We haven't been around that long, folks...no wonder there are still "Big Issues" in BV


It's strange to think but that standards of value chart that we're all familiar with was first published in 1990.

And, we didn't have a clear buildup model, and the first discussion of the adjusted capital asset pricing model (CAPM) wasn't identified in academic literature until 1989.

That's less than a quarter of a century since the first versions of these essential business valuation concepts were first documented, Chris Mercer explained to a keynote group at today's AICPA Forensic & Valuation Services Conference in Orlando. Chris had one of the largest audiences of any speaker at the event.

So, it's no wonder there's still disagreement on key methods, and even some inaccuracies (Mercer referred to a 1992 article he wrote about the distinction between net income and net cashflow which make the mistake of assuming the growth rate would always be the same for both benefit streams.   Ah well--Chris has been right about a lot more in the meantime.)

Chris' topic at the AICPA annual meeting was "The Big 5 Valuation Issues;"  in the context of recognizing that, to some degree, we're still refining both the definitions, and the methods for applying them.  He looked at the various debates like levels of control value (citing the 1990 article by Eric Nath that introduced the argument that a financial control value and the marketable minority value are not the same--even if they are close in most cases).

Another big issue, Mercer argues, comes from adjustments to the income statement--normalizing adjustments to private company earnings stream.  "These are not control adjustments," Mercer asked the audience to repeat after him!  So many factors are involved here but whether or not to normalize is "no longer a matter of appraiser judgment," Mercer emphasized.   The only objective standard by 2012, he says "is to normalize owner compensation," or you haven't "revealed the income stream that is the source of potential value for the buyer."

Or another issue still under debate--the market approach (both GPCM and the comparable transaction method).  "We have to look, or face scrutiny for not considering the marketing approach," Mercer agreed. "But often we fail to understand that the public markets normalize to expected future earnings."  To prove this he cited the many companies that have low earning now but forecast bigger earnings.   If the market believes them, the value of the stock already reflects the value of future earnings (BVR would argue that the over-persuit of value means that the public markets OVER-normalize earnings value, but that's another debate).

Of course, this is both a benefit and a problem for appraisers.   For one thing, it means that the guideline companies' price may in fact be at a different standard of value than the target company.   The ratio analysis for the public companies will reflect current financial data, while the pricing is for future earnings potential.   It will be pretty easy for other appraisers to question your judgment if the growth in earnings potential of "your inner city bike messenger company isn't the same as Fedex'" Mercer joked.   "I've been called 'irresponsible' for not using the GPCM in the face of differences like that."

That's why these methods may require fundamental adjustments for private companies, Mercer argues.  "Hope springs eternal in the public markets," he says, reflecting the somewhat chronic belief in public pricing that "the next quarter or period will experience sharp upward motion."  In specific valuation-formula terms, "G" assumed for public market pricing is rarely going to be accurate for a private company, especially if one takes regression to the mean seriously.

Mercer believes that appraisers who weight the public company methods will therefore tend to overvalue a private company facing a willing buyer-willing seller analysis.

And yet, the methodology of such "fundamental adjustments" are not standardized in the business valuation literature, or even valuation to valuation at the same firm in many cases.  Another sign of the youth of the profession.  Mercer might run an adjusted CAPM method against public company analyses as one way to balance these different market values.   Another appraiser might simply chose the bottom or the top quartile of values directed from market approach analyses.

"And this is just when valuing equity," Mercer said, reflecting the fact that total capital valuations create further variations.

And, of course, the biggest of the unresolved issues in BV, from Chris' point of view--marketability discounts, which move appraisers from the marketable minority value to the nonmarketable minority value.  "This is near and dear to my heart," Chris laughed, "and I've only got another 15 minutes."

But he feels, at a minimum, that averages derived from databases have the same challenge related to other averages--that other factors go into setting pricing.

No one will be surprised to learn that Chris believes his QMDM model helps overcome most of the limitations of applying marketability discounts.   But at the least, he argues that USPAP and other practice standards and guides require that analysts consider income, market (and asset if applicable) approaches when calculating discounts.   So, some combination of methods--again, not agreed upon by the profession--including at least one from the mostly market approach side (like restricted stock studies) and one from the income approach side should be considered.

Another "big issue" where a young profession is coming to terms with variations in practice...

 

 

 


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