Business valuation fundamentals & the maximization of entity value


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In the complex world of business valuation, understanding the valuations process can be of key importance to receiving the highest and best value for your company.
Through a basic understanding of the principles of business valuation (both public and private, closely held) one can learn to navigate the process that touches everything from transactions to taxation.

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  • The birth of business valuation beyond simple appraisalThe IRS was and remains a large catalyst for business valuation
  • Both will yield the SAME result
  • Business valuation fundamentals & the maximization of entity value

    1. 1. In the complex world of business valuation, understanding the valuations process can be of key importance to receiving the highest and best value for your company.Through a basic understanding of the principles of business valuation (both public and private, closely held) one can learn to navigate the process that touches everything from transactions to taxation. By: Joshua V. Azran, CPA/ABV/CFF, CMA, CGMA, CFE
    2. 2. Joshua V. Azran, CPA/ABV/CFF, CMA, CGMA, CFEPartner/Owner – Azran Financial APC – Los Angeles, CaliforniaTel: (310) 691-5040Email: jazran@azranfinancial.comExperience:Joshua V. Azran is a Certified Public Accountant (CPA) with more than a decade of experience in public accounting and industry, providing accounting, tax, audit, and advisory servicesto public and private companies and high net-worth individuals. Prior to public accounting, Joshua worked as a consultant providing financial advisory and strategic managementservices to public and private companies.Joshua formed Maginam Consulting in 2005 which provided financial consulting and strategic management services to private and public companies including interim-CFO services,management consulting, mergers & acquisitions advisory services, and restructuring services. Through his work, he became a trainer for The Analyst Exchange, one of the premierprograms teaching financial modeling to investment bankers and top consulting firms. Previously Joshua owned his own clothing company, worked as a project management consultantfor Goldman Sachs, and was part of Johnson & Johnson’s prestigious Financial Leadership Development Program (FLDP).Wanting to provide more comprehensive solutions for his clients, Mr. Azran entered into Public Accounting. He rapidly pursued and achieved many of the top accounting designationsincluding Certified Public Accountant, Accredited in Business Valuation, Certified in Financial Forensics, Certified Management Accountant, Chartered Global Management Accountantand Certified Fraud Examiner. In November of 2010, Azran Financial was founded, with a vision to utilize technology solutions to provide efficient solutions and the very best service forour clients.Joshua possesses extensive experience ensuring clients’ financial success by providing strategic guidance and management of financial functions. He is a visionary leader with expertise inpublic accounting, corporate finance, strategic management, financial restructuring, management consulting, and business development. Joshua is skilled at identifying value-addedopportunities, implementing solutions, and partnering with professionals at all levels of an organization to ensure the success of financial initiatives. He excels at utilizing a consultativeclient approach to bring integrated solutions to even the most complex issues. Joshua has a strong reputation for “going the extra mile”, mentoring staff, and achieving 100% clientsatisfaction through the creation of high-trust, high-impact relationships with clients.Mr. Azran holds a Bachelor of Science with a dual major in Economics and Finance from Fairleigh Dickinson University in Madison, New Jersey.In addition to Azran Financial, Joshua spends time serving on the boards of charitable and professional organizations. Mr. Azran is also proud to be a lecturer in business at LoyolaMarymount University (LMU). Joshua serves as a Mentor for the Institute of Management Accountants (IMA), and to business students at his Alma Mater, Fairleigh DickinsonUniversity. He recently was chosen to sit as a Beta Tester for the AICPA Certified in Financial Forensics (CFF) Exam.Mr. Azran is a member of the American Institute of Certified Public Accountants (AICPA), California Society of Certified Public Accountants (CalCPA), Institute of ManagementAccountants (IMA), Association of Certified Fraud Examiners (ACFE), and National Association of Certified Valuation Analysts (NACVA). 2
    3. 3. Overview1. Defining Business Valuation2. History and Background of Business Valuation3. Uses of Valuations4. Standards and Premises of Value5. Valuation Approaches 1. Financial Ratio & Trend Analysis 2. Investment Value Principle 3. Defining the Benefit Stream 4. Capitalization & Discount Rates 5. Discounts & Premiums6. Maximizing Entity Value 3
    4. 4. What is Business Valuation? Definition: “The act or process of determining the value of a business, business ownership interest, security, or intangible asset.” (International Glossary of Business Valuation Terms - IGBVT) How does a “Valuation” differ from an “Appraisal”?  Often used interchangeably  Appraisals are used for specific tangible assets  Valuations also include the intangible value of an entity  Valuation is subjective, each business is “one-of-a-kind” 4
    5. 5. Once Upon A Time… 1920: Internal Revenue Service (IRS)  Appeals & Revenue Memorandum 34 (ARM 34)  Nationwide Prohibition Effective January 16, 1920  Breweries and Distilleries must determine lost value  Businesses widely valued on Tangible assets  Need to determine the lost Intangible Value  Introduced two key concepts related to Goodwill 1. Goodwill exists if a business has Excess Earnings  Above the norm of companies with similar activities and size 2. Value is calculated by Capitalizing excess earnings 5
    6. 6. Regulatory Bodies 1959: Internal Revenue Service (IRS)  Revenue Ruling 59-60 (RR 59-60)  Single most important piece of valuation literature  Outlined methods and factors:  Comparable Price Method  Asset Method  Income Method  Shifted focus to “earnings rather than excess earnings”  Fair Market Value (FMV) 6
    7. 7. Regulatory Bodies Internal Revenue Service  Key Revenue Rulings:  RR 59–60 Valuing Closely Held Stock  RR 68–609 Formula Method  RR 83–120 Valuation of Preferred Stock  RR 93–12 Allowance of Minority Interest Discount in Family Owned Business United States Department of Labor (DOL)  Employee Stock Ownership Plans (ESOPs) Financial Accounting Standards Board (FASB) Various Professional Organizations  NACVA  ASA  IBA  AICPA  IACVA  CICBV 7
    8. 8. Uses of Valuations Two Major Categories 1. Tax (Estate, Gift, Income, §338, §1060, 409a) 2. Non-Tax  Financial Reporting  ASC 350 (FASB 142), Goodwill impairment testing  ASC 360 (FASB 144), Impairment or Disposal of Long-Lived Assets  ASC 805 (141(r)), Business Combinations  Mergers, Acquisitions, Divestitures  Buy-Sell Agreements  Employee Stock Ownership Plans (ESOPs)  Litigation (Shareholder disputes, Damages/Economic Loss, Divorce) 8
    9. 9. The Three Standards of Value Fair Market Value (FMV)  Most widely recognized and accepted standard of value  Used in all Federal tax matters  Defined in Revenue Ruling 59-60:  “The price at which the property would change hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.”  International Glossary of Business Valuation Terms (IGBVT)  “The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under the compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.” 9
    10. 10. The Three Standards of Value Fair Value (FV)  Meaning varies depending on purpose  Defined in FASB SFAS 157 as:  “Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”  Uniform Business Corporation Act  “Fair value, with respect to a dissenter’s shares, means the value of the shares immediately before the effectuation of the corporate action to which the dissenter objects, excluding any appreciation or depreciation in anticipation of the corporate action unless exclusion would be inequitable.”  Various State definitions related to:  Business litigation  Martial dissolution 10
    11. 11. The Three Standards of Value Strategic or Investment Value  Definition:“The value to a particular investor based on individual investment requirements and expectations.” (IGBVT)  Value to the owner  May be a premium or discount to FMV or FV  Can reflect synergies 11
    12. 12. Six Premises of ValueDefinition:“An assumption regarding the most likely set of transactional circumstances that may be applicable to the subject valuation” (IGBVT)1. Book Value (Shareholder’s Equity, Net Worth, Net Book Value)  Total Assets – Total Liabilities2. Going Concern Value (“in-place value” – AMA)  “The value of a business enterprise that is expected to continue to operate into the future. The intangible elements of Going Concern Value result from factors such as having a trained work force, an operational plant, and the necessary licenses, systems, and procedures in place.” (IGBVT)3. Liquidation Value  “Net amount that would be realized if the business is terminated and the assets are sold piecemeal.” (IGBVT)  Orderly Liquidation Value, “at which the asset or assets are sold over a reasonable period of time to maximize proceeds received.” (IGBVT)  Forced Liquidation Value, “at which the asset or assets are sold as quickly as possible, such as at an auction.” (IGBVT)4. Replacement Value  “The current cost of a similar new property having the nearest equivalent utility to the property being valued.” (IGBVT)5. Loan Value6. Insurable Value 12
    13. 13. Valuation Approaches1. Asset Based Approach – Usually sets a floor value  Adjusted Book Value  Adjusted Net Asset Method (Replacement Cost, Liquidation or Going Concern)2. Income Approach  Capitalization of Earnings/Cash Flows Method  Discounted Earnings/Cash Flows Method / Discounted Cash Flow (DCF)  Advantages - Most “technical” analysis  Disadvantages - Terminal year based on a perpetuity/multiple3. Market Approach  Guideline Public Company Method / Comparable Company Analysis  Similar companies in the same industry with like scope and scale  Advantages - Gives a current market view of target company  Disadvantages - May be undervalued or overvalued or the target may be private  Comparable Transaction Method / Precedent Transaction Analysis  Advantages - Multiples includes a premium and private companies can be included  Disadvantages - Similar transactions may not exist and the analysis is historical  Dividend Paying Capacity Method 13
    14. 14. Financial Ratio & Trend Analysis Historical and Adjusted (Economic/Normalized): (5 years OR the length of the natural business cycle of the subject company/industry)  Balance Sheets  Also stated as a % of total assets (Common size)  Will serve to provide information for Asset Based approaches  Income Statements  Also stated as a % of net sales (Common size)  Will serve to provide information for Income Based approaches  Cash Flow Statements  Adjusted for owner/manager discretionary items  Will serve to provide information for Income Based approaches 14
    15. 15. Financial Ratios (Major Categories)1. Internal Liquidity  Current; Quick; Cash; A/R, Inventory & A/P Turnover2. Operating Efficiency  Fixed assets; Total Assets3. Operating Profitability  Cost of Sales, Gross Margin, OperatingEx, ROA, ROE4. Business (Operating) Risk Analysis  Sales Volatility; DOL5. Financial Risk (Leverage) Analysis  Debt/Equity or Capital, Coverage 15
    16. 16. Financial Ratio & Trend Analysis Uses 1. Trend analysis:  Compares the company’s own ratios to itself over time  Identifies the company’s strengths and weaknesses  Assists in establishing capitalization rates by helping to identify risk factors particular to the subject company 2. Comparative analysis:  Assists in making comparisons with other companies or industry averages  Assists in selecting appropriate price/earnings ratios or price/asset multiples relative to the company’s indicated performance to comparable companies or industry averages 16
    17. 17. Investment Value Principle Value = Benefit/Risk  Note: If any two of the three variables are known, the value of the third can be calculated. 1. Value of the business (present value) 2. Amount of return (profit) that a business provides 3. Rate of return (yield) expected on the investment  A fundamental relationship exists between rate of return from an investment and the amount of risk involved in the investment  The greater the risk, the greater the required rate of return 17
    18. 18. Defining the Benefit Stream:Why not GAAP Earnings/Net Income?Arguments for Cash Flow vs. Net Income1. Net cash flows represent the type of earnings most investors are seeking and expect to receive2. Most of the cost of capital derived from the capital markets and other empirical data that is used to derive the discount rate represents net cash flows as the type of earnings3. Net cash flows bring into the income approach the expected future changes in the balance sheet (working capital needs, capital expenditures and changes in long-term debt) Alternative Benefit Streams Used: (Note: Definitions & Calculations may differ by source)  Earnings before interest and taxes (EBIT)  Earnings before interest, taxes, depreciation and amortization (EBITDA)  Seller’s Discretionary Cash Flow (SDCF) or Seller’s Discretionary Earnings (SDE)  Operating Gross Cash Flows  Free Cash Flow (FCF)  Unlevered Free Cash Flow (UCFC) 18
    19. 19. Net Cash Flow Calculations Net Cash Flow to Equity (Net Free Cash Flow)  Will result in the value of the equity  Appropriate discount rate is cost of equity Net Income (after-tax) + Non-cash charges (e.g., depreciation, amortization, deferred revenue, deferred taxes) – Capital expenditures necessary to support projected operations – Additions (deletions) to net working capital necessary to support projected operations + Changes in long-term debt from borrowings necessary to support projected operations – Changes in long-term debt for repayments necessary to support projected operations = Net cash flow to equity – Dividends paid to preferred shareholders = Net cash flow to common shareholders equity Net Cash Flow to Invested Capital ([Unlevered] Free Cash Flow)  Will result in the value of the invested capital  Appropriate discount rate is Weighted Average Cost of Capital (WACC) Net income (after-tax) + Non-cash charges (e.g., depreciation, amortization, deferred revenue, deferred taxes) – Capital expenditures necessary to support projected operations – Additions (Deletions) to net working capital necessary to support projected operations + Interest expense net of the tax deduction resulting from interest as a tax deductible expense = Net cash flow to invested capital 19
    20. 20. Using Historical vs. Projected Benefit Streams Primarily defined by the purpose of the valuation Historical  Generally used when:  Historical economic income is indicative of expected future benefits  Company is mature  Future benefit stream is linear  Generally used for:  Divorce/ Matrimonial Valuations  Buy-Sell Valuations  Estate/ Gift Tax Valuations Projected  Generally used when:  Projections are available and are considered indicative of the expected future benefits  Lack of reliable historical data (E.g.. New businesses or emerging markets)  Future benefit stream is non-linear  Generally used for:  Transactional Valuations  ESOPs  Litigation Engagements 20
    21. 21. Capitalization & Discount Rates The “yield rate” on the business investment Mimics the rate of return currently offered to attract capital to the type of business that being valued Must be consistent with the “type” of earnings Comprised of two main elements: 1. Safe (or reasonable) rate of return on secure investments 2. An additional factor of compensation for the relative degree of increased or decreased risk inherent in the investment. 21
    22. 22. Discount vs. Capitalization Rate Discount rate: A rate of return used to convert a series of future income amounts into present value.  Discount Rate = Capitalization Rate + Long Term Sustainable Growth Rate Capitalization rate: A divisor (or multiplier) used to convert a defined stream of income to a present value.  Capitalization Rate = Discount Rate – Long Term Sustainable Growth Rate  Capitalization Rate = Inverse of the Price/Earnings Ratio (P/E) 22
    23. 23. Weighted Average Cost of Capital (WACC) Definition: “The cost of capital (discount rate) determined by the weighted average, at market value, of the cost of all financing sources in the business enterprise’s capital structure.” (IGBVT) Sometimes referred to as “hurdle rate” Used internally for capital budgeting decisions Weighted Average Cost of Capital = After-Tax Weighted Cost of Debt + Weighted Cost of Equity WACC = wdkd + weke + wpkp  The primary problem with the equity formula is that the stock price must be known. If the current stock price were known, there would be no need to go value the company! 23
    24. 24. Capital Assets Pricing Model (CAPM) Definition: “A model in which the cost of capital for any stock or portfolio of stocks equals a risk-free rate plus a risk premium that is proportionate to the systematic risk of the stock or portfolio. (IGBVT)  “Equilibrium asset pricing theory that shows that equilibrium rates of expected return on all risky assets are a function of their co-variance with the market portfolio.” ERi = Rf + β (ERm - Rf )  ERi - Expected return  Rf - Risk free rate (30-day Treasury bill rate)  β – Beta (co-variance of the rate of return on the subject security, with the rate of return on the market divided by the variance of the market)  ERm -Expected return on a market portfolio (Actual capital appreciation of Standard and Poor’s 500) 24
    25. 25. Build-Up Models (Ibbotson) Derived From the CAPM “Builds-Up” the rate from individual components ks = rf + (bs x ERP) + SP + SCR  ks - Cost of equity  rf - Expected return of the riskless asset  bs - Beta for company  ERP - Expected equity risk premium (Erm-Rf )  SP - Size premium  SCR - Specific company risk (unsystematic risk) 25
    26. 26. Capitalization of Earnings & Discounted Earnings Example Year 1 Year 2 Year 3 Year 4 Year 5 PerpetuityNet Cash Flows to (Equity, Invested Capital, Etc.) $ 550.00 $ 575.00 $ 625.00 $ 650.00 $ 750.00 $ 800.00Capitalization Rate (20%) 20% $ 4,000.00Discount Rate (25%) (Implied Growth Rate 5%) 0.800 0.640 0.512 0.410 0.328 0.328Net Present Value (NPV) $ 440.00 $ 368.00 $ 320.00 $ 266.50 $ 246.00 $ 1,312.00(Equity, Invested Capital, Etc.) Value $ 2,952.50 26
    27. 27. Discounts & Premiums Premiums are generally the reciprocal of Discounts Applied after the final value estimate Not additive Relevant Discounts & Premiums one may likely encounter:  Discount for Lack of Marketability (DLOM) (alternatively, Control Premium)(20-40%)  Restricted Stock Studies  Pre-IPO Studies  Discount for Lack of Control / Minority Interest Discount (10-35%)  Determine business direction  Elect directors and appoint management  Set compensation levels  Set company policies  Determine dividend or distribution policy  Decide on what investments and projects are undertaken and how they are financed  Acquire or dispose of assets  Determine when to liquidate the company  Ability to block the above is dependent upon state laws; Be aware of super majority voting issues  Blockage Discount/Market Absorption  Consideration of Supply & Demand in the public markets  Other discounts (Key man, Liquidity, Restrictive Agreements, Restricted Stock) 27
    28. 28. Practical Use How can I use what I now know about business valuation to maximize the value of my company? Of what can I take control of to create more value? 28
    29. 29. RR 59-60 Spells it Out… RR 59-60 (Selected items)  Nature and History of the Business - NO  Cannot change the past  General Economic Outlook - NO  Beyond one’s control  Specific Industry Economic Outlook - NO  Beyond one’s control  Financial Condition - YES  Earnings Capacity - YES  Dividend Paying Capacity - YES  Goodwill or Intangible Value - YES 29
    30. 30. Simplifying the Approach:Three Focus Factors1. Cash Flows  Benefit Stream2. Growth Rate  Benefit Stream  Discount/Capitalization Rate3. Risk  Discount Rate  Capitalization Rate *VALUE = BENEFIT/RISK 30
    31. 31. Understanding & Defining Risk “Broadly defined, risk management is the discipline of improving your chances of survival and success, particularly in uncertainty and turbulence. In this context, we define risk as the potential for failure in terms of loss or harm or missed opportunity.” Source: Surviving and Thriving in Uncertainty: Creating the Risk Intelligent Enterprise 31
    32. 32. Managing Risk = Managing Value Companies need to take risks to create value, and manage risks to protect value  Challenge risk by challenging assumptions about risk and reward  Learn to take the right risks  Consider velocity & momentum, and remain in control  Manage complexity before it manages you  Developing repeatable and sustainable skills, processes and tools  Be vigilant and anticipate failure  Maintain discipline  Build a margin of safety  Some believe that too much focus on compliance and reporting takes away from strategy and operations  Compliance and reporting remain the backbone of effective risk management  Eliminate uncertainty  Control risk and control your discount and capitalization ratesSMALL changes in Discount & Capitalization Rates = HUGE changes in value 32
    33. 33. Common Risk Factors External  Expectations of the general economy  Existing conditions of the general economy  Expectations of a particular industry  Existing conditions of a particular industry  Competitive environment of a particular industry Internal  General expectations of the particular business being valued  Financial position/condition of the business being valued  Competitive position of the business being valued  Size of the business being valued  Nature of the business being valued  Quality and depth of the organization and staffing of the business being valued  Reliability or stability of the earnings of the business being valued Investment  Risk factors associated with the investment itself  Amount invested in the particular business - relative to other investments in the portfolio  Expectations as to capital appreciation of the investment  Expectations as to liquidity of the investment  Level of the expected management burden of the investment 33
    34. 34. Maximizing Entity Value Growth  Revenue and profit growth is #1 driver of value  Establish a Pattern of Growth  Develop a plan with a focus on Profit, Profit Margins (Margin Management), and Cash Flows Products  Proprietary Products/Technologies  Mix and Diversification of Gross Profit Customers  Diversification (i.e. Concentration no greater than 5-10%)  Tenure  Loyalty  Credit Worthiness  Contractually Recurring Revenue – All revenue dollars are not created equal 34
    35. 35. Maximizing Entity Value Management Quality and Depth  Tenure  Experience  Success Record  Education  Employee Contracts & Non-Competes Good Governance  Corporate Transparency  Strong Internal Control Environment  Executive Accountability Contingent Risks Quality Information  Effective Use of Professionals  Appropriate use of Outside Consultants  Strong Outside Counsel  Reviewed or Audited Financials 35
    36. 36. Questions & Answers 36