Chapter 3 Flashcards
What was Revenue Ruling 59-60 written for?
To apply to valuations for estate and gift tax purposes
What does Revenue Ruling 59-60 states are fundamental and requires careful analysis?
Nature of the business and the history of the enterprise from its inception
Economic outlook in general and the condition and outlook of the specific industry in particular
Book value of the stock and the financial condition of the business
Earning capacity of the company
Dividend-paying capacity
Whether or not the enterprise has goodwill or other intangible value
Sale of the stock and size of the block of stock to be valued
Market price of stocks of companies engaged in the same/similar line of business that are actively traded in a free and open market, either on an exchange or OTC
Does VS Section 100 provide rationale for the analysis of a subject company interest?
Yes, because it states that an analysis will assist the valuation analyst in considering, evaluating, and applying valuation methodology.
At a minimum what should be considered when analyzing the subject company under VS Section 100?
Nature of the subject interest Scope of the valuation engagement Valuation date Intended use of the valuation Applicable standard of value Applicable premise of value Assumptions and limiting conditions Applicable governmental regulations or other professional standards
When analyzing the history of the business under Revenue Ruling 59-60, what should an analyst gain an understanding of:
Company's operations and key people Nature of an enterprise's business, products, and services Markets for its products or services Its assets both operating and non-operating Customer and customer dependencies Suppliers and supplier dependencies Revenues and income Quality of management
Under VS Section 100, what nonfinancial information must a valuation analyst analyze?
Nature, background, and history Facilities Organizational structure Management team Classes of equity ownership interest and rights Products/services Economic enivornment Geographical markets Industry markets Key customers/suppliers Competition Business risks Strategy and future plans Governmental or regulatory environment
Why are products and services considered?
The outlook for a company and the risks associated with ownership are directly related to the nature of and outlook for its products and services
Why are customers considered?
Customer relationships and customer dependency can increase or decrease risks associated with ownership. A customer with the ability to dictate pricing could have an adverse effect on earnings.
Why are suppliers considered?
Supplier relationships and availability of materials can increase or decrease risks associated with ownership. Supply constraints and increases in raw material costs could have an adverse effect on earnings and cash flow.
Why is management considered?
Management’s ability to react to changing market conditions could have a significant effect on value. Factors to consider include depth and quality of management and dependence on key managers. Risks associated with key person conditions and situations where inadequate plans for succession exist can have a negative impact on a subject company, including dependence on key customers or suppliers.
Why are non-operating assets considered?
Non-operating assets can provide a safety net in the event of adverse financial performance.
What are the options for the value of non-operating assets in a valuation?
1- Can be a direct add-on to a value indication derived from the income or market approaches.
2- Direct add-on but only if the value indication is for the controlling ownership position
Why are foreign operations considered?
Foreign-sourced income may have adverse tax implications and may not be available for dividends or debt repayments. Could be subject to additional political risk.
VS Section 100 states that the valuation analyst should obtain what ownership information?
Types of ownership interest being valued and ascertain control characteristics
Analyze the different ownership interest and assess the potential effect on the subject interest
Understand the classes of equity ownership interests and rights
Understand the rights included in or excluded from each intangible asset
For a business ownership interest/security: Understand shareholder agreements, partnership agreements, operating agreements, voting trust agreements, buy-sell agreements, loan covenants, restrictions, and other contractual obligations/restrictions on the subject interest
2For an intangible asset: Understand legal rights, licensing agreements, sublicense agreements, nondisclosure agreements, development rights, commercialization or exploitation rights and other contractual obligations
What economic and industry factors could influence a conclusion of value?
GDP (boom or recession period?) Inflation (higher may benefit debtor entities) Interest rates Demographics Stock market (can it finance expansion?) Technology Competition
Under Revenue Ruling 59-60 how many years of balance sheets should the valuation analyst use to analyze book value?
At least two years
Under Revenue Ruling 59-60 how many years of profit and loss statements should be analyzed?
At least five years
Describe the relevance of dividend payments or dividend payment capacity to controlling or minority interests under Revenue Ruling 59-60?
Dividend-paying capacity is more relevant to controlling interests and actual dividend payments is more important in a minority valuation
Under Revenue Ruling 59-60 how is goodwill measured?
Income approach
Market approach
Excess earnings
Measuring individual intangible assets
What factors should be considered when analyzing the prior sales of an interest in subject company and size of block of stock to be valued under Revenue Ruling 59-60?
Sales should be arms length to be meaningful
More recent transactions are most relevant but consider the terms/circumstances
Less consideration to forced/distress sales
Controlling interest more valuable on a pro rata basis than non-controlling
Describe the relationship between exchange listed stocks and OTC when analyzing similar GPCs under Revenue Ruling 59-60?
Actively traded stocks listed on exchanges are usually considered first with OTC trades of secondary significance
Is NASDAQ considered an exchange under Revenue Ruling 59-60?
Yes
What is the primary consideration for profitable operating companies under Revenue Ruling 59-60?
Earnings capacity
What is the primary consideration for investment or holding companies under Revenue Ruling 59-60?
Underlying assets
What factors should be considered when arriving at a capitalization rate under Revenue Ruling 59-60?
Nature of business
Risk or advantages involved
Stability or irregularity of earnings
Economic and industry trends that may impact rate of return
What is the key takeaway regarding averaging in Revenue Ruling 59-60?
No useful purpose is served in taking an arbitrary average
No prescribed formula for mathematical weights to factors or approaches
You must be able to critically consider and defend subjective decisions as part of the valuation
If the issuing company reserves the right to repurchase at a certain price in a restrictive agreement, when does that price reflect FMV under Revenue Ruling 59-60?
If it is legally binding during life and at death
It has a valid business purpose
It is not a testamentary device but a bona-fide business arrangement
What should be considered when analyzing a restrictive agreement under Revenue Ruling 59-60?
The number of shares and the relationship of the parties
What two frameworks are useful when analyzing the qualitative nature of the subject interest?
SWOT (strengths, weaknesses, opportunities, and threats)
Five Competitive Forces (bargaining power of suppliers, bargaining power of customers, threats of new entrants, threat of sub products/services, and competitive rivalry in the industry)
Under VS Section 100, a valuation analyst is required to analyze what following financial information of the subject iinerest in a technical analysis of the company?
Historical financial information (annual/interim) for an appropriate number of years
Prospective financial information (budgets/forecasts)
Comparative summaries
Comparative common size financials
Comparative common size industry financials
Income tax returns
Compensation for owners including benefits/personal expenses
Key person/officer life insurance information
Management responses regarding advantageous/disadvantageous contracts, contingent/off-balance sheet liabilities and assets, and information on prior sales of company stock
What is the definition of a financial forecast per Trugman?
Prospective financial statements that present, to the best of the responsible party’s knowledge and belief, an entity’s expected financial position, results of operations, and cash flows. A financial forecast is based on the responsible party’s assumptions reflecting the conditions it expects to exist and the course of action it expects to take.
What is the definition of a financial projection per Trugman?
Prospective financial statements that present, to the best of the responsible party’s knowledge and belief, given one or more hypothetical assumptions, an entity’s expected financial position, results of operations, and cash flows. A financial projection is sometimes prepared to present one or more hypothetical courses of action for evaluation, as in response to a question such as, “What would happen if…?”
What is the difference between a financial forecast and projection per Trugman?
Forecast is management’s best estimate and a financial projection represents possible outcomes given one or more hypothetical assumptions.
Should a valuation analyst use a financial forecast or financial projection per Trugman?
Financial forecast
What three steps should be taken after obtaining the appropriate financial information?
Determine if the financial information is complete
Determine if it provides sufficient information comparable to industry peers
Determine whether there are apparent departures from GAAP/if they are audited
What six methods are utilized in a subject company financial analysis?
Historical comparative spreadsheet Common-sizing historicals Ratio analysis Comparison with industry data Forecast analysis Trend analysis
How is cash investigated by a valuation analyst?
Excess cash reduces risk and is a direct add-on to value. Need to understand reasons for excess cash (is it excessive? What are historical trends? What does industry analysis suggest? Overall working capital of the company? Are there expansion plans/pending distributions?)
How are marketable securities investigated by a valuation analyst?
Marketable securities also reduce risk and may be a direct add-on to value. For certain industries, like financial institutions, marketable securities is an operating asset and has to undergo vigorous analysis.
How is accounts receivable investigated by a valuation analyst?
Ultimate recovery should be determined. Trends should be analyzed including historical and industry comparison.
How is inventory investigated by a valuation analyst?
Adjustments to change in accounting method (LIFO, FIFO) or to better reflect FMV may be appropriate
How are prepaid expenses investigated by a valuation analyst?
Are refundable items present
How is real estate investigated by a valuation analyst?
For an operating company, excess or non-operating real estate may reduce risk. The net realizable value of such properties may be a direct add on to value. The FMV should be obtained. Adjustments to historical earnings may need to be adjusted if real estate is a direct add on to value.
How are machinery, equipment, furniture and fixtures analyzed/investigated by a valuation analyst?
Adequacy of productive plant should be determined. What is the age of equipment? Buildup of future Capex or repairs? Does current equipment support projected growth?
How are intangible assets investigated by a valuation analyst?
Nature both on and off balance sheet. Separate valuation may be required.
How are leases investigated by a valuation analyst?
Long-term, below-market leases may have significant value
How are long-term receivables investigated by a valuation analyst?
Ultimate collectively should be determined. Are related parties involved?
How are deferred taxes investigated by a valuation analyst?
Will deferred taxes be paid in the foreseeable future? Can deferred tax benefits be used?
Why is the capital structure considered by a valuation analyst when doing a subject company analysis?
Capital structure has a direct effect on risk assumed
How are non-operating and excess assets handled by a valuation analyst in majority interest (control) valuations?
Under market or income approach, these assets are direct additions (FMV - net of taxes/other liabilities associated with asset) to value since market/income approaches only measure the operating value of the entity.
How are non-operating and excess assets handled by a valuation analyst in minority interest (controlling interest doesn’t plan to distribute or sell) valuations?
May be inappropriate as a direct addition. If added, DLOM and discount for lack of control are needed. Income statement adjustments must be made if a direct addition to remove revenue and expenses associated with the asset.
How is revenue investigated by a valuation analyst?
Sources of revenue should be identified, methods of recognition explored, are they consistently applied and appropriate?
How are unreported sales investigated by a valuation analyst?
Adjustments may be warranted and may increase risk with taxes and penalties.
How is cost of goods sold investigated by a valuation analyst?
Methodology for inventory valuation may affect COGS. Adjustments may be warranted.
How are gross profits investigated by a valuation analyst?
Historical trends, ratios analysis
How is depreciation investigated by a valuation analyst?
Should reflect the economic reality of the useful life of the assets or consideration given to replacing annual depreciation with a fixed asset replacement annual reserve
How are other income and expenses investigated by a valuation analyst?
What components are included? Are they representative of operating or non-operating activities?
How are discretionary expenditures investigated by a valuation analyst?
Stockholders’ comp, perquisites, donations, or affiliate transactions are considered for reasonableness and whether they represent continuing expenses
How may financial statements be adjusted for a valuation?
Timing differences
Non-conformance with GAAP
Accounting changes (make consistent across periods analyzed)
Related-party transactions (adjust to arms-length)
Non-operating assets and liabilities (remove as it represents direct add-on to value)
Obsolete equipment
Unusual or non-recurring items
LIFO inventory (from LIFO to FIFO)
Realistic depreciation
Owner’s comp (adjustments for both below market and above market, treat excess as a dividend)
Non-operating income and expenses (remove as it represents direct add-on to value)
What are the two types of ratio analyses?
Historical and industry
What do liquidity ratios measure?
The entity’s ability to meet its short-term financial obligations
What is the quick ratio formula?
Cash + cash equivalents + investments + receivables /current liabilities
What do activity and turnover ratios measure?
Operating efficiency for specific assets
What is the accounts receivable turnover formula?
Sales/AR
What is the inventory turnover formula?
COGS/Inventory
What is the working capital turnover formula?
Sales/Working Capital
What is the fixed asset turnover formula?
Sales/Fixed Assets
What is the total asset turnover formula?
Sales/Total Assets
What do leverage ratios measure?
The entity’s ability to meet its long-term obligations
What are some liquidity ratios?
Current ratio, quick ratio
What are some activity and turnover ratios?
AR turnover, Inventory turnover, Working Capital turnover, Fixed asset turnover, Total asset turnover
What are some leverage ratios?
Total debt to total assets, total equity to total assets, total debt to total equity
What do coverage ratios measure?
An entity’s ability to service its debt obligations
What is the times interest earned ratio formula?
EBIT/Interest Expense
What is the fixed charge formula?
Net Income before Taxes + Interest Charges + LT Lease Payments/Interest Charges + Long-Ter Lease Payments
What are some coverage ratios?
Times interest earned, fixed charge coverage
What do profitability and return on investment ratios measure?
An entity’s operational performance
What are some profitability and return on investment ratios?
Return on common equity, return on investment, return on total assets, net income to sales, gross profit margin, operational profit margin, dupont formula (return on equity)
What is the return on common equity formula?
Net income/common equity
What is the return on investment formula?
Net Income + (Interest * (1-tax rate))/(Equity + LT Debt)
What is the return on total assets formula?
Net income + (Interest * (1-tax rate))/total assets
What is the dupont formula for return on equity?
Net Income/Equity = Net Income/Sales * Sales/Assets *Assets/Equity
What do growth ratios measure?
An entity’s historic growth trends
What is the compound annual growth rate formula?
CAGR = (current/prior)^(1/periods) -1 * 100
