages, the date of the measurement, and the all-important inputs to the pricing. Register for the webinar or consider several series and “bundled” options, including a subscription to the entire Symposium plus print or online copies of the Comprehensive Guide to Lost Profits Damages for Experts and Attorneys (2011 ed.), edited by Nancy Fannon (Fannon Valuation Group).

Before hiring, know what the BV market pays

“Part of defining your compensation philosophy is knowing with whom you compete for talent and how competitive you want to be,” writes Ellen Warden (WorkPlace Synergy) in “Are We in the BV Ballpark?”, a leading article in the current BorrowmanBaker BV newsletter. The two key questions to solidify your hiring and retention practices: Where do you get your BV talent from, and—perhaps even more critically—to whom are you losing (or could you lose) that talent?

“Regular market pricing reviews will help you keep a finger on the pulse of pay rates and spot trends in the market,” Warden advises. “This means you can confidently create and maintain competitive pay plans that help attract and retain key talent and manage the bottom line.”

How do you get access to current pricing data in the BV market? Since business valuation is still a relatively “young” profession, market-specific compensation sources still lag behind those in more “mature” industries. So perhaps the best way to develop BV benchmarks is to help create them, by participating in the 2012 BorrowmanBaker/BVR BV Salary Survey. Don’t wait: the data you input today will become your best resource for hiring and retaining BV talent in the coming year.

Why Facebook might need BVR’s new IP valuation guide

“Facebook did not file its first patent until two years after its inception,” observes Mike Pellegrino (Pellegrino & Associates). “In this age, you can't be an eight-year-old tech company without a strong IP portfolio,” and, of course, the strength of an IP portfolio depends on solid valuation metrics and methodologies.

Consider Facebook’s recent purchase of 750 patents from IBM, “in part to likely counter Yahoo's patent infringement lawsuit against Facebook,” Pellegrino says. “We've seen this story before. For instance, Overture (a search engine later owned by Yahoo) sued Google before Google's eventual IPO in 2004 and received 2.7 million shares of Google in a settlement, which Yahoo sold thereafter. Somewhere in the bowels of Facebook,” Pellegrino says, “you hope someone is paying attention to IP valuation issues.”

Strengthen and solidify your IP valuation expertise: We’ve just released the second edition of BVR’s Guide to Intellectual Property Valuation, the definitive reference used to draw credible and defensible IP value conclusions. Written by Pellegrino, the updated guide provides “real-world” examples of IP valuation and discusses each of the primary IP categories (patents, trademarks, copyrights, and trade secrets) plus discount rate development, royalty rates, and much more. The guide is available in print as well as in an online version, which features bonus content (live news feeds and "real time" updates), IP case law, and training materials. eBook and Kindle-friendly formats are coming soon.

Possibly the best answer when opposing counsel tries to pinpoint your FMV range

The case concerned a contract to develop natural gas reserves in Bulgaria. The reserves were still in the ground when the defendant breached the contract, so their value could range from as low as $32 million to well over $100 million for a 100% interest, according to the plaintiff’s valuation expert. Or, based on a “due diligence” report, prepared by the defendant’s own industry expert, the value of the gas in the ground could be worth as much as $31.5 billion; even a 1% interest could return about $315 million.

When asked to derive “the most likely figure” for the plaintiff’s 38% interest in the project, the valuation expert gave an adept answer. Rather than specify a number, he indicated that the jury could consider “all of the evidence” and come to its own conclusion of FMV. Indeed, the jury returned a verdict of $66.5 million—or more than twice the value of the expert’s “cash flow” model, and far more than the $8.5 million that the defendant had agreed to pay for a 10% interest. The trial court reduced the award to $31 million, but on review, the appellate court reinstated the entire amount, finding it supported by sufficient evidence. In particular, the court commended the plaintiff’s valuation expert for “appropriately deferring to the jury, in its role as fact finder, to make its own assessment of fair market value.” Read the complete digest of Carlton Energy Group, LLC v. Phillips, 2012 Tex. App. LEXIS 1299 (Feb. 14, 2012) in the upcoming Business Valuation Update; the court’s opinion will be posted soon at BVLaw.

Over 20 reasons your ESOP clients may need a fairness opinion

A new article by Mercer Capital in Valuation Matters provides a comprehensive FAQ on fairness opinions in ESOP transactions. Among the most important is a list of over 20 ESOP transactions that might trigger the need for a fairness opinion—a good reminder for ESOP specialists and their clients. “Despite the breadth of the listed circumstances, there are many other situations which likely accompany ESOP transactions and transactions of ESOP owned companies,” the article advises. Any ESOP-related financial transaction “should be thoroughly reviewed from the financial perspective of the ESOP. The transaction process, evolution, negotiations, and other factors that comprise the event (and any circumstances) should be systematically analyzed and documented within the fairness opinion.”

Just one week left to apply for TAF boards

The Appraisal Foundation (TAF) is still taking applications from qualified candidates to fill four seats on its board of trustees and three vacancies on the Appraisal Practices Board (APB). In particular, TAF is encouraging BV specialists to apply. Completed applications must be received by April 2, 2012, however (in part so that the search to fill vacancies on other TAF boards can begin after that time). Download application packages for the at-large trustee vacancies here. Applications for APB vacancies are available here.

‘Ask Damodaran Day’

The historical vs. implied equity risk premium is sure to be one of the hot topics covered by Aswath Damodaran on Friday, April 20, when the Valuation Roundtable (VRT) of San Francisco hosts its 26th annual meeting at the Claremont Resort & Spa in Berkeley, Calif. The Professor’s “Total Beta” concept might well be on the table, along with other difficult aspects of the valuation process and a discussion of the most difficult types of companies to value. The VRT has just posted the day-long conference agenda here; for more information, contact Claudia Martin at 408-961-6320 or

PCAOB updates its 2012 standard-setting agenda

This week the Public Company Accounting Oversight Board posted its newly updated Standard-Setting Agenda, which outlines milestones on various standard-setting projects. Of particular note, the PCAOB plans to issue a proposal on auditing “Specialists” for public comment in the third quarter of this year, with a final proposal (or a re-proposal) due by the second half of 2013. In its agenda overview, the PCAOB notes that the specialists project arose from “issues identified during the inspection of accounting firms, lessons learned from the economic crisis, and comments received from members of SAG,” the PCAOB’s Standing Advisory Group. For more on SAG’s project on using the work of a specialist in auditing fair value measurements, see the original 2009 announcement.

Quist Valuation partners with InSite

Quist Valuation (Boulder, Colo.) and Shareholder InSite, the developer of a shareholder software services and management tools (Nashville, Tenn.), announced their strategic partnership this week. The new partners will offer “complementary services and tools to help venture capital [and] private equity investors and their portfolio companies meet new compliance requirements and improve valuation reporting,” according to a joint release.


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Copyright © 2012 by Business Valuation Resources, LLC
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