There are shortcomings to using historical data in developing an equity risk premium (ERP) when estimating the cost of capital, points out Eric Nath (Eric Nath & Associates LLC) in the February issue of Business Valuation Update. His comments were triggered by the release of BVR’s Cost of Capital Professional, but they refer to any process to estimate the cost of capital that uses historical data or Damodaran’s implied ERP. The issue is illuminated by the feature in the Cost of Capital Professional that allows users to use different start and end dates for historical data, a “positive aspect” of the platform, he notes.

“What’s needed is a truly forward-looking required rate of return system that gives appraisers an understanding of how to estimate cost of capital for private companies and interests in private companies,” Nath says. In response, Ron Seigneur (Seigneur Gustafson LLP), a co-chair of the Cost of Capital Professional advisory board, points out that one of the ideas behind the platform is to “give valuators insights into the data they’re using so they can be empowered with information and flexibility.” Historical data are useful but should not be used in isolation, he says, and professional judgment must be used in how to apply the data.

Better way: To estimate returns, Nath says the better alternative is to find out what returns investors required on the investments they recently made. The Pepperdine Survey of the private capital market does this to a certain degree. Nath maintains that, if we focused more on improving this type of research, “we would be a lot further ahead in understanding how to estimate required rates of return.”

Extra: Pepperdine’s annual cost of capital survey is now open and seeks input from investors, lenders, business owners, and anyone else involved in the funding of private businesses.

Simplified MUM approach weathers attacks in Illinois divorce case
One of the key questions in an Illinois divorce case was how to allocate goodwill between enterprise and personal goodwill. One expert used the “with-and-without” method; the other used the MUM approach in a simplified version. The latter prevailed. Although the appellate court’s opinion is unpublished, valuators should take note because the court’s discussion of the dispute over the validity of MUM reflects an ongoing debate in the valuation community.

At issue was the value of a company offering design assistance and engineering services as well as machining and molding assembly. The husband was the sole shareholder and, by the wife’s admission, the “key guy” at the company. Both sides retained seasoned, credentialed business appraisers who used a similar methodology to value the company, weighting the results of the income and market approach. But the analyses diverged in a number of respects, including the approach for determining the value of goodwill attributable to the husband—a value that was not marital property and therefore excludable from the company’s overall value.

The wife’s expert used the “with-and-without method,” comparing the company’s projected cash flow over five years under two scenarios: if the husband left the company having signed a noncompete and if he left without signing a noncompete agreement. The expert valued personal goodwill at nearly $1.1 million.

The husband’s expert used the multiattribute utility model (MUM) for which he selected 10 attributes that he scored in a binary manner, i.e., the attribute either existed or did not exist. (The traditional MUM method uses an elaborate scoring system, but the expert used a simplified version.) He determined that two-thirds of the total goodwill value, $2.1 million, represented personal goodwill and one-third was enterprise goodwill.

The wife’s expert acknowledged that MUM was an accepted goodwill allocation method but criticized it for being “subjective” in terms of selecting the attributes and the binary scoring. The “with-and-without” methodology was able to eliminate subjectivity, the wife’s expert said.

The trial court adopted the value determination the husband’s expert proposed, awarding the wife half of it. In appealing the trial court’s valuation decision, the wife attacked the opposing expert’s personal goodwill determination as “far too subjective, and far too suspect, to be accepted by the court.” MUM, the wife argued, allowed for “cherry-picking” and for skewing the results. The appellate court was not persuaded. It found the trial court faced conflicting valuation testimony, considered the weakness in each expert’s opinion, and noted that both goodwill methods were accepted in the profession. Under the applicable standard of review, the appellate court said it was required to give deference to the trial court as fact finder.

A digest of In re Marriage of Preston, 2018 Ill. App. Unpub. LEXIS 1281 (Aug. 1, 2018), and the court’s opinion are available at BVLaw.

Extra: Goodwill is just one of the many topics on the agenda of the upcoming AAML/BVR National Divorce Conference, which will take place in Las Vegas, May 8-10. In addition, the conference offers attendees a great opportunity to explore a host of other legal and valuation-related topics and interact with peers.

Final regs issued on PTE QBI deduction
The Treasury has issued final regulations explaining who qualifies for the new tax law’s 20% “qualified business income” (QBI) deduction for pass-through entities (PTEs). This provision affects business cash flow, operations, and long-term strategy that will impact valuations of businesses that range from mom-and-pop convenience store owners to private equity investors. The final rules provide details on the type of service businesses that are excluded from claiming the deduction above a certain income threshold. Specific industries including healthcare, law, accounting, and consulting do not qualify. But others, such as the real estate industry, architects, and engineers, receive the benefit.

While the Tax Cuts and Jobs Act (TCJA) provided permanent tax relief to corporations, which saw their tax rate slashed from 35% to 21% and an end to U.S. taxes on much of their foreign profits, PTE owners got only temporary relief under the law’s individual tax provisions, which are due to expire after 2025. IRC Code Section 199a allows a 20% write-off of QBI for certain sole proprietors, owners of S corporations, and members of partnerships/LLCs.

Extra: Three other related pieces of guidance were also issued: proposed regulations on several aspects of the QBI deduction, including qualified REIT dividends received by regulated investment companies, a revenue procedure on determining W-2 wages for QBI deduction purposes, and a notice on a proposed revenue procedure providing a safe harbor for rental real estate.

For the first time, PwC used a drone in an audit to assess the value of inventory, in this case, coal inventory for the German energy giant RWE in Aberthaw, South Wales, the firm says in a statement. The traditional method of hand-counting inventory would have taken four hours, but the drone captured 300 images in 30 minutes, a reduction in time of 85%, the firm asserts. The images were used to create a “digital twin” of the coal pile to measure its volume. The value of the coal was then calculated to within 99% accuracy. “Sectors with large assets in hard-to-reach areas are the most obvious starting points for expanding this kind of work further—from mining to agriculture and forestry,” says Elaine Whyte, U.K. drones leader at PwC.

IVSC 2018 year in review video posted
More than 120 organizations are now members of the International Valuation Standards Council (IVSC) and are working together to advance the global valuation profession, the IVSC announced in its 2018 year in review video. The video also points out that IVS is now being applied in more than 100 countries. Some of the other highlights of 2018 include efforts to improve financial instrument valuations, the work of the IVSC technical boards, and the translation of IVS into other languages, including Arabic, Chinese, Czech, and Spanish.

Preview of the February 2019 issue of Business Valuation Update
Here’s what you’ll see:

• “Letter to the Editor: Comments on the Cost of Capital Professional” (Eric Nath). A user who tested BVR’s new platform for estimating the cost of capital has some very thought-provoking comments on the use of historical data for the equity risk premium.

• “Response to Eric Nath’s Comments on the Cost of Capital Professional” (Ron Seigneur). Comments in response to the need to develop a “truly forward-looking required rate of return system that gives appraisers an understanding of how to estimate cost of capital for private companies and interests in private companies.”

• “Current Observations on the Valuation Impact of the TCJA” (BVR Editor). Based on sessions at the 2018 AICPA Forensic & Valuation Services (FVS) Conference in Atlanta.

• “Calculation Engagements: Still Broken, Still Bad” (Michael Paschall). A response to a number of rebuttals of the author’s previous article that strongly criticizes the use of calculation engagements.

• “Tips for Valuing—and Designing—Buy-in/Buyout Agreements for Medical/Dental Practices” (Mark O. Dietrich). After hundreds of engagements, the author identifies a number of best practices for both the valuation analyst and the consultant with respect to buy-in/buyout arrangements.

• “‘Oh, What a Tangled Web We Weave’: Recent Developments in Delaware on Investment Bank Liability for M&A Services” (Arthur H. Rosenbloom and Gilbert E. Matthews). Anyone who provides fairness opinions or other advice on company acquisitions or restructuring can be exposed to liability.

• “Work File Checklist for Documenting the Fair Value of Inventory” (BVR Editor). A practice aid based on the Mandatory Performance Framework (MPF) for the Certified in Entity and Intangibles Valuation (CEIV) credential.

• “Update on the AICPA’s New CVFI Credential” (BVR Editor). Insights into the upcoming Certified in Valuation of Financial Instruments (CVFI) credential the AICPA is launching.

The issue also includes:

• An expanded section of “BV News and Trends/Global BV News and Trends.”

• Regular features: “Ask the Experts” and “Tip of the Month.”

• BV data spotlight: “DealStats MVIC/EBITDA Trends,” “ktMINE Royalty Rate Data,” “Economic Outlook for the Month,” and “Cost of Capital Center.”

• BVLaw Case Update: The latest court cases that involve business valuation issues.

To stay current on business valuation, check out the February issue of Business Valuation Update.

BV movers...

People: Frank Rudewicz has been admitted to the partnership at West Hartford, Conn.-based blumshapiro; he will lead the firm’s litigation and valuation practice from the Boston office … Nicholas Norton has been admitted as a new partner at Peterson Sullivan of Seattle where he will oversee growth of the firm’s advisory practice, which includes valuation advisory and strategic business consulting services … Tom Buetow and David Dick, formerly of BLD, a CPA and advisory firm in Louisville, Ky., have joined Lexington, Ky.-based Dean Dorton Allen Ford, and they brought along other former BLD employees.

Firms: Cherry Bekaert, based in Richmond, Va., has acquired Flieller Kruger & Skelton of Austin, Texas, which expands its Austin presence to eight partners and more than 65 associates … Carmel, Ind.-based Blue & Co. has joined with the consulting firm Professional Practice Management Inc. (PPM) of Worthington, Ohio, a firm that has worked primarily with physicians, dentists, and other healthcare professionals since 1934; the combined staff of Blue & Co. and PPM will total more than 400 professionals in 10 offices across three states … Chicago-based Baker Tilly has announced a three-way combination with municipal advisory firms H.J. Umbaugh and Associates and Springsted Inc.; the firm says this will be one of the largest independent municipal advisory practices in the U.S. … Two Los Angeles firms, Dreyer Robbins and Associates and Holthouse Carlin & Van Trigt (HCVT), have joined; HCVT focuses on serving high-net-worth individuals and their related entities … Chicago-based BDO USA has acquired the assets of Lootok, a crisis management and business continuity consulting and technology firm headquartered in New York City … San Francisco-based Shea Labagh Dobberstein Accountants and Advisors expanded its tax practice in the Bay Area by adding A. L. Nella, also in San Francisco … Sklar Heyman Hirshfield & Kantor LLP (Bellmore, N.Y.) has merged with Block & Block of New York City; the new name of the firm is Sklar Kantor Block LLP.

Please send your professional and firm news to us at editor@bvresources.com.

Upcoming BVR training events

• FREE WEBINAR: Benchmarking with BizMiner: Live Demo and Case Study (January 24), with Don Drysdale (Drysdale Valuation PLLC) and Galen Pugh (BizMiner).
  
  BizMiner is a source of current industry-specific financial data and market analysis. This webinar gives a demonstration on how to use BizMiner and a valuation expert presents a case study using its granular financial data.

• Auto Dealership Valuation and Damages: Under the Hood (A BVR Web Workshop) (January 31), with Adam Lawyer (Dixon Hughes Goodman), Robert Davis (Dixon Hughes Goodman), Stephen Dietrich (Holland & Knight), and Joseph Roesner (The Fontana Group).
  
  Learn about the current environment of auto dealership valuations, damage claims frequently occurring within dealerships, and the impact on the economics of dealership operations.

New and trending LinkedIn discussions

The Absence of a Size Effect Relevant to the Cost of Equity

Is a Merger Causing a Culture Clash in Your Organization?

OPM Backsolve and Convertible Debt Financing

Your discussion could be featured here—BVR’s LinkedIn group is a place for valuation professionals to share, discuss, and learn about compelling BV topics. If you’re not already a member, request to join today.