Are your cash flow forecasts getting less attention
than they should?
Inputs for the cost of capital are increasingly evolving, and much debate takes place over which sources reign supreme—just look at the loyal camps that support ERP data from Duff & Phelps and those that support Ibbotson’s. With all this debate and focus on the cost of capital, are appraisers inadvertently reducing their focus on earnings forecasts?
Linda Trugman (Trugman Valuation Associates) thinks so. In her presentation at the NACVA conference in Miami the week before last, Trugman posited that “people have become so focused on the denominator—the cost of capital—they forget the importance of the numerator.” We all know how a few percentage points in the cost of capital can affect your value conclusion, but cash flow predictions are equally important. When using a capitalization rate to forecast cash flows into perpetuity, she urged attendees to stop and think: “Does this make sense?”
With the cost of capital taking center stage, she has seen some appraisers put little time and effort into forecasting cash flows, such as inappropriately using a five-year average when it’s not a proper indicator of the future. Was the company making large capital outlays in the last few years, but unlikely to be making expenditures of this size in the future? Was the company making sizable payments towards debt in the last few years that are unlikely to continue (the debt will be paid off and they are unlikely to require more debt capital)?
“Think outside the box,” urged Trugman. “We get so wrapped up in our models and spreadsheets that we forget the basics.” Food for thought.
Trend analysis really a hidden regression analysis – and an ideal tool to forecast sales in a DCF
At the NACVA conference two weeks ago in Miami Beach, Richard Eichmann (FTI Forensic and Litigation Consulting) walked his audience through a case study that put regression analysis at the center of revenue forecasts. “Rarely do I see valuation analysts utilize regression analysis in forecasting top line sales—arguably the key driver of a valuation. Value = Economic benefit/Risk—and we can do a better job of accounting for uncertainty in the numerator with a projection of the expected income stream within our valuations,” Eichmann asserted. “The best forecast is the one that yields the forecast error with the minimum variance.” Since regression analysis expresses relationships with equations, trending sales and year-over-year growth rates (Eichmann recommends at least 5 years' worth of financial inputs—or at least enough to cover a complete business cycle) can deliver quantitative support for your revenue projections.
Supply-side ERP more reliable, says Delaware Chancery
In the latest “must read” statutory fair value appraisal from the Delaware Chancery Court, the decision (by V.C. Strine) tackles such critical valuation topics as deference to the market price, determination of the terminal growth rate, historic versus supply-side equity risk premium (ERP), and selection of appropriate beta. In a case that was “largely dominated by the testimony of the experts,” the court also found that currency and consistency, plus reliance on peer-accepted methods and data, was critical to the experts’ credibility.
Determination of the ERP was a source of major disagreement between the experts, whose per-share values of the Russian telecom company at stake differed by more than 30%. The company’s expert chose 7.1%, based on the long-term, historical rate in Ibbotson’s 2008 SBBI. In support, he cited materials from Ibbotson’s as well as two articles from the Business Valuation Update™; (Peng Chen, James Harrington, “Ibbotson Authors Discuss Historical and Supply-Side Estimates of ERP,” Jan. 2008; and James Hitchner, Katherine Morris, “Cost of Capital Controversies: It’s Time to Look Behind the Curtain,” Jan. 2005, both available at BVResources.)
Critically, all the cited materials discussed supply-side ERP as well. Accordingly, the petitioners’ expert chose the supply-side ERP of 6% reported in Ibbotson’s 2007 Yearbook, which says “the historic approach wrongly assumes that the relationship between stocks and bonds observed in the past would remain stable into the future,” and over the long run, “the equity return should be close to the long-run supply estimate.” This selection had “substantial support in the professional and academic valuation literature,” the court held, in adopting the 6% ERP. “Shannon Pratt, for example, has urged his readers who still use an ERP of 7% to ‘immediately make a downward adjustment to reflect recent research results,’ and has written that the ‘ERP as of the beginning of 2007 should be in the range of 3.5% to 6%,’” the court said, (citing Pratt and Roger Grabowski, Cost of Capital: Applications and Examples, 3rd ed. 2008, also available at BVResources).
Read the complete digest of Global CT LP v Golden Telecom, Inc., 2010 WL 1663987 (Del. Ch.)(April 23, 2010) in the next (July 2010) BVUpdate; the court’s opinion will be available soon at BVLaw™.
Damodaran’s definition of fair value
With the push towards fair value accounting, Aswath Damodaran (NYU Stern School of Business) recently offered his “simple definition (and test) of fair value” in his blog Musings on Markets:
“If an asset is valued at fair value, the appraiser (or his client) should be indifferent to being either a buyer or a seller at that value. If you are an appraiser valuing your business for tax purposes, would you really be willing to sell your business at the appraised value? If the answer is yes, you have stayed true the notion of fair value. If the answer is no, the talk about fair value is just talk... If you are the tax authority valuing the same business (for tax purposes), would you be willing to buy the business at the appraised value? If the answer is no, you too are guilty of hypocrisy.”
Read the full blog post here.
Follow Columbo’s lead when it comes to M&A due diligence
To put it bluntly, “virtual data rooms make people lazy” when it comes to a transactional valuation, concluded Andrew Sherman, JD (Jones Day) in his presentation at the NACVA conference in Miami Beach two weeks ago. Sherman expounded upon the concept of due diligence as an art form, reminding his audience numerous times that “no one likes a surprise!” He requires an organizational “ecosystem” be charted out, and that it includes every possible stakeholder imaginable. “We all know vendors come out of the woodwork at the eleventh hour,” quipped Sherman, who also challenged the audience to admit that a “12-year-old could write the majority of due diligence reports” he sees.
Sherman’s co-panelist Scott Whitaker (Whitaker & Co.) echoed Sherman’s appeal for deeper due diligence by acknowledging that the most common cause of failure in M&A transactions “is a lack of planning. You should at least steer totally clear of ‘short-term-it-is,’ which trades long term strategic planning in for near term expediency. People will freeze until they know who they report to.”
Whitaker’s top six reasons for “synergy bust” are:
- Synergy targets are inflated to make deal look positive
- “Negative” synergies are never accounted for
- Key integration workstream issues are delayed
- No one has accountability for synergy targets
- Proper plan to attain synergy targets is not developed
- Poor tracking and variance reporting.
Sherman reminded listeners that it was Columbo’s “one more question” that often solved the case.
“Covert” forensic tools from Dorrell and Lara
The web offers appraisers and forensic accountants a huge number of new ways to track funds, and corporate entities—and particularly individuals. Some of Darrell Dorrell’s (Financial Forensics) favorite “covert” forensic tools for finding information on individuals were presented at the recent NACVA conference in Miami. They include:
And don’t forget the social networking sites (e.g. Facebook, LinkedIn) added Odalys Lara (Perzel and Lara), filling in for Dorrell. “You’d be amazed at what people write about themselves online,” says Lara. She has caught subjects in a lie, and has used the sites to determine relationships, friends and business connections.
Experts address the challenges of valuing software companies
On Thursday June 24th, BVR’s Webinar Industry Spotlight Series presents “Software Company Valuation,” hosted by Mike Pellegrino (Pellegrino & Associates) and Robert Schlegel (Houlihan Valuation Advisors). Schlegel and Pellegrino, a former software engineer and author of BVR’s Guide to Intellectual Property Valuation, will tackle the valuation challenges appraisers face when valuing software companies. For more information or to join us, click here. Two CPE credits are available.
New financial benchmarking data posted
The 2009 financial content has been posted to BizMiner. This means that all BizMiner industry reports and competitive research now can include historical data from 2002 through 2009. BizMiner covers 16,000 lines of business in 300 U.S. markets. No other source reports at this level of detail.
Learn more about these financial reports and view samples here.
Best-in-class programming from leading experts at fall events
- BVR/Morningstar 3rd Annual Summit on Business Valuation in Divorce – Chicago, September 13-14. This year’s summit, co-chaired by Jay Fishman (Financial Research Associates) and William Morrison (Morrison & Company), is co-presented with Morningstar at its global headquarters and will feature topics such as divorce testimony, e-discovery, the use of databases, and active vs. passive goodwill.
- BVR/Morningstar Summit on Best Practices in Valuing Intellectual Property is chaired by Mike Pellegrino (Pellegrino & Associates) and focuses on all aspects of IP valuation. The Summit, co-presented with Morningstar, features speakers from international regulatory bodies, valuation and law firms takes place in Chicago on September 15-16, the day after the Summit on BV in Divorce.
- 2010 BVR/Georgetown School of Law Summit on Tax, Valuation, and Estate Planning is a gathering of top appraisers, lawyers, judges and regulators in taxation and valuation. The event takes place in Washington, D.C. on November 10 (immediately following the AICPA Business Valuation Conference). The Hon. David Laro (U.S. Tax Court), Mel Abraham, John Porter (Baker Botts) and Jim Hitchner (Financial Valuation Advisors) are chairing the event.
Stay tuned for more information on these events, or check BVR’s conferences page.
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