BVR Logo October 9, 2019 | Issue #205-2

BVWire is your go-to source for the latest in the business valuation profession. Highlights for this week include:

New meta-analysis study finds diminished size premium in stock returns

The debate over the size premium in stock returns has raged for years, with no consensus over the magnitude or stability—or even the existence—of the size premium. There have been many studies on the size premium but with conflicting results. Now, the first “meta-analysis” of the size premium provides an estimate that is smaller than what many people believe, according to a new paper.

Meta-analysis is a quantitative research method designed to aggregate and synthesize past findings and explain differences in earlier studies. It is particularly useful when earlier studies have conflicting results. Authors of the new study collected 1,746 estimates of the effect of size on stock returns reported in 102 published studies and conducted a meta-analysis. The paper, “Firm Size and Stock Returns: A Quantitative Survey,” has been accepted for publication in the Journal of Economic Surveys.

Key point: The study finds that published academic research tended to overstate the size premium, so the authors adjusted for the publication bias using established statistical techniques. “The researchers found a strong bias of selective publication where journals initially published studies showing a statistically significant size premium in smaller stocks but the bias fell in later years as journals published studies with different findings,” says Dr. Michael A. Crain (Florida Atlantic University), who is both a valuation practitioner and academic. “The authors suggest as more people accepted the idea that the size premium diminished after it was first documented in the early 1980s that journals published research with other findings,” says Crain. The study found a drop of about 50% in the magnitude of the size premium in studies using data after 1981 compared to studies with earlier data.

The meta-analysis finds that the size premium in traded stocks was much larger prior to the publication of the first study on the topic (early 1980s). The researchers say, “[O]ur findings support the proposition that the magnitude of the size premium varies over time (Horowitz et al., 2000a; van Dijk, 2011) and more specifically that it has decreased after [the] 1980s.” Crain comments: “These findings should give BV practitioners pause in using return data from the distant past to estimate forward-looking size premiums.”

As to the practice of using data from traded stocks to pinpoint a precise size premium for a private firm, these data are “not an ideal proxy,” says Crain. He acknowledges that some data show price multiples of smaller private firms lower than multiples of larger private firms, which may be evidence that a size premium exists in private firms. “But illiquidity and inefficient markets for private firms may be confounding factors in the multiples,” he says.

The new paper’s authors are Anton Astakhov, Tomas Havranek, and Jiri Novak of the Institute of Economic Studies, Faculty of Social Sciences (Charles University, Prague).

Tax Court's Amazon valuation ruling stands up to 9th Circuit scrutiny

The 9th Circuit recently affirmed the U.S. Tax Court’s 2017 decision in favor of Amazon in this key transfer pricing case, finding the governing regulations limited the definition of “intangible” to independently transferrable assets. This interpretation supported the Tax Court’s favoring the comparable uncontrolled transaction (CUT) method over the discounted cash flow (DCF) analysis to value groups of intangible assets Amazon had transferred to its European subsidiary.

Residual business assets excluded: Around 2004, Amazon undertook restructuring efforts to reduce its tax liability. It set up a European subsidiary (ES) as a holding company to ensure the bulk of Amazon’s European business would be taxed at a low rate. In 2005 and 2006, Amazon transferred to ES three groups of intangible assets: (1) website-related technology; (2) marketing intangibles, including trademarks, trade names, and domain names relating to the European business; and (3) customer lists and related information. Under a cost-sharing agreement, ES made a buy-in payment to compensate Amazon for existing transferred intangibles. The agreement also provided for annual cost-sharing payments related to later technological innovations to the extent ES benefitted from them.

The buy-in payment was taxable income to Amazon, and the cost-sharing payments reduced the deductions Amazon could claim for research and development costs. Section 482 of the Internal Revenue Code applies to transactions between entities that are owned or controlled by the same interests. The implementing Treasury regulations require that parties to a controlled transaction state the “true taxable income” by ascertaining the income a controlled taxpayer would have earned if it had dealt with unrelated parties at arm’s length. The fair market value standard applies.

Amazon claimed the buy-in amount was $254.5 million, to be paid over seven years. The IRS maintained Amazon undervalued the intangibles; the buy-in amount was about $3.6 billion. Amazon won in the Tax Court, which adopted Amazon’s CUT methodology and found the company’s narrative related to royalty calculations was more persuasive. The court noted the IRS’ DCF analysis improperly included all contributions of value, including value derived from the business itself, i.e., workforce in place, going-concern value, goodwill, and other business attributes. These residual business assets were not separate from the business and were not “intangibles” under the cost-sharing regulations, the Tax Court concluded.

On appeal, the IRS argued the residual business assets satisfied the regulation’s definition of “intangible.” Amazon said the IRS’ interpretation of the regulatory language was too broad. The then controlling regulations defined “intangible” as an item that can be bought and sold independently of the business.

The 9th Circuit, using the “traditional tools” of statutory and regulatory construction (examining the text of the regulations, the regulatory scheme “as a whole,” and the rule-making history) found they favored Amazon’s interpretation “that intangibles were limited to independently transferrable assets.”

But the Court of Appeals cautioned that the then governing regulations currently were outdated. And, said the court, “nothing in our decision should be construed as an outright rejection of any particular valuation methodology.”

A digest of, Inc. v. Commissioner, 2019 U.S. App. LEXIS 24453; __ F.3d __; 2019 WL 3850580 (Amazon II), and the 9th Circuit opinion will be available soon at BVLaw. A digest of, Inc. v. Commissioner, 148 T.C. 108 (March 23, 2017), and the Tax Court opinion, are available now to BVLaw subscribers.

WeWork: Translating a business into a story
with numbers

A great example of taking a business model and turning it into a narrative with numbers (something that is critical for a good valuation report) is in a recent blog post by Dr. Aswath Damodaran (New York University Stern School of Business) on the unraveling of the WeWork IPO. “Valuation is a bridge between stories and numbers, and for young companies, it is the story that drives the numbers, rather than the other way around,” he writes. As for WeWork, he confesses that he “never liked the company,” but he does a good job at giving the company the benefit of the doubt. (Note: The post was done before WeWork shelved its plans for an IPO.)

Dark side: Damodaran also points out that there’s a danger when the story rules, which is what you have with a new company and what it says it will do in the future. There’s a risk that the “numbers become props or are ignored, that the pricing that is attached to a company can lose its tether to value,” he says. This is the peril of the “runaway story” that led to the meltdown of Theranos, he points out. “As we saw with Theranos, in its rapid fall from grace, there is a dark side to story companies and it stems from the fact that value is built on a personality, rather than a business, and when the personality stumbles or acts in a way viewed as untrustworthy,” he writes. As to how this relates to WeWork, Damodaran says he does not trust CEOs “who seem more intent on delivering life lessons for the rest of us, than on talking about the businesses they run.” Of course, Damodaran is working just from information found in the WeWork prospectus and other public information and not from management interviews.

Extra: Damodaran will give a keynote, “Narrative and Numbers: The Story Behind Your Valuation,” at the European Association of Certified Valuators and Analysts (EACVA) 13th Conference for Valuation Professionals in Berlin, Germany, December 5-6.

Reasonable comp: What's in a title?

When using the market approach to determine replacement compensation, very often you begin by asking somebody his or her title. “You may want to use that in benchmarking, but I would suggest you go beyond that because sometimes a title is not very descriptive,” says compensation consultant Stephen Kirkland (Atlantic Executive Consulting Group LLC). Someone might have the title of vice president or even CEO, but that might not really tell you what they do. Kirkland, speaking during a BVR webinar, related his experience with two commercial construction companies, one on the East Coast and one on the West Coast. Even though the companies were somewhat similar and both very successful, the two CEOs did very different things. One CEO devoted almost all of his time to quality control in the field on job sites, and the other CEO devoted almost all of his time to marketing and business development. “You need to be careful when you look at the title someone uses,” he says. “Maybe his title is CEO, but maybe he is really functioning more as a CFO, and maybe we need to benchmark him that way.” Kirkland presented a webinar, Reasonable Compensation for Closely Held Businesses + RCReports Demo, along with Paul Hamann (RCReports).

'Quite a ride' ahead for global transfer pricing

In the latest issue of Bloomberg BNA’s Transfer Pricing Forum, international transfer pricing practitioners provide their insight on how the tax authorities, as well as multinationals in their jurisdictions, are preparing for the anticipated Organization for Economic Co-operation and Development (OECD) harmonized global approach to the digitalization of the economy. “Some jurisdictions have acted unilaterally, some have made failed attempts, while some have adopted a ‘wait and see’ approach,” the report says. “The one consistent theme is that we are in for quite a ride over the next few years, as the global efforts to address this topic are further developed and implemented.” The OECD issues transfer pricing guidelines that are voluntary for member nations. The 96-page Transfer Pricing Forum document has perspectives from practitioners in 23 countries, including the U.S., U.K., China, Japan, Russia, Italy, India, Germany, France, and others.

BV movers ...

People: Mark L. Zyla, CPA/ABV, CFF, CFA, ASA, has opened Zyla Valuation Advisors LLC, a valuation and litigation consultancy firm in Atlanta’s Ponce City Market; Zyla will lead the firm as managing director and is joined by director Camille Pacht and manager Allan Raulerson, CPA/ABV, CVA, CFE … Derek Stross, CPA, CVA, has joined the firm of Hamic Previte & Sturwold (Lakeland, Fla.) … Margaret Franklin is the new president and CEO of the CFA Institute; she was previously president of BNY Mellon Wealth Management in Toronto.

Firms: Tronconi Segarra & Associates of Williamsville, N.Y., a firm with 113 associates, is adding Scott A. Cain, CPA, and six associates from his previous firm, Wittlin Cain & Dry (Lockport, N.Y.); the firm will maintain both locations … Chicago-based BDO USA is acquiring Peterson Sullivan of Seattle, marking further expansion into the Pacific Northwest; the acquisition adds 175 staff members, including partners; the deal should be complete November 1 … New York-based EisnerAmper has relocated into a new Dallas office in the Harwood District, a move prompted by the firm’s growth in both Texas and the central United States … Greensboro, N.C.-based DMJ & Co. announced that it will join forces with Wilmington, N.C.-based Miller & Co. November 1; the combined firm will employ more than 85 people, including 11 partners … Eden Prairie, Minn.-based Boulay has acquired Robert Steffen & Associates, an investment advisor firm in Bloomington, Minn., that serves more than 250 families and businesses; the combined firms will have 33 partners and more than 180 employees … St. Cloud, Minn.-based BerganKDV and Brooks Lodden of West Des Moines, Iowa, have merged, bringing 31 staff members to the newly merged firm; the Des Moines location now has 61 employees and 459 team members firmwide … New York-based Prager Metis has combined with LFL Veritas of Teaneck, N.J. Milwaukee-based Wipfli LLP announced that Porter Keadle Moore (PKM) of Atlanta joined the firm October 1; 70 PKM professionals, including nine partners, have joined Wipfli, which now has about 2,400 associates in 49 offices.

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