CRAM - ABV1 - Sheet2 Flashcards
What are the two types of engagements used to estimate value as outlined in the AICPA’s SSVS No. 1?
A valuation engagement – an engagement to estimate value of a subject interest by performing appropriate valuation procedures and is free to apply the valuation approaches and methods he or she deems appropriate.\n \nA calculation engagement – an engagement to estimate value wherein the valuation analyst and the client agree on the specific valuation approaches and valuation methods that will be used. A calculation engagement generally does not include all of the valuation procedures required for a valuation engagement.
What is the AICPA Code of Professional Conduct – Rule 101
Rule 101 deals with the responsibility of the professional to be independent in order to perform certain professional services such as audits and reviews of financial statements.
What is the AICPA Code of Professional Conduct – Rule 102
Rule 102 covers ethical considerations (integrity and objectivity). The analyst should maintain objectivity and integrity, shall be free of conflicts of interest, and shall not knowingly misrepresent facts or subordinate his or her judgement to others. The analyst is an advocate for his or her professional opinion, not the client.
What is AICPA Code of Professional Conduct – Rule 201
A member shall comply with the following:\n \nProfessional Competence\nDue Professional Care\nPlanning and Supervision\nSufficient Relevant Data
What is Revenue Ruling 59–60?
In valuing the stock of closely held corporations, or the stock of corporations where market quotations are not available, all other available financial data, as well as all relevant factors affecting the fair market value must be considered for estate tax and gift tax purposes. No general formula may be given that is applicable to the many different valuation situations arising in the valuation of such stock. However, the general approach, methods, and factors which must be considered in valuing such securities are outlined.
What is Revenue Ruling 65–192?
The general approach, methods and factors outlined in Revenue Ruling 59–60, C.B. 1959–1, 237, for use in valuing closely–held corporate stocks for estate and gift tax purposes are equally applicable to valuations thereof for income and other tax purposes and also in determinations of the fair market values of business interests of any type and of intangible assets for all tax purposes.
What is Revenue Ruling 65–193?
Revenue Ruling 59–60, C.B. 1959–1, 237, is hereby modified to delete the statements, contained therein at section4.02(f), that `In some instances it may not be possible to make a separate appraisal of the tangible and intangibleassets of the business. The enterprise has a value as an entity. Whatever intangible value there is, which issupportable by the facts, may be measured by the amount by which the appraised value of the tangible assetsexceeds the net book value of such assets.’The instances where it is not possible to make a separate appraisal of the tangible and intangible assets of a businessare rare and each case varies from the other. No rule can be devised which will be generally applicable to such cases.
What is Revenue Procedure 66–49?
The purpose of this procedure is to provide information and guidelines for taxpayers, individual appraisers, and valuation groups relative to appraisals of contributed property for Federal income tax purposes. The procedures outlined are applicable to all types of noncash property for which an appraisal is required such as real property, tangible or intangible personal property, and securities. These procedures are also appropriate for unique properties such as art objects, literary manuscripts, antiques, etc., with respect to which the determination of value often is more difficult.
What are the valuation engagement steps?
- Define the engagement\n2. Gather the information on the subject interest\n3. Analyst the information\n4. Determine an indication of value for the subject interest\n5. Issue a report
What are the types of reports?
- Valuation Detailed Report\n2. Valuation Summary Report\n3. Calculation Report\n4. Oral Report
What company specific factors does Revenue Ruling 59–60 identify as fundamental and requiring careful analysis?
- Nature of the business and the history of the enterprise from its inception\n2. Economic outlook in general and the condition and outlook of the specific industry in particular\n3. Book value of the stock and the financial condition of the business\n4. Earning capacity of the company\n5. Dividend–paying capacity\n6. Whether or not the enterprise has goodwill or other intangible value\n7. Transactions involving company’s stock\n8. Market price of stocks of companies engaged in the same or similar lines of business that are actively traded in a free and open market
What information does SSVS No. 1 identify as necessary to perform a subject company analysis?
- Nature of the subject interest\n2. Scope of the valuation engagement\n3. Intended use of the valuation\n4. Applicable standard of value\n5. Applicable premise of value\n6. Assumptions and limiting conditions\n7. Applicable governmental regulations or other professional standards
What non–financial information should a valuation analyst consider under SSVS No. 1?
- nature, background and history\n2. facilities\n3. organizational structure\n4. management team\n5. classes of equity ownership and rights\n6. products/services\n7. economic environment\n8. geographical markets\n9. industry markets\n10. key customers and suppliers\n11. competition\n12. business risks\n13. strategy and future plans\n14. governmental or regulatory environment
What non–financial information should a valuation analyst consider under Revenue Ruling 59–60?
- operating and investment assets\n2. capital structure\n3. sales\n4. non–recurring or non–operating items
What is Revenue Ruling 59–60’s guidance on restrictive agreements?
If the issuing company reserves the right to repurchase ownership interests at a certain price, the price under certain circumstances may be reflective of fair market value for estate tax purposes, but not necessarily for gift tax purposes.
Describe Port’s Five Competitive Forces
- Bargaining Power of Suppliers\n2. Bargaining Power of Customers\n3. Threat of New Entrants\n4. Threat of Substitute Products/Services\n5. Competition Between Companies
Under SSVS No. 1 what financial information should a valuation analyst obtain?
- Historical Financial Information\n2. Prospective Financial Information\n3. Comparative Summaries of Financial Statements\n4. Comparative Common–Size Financial Statements\n5. Comparative Common–Size Industry Financial Information\n6. Income Tax Returns\n7. Owner Compensation\n8. Key Person/Officer Life Insurance\n9. Management’s Responses to Contracts, Off–Balance Sheet Items and Prior Sales of Company Stock
Define the DuPont formula.
The DuPont formula is also referred to as a return on equity ratio. It integrates profitability, asset turnover, and leverage into one financial measure.
What are the four most common methods of applying the Market Approach?
- Prior Transactions of Company Stock2. Guideline Public Company Method (Using Multiples)\n3. Merger and Acquisition Method (Guideline Company Transaction Method or Direct Market Data Method)\n4. Rules of Thumb (Industry Method)\n\n
In what types of valuations does Revenue Ruling 59–60 and related tax regulations suggest consideration of the Market Approach?
- Estate and gift tax–related valuations
What are the primary considerations when evaluating a subject company’s prior transactions of stock?
- Were the transactions arms–length?\n2. How many transactions have occured?\n3. What are the dates of the transactions?\n4. What were the types and size of the block of stock sold? (Voting vs. Non–Voting, Control vs. Minority)
What are the steps of applying the Guideline Public Company Method?
- Obtain financial statements for the subject company\n2. Analyze and adjust the financial statements of the subject company as needed\n3. Adjust tax expense accordingly\n4. Perform a search, and select, publicly traded guideline companies\n5. Obtain appropriate financial information for a representative period of time for the selected guideline public companies\n6. Consider adjusting or normalizing the guideline public company financial data\n7. Analyze the differences between the subject company and the guideline public companies (operations, financial condition, business description)\n8. Select appropriate valuation multiples for guideline public companies\n9. Calculate valuation multiples for guideline public companies\n10. Select and adjust multiples as appropriate for the subject company\n11. Apply selected multiples to subject company\n12. Determine if and when to add net non–operating assets of the subject company
What are the commonly used valuation multiples in the Guideline Public Company Method?
- MVIC/EBIT\n2. MVIC/EBITDA\n3. MVIC/Revenues\n4. Price/Earnings\n5. Price/Book Value of Equity
When calculating valuation multiples under the Guideline Public Company Method, what can be used as the numerator?
- Stock price at the valuation date\n2. Market Value of Invested Capital
What are the common multiples used in the Guideline Merger and Acquisition Method?
MVIC to \n1. Revenues\n2. Net Income\n3. EBIT\n4. EBITDA\n5. Book Value
What are the common sources for smaller company and private transactions?
- Institute of Business Appraisers (IBA) Database\n2. BIZCOMPS\n3. Business Brokers\n4. Pratt’s Stats\n5. Done Deals
What are the common sources for publicly traded companies?
- Dialog\n2. Mergerstat\n3. Thomson Securities Data Company\n4. Public Stats
What information can be found in Pratt’s Stats?
Private company merger and acquisition transaction data. Pratt’s Stats provides both stock and asset sales and many of the details are provided for each transaction. All multiples provided are based on the market value of invested capital, and the database provides the date of the financial information provided for the target company. An advantage of Pratt’s Stats is that it contains more data points for each transaction.
What information can be found in Done Deals?
Done Deals provides both public and private merger and acquisition transaction data. This database provides both equity and invested capital multiples, as well as asset and stock sales. Done Deals annualizes the most recent interim financial period of 6 to 11 months.
What information can be found in the Institute of Business Appraisers Database?
Sales of mostly smaller, private, companies. Historically, IBA’s position is that typically, asset sales include inventory, fixed assets (excluding real estate), and intangible assets (Book Value of the Business). IBA defines discretionary earnings as the annual earnings before owner’s compensation, interest and taxes. Contains largest known source of transactions of small closely held businesses.
What information can be found in BizComps?
Sales of mostly smaller, private, companies. BizComps excludes inventory from the sales price of asset sales since it believes that the amount of inventory can vary greatly and can skew multiples. BizComps defines the seller’s discretionary earnings as net profit before taxes, one owner’s compensation, plus amortization, depreciation, interest, and other non–cash expenses, and non–business related expenses.
Define “cost of capital”
The cost of capital is defined as the expected rate of return that the market requires to attract funds to a particular investment. The cost of capital is also referred to as the discount rate. This rate is used under the income approach to determine an indication of value for a business based on its ability to generate net cash flow or income to the owners.
What are the three types of economic risks inherent in the capital markets?
- Maturity risk (interest rate risk)\n2. Market risk (systematic risk)\n3. Specific Company risk (unsystematic risk)
Define market risk.
Market risk, also know as systematic risk, is the uncertainty of future returns due to factors that affect the stock market as a whole. It can not be eliminated by portfolio diversification.
What are the assumptions of the capital asset pricing model?
- Investors are risk–adverse\n2. Rational investors seek to hold efficient portfolios\n3. All investors have identical time horizons\n4. All investors have identical expectations around expected rates of return and how capitalization rates are generated\n5. There are not investment–related taxes or transaction costs\n6. Relative return volatility is a modifier of equity market risk and required return\n7. The rate received from lending money is the same as the cost of borrowing money\n8. The market has perfect divisibility and liquidity
What is the risk–free rate of return?
Based on yield to maturity of U.S. treasury stocks. Reflects the rental rate for lending the funds over the investment period, inflation (investment rate risk) over the term of the investment, and maturity risk (risk that the principle market value will rise or fall during the period until maturity) The 20–year U.S. Treasury bond yield is often used for the risk–free rate of return.
What is the equity risk premium?
Commonly used sources are calculations in Morningstar’s Stocks, Bonds, Bill and Inflation Yearbook (SBBI). It is the premium investors require above the risk–free rate to compensation for the increased risk of an equity investment. Estimated equity risk premiums are often based on the historical average return on stocks minus the historical average risk–free rate
What is beta?
A measure of market risk volatility. The market has a beta of 1, a beta greater than 1 represents more volatility than the market, a beta less than 1 represents less volatility than the market. Sources for determining beta include Value Line Investment Source, S&P Compustat, NYSE, and Yahoo Finance.
What is the size risk premium?
Often estimated based on data provided from SBBI or the Duff and Phelps Risk Premium Report. Additional premium investors require over and above the equity risk premium to compensation for the increased risk of an investment in smaller companies for size characteristics only.
What is the specific company risk premium?
Addresses specific risks associated with the target company suck as thin management, smaller size relative to small cap stocks, financial performance, lack of diversification, geographic concentration, demographics, limited access to capital, litigation, environmental issues, concentration of customers, and limited supply sources
What is the Butler–Pinkerton Calculator?
A new tool available from Business Valuation Resources that provides a market–based calculation for estimating total returns, including specific company risk, for the guideline companies. It can be used as an additional methodology for supporting the cost of capital.
What is the Morningstar SBBI?
Study of the long–term returns by asset class including the equity risk premium and size risk premium.
What is the Duff & Phelps Risk Premium Report?
An alternative to the Morningstar SBBI, reports differences in stock returns as a function of firm size measured by the market value of equity. Reports size metrics. This report is used to estimate the size risk premium.
What is the debt discount rate?
Defined as the pretax borrowing rate of the subject company that is then adjusted by the tax benefits associated with the deductibility of interest expense. \nPretax borrowing rate * (1– tax rate)
What is a capitalization rate?
Discount rate minus long–term sustainable growth equals the cap rate. The long–term growth rate selected should reflect the present value of expected future growth in the benefit stream selected.
What are the advantages of a income approach?
The income approach produces a value based on the expected benefits. It values an enterprise based on its earnings or cash flow generating abilities. At times, it is the only approach that can be used to value intangible assets.
What are the disadvantages of the income approach?
It requires an estimated level of sustainable benefits that can be challenging to estimate for smaller companies. It can be hard to develop the appropriate capitalization and discount rate, and require the analyst to use subjective judgement.
What is the discounted cash flow method?
A multiple period valuation model that converts a future series of benefit streams into value by discounting them to present value at a rate of return that reflects the risk inherent in the benefit stream. It is discounted by the cost of equity capital when valuing equity, and the WACC when valuing invested capital.
What is the capitalized cash flow method?
A single period valuation model that converts a benefits stream into value by dividing the benefits stream by a rate of return that is adjusted for growth. The CCF method is an abridged version of the DCF method when the valuation analyst expects long–term, stable cash flows into perpetuity.
What is the direct equity valuation model?
The net cash flow would be the amount that is available to common stockholders of a company. Based on net cash flow to equity. It is the amount that is left over after the company reinvests in itself to continue its operations while providing for growth.
What is the invested capital valuation model?
Valuing the enterprise on a debt–free basis so that the cash flow is to both the equity and interest–bearing debt holders. This method adds back interest expenses, net of taxes, to the cash flow and does not consider changes in debt. Often used when the capital structure is expected to change.
What is the direct equity formula for DCF?
Present Value = Net Cash Flow to Equity/(1+discount rate of equity) for each period with the discount rate being adjusted appropriately (1+ Discount Rate) Squared, etc. for each future period.
What is the invested capital formula for DCF?
Present Value = Net Cash Flow to Invested Capital/(1+WACC) for each period with the WACC being adjusted appropriately (1+ WACC) Squared, etc. for each future period.
What is the direct equity formula for CCF?
PV = Net Cash Flow to equity for the next period / (Discount Rate for Equity – Long Term Expected Growth Rate)
What is the invested capital formula for CCF?
PV = Net cash flow to invested capital for the next period / (WACC – long–term expected growth rate)
What is the calculation for cash flow to total equity?
Normalized Net Income\nPlus: Non–Cash Charges (D&A, Deferred Taxes)\nLess: Incremental Working Capital\nLess: Anticipated CAPEX\nPlus: New Debt Principal (Borrowings)\nLess: Debt Principal Out (Repayments)
What is the calculation for net cash flow to invested capital?
Normalized Net Income (After Tax)\nPlus: Interest Expense (Tax Affected)\nPlus: Non–Cash Charges (D&A, Deferred Taxes)\nLess: Incremental Working Capital (No Int. Debt)\nLess: Anticipated CAPEX
What is the Gordon Growth Model formula?
Direct Equity DCF Residual Value = NCFe(1+g)/(Discount–g)\n\n\nIC Terminal Value = NCFic(1–g)/(WACC–g)
How does revenue ruling 59–60 refer to the Asset Based Approach?
Earnings may be the most important criteria of value in some cases, whereas asset value will receive primary consideration in others. Primary consideration is given to earnings when valuing stocks of companies which sell products or services to the public. Conversely, in an investment or holding type of company, the appraiser may give the greatest weight to the underlying assets.
What is the theory behind the Asset Based Approach?
Current value of all assets, tangible and intangible\n\n\nminus\n\n\nCurrent value of all liabilites\n\n\nequals\n\n\nThe current value of equity of the subject company
What is the economic principal of substitution?
The principal of substitution states that a buyer would not pay more than the value of an equally desirable substitute.
When should you use the Asset Based Approach?
The Asset Based Approach yields the most appropriate estimate of value when the value of the cash flows generated by the current use of assets is less than the cash flows that can be generated by alternative uses, or the returns available by the shareholders are not a fair indication of the value of the underlying assets.
The Assets Based Approach is more appropriate when valuing what types of companies?
- Real estate, investment, or asset intensive holding companies\n2. Companies with a high percentage of nonoperating assets\n3.Start up or troubled companies with limited earnings history\n4. Natural resource companies\n5. Utilities\n6. Not–for–profit organizations\n7. Manufacturing companies\n8. Controlling interests that can liquidate assets
