SPECIAL ASA/AICPA CONFERENCE ISSUE
Dante meets DCF in Damodaran’s “ten circles of hell”
“I want to take you through the ten layers of hell,” Professor Aswath Damodaran of NYU Leonard N. Stern School of Business told a rapt general session on day two of the AICPA/ASA joint BV conference in Las Vegas.
Always an intelligent, insightful—and entertaining—speaker, Damodaran’s session on “Valuation Inferno: Dante Meets DCF” once again challenged valuation analysts to question their most common and deeply-held assumptions. “Let’s be honest, when you sit down [to do a valuation] you have a number in mind, and you spend the entire process trying to back into this number by playing with the growth rate,” he told attendees, citing just one element of the discounted cash flow (DCF) method that can earn some valuators a spot in their own special hell. “The terminal value is not an ATM,” he explains. “You cannot keep going and withdrawing cash any time you like.” In a similar vein, Damodaran questioned the ten elements and assumptions of the DCF that—while they may be hellish, can cause analysts some true heartburn:
- Current year numbers: “It’s amazing how wedded we are to that one-year, baseline number.”
- Cash flows. “You can’t stop forecasting cash flows until you’re willing to make an extraordinary assumption: that your cash flows are going to grow at a constant rate into perpetuity,” Damodaron told attendees. “It’s the tail that wags every valuation dog.”
- Taxes: Damodaron explains: “We double count some, add some, ignore some.”
- Growth. “We want all our businesses to grow, but ask the wrong people—the owners and managers—and you’ll get ‘30% growth rate for as far as the eye can see.” Don’t ever let the growth rate exceed the risk-free rate, he explains.
- Discount rate. “I think we spend far too much time talking about cost of equity, cost of capital, cost of debt—and not enough on cash flows.” Damodaran says. Analysts “outsource” so many of the elements of the calculation (to Ibbotson’s data, Bloomberg data, Duff & Phelps, etc.), “that it’s frightening.”
- Growth rate revisited. To grow a business, owners have to put money back into the business, and that’s a cost of growth analysts may overlook. Instead, the focus should be on the quality of the business’ growth.
- Debt ratio revisited. “We spend a lot of time trying to get the discount rate right,” Damodaran says. “But given your own assumptions about the company, you should expect the discount rage to change [over time].” Instead, “the discussion should be about the discount rates.”
- Garnishing valuations. The noted Professor confides that the only time he received hate mail was in response to a presentation, “Stop the Garnishing,” which challenged “add-ons” such as control premium, minority discounts. “The practice of garnishing defeats the entire point of the valuation,” he maintains. “It puts you back to…trying to get the number that you want and puts all of our biases into play.”
- Per-share value. An issue primarily for public company valuations, which questions the “easy” practice of determining per-share value by dividing the company’s market value by the number of shares—but often overlooks stock options, liquid/illiquid shares, etc.
- I-bankers inferno. The “darkest, deepest” layer of hell is reserved for those investment bankers who have forgotten the “purpose of a valuation,” and in pricing an M&A deal, will often pick the wrong company (the target company instead of the acquirer) and the wrong discount rate (cost of debt instead of cost of equity) to arrive at the number (fees) they want.
Professor Damodaran routinely posts his presentations at his website; a must-see for all BV experts. This one—with its extensive illustrations of the DCF inferno into which some analysts can fall, promises to be one of the more provocative.
NICE gives you a lifeboat—and a compass
Will Frazier, ASA of Howard Frazier Barker Elliot, Inc. spoke about the Non-marketable Investment Company Evaluation Method (NICE) at the ASA/AICPA National Business Valuation Conference in Las Vegas this week. NICE is used when determining the fair market value of equity interests in closely held investment entities like Family Limited Partnerships (FLPs), that hold a portfolio of assets in long term investments. “All the action in the Tax Court is with Discount for Lack of Marketability (DLOM). NICE bypasses the DLOM “action” by focusing on the rates of return of the various assets held,” Frazier told a packed house in Las Vegas.
NICE is based on Modern Portfolio Theory where there are observable sources of information, risks and rewards are investigated, assets are allocated and the expected holding periods are considered. NICE “doesn’t drop you in the ocean and hope you can swim—it gives you a lifeboat and a compass.” NICE is a tool that helps the appraiser find the value at which the rate of return satisfies the objectives of both the seller and buyer – thereby determining fair market value. Frazier’s goal is to have NICE available as a commercially available web-based tool by the end of next spring, at the latest. The BVWire™ will keep readers in the know about its availability.
More on Non-marketable Investment Company Evaluation (NICE)
The new 2009 Edition of BVR's Guide to Business Valuation Issues in Estate and Gift Tax includes new court case abstracts from the past year, including in-depth analysis on the Astleford, Bigelow, Holman, and Jelke decisions. Several new articles exclusive to the Guide have also been added, including Will Frazier’s Non-Marketable Investment Company Evaluation (NICE) method and Owen Fiore’s overview of the impact of the before mentioned court decisions, as well as a list of success factors for creating FLPs/LLCs, which were discussed in the #72-1 BVWire™.
Other new additions include full-text court decisions, teleconference transcripts, and presentations, which have all been added to the accompanying compact disc. For more information on BVR's Guide to Business Valuation Issues in Estate and Gift Tax or to order, click here.
Assessing the impact of SSVS No. 1
Robert Reilly, ASA, CPA/ABV, CM&A of Willamette Management Associates moderated a panel that included several BV heavy hitters in Las Vegas this week. Those of you who missed this ASA/AICPA presentation (the event drew some 1400 attendees) missed an informative and spirited discussion about the impact of SSVS No. 1 and what BV practitioners are seeing in various regions across the U.S.
One of those discussions pertained to calculations versus opinions and how courts in different parts of the U.S. are interpreting them – some determine a calculation to be an opinion and some throw a calculation out as an opinion.
One of the others offered insights about when an appraiser is required to adhere to the new standards, and when they’re not. Consider: If appraiser A is looking at an opposing expert’s report and determines that report contains an error – if appraiser a makes a correction to that report, do they have to follow SSVS No. 1? The answer? No, because the correction was not appraiser A’s opinion, but rather the correction of an error and the recalculated value based on that correction. But if appraiser A is asked their opinion about the opposing expert’s report, then the appraiser is expressing their opinion and the appraiser must follow SSVS No. 1.
Is this semantics? It may be, but the panel of experts believed there was a bright yellow line distinguishing these two situations. In the first situation, appraiser A is fixing the multiple or fixing a formula or data point, but they didn’t pick the guideline companies, the methodology, or anything else—so they’re not expressing their opinion. If their opinion is requested in court, one expert suggested a response something like “Give me a couple of weeks and more money and I can give you my opinion.” The bright yellow line is differentiated by “I’m correcting the opposing expert’s mistakes” versus “I’m using my own judgment, approaches and procedures.”
Look for more on the AICPA’s SSVS No. 1 and how it compares to the standards from other professional organizations and USPAP in an article penned by David Anderson, ASA of Amper Politziner & Mattia and Donald Wisehart, ASA, CPA/ABV, CVA, of Wisehart Inc., a North Kingstown, Rhode Island-based CPA firm, in the upcoming December issue of the Business Valuation Update™ newsletter. It will include a comprehensive comparison comparative table of all standards.
Has the current financial meltdown affected early stage valuations?
At the ASA/AICPA session on Early Stage Company Valuations, Neil Beaton, CPA/ABV, CFA, ASA with Grant Thornton explains “The financial meltdown could have a dramatic impact on early stage company valuation and liquidity.” Even given an early stage company’s relative insulation from the economy, the current economic situation will most likely impact them at some point. “If your company went out for a round of financing a year ago as opposed to now, you’d likely get a different result.” In the session, Beaton and professor Atulya Sarin with the Department of Finance Leavey School of Business Santa Clara University point out that, under the current market conditions, mergers and acquisitions will decrease, prices will decrease, acquiring entities will favor profitable companies, and IPOs will continue to decrease and take longer. These factors will result in overall lower valuations.
So is the sky falling? “Maybe,” Beaton contends, adding that, “It depends on your company. If your company is well funded, you’re probably going to be okay. If you’re looking for funding, you’re facing a tough situation.” How do you incorporate these influences in valuing early stage companies? Beaton and Sarin suggest increasing funding risk, increasing liquidity risk, increasing operational risk, and a longer runway to product development. Beaton adds that, “it’s important to remember that, although the short term economic picture is challenging, market ups and downs are cyclical and conditions will improve." For more information on valuing early stage companies, watch for Beaton’s upcoming guide from BVR on this topic in early 2009.