My discussion of interesting valuation topics at the NACVA-GSCPA Atlanta Chapter meeting on August 21, 2012

1. Topics in Valuation that Nobody is
Talking About – Predictions of Future
Hot Topics
Michael S. Blake, CFA, ASA
Director of Valuation Services
Habif, Arogeti & Wynne, LLP
michael.blake@hawcpa.com
@unblakeable
www.unblakeable.com

2. Disclaimer
 The intent of this discussion is to provide
guidance to non-appraisers to perform
internal valuation analyses. Applying the
concepts and data contained herein is in no
way a substitute for an analysis performed by
a qualified appraiser.
 Use at your own risk.
 Legal counsel should be consulted before
doing anything whatsoever.

3. Disclaimer #2
 The opinions expressed in this presentation
are my own and do not necessarily represent
those of HA&W, NACVA, the GSCPA or the
Government of Freedonia.
 The intent of this speech is to provoke thought
– not provide easy answers.
 Disagreement leads to enlightenment.

4. What Won’t Happen Here
 Discussion of discounts and
court cases
 Discussion of tax-affecting for S
corporations
 Discussion of loss of US AAA
Credit Rating
 Discussion of dueling BV
standards
 Talk about Facebook

5. WHAT HAPPENED TO THE MARKET
APPROACH?

6. The Disappearing Market
 Every major set of BV
standards requires
consideration of market
approach
 ASC 820 implies
consideration of market
approach (Level 1/2 inputs)
 Rev. Rul. 59-60 indicates
consideration of market
approach

7. Kicked to the Curb?
 Laziness
 Effort to conserve hours
 Poor training at the association level (ASA)
 Collective professional don’t-ask-don’t-tell
 Genuine disbelief in market data or
information

8. The Market Approach is Important
 Professional standards
require it
 Abandoning the market
approach undermines
credibility of other
valuation techniques
 Often the only piece of
information that is
interesting to the client

9. SAS 73: WHAT DOES IT REALLY
MEAN?

10. What Reviewers Need to Do is Clear
 Perform tests of the data
 Assess valuation
methodologies in terms
of acceptability
 Validate qualifications of
the specialist

11. Or is it…?
 No FASB or AICPA
guidance on how much
review is enough
 No clear best practices
from industry leaders
 No checklists
 Client experience varies
from auditor to auditor

12. Our Take
 Tie all assumptions to something verifiable
 Management representations viewed with
healthy skepticism
 Test probability-driven models with statistics,
simulations, option theory
 Replicate the valuation (do the math)
 Complete analyses in conformance with
professional standards

13. Summary of PCAOB FV Comments
 37/89 or 42% of criticisms of the Big 4 were
related to fair value
 Hard-to-Value securities seemed to generate
most frequent criticism
 Failure to challenge/support projections
figured prominently
 Overreliance on third parties
 Too much “black box”

14. HOW THE FED IS MESSING WITH
THE M&A MARKET

15. 0.0
0.5
1.0
1.5
2.5
3.0
3.5
4.0
5.0
2.0
4.5
2008-08
2008-10
2008-12
2009-02
2009-04
2009-06
2009-08
2009-10
2009-12
2010-02
2010-04
2010-06
2010-08
2010-10
The Fed Punishes Savers
2010-12
2011-02
20-year Treasury Yield (%)
2011-04
2011-06
2011-08
2011-10
2011-12
2012-02
2012-04
2012-06

16. Selling a Business Turns you into a
Saver
 Your income goes
from active to passive
 Your available risk-
free return to replace
income is cut in half
 Usually prevented
from going into same
business

17. Where Fair Value Meets
Alternate Reality
Investment Value –
Seller – Low return
on funds received.
Fair Value – Buyer
and Seller Agree Bid-ask spread
Investment Value –
Buyer – Low return
on funds invested

18. Do Owners Have to Sell?
Myth Reality
 Aging owners must sell  They can work longer and are
 Foreign competition will getting better at succession
scare owners out of  See Clint Eastwood and
business Halftime for America
 Banks calling loans will  Owners are winning games of
force sales chicken with the banks
 Owners will adjust to the  Entrepreneurs are by definition
new normal and capitulate hopeless optimists
 Buyers can wait owners  Buyers only make money if
out they actually buy the business

19. Activity in Small M&A on Decline
Number of Closed Transactions*
2000
1800 1730
1626
1600
1400 1219
1200 1081
1001
1000
800
600
400
200 32
0
2007 2008 2009 2010 2011 2012
*2012 data through 4/24/12

20. Closing Time
Average Days to Transaction Close
250 229
225 219 226
201
200
160
150
100
50
0
2007 2008 2009 2010 2011 2012

21. Money on the Table
% Cash Down at Closing
90%
78% 79%
80% 74%
69% 71%
70% 64%
60%
50%
40%
30%
20%
10%
0%
2007 2008 2009 2010 2011 2012

22. A Buyer’s Market
% of Sales as Asset Sales
100%
85% 86% 88%
90% 84% 82%
80% 73%
70%
60%
50%
40%
30%
20%
10%
0%
2007 2008 2009 2010 2011 2012

23. M&A Takeaways
 Very much a buyers’
market
 Likely increase in
distressed sales
 Sellers are digging in
 Tax policy not likely
driving the M&A market
 M&A should continue
to be slow into next
year

24. BLACK-SCHOLES DOESN’T WORK

25. A Review of Black Scholes
 There is no arbitrage opportunity (i.e., there is no way to make a
riskless profit)
 It is possible to borrow and lend cash at a known constant risk-free
interest rate
 It is possible to buy and sell any amount, even fractional, of stock
(this includes short selling)
 The above transactions do not incur any fees or costs
(i.e., frictionless market)
 The stock price follows a geometric Brownian motion with constant
drift and volatility
 The underlying security does not pay a dividend
 The option is European in style
 No counterparty risk

26. So What’s Wrong?
 Most options are not European
style
 Counterparty risk not
contemplated
 Dividends increasingly common
 Private securities not in a
frictionless market
 Black Scholes only appears to
work with low-volatility stocks

27. Possible Solutions
 Move away from option
models to simulations
 Adopt more complex
option models (Hull-
White, EPV, Whaley
models)
 Real options theory
 Current value methods
 Accept the bad model

28. APPRAISERS AND ACCOUNTANTS
PLAYING NICELY

29. Mars and Venus
Accounting Business Valuation
 Profession is externally  Profession is largely self-
regulated and licensed policing
 Heavily reliant upon
 Highly rules-driven judgment
 Math is limited to  Unlimited complexity to
arithmetic math
 Views BV as a necessary  Views CPAs as referral
evil source
 Right vs. wrong  Hard to be definitively
relatively defined “wrong”

30. We Need to Educate
 Good reports = improved
transparency
 Audit procedures don’t
always match up with
credible value
 Surprises = friction
 Overreliance of CPA on
the appraiser

31. 5th CPA Exam?
 AICPA should consider adding a 5th exam to
cover valuation
 Every CPA must be able to critically read a
valuation report
 CPA’s must help their clients understand the
work product

32. Thanks! Questions?