October 24, 2012 | Issue #121-4  

Even the ‘settled’ aspects of DCF analysis … aren’t

The vast majority—nearly 92%—of respondents to last week’s survey on DCF inputs and assumptions typically maintain the same weighted average cost of capital throughout the forecasting period. A mere 8% adjust the WACC for market, company-specific, or other risks. So the BV community has largely settled that aspect of the analysis, right? In their comments, many respondents qualified their “yes” in these ways:

  • “I would consider changing it for a company that is either a start-up and/or in expansion mode,” writes one respondent.
  • “In more and more cases, the risk in the terminal [value] may be adjusted for the uncertainty of maintaining that level of profitability into perpetuity,” says another, who might also adjust the risk for anticipated “spikes” during the projection period.
  • If the company does not have the capacity to maintain a constant WACC and/or a minority interest is at stake, “we typically use an equity return rather than a WACC, [adjusted] to reflect reduced risk associated with lack of leverage.”
  • “There are times when debt is expected to be paid off or unique risks are present.”

And yet—“It is folly and academic nonsense to think that one could adjust WACC at different points for different risks,” says another respondent. “No buyers in the real world do this.” Another agrees, but for a slightly different reason: “A valuation is as of a point in time, and the WACC should reflect the facts and circumstances as of the valuation date.” But what if changing circumstances are known (or knowable) as of the valuation date? “Every situation is unique,” says another commentator, and analysts may apply a changing WACC if they “expect the company’s risk or leverage to change over the forecast period.”

“It is not clear,” says a final respondent. “There is a good argument for both sides.”

As there is for every question. In the same way, a strong majority of survey respondents—nearly 83%—add only cash in excess of working capital back into their DCF, but the comments also reveal the “yes, but … ” or “it depends” disclaimers. By contrast, other aspects of the DCF are clearly unsettled, such as whether to apply a marketability discount to a controlling interest and how to adjust for officer compensation. Predictably, the company-specific risk premium still generates wide debate, as does any presumption that depreciation should equal capex in the terminal year. We’ll highlight these issues next week, and Rod Burkert (Burkert Valuation) will provide a complete analysis for the Business Valuation Update. Given the liveliness of the discussion, we’ve kept the online survey open; to add your views, click here now.

The 25% rule of thumb is really, really dead

As last week’s BVWire reveals, auditors may still expect it, and IP appraisers may still use it—if only as a reasonableness check—but according to the most recent pronouncement by the U.S. Court of Appeals for the Federal Circuit, its decision in Uniloc v. Microsoft effectively “discarded” the 25% rule of thumb as a reliable measure of patent infringement damages, making it “inadmissible” in any calculation of reasonable royalty damages.

At the same time, the Federal Circuit is showing some leniency for parties and financial experts who applied the 25% rule of thumb before Uniloc but prior to their case reaching appeal. That’s what happened in this latest decision, which vacated an $8 million damages award. Moreover, both of the parties’ experts used the 25% rule, without any objection from either side, and so the Federal Circuit did not reverse on this ground alone. Instead, it criticized the plaintiff’s expert for first applying the 25% rule to the infringer’s profits, and then, after applying the Georgia-Pacific factors in a loose and “conclusory” fashion, for expressing a final royalty rate as a percentage of revenue. The Federal Circuit also discredited the expert’s reliance on noncomparable, lump-sum licenses as well as his ultimate conclusions, which would have swallowed up to three-quarters of the defendant’s profits and were, “frankly, out of line with economic reality.”

Read the complete digest of Whitserve, LLC v. Computer Packages, Inc., 2012 U.S. App. LEXIS 17510 (Aug. 7, 2012) in the December Business Valuation Update; the Federal Circuit’s opinion will be posted soon at BVLaw.

Market evidence—not ‘hired’ experts—should decide most corporate valuation disputes in bankruptcy, says new article

The “laborious and costly process” of permitting valuation experts to testify in bankruptcy cases—including the time and expense of discovery, disclosure, depositions, and pretrial Daubert motions—“contributes nothing to the resolution of the disputes,” says a new article, “Campbell, Iridium, and the Future of Valuation Litigation,” by Michael W. Schwartz and David C. Bryan in The Business Lawyer, August 2012 (subscription required).

To support their premise, the authors examine two “landmark federal valuation decisions”: VFB LLC v. Campbell Soup Co. (3rd Cir. 2007) and In re Iridium Operating LLC (Bankr. S.D.N.Y.)(both available at BVLaw). Both cases held “that market evidence—rather than the testimony of paid litigation experts—should be relied on to value corporations for purposes of litigation.” Moreover:

While a number of decisions have followed Campbell and Iridium, their full potential to make business valuation litigation less costly and less susceptible to hindsight bias has yet to be realized. Courts can and should take advantage of the full panoply of types of market evidence relied on by [the court] in Campbell, and ordinarily equally available to the finder of fact in other business valuation disputes—even in cases [in which], unlike Campbell and Iridium, the company to be valued has no publicly traded securities.

Such market evidence, even for non-publicly-traded companies, would include the opinions of lenders, creditors, investors, and other market participants who act just before or during a subject transaction as well as the “contemporaneous views of expert advisors expressed at or near the valuation date.” In fact, courts should not even permit the parties to present “paid” valuation experts without first establishing, in pretrial motions, that any “non-expert contemporaneous market evidence is insufficient to permit the finder of fact to make a reasoned determination of value.”

Is that just a Daubert motion by another name? If you have an opportunity to read the article, please email your opinions to the editor.

Federal judge says lack of valuation evidence—
and expert—is why most plaintiffs lose their claim for damages

“The most common reason that civil cases fail is not the failure to establish liability, but the failure to think about a damages case,” said the Hon. G. Murray Snow, who sits on the U.S. District Court in Arizona. Speaking on a panel at the ASA’s recent BV conference in Phoenix, which aslo included a state court judge and a local attorney, Judge Snow used two recent cases to illustrate his point.

In the first, one of the two major competitors in an industry accused its opponent of stealing trade secrets. The plaintiff sued “for enough money to put the defendant out of business,” Judge Snow said. The lawyers spent “millions” preparing the case for a three-week jury trial and “endless” testimony, none of which included any damages evidence by an expert to explain “what the trade secret loss cost.” Instead, the plaintiff presented only corporate insiders and documents to estimate damages. During deliberations, the jury asked, “If we determine that the defendant did steal the trade secrets but we can’t determine [the plaintiff] was damaged, what do we do?” Within minutes of receiving an answer, the judge said, the jury returned a verdict for the defendant.

The second case concerned a law firm that “blew up,” with several of the partners suing the main principal for breach of fiduciary duty. After the judge issued sanctions preventing the defendant from presenting any evidence in the case—limiting him only to cross-examination—the plaintiffs were “ecstatic.” But then they did not present a single witness—including any business appraiser—to calculate the value of the law firm. “The [plaintiff] attorneys told me much later that they couldn’t afford a damages expert,” Judge Snow said, but that could have been a post-hoc rationale for losing a case they had all but won.

We’ll have more from the ASA legal panel—including practice tips for Daubert preparation and how to handle draft reports under the recently amended federal rules—in the next Business Valuation Update.

Goodwill value of medical practices is
trending down

Intangibles as a percentage of total purchase price for medical practice and related industry businesses (those in SIC 80, generally) have decreased over the past 12 months, according to Charles Wilhoite (Willamette Management Associates), who also spoke at the ASA’s recent confab in Phoenix. One explanation for the downward trend: As more hospitals and other large providers acquire medical practices, patients have become less loyal to a particular physician and learned to adjust to a new insurance plan. As the patient base becomes less stable, less value is attributable to the professional goodwill of any medical practice—not just those subject to acquisition.

Other trends in the medical practice industry include:

  • Higher debt-to-equity ratios;
  • Slower growth; and
  • Lower profits, due in part to the impact of physician compensation (and what else the owners might have taken out of the business).

Get current on all the trends and valuation techniques. On October 30, join Timothy Smith (Touchstone Valuation) for Valuing Physician Employment Arrangements, Part 10 of BVR’s Online Symposium on Healthcare Valuation. As hospital-physician integration increases, new studies are questioning many of the traditional methods and assumptions when valuing current physician compensation/employment arrangements under an FMV analysis. Smith will review this new data in depth to provide current best practices.

New criticism points out ‘serious flaws’ in the IRS fractional interest model

Neil B. Mills-Mazer, an IRS engineer team manager, first published his article, “Valuing a Majority Fractional Interest and the Minority Premium Model,” in the November 2011 Business Valuation Update. Now comes one of the first published responses and criticisms of Mills-Mazer’s model.

“Does the ‘Minority Premium Model’ Hold Up?” ask authors John Ramsbacher and Annika Reinemann in the October Trusts and Estates (subscription required). Their article points out three potential problems with the IRS model:

  • It develops an “arbitrary premium range,” without providing an adequate explanation or basis for support.
  • It incorrectly assumes “that a majority owner is always willing to pay a premium to achieve a 100 percent interest in the asset.”
  • It is “seriously flawed” in its legal application, because the model ignores or at least doesn’t properly apply the fair market value, willing buyer/willing seller standard.

“Admittedly, valuing fractional interests in real property is a challenging assignment,” the authors conclude, “because direct comparables are scarce. However, the valuation community must be careful not to look, out of desperation, to a simplistic approach that doesn’t take into account all the variables.”

Settling the many questions re: control premiums and discounts

As we mentioned in the discussion of our DCF online survey, the application of a marketability discount to a controlling interest in a private company is still subject to wide debate among BV professionals. For example, a small DLOM (10%) is appropriate to account for the costs of selling the company in its entirety, says one survey respondent, but another one points out that during the sale period, the 100% owner will always have access to the same cash flows that lead to a control-basis value. Most of the participants simply say, “it depends,” primarily on the facts and circumstances of the subject company as well as the purpose of the valuation engagement.

To help settle the more difficult questions, on November 1 join Jim Alerding (Alerding Consulting) and Jim Ewart (Dixon Hughes Goodman) for Control Premiums & Discounts. The pair of experts will review the current landscape of legal cases as well as both sides of the professional debate on the complex and sometimes controversial topic of premiums and discounts. They will look at business operations, income, goodwill, and other factors to help make the determination as objective and supportable as possible.

IFRS Foundation rolls out new guidance on fair value measurements

As part of its continuing educational initiative, the IFRS Foundation—the parent company of the International Accounting Standards Board—is developing material to support IFRS 13 Fair Value Measurement, with the assistance of a valuation expert group. The material will cover the application of IFRS 13 across a number of topics, which will be published in individual chapters as they are completed; last week, the foundation released the first such chapter: “Measuring the Fair Value of Unquoted Equity Instruments Within the Scope of IFRS 9 Financial Instruments.”

Notably, the foundation is not seeking comments on the draft, but is making the chapter available to any interested parties until the end of November 2012. To obtain your review copy, click here. The IFRS Foundation expects to publish a final version of the document (whose content will not be authoritative) in December 2012, according its announcement.

ASA debuts cost of capital course online

The American Society of Appraisers (ASA) announces a new Cost of Capital advanced online education course for valuation professionals beginning November 1-2. Presented by Roger J. Grabowski, ASA, this course is designed for practitioners who may be unaware of the criticisms of and recent developments in the most commonly used methods for estimating cost of capital.

Grabowski will examine the latest issues on data sources, the risk-free rate, the equity risk premium, Beta and other measures of risk, alternative cost of equity capital models, issues with distressed companies, and pass-through entities. This course is an update of the Center for Advanced Valuation Studies’ cost of capital seminar, which Grabowski developed.


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