Jim Hitchner, CPA/ABV/CFF, ASA - macpamedia.orgmacpamedia.org/media/downloads/2015FVS/Hitchner_PPT2pp.pdf14 Dr. Aswath Damodaran’s Views on Developing Cost of Capital • • •‐

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MACPA2015 Forensic Valuation Conference

Baltimore April 24, 2015

Jim Hitchner, CPA/ABV/CFF, ASA

New Concepts, Data, Models, and Methods for 2015

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Jim Hitchner, CPA/ABV/CFF, ASA• Managing Director, Financial Valuation Advisors, Inc.• CEO, Valuation Products and Services LLC• President, Financial Consulting Group LLC• Editor in Chief, Financial Valuation and Litigation Expert• 35 years in valuation services

• Inductee in the AICPA BV Hall of Fame

• Former member of the AICPA task force on BV standards• Coauthored over 20 courses; taught over 60 courses• Published over 100 articles; made over 200 presentations• Editor and/or coauthor of the books:

• Financial Valuation: Applications and Models, 3rd edition• Financial Valuation Workbook, 3rd edition • Valuation for Financial Reporting: Fair Value, Business Combinations, Intangible Assets, Goodwill, and Impairment Analysis, 3rd edition

• PPC’s Guide to Business Valuations, 25th editionCopyright 2015 Valuation Products and

Services, LLC

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Outline

The latest in cost of capital:• The new Duff & Phelps Valuation Handbook for the build‐up model and the modified capital asset pricing model

• The latest version of the Private Cost of Capital Model (PCOC) and the Pepperdine private capital markets project (based on survey data)

• Dr. Damodaran’s latest views on the equity risk premium

• Pertinent highlights from Pratt and Grabowski’s Cost of Capital, 5th edition

Copyright 2015 Valuation Products and Services, LLC

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Outline

New techniques and research in DLOMs:

• A new probabilistic method

• Support for a DLOM in control valuations

• Changes to the FMV restricted stock database

• A fresh look at the use of public vs. private company DLOM studies including both the multiples and acquisitions methods


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Outline

Control premiums and BV standards:

• A new view on the application of control premiums

• New insight into the use of calculation engagements and calculation reports including:

– A very recent Daubert challenge

– USPAP compliant calculations


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Acknowledgements and Citations• Valuation Products and Services, LLC – Financial Valuation and Litigation Expert

and various webinars• Duff & Phelps 2014 Valuation Handbook – Guide to Cost of Capital• Pratt and Grabowski, Cost of Capital Applications and Examples, 5th edition,

2014, Wiley• Business Valuation Resources, LLC – Business Valuation Update• National Association of Certified Valuators and Analysts – The Value Examiner• FMV Opinions, Inc. – FMV Opinions Restricted Stock Database• Thomson Reuters ‐ Valuation Strategies• Dr. Aswath Damodaran, “Equity Risk Premiums (ERP): Determinants, Estimation

and Implications – The 2015 Edition,” Updated: March 2015, Stern School of Business, NYU – obtain free at http://people.stern.nyu.edu/adamodar/

• 2015 Capital Markets Report – obtain free at www.bschool.pepperdine.edu/privatecapital

• Many of the following slides are edited quotes and/or paraphrased for presentation purposes. Each section cites the source where the material came from. We encourage the participants to obtain and read each original source for additional information and the exact quotes.

6Copyright 2015 Valuation Products and

Services, LLC

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Duff & Phelps 2014 Valuation Handbook –Guide to Cost of Capital *

• The Valuation Handbook includes data previously available in the Ibbotson® Valuation Yearbook, as published by Morningstar, Inc., and data available in the Duff & Phelps Risk Premium Report, as published by Duff & Phelps, LLC.

• Analysts should not use this information on a standalone basis without first reading the Valuation Yearbook. It is highly recommended that analysts purchase and read each annual Yearbook.

Note: The 2015 Valuation Handbook was published last March.

*James Hitchner, “Twenty Ways to Calculate the Cost of Equity Capital: A Case Study,” Financial Valuation and Litigation Expert(FVLE), Issue 51, October/November 2014. (Handout)


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An Overview of the Duff & Phelps 2014 Valuation Handbook –Guide to Cost of Capital

• To keep things straight, Duff & Phelps refers to the “old” Ibbotson SBBI Valuation Yearbook size premia data as the “CRSP Deciles Size Premia” exhibits

• The CRSP stands for the Center for Research in Security Prices at the University of Chicago Booth School of Business www.crsp.com

• The data published in the Duff & Phelps Risk Premium Report is still referred to as the “Risk Premium Report” exhibits

• The following data (some old, some new, and some changed) is now available in the Valuation Handbook


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The Case Study

• See charts 1, 2, and 3 and the endnotes in the separate handout

• Smaller company where CRSP 10th decile and D&P 25th

category apply

• Risk‐free rate normalized and not normalized as of 8/1/14

• Present CRSP unadjusted, D&P unadjusted, and D&P adjusted/recommended

• Used suggested adjustments in D&P to convert IRP

• Company‐specific risk is the same for all calculationsCopyright 2015 Valuation Products and

Services, LLC9


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Private Cost of Capital Model (PCOC)• Dr. Craig R. Everett is Director of 2015 Pepperdine Private Capital Market Project

• 2015 Capital Markets Report – obtain free at www.bschool.pepperdine.edu/privatecapital

• Surveys deployed in October 2014

– Investment bankers (104)

– Private equity groups (64)

– Business appraisers (166)

– Brokers (41)

– Business owners (681)Copyright 2015 Valuation Products and

Services, LLC14

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Private Cost of Capital Model (PCOC)

2015 Capital Markets ReportInvestment Bankers (p. 9)

Metric (EBITDA) 0‐1M 2‐5M 6‐10M 11‐25M 26‐50M >50M

EBITDA Multiple 4.5 5.6 6.5 7.4 8.3 8.6


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2015 Capital Markets ReportPEGs (pp. 5, 17, 18)

Metric (EBITDA) 1M 5M 10M 25M 50M

EBITDA Multiple 3.7 4.8 5.3 7.1

Expected Return 30 30 25 25 25

Required RoR 25 25


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2015 Capital Markets ReportBrokers (pp. 65‐66)

(Median of 11 broad industry groups)

Metric (Revenue) <500K .5‐1M 1‐2M 2‐5M 5‐50M

EBITDA Multiple 2.0 2.5 2.7 3.3 4.1

SDE Multiple 1.5 2.0 2.6 3.2 4.0


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Private Cost of Capital Model (PCOC)2015 Capital Markets Report ‐ Appraisers (p. 60)

Averages

• Risk‐free rate 3.4%

• Equity risk premium 6.1%

• Terminal year growth 3.3%

• DLOM Min. Cont.

– $100 thousand revenues 21% 17%

– $1 million revenues 25% 14%

– $25 million revenues 29% 11%

– $250 million revenues 33% 8%Copyright 2015 Valuation Products and Services, LLC

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Private Cost of Capital Model (PCOC)2015 Capital Markets ReportBusiness Owners (pp. 67, 69, 77)

• 50% less than or equal to $1 million revenue

• 72% less than or equal to $5 million revenue

• Cost of equity capital*– 52% less than or equal to 12%

– 22% between 16% and 26%

– 25% between 0% and 8%


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*Doesn’t look right – That’s why they hire us

Dr. Aswath Damodaran’s Views on Developing Cost of Capital

Dr. Aswath Damodaran, “Equity Risk Premiums (ERP): Determinants, Estimation and Implications – The 2015 Edition,”Updated: March 2015 (8th update), Stern School of Business, NYU – Obtain free at http://people.stern.nyu.edu/adamodar/

• It is surprising how haphazard the estimation of equity risk premiums remains in practice (p. 2)

• Three approaches used to estimate ERPs

– Survey subsets of investors, managers and academics

– Assess the returns earned in the past on equities relative to riskless investments

– Estimate a forward‐looking premium based on the market rates or prices on traded assets today ‐ implied premiums (p. 19)


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Survey Premiums (Investors)• Very few practitioners seem to be inclined to use the numbers from these surveys:– Survey risk premiums are responsive to recent stock price movements, with survey numbers generally increasing after bullish periods and decreasing after market decline

– Survey premiums are sensitive to whom the question is directed at and how the question is asked

– Studies indicate that if they have any predictive power, it is in the wrong direction (pp. 20‐21)


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Survey Premiums (Managers)• Hurdle rates used by companies …are affected by the equity

risk premiums that they use and have significant consequences for investment, financing and dividend decisions (p. 21)

Survey Premiums (Academics)• Academics are neither big players in equity markets nor do

they make many major corporate finance decisions• What they think about ERPs may matter for two reasons

– Many of the portfolio managers and CFOs that were surveyed received their first exposure to the ERP debate in the classroom

– Practitioners often offer academic work (textbooks and papers) as backing for the numbers that they use (pp. 22‐23)

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Historical Premiums• Most investors and managers look at historical data• The most widely used approach to estimating equity risk

premiums (p. 24)• May have developed a consensus that an historical premium is

the best estimate of the risk premium looking forward• There are surprisingly large differences…with the numbers

ranging from 3% to 12% – Different time periods for estimation– Differences in risk‐free rates and market indices – Differences in the way in which returns are averaged (p. 24)


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• How much will the premium change if we make different choices on historical time periods, risk‐free rates and averaging approaches?

• Estimated the arithmetic and geometric risk premiums for stocks over both treasury bills and bonds over different time periods (1928‐2014, 1965‐2014, 2005‐2014)

• The premiums range from 2.73% to 8.00%• If we use a long‐term geometric average premium over the long‐

term rate the equity risk premium that we would use would be 4.60%

• This estimate comes with significant standard error and is reflective of time periods (such as 1920s and 1930s) when the U.S. equity market (and investors in it) had very different characteristics (p. 30)


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• There is one more troublesome (or at least counter‐intuitive) characteristic of historical risk premiums

• The geometric average ERP through the end of 2007 was 4.79%, higher than the 3.88% estimated though the end of 2008

• Every single ERP would have been much higher, if we had stopped with 2007 as the last year

• Adding the data for 2008, an abysmal year for stocks and a good year for bonds, lowers the historical premium dramatically, even when computed using a long period of history

• As a general rule, historical risk premiums will tend to rise when markets are buoyant and investors are less risk averse and will fall as markets collapse and investor fears rise (p. 31)


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Implied Equity Premiums• The problem with any historical premium approach, even

with substantial modifications, is that it is backward looking

• Given that our objective is to estimate an updated, forward‐looking premium, it seems foolhardy to put your faith in mean reversion and past data

• Consider approaches for estimating equity risk premiums that are more forward looking (p. 66)


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• The very act of valuing companies requires taking a stand on the appropriate equity risk premium to use

• For many years prior to September 2008, I used 4% as my mature market equity risk premium when valuing companies, and assumed that mean reversion to this number (the average implied premium over time) would occur quickly and deviations from the number would be small

• I think that the banking and financial crisis of 2008 has created a new reality, i.e., that ERPs can change quickly and by large amounts even in mature equity markets

• I now vary it [ERP] year to year, and even on an intra‐year basis, if conditions warrant (p. 83)


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• After the crisis, in the first half of 2009, I used equity risk premiums of 6% for mature markets in my valuations

• As risk premiums came down in 2009, I moved back to using a 4.5% ERP in 2010

• With the increase in implied premiums at the start of 2011, my valuations for the year were based upon an ERP of 5% for mature markets and I increased that number to 6% for 2012

• [In 2013 Damodaran used 5.8%; in 2014 he used 5.00%]• In 2015 he is using 5.75%• When valuing individual companies, I want my valuations to

reflect my assessments of the company and not my assessments of the overall equity market

• Using equity risk premiums that are very different from the implied premium will introduce a market view into individual company valuations (p. 83)

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Which approach is the “best” approach?• In conclusion, there is no one approach to estimating equity risk premiums that will work for all analyses

• If predictive power is critical or if market neutrality is a prerequisite, the current implied ERP is the best choice

• For those more skeptical about markets, the choices are broader, with the average implied equity risk premium over a long time period having the strongest predictive power

• Historical risk premiums are very poor predictors of both short‐term movements in implied premiums or long‐term returns on stocks (p. 103)


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Five myths about equity risk premiumsThere are widely held misconceptions about equity risk premiums that we would like to dispel in this section

1. Services “know” the risk premium2. There is no right risk premium3. The equity risk premium does not change much over

time4. Using the same premium is more important than

using the right premium5. If you adjust the cash flows for risk, there is no need

for a risk premium (pp. 105‐106)


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Cost of Capital, 5th EditionA Few Things to Know About

Shannon P. Pratt and Roger J. Grabowski, Cost of Capital Applications and Examples, 5th edition, Wiley, 2014

Are the Build‐Up Model and MCAPM No Longer Valid and Supportable?

– Some vocal analysts presenting alternative data and models say this is true


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Are the Build‐Up Model and MCAPM No Longer Valid and Supportable?• Cost of Capital for Closely Held Businesses (pp. 693‐709)

• “The two commonly used models to estimate the cost of capital for discounting or capitalizing expected net cash flows for a closely held business are the build‐up method and the modified version of the capital asset pricing model (CAPM).” (p. 693)


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Are the Build‐Up Model and MCAPM No Longer Valid and Supportable?• “As the magnitude of the effects of the differences between the private and public capital markets have on the cost of capital is further researched and the databases and surveys of closely held companies are expanded and improved, the estimation of a cost of capital directly from the private markets will become more reliable and defendable.” (p. 709)

• “For now, however, the build‐up method and the expanded CAPM still remain the best tools available for estimation of a cost of capital for a closely held business.” (p. 709)


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Criticisms of the Size Premium (pp. 331‐371)

• “The size effect is not without controversy, though, and various commentators question its validity. In fact, some commentators contend that the historical data are so flawed that practitioners can dismiss all research results that support the size effect.” (p. 331)

– “Is beta not measured correctly?

– Are market anomalies causing the size effect?

– Is size a proxy for other factors correlated with size, e.g., liquidity?

– Is the size effect hidden because of unexpected events?” (p. 331)


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Criticisms of the Size Premium

• “The authors do not dispute that the size effect does indeed wax and wane, and may even be negative over significant lengths of time, or that it may be systematically diminished in more recent times. However, the research does suggest that:

– The size effect is cyclical.

– The longer the holding period over which small stocks and large stocks are measured against each other, the more likely it is that small stocks will outperform large stocks.

– This implies that over the long run, the size effect is indeed a significant factor that should likely be accounted for in the development of cost of capital estimates.” (p. 362)


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Criticisms of the Size Premium

– “The 1980s were not kind to small stocks. During this period, the size effect likely was on a cyclical low, or even negative.

– There is evidence that after the 1980s, the size effect may again be entering a cyclical period of strength.” (p. 362)

• “The validity of the size effect has received recognition by academics and the courts. For example, in a recent Delaware Court of Chancery decision [Sunbelt Beverage]…The issue was not whether it was appropriate to apply a size premium; rather, the issue was how to measure the size premium.” (p. 362)


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Levering and Unlevering Betas (pp. 247‐253)

• Hamada

– Assumes constant debt, not debt changing at a constant percentage of equity capital as a firm’s cash flows grow

• Other formulas (Miles‐Ezzell or Harris‐Pringle) adjust for increasing debt

– Somewhat more complicated to use

– At certain debt levels and assumptions, the difference may not be material, but at other levels and assumptions it can be


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Probability Based DLOMs

• Marc Vianello, CPA, ABV, CFF, “Calculating Probability‐Based Discounts for Lack of Marketability,” Valuation Strategies, November/December, 2014, Thomson Reuters

• Marc Vianello, CPA, ABV, CFF, “How Probability Affects Discounts for Lack of Marketability,” Business Valuation Update, Vol. 20, N0. 7, July 2014, Business Valuation Resources, LLC (The following slides are from this source)


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• DLOMs should reflect price risk during an anticipated marketing time

• Relies on variation to the Longstaff lookback option pricing model

– Time period of a restriction on marketability

– Price volatility during the restriction period (pp. 1, 4)


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• Five Observations:

1. The time period starts at the valuation date and is the period of time that the asset is expected to be offered for sale

2. Price volatility is equated with the expected marketing period of the asset

3. Perfect timing exists in the valuation context because it always is at the valuation date

4. Uses average volatility that puts price risk to the average investor and eliminates “perfect knowledge”

5. Capping the DLOM at 100% for higher volatilities and longer periods of time (p. 4)


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Probability Based DLOMsBV Update, p. 8


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Probability Based DLOMsBV Update, p. 8


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DLOMs in Control Valuations

Edward Bortnick, CPA, CVA, MAFF, CFF, “Do Not Be Too Quick to Discount a Discount for Controlling Interests,” Valuation Strategies, July/August 2014, Thomson Reuters

• IRS Job Aid – Expectation that DLOMs for controlling interests would be lower than that applied to minority interests

• Most DLOM market studies are based on minority interests (restricted stock, pre‐IPO studies, and Paglia Study)

• Limited studies on DLOMs on interests in private companies (Private Company Discount Studies ‐ Acquisition Approach)

• Court decisions

• DLOMs may be applied in valuations of controlling interest but the amount will need to reflect the facts and circumstances of the appraisal Copyright 2015 Valuation Products and

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• DLOM reflects:– Time ‐ the stated price is not immediately realizable in cash – Risk ‐ uncertainty about the eventual receipt of the stated price

• Both are factors in transactions involving sales of controlling interests in privately held companies

• Time between listing and closing a transaction –– Average of 193 to 197 days in the Bizcomps and Pratt’s Stats databases

– Bizcomps only tracks up to 999 days and some deals take longer to complete

– Pratt’s Stats ‐ some deals take as long as 7,007 days

• Risk: Only a small number of companies that are listed are eventually sold, perhaps only 20%


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• DLOM Studies on Controlling Interests– The Existence of, and Earnings Quality Explanations for, the Private Company Discount, by Gus De Franco, Ilanit Gavious, Justin Tin, and Gordon D. Richardson in 2006

• Compared private acquisitions of 100% ownership interests in private companies to acquisitions in public companies

• Sample size is 673 private companies and 2,249 public companies

• Implied DLOMs between 21% and 37%

– The Private Company Discount, by John Koeplin, Atulya Sarin, and Alan C. Shapiro in 2000

• Domestic private companies are acquired at a 20% ‐ 30% discount relative to similar public companies


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• DLOM Studies on Controlling Interests (continued)– A New Examination of The Private Company Discount: The Acquisition Approach, by Maher Kooli, Mohamed Kortas, and Jean‐Francois L’Her in 2003• Implied DLOM is 34%

• Issues:– Assumptions in the studies may be challenged– Studies may not provide support in adjudicated judicial cases


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• Tax Court Decisions – DLOMs have been allowed for controlling interests on several occasions• Estate of Dougherty

–100% interest in a trust that owned 100% of the common stock of A.L. Dougherty Co., Inc., a corporation with assets including securities, notes receivable, and real estate

–Court found a 25% DLOM to be appropriate, as well as a 10% discount for incremental management costs


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• Tax Court Decisions (continued)

• Estate of Bennett• 100% ownership interest in the common stock of Fairlawn Plaza Development, Inc.

• Court allowed a 15% DLOM based on the facts– Real estate company with varied and non‐liquid assets

– Corporate form – difference in owning the assets and liabilities directly and owning stock of Fairlawn

– Discount would be required to buy the package of desirable and less‐desirable properties

– Reflects difficulty in holding non‐liquid assets in corporate form


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FMV Opinions Restricted Stock Database ‐ Update

• Lance S. Hall, ASA, “FMV’s Two‐Year Equivalent Discounts for Lack of Marketability Methodology and Calculator,” Business Valuation Update, Vol. 20, N0. 10, October 2014, Business Valuation Resources, LLC

• Determining Discounts for Lack of Marketability ‐ A Companion Guide to the FMV Restricted Stock Study, 2014 edition, FMV Opinions, Inc., www.bvmarketdata.com

• Convert one‐year and six‐month holding periods to a two‐year equivalent holding period which is more relevant


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FMV Update

• Holding period median discounts

– Six‐month 12.0%

– One‐year 15.7%

– Two‐year 22.1%

• With and without registration rights

– With 13.3%

– Without 18.6%


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FMV Update

• Equivalency process

– Excluded transactions in the top VIX quintile

– Excluded SIC code 6 – finance, insurance and real estate

– Excluded transactions ‐ block size greater than 20%

– Excluded all transactions with a premium

• Two‐year equivalency adjustments

– Six‐months without registration rights 5.7%

– One‐year without registration rights 3.8%

– Six‐months with registration rights 6.6%Copyright 2015 Valuation Products and Services, LLC

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Public vs. Private Company DLOM Studies

Kevin Zanni, ASA, CVA, CBA, CFE, “Private Company Discount Studies and Application to Non‐Marketable Interests,” The Value Examiner, July/August 2014• Demonstrate that private companies sell at lower pricing

multiples than public companies, which may reflect illiquidity

• May be used to support DLOM or guideline company multiple selection in Market Approach

• Two types of study:– Multiples Approach

– Acquisition Approach

• Compare financial fundamental transaction multiples52


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Multiples Approach – Compares guideline publicly traded company multiples to private company acquisition multiples• Paglia Study (2010)• Assumes that publicly traded market prices approximate controlling interest values

• Study Process:– Screening– Matching– Calculate Market Value to Invested Capital (MVIC) multiples– Compare matched pairs MVIC/Net Sales and MVIC/EBITDA


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Paglia Study (2010) Findings• All measures of multiples for private companies were less than multiples for publicly traded companies

• Mean and median profitability measures (ROE, profit margins, etc.) for private companies were generally equal to or greater than the matched publicly traded business (logical since profitability was one of the criteria in selecting matched pairs)

• Data provided by NAICS Code – Industry Sector


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Paglia Study (2010) Findings (continued)• Implied DLOM comparing:

– MVIC/Sales – Private company multiples were average of 67% lower and median of 73% lower

– MVIC/EBITDA – Private company multiples were average of 66% lower and median of 72% lower

• Conclusion: Private firms with larger book value of assets, positive net income, and lower probability of financial distress had significantly lower PCD DLOM indications


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Acquisition Approach – Compares transaction multiples of public companies to transaction multiples of private companies• Koeplin Study (updated by Block)• Kooli Study• Officer Study (De Franco Study is similar)


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Koeplin Study (2000)

• 84 domestic transactions and 108 foreign transactions between 1984 and 1998

• Excluded regulated utilities, financial services, and acquisitions of less than controlling interest

• Matched pairs based on SIC code, proximity of transaction date, and size based on sales

• Calculated transaction multiples to enterprise value

– EV/EBIT, EV/EBITDA, EV/BV, and EV/Sales


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Koeplin Study (2000) (continued)• Conclusion:

– Earnings multiples provided statistically significant guidance

– Private domestic companies sell at multiples 20% to 30% lower than public

– Private foreign companies sell at multiples 40% to 50% lower than public

• Kooli criticism ‐ Private companies smaller and different growth rates than matched public companies

• Study did not capture differences in employment contracts that might have been a form of consideration – results in imperfect comparison


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Kooli Study (2003)• Similar to Koeplin, but compares a portfolio of guideline

company transactions to private transactions• 331 U.S. private company transactions from 1995 to 2002• Data available by industry sector• Transaction multiples of public companies greater than

private companies– 17% greater based on Sales– 34% greater based on Earnings– 20% greater based on Cash Flow

• Conclusion: Private company discount is smaller for large (assets) and growing companies

59Copyright 2015 Valuation Products and Services, LLC


Officer Study (2007)

• Calculates PCD and attempts to determine if illiquidity of the target influences the size of PCD

• Analyzed private company acquisition pricing multiples and unlisted subsidiary acquisition pricing multiples compared to public company acquisition multiples

• 12,716 company acquisition bids (successful and unsuccessful) between 1979 and 2003

• Compared portfolios of publicly traded targets to each unlisted target


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Officer Study (2007) (continued)

• Matched using SIC code, deal value excluding liabilities, proximity of timing (3‐year window)

• Unlisted targets (private and unlisted subs) are acquired at 15% to 30% lower multiples than public

• Conclusion:

– Acquisition prices are sensitive to liquidity needs of the target company owners

– Selling parties are willing to sell assets at a discount because of liquidity needs


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A New Look at Control Premiums

• Lance S. Hall, ASA, “Determining Control Premiums: A Better Approach,” Valuation Strategies, March/April 2014, Thomson Reuters

• Rejects the general opinion that control is always about just the cash flows and cites the Market Participant Acquisition Premium (MPAP)

• This concept shows a misunderstanding about the public vs. acquisition marketplace

• Recommends using Mergerstat in a different way

– Evaluate synergistic vs. non‐synergistic dealsCopyright 2015 Valuation Products and

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• Synergistic acquisitions were at a 36.8% premium

• Non‐synergistic acquisitions were at a 32.7% premium

• Evaluates non‐synergistic transactions where the target has an S&P quality rating of A*

– Low cash flow enhancement opportunities

– Median control premium was 25.3%

* Rankings reflect variability in growth and stability of a company’s earnings and dividends



• Companies rated below A are more likely to have cash flow enhancement opportunities

– B companies – median 32.3% premium

– C companies – median 35.1% premium

• Volatility amongst non‐synergistic acquisitions

– Quintile 1 (least volatility) 20.0% premium

– Quintile 5 (most volatility) 52.4% premium


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• Size amongst non‐synergistic acquisitions

– Quintile 1 (highest value) 29.3% premium

– Quintile 5 (lowest value) 40.5% premium

• Future Growth (five‐year EPS) amongst non‐synergistic acquisitions

– Quintile 1 (highest growth) 28.2% premium

– Quintile 5 (lowest growth) 35.0% premium

• Another article coming that looks even further into the data


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New Insight Into the Use of Calculation Engagements and Calculation Reports


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Please note that Hitchner does not represent the AICPA, ASA, IBA, NACVA, or The Appraisal Foundation and the views and answers he shares here are solely his own and are not the official position of the AICPA, ASA, IBA, NACVA, or The Appraisal Foundation.

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Use of Word “Opinion”

• For CPAs, “opinion” has special meaning from an audit perspective

• Word “opinion” purposely left out of the AICPA’s Statement on Standards for Valuation Services No. 1 (SSVS No. 1)*

• No prohibition in SSVS No. 1 on use of opinion of a calculated value or opinion of conclusion of value

• No explicit endorsement either ‐ Silent on this issue

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* Unfortunately, the word “opinion” is included SSVS No. 1, paragraphs 65.a., 65.g., and Appendix A, No. 6. This was unintentional and should not be in the Standards.


Opinion of Value/CalculationsLitigation Engagements

The Federal Rules of Evidence, Rule 702, Testimony by Expert Witnesses, states the following:

• A witness who is qualified as an expert by knowledge, skill, experience, training, or education may testify in the form of an opinion or otherwise if:

– (a) the expert’s scientific, technical, or other specialized knowledge will help the trier of fact to understand the evidence or to determine a fact in issue;

– (b) the testimony is based on sufficient facts or data;

– (c) the testimony is the product of reliable principles and methods; and

– (d) the expert has reliably applied the principles and methods to the facts of the case. [emphasis added] 68


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• Sufficiency and reliability are major factors

• Black’s Law Dictionary, 10th edition, 2014, defines a credible witness as “A witness whose testimony is believable”

• In some litigation settings, an opinion is given with “reasonable certainty”

• Can a calculation and calculated value be provided that is sufficient, reliable, believable, and/or with reasonable certainty?

• Given language in paragraphs 21b and 77 in SSVS No. 1, you would think that the answer is no

69Copyright 2015 Valuation Products and Services, LLC


Agreement with the client

• Not a big deal

• Most clients unfamiliar with approaches, methods, procedures, assumptions, applications, data choices, etc.

• Client wants less expensive process to estimate a value

• Although client must agree to extent of work performed, valuation analyst decides what is to be done

• Analyst must withstand criticisms that he/she and client are in cahoots and that the client is driving process to obtain desired result

• The buck stops with you


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More limited procedures that do not include all the procedures required in a valuation engagement ‐ Had a valuation engagement been performed, the results might have been different

• A big deal, particularly in litigation setting ‐ How does this sound? “My opinion of the calculated value of XYZ Company is $4,000,000.”

• What you are really saying is, “My opinion (which is sufficient, reliable, believable, and with reasonable certainty) of the calculated value (which is not sufficient, reliable, believable, or with reasonable certainty) of XYZ Company is $4,000,000.”


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Calculation Survives Federal Court Daubert Challenge

• Teresa Hipple v. SCIX, LLC, et al., In The United States District Court For The Eastern District Of Pennsylvania, Civil Action 12‐1256, Memorandum, August 14, 2014

– James Hitchner, “Calculation Survives Daubert Challenge –Does This Help Open the Door for Calculations in Litigation?” Financial Valuation and Litigation Expert, FVLEIssue 52, December 2014/January 2015. (Handout)

• Motion in limine to exclude the proposed testimony of plaintiff’s expert ‐ CPA/ABV, CVA, CFE, and CFF with 25 years of experience in forensic accounting


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Hipple

• The defendants argued that the plaintiff’s expert’s proposed testimony concerning the value of certain assets was inadmissible because it did not comply with Federal Rule of Evidence702 (see previous)

• The expert prepared a calculation of value

• The expert used a multiple of seller’s discretionary earnings to determine the value

• The Court denied the motion to exclude this testimony


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Hipple

• “Under Daubert, courts must address a ‘trilogy of restrictions’ before permitting the admission of expert testimony: qualification, reliability and fit.”

• “Defendants argue that Mr. [Expert]’s proposed testimony fails both the fit and reliability restrictions set forth in Daubert because he completed only a limited ‘Calculation of Value’ rather than a more extensive ‘Opinion of Value.’”

• “A Calculation of Value is an engagement whereby the ‘analyst and the client agree on the valuation approaches and methods’ and ‘does not include all of the procedures required for a valuation engagement [i.e., Opinion of Value].’”


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Hipple

• “An Opinion of Value is an engagement that allows the analyst to ‘apply the valuation approaches and methods he or she deems appropriate in the circumstances,’ and the result is a ‘conclusion of value.’”

• “The Court rejects defendants’ argument and concludes that the proposed testimony of Mr. [Expert] is admissible.”

• “Both a Calculation of Value and Opinion of Value are engagements approved of by the American Institute of Certified Public Accountants.”

• “Mr. [Expert] stated during his deposition that he could not complete an Opinion of Value because he had only limited information about the financial records of SCIX.”


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Hipple

• “Mr. [Expert] conducted his analysis based on limited available information and his assumptions and methodology are clear.”

• “Thus, the appropriate weight to afford Mr. [Expert]’s proposed testimony will be determined by the Court after cross‐examination during trial.”

• “‘As long as an expert’s scientific testimony rests upon “good grounds, based on what is known,” it should be tested by the adversary process — competing expert testimony and active cross‐examination — rather than excluded from jurors' scrutiny for fear that they will not grasp its complexities or satisfactorily weigh its inadequacies.’”


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Type of Engagement AICPA NACVA IBA ASA USPAP

Valuation X X X

Calculation X X X

Appraisal X

Limited Appraisal X

Calculation X

Appraisal X

Type of Value AICPA NACVA IBA ASA USPAP

Conclusion of Value X X X

Calculated Value X X X

Unambiguous Opinion of Value X

Estimate of Value X

Approximate Indication of Value X

Opinion of Value/Conclusion XCopyright 2015 Valuation Products and Services, LLC

ASA/USPAP CalculationsA New View

• Scope of work

• Intended use

• Appraiser’s responsibility

• Based in large part on Carla Glass’s article “The Question of Calculations and USPAP – Another Round,” Financial Valuation and Litigation Expert, FVLE Issue 47, February/March 2014 (Handout)


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• “Appraisal: (noun) the act or process of developing an opinion of value; an opinion of value.”

• “Scope of Work: the type and extent of research and analysis in an appraisal or appraisal review assignment.”

• USPAP does not define the word “opinion”

• As such, it is open to interpretation


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www.merriam‐webster.com “Opinion”

• “a belief, judgment, or way of thinking about something : what someone thinks about a particular thing”

• “advice from someone with special knowledge : advice from an expert”

• As previously mentioned, this is NOT “with reasonable certainty”


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• The word “appraisal” as used in USPAP is intended to mean an opinion reached as the result of a variety of scopes of work – from very limited to very extensive

• USPAP 2005 had the same definition of “appraisal” as is used today

• However, USPAP 2005 also had two types of appraisals:

– Complete Appraisal – Did not invoke Departure Rule

– Limited Appraisal – Did invoke Departure Rule


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• USPAP 2006 – Departure Rule, Complete Appraisal, and Limited Appraisal were eliminated

• Replaced with Scope of Work Rule

• Again, the definition of “appraisal” did not change

– In 2005 it was applicable to both a Complete Appraisal and a Limited Appraisal

• As such, under USPAP you can do a Valuation/Appraisal Engagement or a Calculation Engagement


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• To perform a calculation engagement, USPAP would require that the lesser scope of work be deemed appropriate in the context of the intended use of the assignment results

• USPAP indicates that the appraiser is responsible for making sure that the scope of work performed is appropriate – It is the appraiser’s decision

• USPAP requires that the appraiser not allow the scope of work to be limited “to such a degree that the assignment results are not credible in the context of the intended use”



• A “calculation” is an “appraisal” under USPAP with a lesser scope of work

• The Scope of Work Rule was specifically written to allow for a full spectrum of extents of research and analysis


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Jim Hitchner, CPA/ABV/CFF, ASA - macpamedia.orgmacpamedia.org/media/downloads/2015FVS/Hitchner_PPT2pp.pdf14 Dr. Aswath Damodaran’s Views on Developing Cost of Capital • • •‐

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