August 10, 2011 | Issue #107-2  

Has the BV community lost sight of the
discount rate?

That’s what Gary Trugman (Trugman Valuation Associates) wondered after reading the lead item in last week’s BVWire about the potential downgrading of U.S. debt, now an economic (and emotional) reality. His response:

Although I agree wholeheartedly with Roger Grabowski, the question raised is much more fundamental. I am seeing valuation analysts plug risk-free rates into a build-up or CAPM model without considering whether the answer, as opposed to the components of the model, makes sense. It seems that the business valuation community has lost sight of what a discount rate really is. A discount rate is the required rate of return that is necessary given the risk of the projected benefit stream from the subject investment. This means that the BV analyst should be looking for comparable investment vehicles, and their yields, with a similar set of future return risks as those from the interests at issue. 

It doesn’t matter which component of the discount rate you’re discussing, because if it does not reflect the expected future return, the answer will be wrong. We can get very technical about this discussion but it is time to keep it simple (K.I.S.S.) and remember that the total discount rate is what we are after and not just a single component. 

Regardless, the Principle of Substitution tells us that we should be looking for an alternative investment in the market with similar risk characteristics to use as a surrogate in determining the required rate of return in the subject investment at the valuation date. This is valuation theory 101.

What the credit downgrade means for your cost of capital analysis: On Tuesday, August 16th, BVR welcomes Ron Seigneur (Seigneur Gustafson) and Don DeGrazia (Gold Gocial Gernstein) for a special one-hour webinar, “Credit Ratings & Debt Ceilings: How will Recent Actions by the S&P and Federal Government Affect Business Valuation?” Learn what the experts are saying about the recent market volatility—and earn CPE, too.

The size effect is practically nil

So said Mike Crain (Financial Valuation Group) in the recent BVR webinar, The Diminishing Size Effect and Link to Liquidity Risk. The empirical research finds that the size effect in listed stocks (meaning public company stocks listed with the regulator) has disappeared or diminished in the U.S., the U.K., and globally since the 1980s,” said Crain.

Co-presenter William Kennedy (FTI Consulting) concurred. “We really do have a very different market structure and market conditions today than we did in those earlier decades, and these structural changes may render some of the statistical results that we we’re seeing from [that earlier time] not relevant to today's markets and trading environment.”

For more data, analysis, and citations to authority, consult Crain’s comprehensive article, “Literature Review of the Size Effect” on, and,  “Has the Size Effect Disappeared?” in the Business Valuation Update (Dec 2010). 

Another blow to IRS: 9th Circuit upholds defined value clause

As reported in a prior ‘Wire, the Tax Court delivered a first blow to the IRS’s long-held opposition to formula-defined value clauses in Estate of Petter v. Commissioner (T.C. Memo. 2009-280). The government appealed, and just last week the 9th Circuit might have buried the “void for public policy” argument, as the IRS didn’t even assert this angle, but instead claimed that the defined value clause violated the regulations against applying a condition precedent to a charitable deduction. The 9th Circuit disagreed: the estate’s transfers became effective immediately on executing the controlling documents and delivering the partnership interests, it ruled. The only post-transfer question left unanswered was the value of the transferred units, which was subsequently determined by the applicable Code provisions and principles:

Aside from the fact that only the dollar formula clause of the sale documents uses the phrase ‘as finally determined for federal gift tax purposes,’ a taxpayer who files a return cannot conjure up a value for federal gift tax purposes out of thin air; rather, she must use federal gift tax valuation principles. Under these principles, the value of an asset ‘as finally determined for federal gift tax purposes’ is the fair market value of that asset.

Another victory for Porter, et al.: Kudos once again to attorney John Porter and his Baker Botts colleagues, who successfully represented the taxpayer during the Petter appellate proceedings as he also did in the recent Hendrix decision, in which the Tax Court upheld a formula value clause. Look for the digest of the 9th Circuit decision in Petter (No. 10-71854, August 4, 2011) in a future BVUpdate; the court’s complete opinion will be posted soon at BVLaw.

Expert’s ‘hyberbole’ comes back to haunt in Daubert hearing

Experienced litigation experts know that their published articles and statements (even on a blog or in a professional discussion group) can be used against them in a courtroom. That’s what happened in a recent bankruptcy case, when the expert conducted an insolvency analysis without interviewing management or visiting the subject properties, yet wrote in a prior family law article that “it was malpractice” to omit these steps when conducting a business valuation.

Fortunately, the federal district court realized that the expert’s article was directed specifically to divorce lawyers. Moreover, the expert had to value the bankrupt debtor in this case as of a past date, for which a present site visit would not have been relevant. Likewise, talking to the owners wouldn’t have been fruitful, since they were largely responsible for the debtor’s downfall. Nothing in Daubert excluded the expert’s report “merely because he made some hyperbolic statements in an article that was exploring valuation issues in a context entirely different than the present one,” the court held. It also used the expert’s insolvency analysis, under a balance sheet test and a DCF, to recover $2.75 million as fraudulent conveyance, despite some “professional disagreement” among the experts as to the reliability of the 10b versus 10a size category data and the calculation of company-specific risk. Look for the complete digest of Nelson v. Walnut Investment Partners, Ltd., 2011 WL 2711318 (S.D. Ohio)(July 13, 2011) in a future BVUpdate; the court’s opinion will be posted soon at BVLaw.

What is the key valuation multiple when appraising wholesalers?

“Appraisers should analyze MVIC/Gross Profit multiples for all distribution clients,” says Warren Miller (Beckmill Research, LLC.) “In our experience with small and medium-sized distribution companies, MVIC/GP often has a low coefficient of variation. If that multiple is not already in your guideline public company template, it should be,” he adds.  

Pre-order your copy of Miller’s BVR’s Guide to Valuing Wholesalers, scheduled to ship in September 2011.

LinkedIn BV-forum update

LinkedIn’s business valuation-related groups are increasingly popular forums for professional discussion—though it takes time to sort through the most provocative and productive debates, as we did for this past week’s topics:

Business Valuation Professionals group

  • Best Tools for Analysis of Private Companies?
  • Company-specific risk. How do you measure it? Do you explain the other options in your reports? If not, why not?
  • What’s a quality resource database on comparable compensation / reasonable compensation that works for a variety of industries.

Business Valuation & Advisory Network group

  • What are the available resources for industry overviews, priced for a small-to-medium size valuation practice?

Business Valuation Resources group

  • In today's economy, is it appropriate to use the capitalization of earnings method when valuing a local residential home building company?

Upcoming BVR Training: how to achieve perfection in an appraisal and accuracy when assessing FMV in Life Sciences

This Thursday, August 11, BVR will host attorney L. Paul Hood Jr. and appraiser Timothy Lee (Mercer Capital) for “The Business Appraisal Report: Perfecting the Art.” Hood and Lee will address what every appraiser needs to know when authoring a comprehensive, credible valuation report. Learn what makes a good report great, and how an in ill-prepared report can quickly turn irrelevant from the perspective of courts, clients—and even your colleagues.

On August 23, BVR presents The Online Symposium on Healthcare Valuation continues with “Fair Market Value: Ensuring Compliance within the Life Sciences.”  Featuring a trio of experts from HealthCare Appraisers, Ann Brandt, Jason Ruchaber, and Timothy Smith, this program focuses on recent trends in the government’s oversight of the life sciences industry—including closer scrutiny of company practices and tighter enforcement of regulations—and what it means for your FMV analysis of these complicated firms.

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Copyright © 2011 by Business Valuation Resources, LLC
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