Chapter 6 Flashcards
What is the term for companies utilized in the market approach?
Guideline public companies
What are the three most common methods under the market approach?
Prior transactions of company’s own stock
GPC method
M&A method (transaction method, guideline company transaction method, direct market data method)
What is rule of thumb indicator?
Typical industry benchmark based on experience, observation, hearsay, or combination that provide a sanity check of the value indications but should not be used as the only method
What does Revenue Ruling 59-60 indicate about the market approach?
That it should be considered in valuations for gift and estate tax purposes
What do Tax Court opinions historically indicate about the market approach?
That it should be the primary focus and that opinions have been rejected for ignoring market data. More recently judges have been more critical of the approach.
Why is the market approach useful and relevant?
Places all indications of value into the larger context of the market realities and subjects them to stringent reasonableness checks
When is the market approach not useful under the prior transaction method?
1) prior transactions not at arms-length
2) not enough information to be useful
3) too dated or under substantially different economic conditions
When is the market approach not useful under the GPC method?
1) sufficient financial information unavailable for GPCs (thinly traded stocks/penny stocks)
2) Narrow, unique niche of subject company
3) Not similar enough to subject company
4) If subject company is a small business such as a professional practice or service provider (lawyer, beauty salon, gas station, grocery store, car wash) - should consider transaction method
When is the market approach not useful under the M&A/transaction method?
1) narrow, unique niche of subject company
2) too few transactions in the industry grouping
3) too dated or under substantially different economic conditions
4) limited or conflicting information available about the transactions
What records should a valuation analyst keep when performing a market approach analysis?
Steps performed, companies considered, accepted, and rejected, reasons were/were not used, and sources
What is the definition of market approach?
A general way of determining a value indication of a business, business ownership interest, security, or intangible asset by using one or more methods that compare the subject to similar businesses, business ownership interests, securities, or intangible assets that have been sold
What is the definition of a market multiple?
Market value of a company’s stock or invested capital divided by a company’s measure
Under what method(s) are guideline companies identified?
GPC method or M&A method
What is the definition of invested capital?
The sum of equity and debt in a business enterprise with debt typically being all interest-bearing debt or long-term, interest-bearing debt
Revenue Ruling 59-60 specifically refers to the ______ marketplace for the market approach
Public
Although Revenue Ruling 59-60 specifically refers to the public marketplace for the market approach, should the private marketplace be considered?
Yes
What are the four contentions that are typically discussed in case law with respect to the market approach?
1) are the public companies sufficiently comparable to the subject company
2) what specific factors make the companies similar
3) what adjustments are appropriate tot he market multiple
4) which market multiple is most appropriate
What agreements should be considered when the valuation analyst analyzes prior sales of the companies own stock?
Buy-sell agreements, stock redemption agreements, and other enforceable documents
What may buy-sell agreements, stock redemption agreements, and other enforceable documents create?
A ready market for the sale of stock by requiring the company or other shareholders to purchase stock under certain circumstances (like disability/death)
Are buy-sell agreements binding for estate tax purposes?
They may not be binding
Are buy-sell agreements binding for marital dissolution purposes?
They may not be binding
What is the principle issue when considering prior sales of a company’s stock?
Whether the transaction was at arms-length (also noted in Revenue Ruling 59-60)
Why are the terms of the sale considered when analyzing prior stock transactions?
Confirm terms reflect a cash equivalent value
Prior transactions of stock sales are particularly useful when there are _____ transactions
Many
Why must the type and size of block of stock sold be carefully considered?
Is it voting/non-voting, controlling/minority
Why must the dates of prior stock sale transactions be considered?
In the context of changes in the economy, market, subject business
How would a valuation analyst determine if a prior stock sale was at arm’s-length?
Determine whether the prior transaction price was determined through an external valuation, buy-sell formula, negotiated value, or some other method, in addition to the motivations of the parties
What are the 13 steps to implementing the GPC method?
Assessment of comparability:
1) Obtain financial statements for subject company
2) Analyze and adjust financial statements of subject company
3) Adjust tax expense accordingly given other adjustments
Search for and selection of GPCs:
4) Perform search and select publicly traded guideline companies
Analysis of GPC data:
5) Obtain appropriate financial information for a representative period for the GPCs
6) Consider adjustment or normalization of financial data for GPCs
7) Analyze the differences between the GPCs and the subject companies with respect to business description, company operations, financial condition, and other considerations - ratio analysis is important
Selection of types of valuation multiples for GPCs:
8) Select appropriate valuation multiples
9) Calculate valuation multiples for GPCs
Selection and application to subject company:
10) Select and adjust multiples appropriate for the subject company
11) Apply multiples to subject company
12) Determine if and when to add net non-operating assets of the subject company
Consideration of discounts and premiums:
13) Consider whether any discounts or premiums should be applied
Why should the valuation analyst ensure that GPC stocks are actively traded and are not penny stocks?
Must be actively traded so that an equilibrium price can be established to provide a meaningful indication of FMV
If cyclicality is an issue, what should the period analyzed by the valuation analyst encompass?
A full business cycle
What other valuation multiples may be considered beyond earnings and revenue for holding companies or asset-intensive companies?
Book value, net asset value, or total assets
What does the numerator of the valuation multiple consist of?
Stock price at valuation date (can be average of low and high for the day or closing price) or market value of invested capital (MVIC) for the public company
Should unadjusted or adjusted historical stock prices be used?
Unadjusted to be consistent with the 10-Ks and 10-Qs used in historical valuations
What does the denominator of the valuation multiple consist of?
Any one of a number of benchmarks that demonstrate the financial performance or position at a given point in time and can represent historical, forecasted, or average values
What are 5 commonly used valuation multiples?
MVIC/EBIT MVIC/EBITDA MVIC/Revenue P/E (price to earnings) Price/Book value of equity
What comparability factors may drive adjustments to the valuation multiple?
Growth rate
Size
Risk
If discretionary normalization adjustments ARE made to the subject company’s earnings measure then a ______ basis is produced
Controlling
If discretionary normalization adjustments ARE NOT made to the subject company’s earnings measure then a ______ basis is produced
Minority
How quickly can shares of public companies be converted to cash?
Three days
Why is a discount for lack of marketability appropriate when valuing a privately held entity that can not be converted to cash in three days?
Marketability is assumed in the multiple of a public company
Does the market approach assume that non-operating assets/liabilities are removed from earnings?
Yes
What is a fundamental adjustment to multiples?
Adjusting multiples for certain factors based on comparability with GPCs
What is the theory behind the guideline merger and acquisition method?
Prices paid in the marketplace to acquire an entire company that is similar to the subject business provide a reasonable approximation of the value of the subject company and are turned into pricing multiples.
Does guideline merger and acquisition method arrive at an indication of value on a control or minority basis?
Control because the underlying transactions represent the sale of the entire company
What are three advantages of the merger and acquisition method?
1) Transactions are objective because they come from the market
2) Transactions are assumed to be between informed buyers and sellers and are good representations of fair market value
3) Involve entire companies that have changed hands making it a very logical application
What are six disadvantages of the merger and acquisition method?
1) Difficulties obtaining detailed information hindering effort to understand the nature of the acquisition and impact on value
2) Historical financial data or business descriptions may be missing making transaction analysis impossible
3) Difficult to assess synergistic efficiencies from acquisition which may result in investment value rather than FMV
4) Specific assets acquired and liabilities assumed and their specific values may not be known
5) Consideration may include more than cash up front - terms are very important
6) Data on motivations of the buyers/sellers, skill level of the negotiators, financial position of the parties, and regulations may not be available for privately held businesses
Should a multiple from the merger and acquisition method be applied to a control earnings stream?
Yes
What is the definition of aggregate consideration?
MVIC
What are 7 sources of small and private transactions?
Pratts Stats Done Deals IBA Market Database BIZCOMPS Mergerstat/BVRs Control Premium Study Thomson Financial Mergers and Acquisitions Other sources
What are 8 sources for public transactions?
Dialog Mergerstat Thomson Securities Data Company Public Stats Capital IQ Wall Street Journal Business Week Discussions with management, securities analysts, and trade associations
What are differences that can be present about the same transaction depending on the database?
SIC codes
Asset sales vs. stock sales
What is the difference between an asset sale and a stock sale?
Asset sales include the fixed and intangible assets that transfer with all other assets added and all liabilities subtracted to calculate the equity value.
Stock sales have value derived through the application of a methodology gives an indication of the value of equity
Are non-operating assets or liabilities included in an asset sale or a stock sale?
No
Describe the key facts about Pratt’s Stats
- Provides both asset and stock sales
- For stock sales, entire legal entity of the company transfers including all assets and liabilities unless specified in the acquisition agreement
- For asset sales, fixed assets excluding real estate and intangible assets (goodwill) are transferred
- Many details are provided
- All multiples based on MVIC
- Date of the financial information provided for the target company
Describe the key facts about Done Deals
- Many are public company transactions
- More information may be available by looking at the SEC filings
- Provides both equity and invested capital multiples
- Provides asset and stock sales
What are the types of company transactions reported in IBA?
Mostly asset sales of smaller companies
What are the types of company transactions reported in BIZCOMPS?
Mostly asset sales of smaller companies
What are the two big differences between IBA and BIZCOMPS?
1) IBA transactions typically (but not always) includes inventory whereas the BIZCOMPS transactions do not which would require the addition of the inventory to the value indication
2) Earnings definition does not add back depreciation and amortization for IBA - BIZCOMPS defines seller’s discretionary earnigns as net profit before taxes, one owner’s compensation (including perqs), plus amortization, depreciation, interest, other non-cash expenses, and non-business-related expenses whereas IBA defines discretionary earnings as annual earnings before owner’s compensation including perqs, interest and taxes
What is IBA’s typical position regarding assets transferred in an asset sale?
Includes inventory, fixed assets excluding real estate, and intangible assets or the book of business
What is BIZCOMPs position regarding assets transferred in an asset sale?
Includes fixed assets excluding real estate, intangible assets or the book of business
How do the different transaction databases treat real estate, noncompete agreements, consulting and employment agreements with respect to the transaction price?
Pratt’s Stats excludes real estate, employment and consulting agreements from the transaction price but includes noncompete agreements
IBA excludes real estate but includes employment and non-compete agreements
Done Deals and BIZCOMPs do not make a distinction but BIZCOMPs excludes real estate
What are five common errors in the application of the merger and acquisition method?
1) mixing databases - cannot be done unless adjustments are made to prices and earnings to make them comparable
2) not eliminating dupes
3) mixing asset and stock sales transactions
4) multiples that mismatch numerator and denominator
5) reliance on averages for multiple selection without comparative analysis
What should be considered when determining whether to utilize equity versus invested capital?
Risk elements
Comparison between subject and guidelines for growth expectations, size, financial performance, capital structure/leverage
What might a valuation analyst chose to do if there are significant differences in the capital structure of the subject company and GPCs?
Value invested capital to remove the impact of leverage or arrive at the most prudent capital structure or value earnings directly using an earnings multiple
What are two ways an equity multiple is derived?
1) Divide guideline company’s stock price at the valuation date by earnings to equity holders per share
2) Total market value of equity (stock price as of valuation date multiplied by the number of shares outstanding) by its book value of equity
Does an equity multiple use an earnings stream after debtholders have been compensated?
Yes, net of interest expense
What value indication will result from an equity muliple?
Indication of value of the subject company’s equity
What are 4 common equity muliples?
Price-to-net earnings
Price-to-pretax earnings
Price-to-cash flow
Price-to-book value
When do you use a price-to-net earnings equity muliple?
When a company has relatively stable earnings, depreciation that approximates actual/economic wear and tear, normal tax rates (if a pass-through consider tax-affecting using C-corp tax rates for comparison with GPCs)
When using a price-to-net earnings equity multiple what should be considered when comparing with GPCs?
Historical/potential growth, volatility of earnings, depth of management, other risk factors
When do you use a price-to-pretax earnings equity multiple?
Relatively stable earnings, depreciation that approximates actual/economic wear and tear, abnormal tax rates
When do you use a price-to-cash flow equity multiple?
When a company has relatively low level of earnings compared to depreciation
When do you use a price-to-book value equity multiple?
When companies are asset-intensive and when strong relationship exists between price to book ratios and return on equity
How do you adjust an equity multiple to an invested capital multiple?
Numerator - market value of GPC’s interest-bearing debt must be added to market value of equity to arrive at GPC’s MVIC
Denominator - Earnings needs to be available to both equity and debtholders - need to add back interest expense and the tax benefit of interest (Net income after taxes + (interest expense - (interest expense * effective tax rate))
Once an MVIC multiple has been applied to the corresponding earnings stream, what is done to arrive at equity value?
Subtract the FMV of the subject company’s debt
What are three common MVIC multiples?
MVIC or revenue
MVIC or EBITDA
MVIC or net cash flow to invested capital
What should be considered when using MVIC or revenue multiples
- Sales multiple demonstrates a closer relationship between subject and GPCs
- Profit margins/growth are most important factors and correlation of return on sales
- Sales stability reduces risk and is a major factor
- Consider relative profitability and leverage
- Cost structures need to be similar to GPCs
What are statistical measures of central tendencY?
Arithmetic mean (simple average), median (middle observation) and mode (most frequent observation)
What are measures of dispersion and why are they useful?
Variance and standard deviation
A highly dispersed data set is not as useful as a tight distribution
What is a coefficient of variation?
Ratio of the standard deviation from the mean
How does a valuation analyst use a coefficient of variation?
Computes for each multiple and gives more weight to the multiples with the lowest coefficients of variation
What are measures of relative position?
Rank such as deciles, quartiles
What does a regression analysis demonstrate?
The strength of the relationship between two variables
What is R squared (R2)?
Coefficient of determination - the proportion of the variance in the dependent variable that is predictable from the independent variable. If R2 is 1.0, it is a perfect correlation, the lower the number the weaker the relationship
What are some limitations with a statistical analysis to the market approach?
Restricted due to small data set that cannot provide a meaningful stats analysis
Can only make inferences
Additional adjustments might be necessary
What are some sources for rules of thumb?
Published compilations like Business Reference Guide, industry sources, business brokers, trade associations, and industry members
What are the disadvantages of rules of thumb?
Different sources may provide different rules of thumb for same industry
Application of an uninformed rule of thumb may result in an incorrect value estimate
May ignore the economic reality
Information about source transactions unknown
