How does business valuation differ from real estate appraisals?
It is less rigidly structured and more complex due to multiple assets being involved
What are some strengths and weaknesses of the market approach?
Strength: easy to get data, direct method of valuation if similar comps found, a lot of information and research available
Weakness: hard to find truly similar company
What are the four key components of a business?
1. strategy
2. people
3. systems
4. tangible and intangible assets
Investment value (strategic value)
The value to a particular buyer, typically characterized by a premium because of some unique factor perceived by the buyer
What two contexts is fair value typically used in?
Legal purpose and financial reporting purposes
fair value (legal purposes)
the value used in the court of law where the standard of value arises between jurisdiction and is legal community based rather than economically or market based.
What is Fair value for financial reporting?
the price that would be received to sell an asset or paid to transfer a liability (transaction costs excluded)
The fair value hierarchy
prioritizes the inputs used in valuation and impact the level of disclosure
What are the specific types of business risk?
1. Operational risk
2. Turnover risk
3. Financial risk
4. Liquidity risk
What is turnover risk?
the decline in ROA due to underuse of assets
What is the purpose of Revenue Ruling 59-60?
To outline and review in general the approach, methods and factors to be considered in valuing shares of the capital stock of closely held corporations for estate tax and gift tax purposes
What must the appraiser identify and define in a business appraisal?
1. What's being valued
2. The standard of value
3. Effective date of appraisal
4. Purpose and intended use of the valuation
5. Nature and scope of assignment
What are the three scopes of appraisal work?
1. Appraisal- as precise as possible
2. Limited appraisal- an estimate of value
3. Calculation- an approximate indication of value
What opportunities does globalization provide firms with?
1. access to new markets
2. access to a variety of labor, capital, and knowledge
3. global production networks
What challenges does globalization create for firms?
1. Foreign competitors
2. domestic competitors also taking advantage of globalization
3. firms have to remain efficient while expand geographic reach
What are the global-specific risks?
Country risk, exchange rate, and political risk
What are typical regional and local factors that affect a valuation?
1. labor pool
2. facility availability and cost
3. distribution infrastructure
4. local regulations
What are Porter's Five Forces?
1. threat of new entrants
2. bargaining power of suppliers
3. bargaining power of customers
4. threat of substitutes
5. rivalry among existing firms
What are the market conditions affecting impact of the threat of new entrants?
1. Economies of scale
2. product differentiation
3. capital requirements
4. switching costs to buyers
5. access to distribution channels
6. other cost advantages
7. government policies
What are some examples of barriers to entry?
1. government created barriers
2. patents and proprietary knowledge
3. asset specificity
4. organizational economies of scale
When do customers have significant bargaining power?
1. If there are few customers with significant market share
2. customers buy a lot of output
3. customers possess credible backward integration threat
When do customers not have good bargaining power?
1. Suppliers threaten forward integration
2. significant customer switching costs
3. there's a bunch of 'em
4. Suppliers supply critical number of the customers input
When do suppliers have significant bargaining power?
1. the supplier has credible forward integration threat
2. suppliers are concentrated and few
3. If their own suppliers have significant switching costs
4. customers are weak (only have a few suppliers)
When are suppliers weak?
1. If there are many competitive suppliers
2. customers have credible backward integration threat
3. concentrated customers
4. customers have significant bargaining power
What are some competitive responses to rivalry?
1. change prices
2. improve product differentiation
3. creatively use channels of distribution
4. exploit relationships with suppliers
What are some generic strategies for effectively competing in light of Porter's five forces?
1. overall cost leadership
2. differentiation from competitors
3. focusing on specific customer groups
What are the four basic types of company analysis?
1. general economic and political analysis
2. industry analysis
3. operational analysis
4. financial analysis
What are liquidity ratios?
they measure the ability of a company to meet its short term financial obligations as they become due
What are activity or turnover ratios?
They measure how effectively a company employs its assets
What are the four purposes for adjustments to the financials when analyzing the financial statements?
1. GAAP adjustments to make the SC more comparable to guideline companies
2. Non operating assets ( separate out)
3. To exclude nonrecurring items
4. discretionary items and whatever the best way is to handle it
What is the DuPont Formula?
Net Profit Margin X Asset Turnover X Leverage(TA/SE)
What is the purpose of the DuPont formula?
It focuses on how well the company is managing the company's financial returns on an enterprise investment level
What are the four bare minimum sources for learning about or finding potential GPCs?
1. management
2. SIC or NAICS code search
3. Online databases
4. Industry research
Principle of Substitution
prudent buyer will pay no more for a property than it would cost to acquire a substitute property with the same
utility
ASA definition of a business?
A commercial, industrial, service, or investment
entity (or a combination thereof) pursuing an economic activity.
Real world view definition of a business?
A group of individuals with a plan (strategy) incorporating systems and procedures to efficiently utilize the tangible and intangible assets they have available to meet the needs and wants of their identified customer base
Equity cash flow formula, starting from NI?
NI + Dep and Amor - Increase in WC - Cap ex +/- change in debt principal
invested capital cash flow formula?
EBIT - Income taxes + Dep and Amor - Increase in WC - Cap ex
Appraisers job?
to estimate economic value, achieve this goal by exercising the three approaches
Key factors in Fair Market Value
1. Presumed ownership change at a specific date
2. hypothetical willing buyer, seller
3. no compulsion to transact
4. reasonable knowledge by both parties
5. cash or cash equivalent price
6. transaction costs not included
7. includes covenant to not compe
Investment Value characteristics
1. Value to a particular buyer
2. premium due to unique synergies
What legal purposes is fair value used in?
dissenting stockholder actions and shareholder oppression cases
Fair value is _____ community based, not economically or market-based
legal
fair value for financial reporting definition?
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.
Fair value for financial reporting characteristics
1. exit price (sell-side).
2. transaction costs excluded
3. market partipants are unrelated to reporting entity, and knowledgeable about factors.
4. market participants have the financial and legal ability to transact, and are willing to transact without
Fair value hierarchy level 1
quoted prices in active markets for identical assets/liabilities
fair value hierarchy: level 2
1. Observable prices for similar assets
2. prices for identical assets in an inactive market
3. directly observable inputs for a substantially full term of an asset
4. market inputs derived from or corroborated by observable market data
Fair Value Hierarchy: Level 3
Unobservable inputs based on the reporting entity's own assumptions about the assumptions a market
participant will use
fair value assumes what use for an asset?
highest and best use
highest and best use is in-use if:
asset has maximum value in combination with other assets as a group, typically not financial assets
highest and best use is in exchange if:
asset has maximum value on a standalone basis, typically financial assets
DLOC equation
DLOC = 1 - [1/ (1 + Control Premium)]
Operational Risk
uncertainty or volatility of operating flows: revenue, earnings and cash flows
Turnover Risk
the decline in return on assets (ROA) due to the
underutilization of assets
Financial risk
the fluctuation of earnings available to common shareholders, measured by calculating the degree of financial leverage and various leverage, coverage and liquidity ratios.
Liquidity Risk
the ease with which the asset can be converted to cash (In business valuation, this is typically quantified in the discount for lack of marketability.)
company external risk factors
economic conditions, industry conditions, market conditions
Revenue Ruling 59-60 key items
nature of business and history, economic and industry outlook, book value of stock, financial condition of ompany, earnings capacity, dividend paying capacity, intangible value, size of block to value, market price of comparable stocks
Helpful aspects of court decisions?
Interpret standard of value, indicate important factors to consider, suggest approaches to value that are persuasive
Why must caution be placed in applying court decisions?
case decisions are fact-specific and may not apply to your specific subject company
Three scopes of appraisal work
appraisal, limited appraisal, calculation
General economic data sources
U.S. Bureau of Census and Department of Commerce, Bloomberg's Business Week, Government publications
Regional economic data sources
Federal Reserve's Beige Book, BLS, state or local departments, local or regional chamber commerce
small company transaction databases?
BIZCOMPS, ValuSource, DealStats
What studies can be used to observe DLOMs?
restricted stock studies, IPO studies
opportunities from globalization
access to new markets, ability to tap new resources like labor and capital, participation in global production networks
challenges from globalization
foreign competitors entering market, domestic competitors reducing their costs from outsourcing, forcing firms to become more efficient while also extending geographic reach
global-specific risks
country risk, exchange rate risk, political risk
implications of globalization on valuation
increases risk analysis complexity, valuation exist beyond U.S. borders, understanding non-U.S. conventions
It is easy to enter a market if there is:
common technology, little brand franchise, access to distribution channels, low scale threshold
it is easy to exit a market if:
salable assets, low exit costs, independent businesses
it is difficult to enter a market if:
patented or know-how, difficult in brand switching, restricted distribution channels, high scale threshold
it is difficult to exit a market if:
specialized assets, high exit costs, interrelated businesses
What are the market conditions affecting the impact of substitutes?
relative price of substitutes, relative quality of substitutes, switching costs to customers
What are some competitive response to rivalry?
changing prices, improving product differentiation, creatively using channels of distribution, exploiting relationships with suppliers
The intensity of rivalry is influenced by:
large number of firms, slow market growth, high fixed costs, low switching costs, low product differentiation, high exist barriers, diversity of rivals, industry shakeout
risks associated with the strategy of differentiation include:
customers sacrificing image for large cost savings, customers needing change, imitation by competitors
When is the threat of new entrants high?
when entry barriers and/or switching costs are low
When is the power of substitution high?
substitute products are of the same quality
What are the four basic types of company analysis?
general economic and political, industry, operational, and financial
objectives of financial performance analysis
identify trends and causes, identify unusual items, compare to industry norm or peer group, provide basis for GPCM, provide basis for financial projections
An increase in an asset account is a negative cash flow and _________ cash on hand
decreases
A decrease in an asset account is a ________ cash flow and ________cash on hand
positive, increases
An _________ in a liability account is a ________ cash flow and increases cash on hand
increase, positive
A _________ in a liability account is a ________ cash flow and decreases cash on hand
decrease, negative
why is common-size analysis useful?
comparing companies of different sizes, identify relative trends, make projections and budgets
Quick (Acid Test) Ratio
(Cash and Cash Equivalents + Trade Receivables) / Current Liabilities
Working capital turnover
sales / working capital
what is the purpose of activity or turnover ratios?
measures how effectively a company employs its assets
Inventory Turnover
COGS/Inventory
AR Turnover
Sales/AR
Average Collection Period
AR/Sales per day
Fixed Asset Turnover
Sales/Fixed Assets
Working Capital Turnover
Sales / Working Capital
Total Asset Turnover
Sales/Total Assets
What is the purpose of leverage/coverage ratios?
Measures the ability of the company to cover its debt obligations
Times Interest Earned
EBIT/ interest expense
Fixed Charges Coverage
(EBIT + Fixed Expense) / (Interest Expense + Fixed Expense)
After Return on Total Assets
Net Income / Total Assets
After Tax Return on Equity
Net Income Available to Stockholders / Stockholders Equity
Dupont Formula
(NI / Sales)
(Sales / Assets)
(Assets / Equity)
What margins should you use for invested capital basis?
Instead of pretax or net income margins on equity, use EBITDA, EBIT, or NOPAT margins
Should (Gross Profit / Sales) ratios be used for equity multiples or invested capital multiples?
both
Should (Operating Profit / Sales) ratios be used for equity multiples or invested capital multiples?
equity
Should (Pretax Income / Sales) ratios be used for equity multiples or invested capital multiples?
equity
Should (EBITDA Cash Flow (pretax) / Sales) ratios be used for equity multiples or invested capital multiples?
invested capital
Should (NIAT / Sales) ratios be used for equity multiples or invested capital multiples?
equity
Should (Gross Cash Flow (after tax) / Sales) ratios be used for equity multiples or invested capital multiples?
equity
What are the four purposes of adjustments?
GAAP, non-operating or excess items, nonrecurring items, and discretionary items
Which is a better economic representation of the balance sheet: FIFO or LIFO?
FIFO
external risk factors to a company?
macroeconomic environment, political environment, micro economic environment
What are the three financial factors monitored via the DuPont formula (ROE)?
profitability, turnover, leverage
The company's _________ is used to monitor the effects of management's decisions related to the efficiency of operations
profitability
The company's ________ is used to monitor how effectively management is using its asset investments in the company
turnover
The company's ______ is used to monitor how effectively management is controlling its financial capital structure
leverage
What is the first stage of the SWOT analysis?
collecting input from the management team
What is a criticism of the SWOT analysis?
lacks a disciplined approach to analysis and collecting management input
What are the strengths of the market approach?
easy to get data, easy to understand and apply, includes all assets, doesn't rely on forecasts, objective and reliable, incorporates current market conditions (investor growth and risk expectations)
What are the weaknesses of the market approach?
finding comparable companies, cannot be used for individual assets, hidden assumption, synergistic and buyer specific value
What characteristics should you look for when finding comparable under the market approach?
industry, size, growth, business and financial risk
what are some examples of commonly used equity multiples?
Price / Net Earnings, Price / Pretax Earnings, Price / Gross Cash Flow, Price / Book Value, Price to Divided Paying Capacity
When should Price to Net Earnings multiples be used?
when the subject has high income
compared to its depreciation, or when
depreciation represents actual or economic physical wear and
tear. When subject has normal tax rates
When a company has large capital expenditures, should cash flow multiples or earnings multiples be used?
cash flow multiple
If the company has a unique tax structure, what type of multiple could be used?
Pretax earnings multiple
When should price to pretax earnings be used?
The company has high income compared to its depreciation, or when depreciation represents actual physical
wear and tear, but has abnormal tax rates
When should price to cash flow multiples be used?
subject has low level of income compared to its depreciation, or when depreciation represents a
low level of physical, functional, or economic obsolescence.
When should MVIC to sales multiples be used?
When subject is homogeneous to guideline companies in terms of operating expenses, and for smaller businesses, typically, cash businesses
When should Price to Dividend multiples be used?
When the subject pays dividends, or when they have the ability to pay dividends
When should a Price to Book multiple be used?
When the subject is in an industry that has a meaningful relationship between the book value and the price of stock
When should an invested capital multiple be used instead of an equity multiple?
If the subject's capital structure is significantly different from those of the publicly traded guideline companies.
If a subject company is highly leveraged, but the industry has a very different debt-equity relationship, what type of multiple should be used?
invested capital multiple
market multiples of the inverse of what?
capitalization rates
Market multiples include the market's assessment of what two items?
the risk adjusted cost of capital, and the present value weighted expected earnings growth rate
Why is Price to EBIT considered a MVIC multiple?
because it matches the measure of inflow to the providers of capital in the denominator. EBIT will have to be paid to both debt and equity holders
Which type of multiple is better suited when you are valuing a minority interest and the subject and public company have similar capital structures?
equity multiples
Which type of multiple is better suited when you are valuing a control interest and there is no similarity in capital structure between the subject and public company?
invested capital multiples
how do you calculate market capitalization?
number of shares * price per share
Which type of risk is this: analyzing how the subject company differs from the guideline companies. Subject company analyzed in terms of risk associated with factors such as sales volatility and volatility of Company's growth.
business risk
Which type of risk is this: The _______ risks associated with a business include such factors as the fixed versus variable cost structure of the appraisal subject. The valuation analyst must analyze the cost structure of the appraisal subject to determine
operating risk
Which type of risk is this: the amount
of leverage the company uses and the company's ability to cover its
debt payments.
financial risk
Which type of risk is this: company that has little diversification in its
product line or has a product line that may become extinct with the
introduction of a newer product by a different company.
product risk
Do higher or lower asset turnover ratios indicate more efficient use of productive capital to generate sales activity?
higher
Market multiples used in the GPC method are the inverse of what?
Capitalization rate
A company's original pricing multiple is 15. The growth of the GPC is 5%, and the growth of the subject company is 7%. Calculate the growth adjusted pricing multiple
1 / pricing multiple = benefit /value ratio
Benefit /value ratio + (GPC g - Subj g) = 4.67%
1 / 4.67% = 21.4
21.4 is new adjusted pricing multiple
Why is it hard to compare Microsoft with a small software development company?
size of the company
Evaluate the following statement regarding the GPCM: the prices of the stocks utilized should be on or near the valuation date. T or F?
True
Market Value of Equity / Net Income is also known as what multiple?
Price to Earnings Multiple
Which of the following companies are considered to be a good candidate for the application of MVIC to sales multiple? Manufacturing, service, distributor, real estate holding.
Service
In what scenario should a price to earnings multiple never be used?
When the appraisal subject has abnormal tax rates
Is Gross Cash Flow / Sales a profitability ratio for invested cash flow?
No
What are positives of the M&A method?
Easy to understand, uses real transactions in the industry, straightforward application
What are negatives of the M&A method?
difficult to find truly comparable company, limited sample of transactions, underlying synergies
What are some commonly used public databases?
Capital IQ, BVR, SEC, Google Finance, DealStats
Common private company databases?
BIZCOMPs, ValuSource
Are most transactions in online databases for a controlling or non-controlling interest?
controlling
When is it appropriate to use a price / net income multiple?
Similarity in capital intensity, depreciation methods, tax rates
When is it useful to use a Price / EBT multiple?
Similarity in capital intensity and depreciation methods
When is it useful to use a Price / Sales multiple
Useful when there is a uniform profit margin in the industry or when
there is a strong correlation between price/sales and return on sales.
When is it useful to use a Price / Book multiple?
Useful when there is a strong correlation between book value of equity and return on equity balance sheet.
When is it useful to use an MVIC / NOPAT multiple
Similarity in capital intensity, depreciation methods, and tax rates
When is it useful to use a MVIC / EBIT multiple?
Similarity in capital intensity, depreciation methods, eliminates effect of tax rate disparities
When is it useful to use a MVIC / EBITDA multiple?
eliminates disparities in capital intensity and depreciation methods?
Are M&A transactions marketable or non-marketable?
M&A transactions are presumed to incorporate the discount for lack of
marketability since the parties to the transaction negotiated the price
knowing the subject interest was not fully marketable.
Are sales of public company shares marketable or non-marketable?
marketable
If a transaction search yields only one or two usable transactions, the best course of action for the appraiser is to do what?
Describe the transaction search and results but use the merger and acquisition
method only as supporting evidence for other valuation approaches.
What does BVS-V say about rule of thumb?
provide insight on the value of a business, business ownership interest, or security. However, value
indications derived from use of rules of thumb should not be given substantial weight unless supported by other valuation methods
What are rule of thumbs for an industry based on?
industry-specific and represent means, medians or most common conditions
What are some characteristics of a buy-sell agreement that proves as a valid indication of value?
Price is fixed and unambiguous. Applies to voluntary withdrawal of an owner. Arm's length, economic formula.
Regarding buy-sell agreements, if a remaining shareholder has the ability to reject the price, is it a valid indication of value?
No
Bona fide offers to buy may or may not provide an arm's length basis. True or False?
True
Regarding acquisitions, prior acquisition always reflect the same economic and industry circumstances. True or False?
False
Per the ASA BV Standards, BVS-II applies to which valuation approach?
Asset Approach
Per the ASA BV Standards, BVS-IV applies to which valuation approach?
Income Approach
Per the ASA BV Standards, BVS-V applies to which valuation approach?
Market Approach
What are the 4 Invested Capital Multiples?
MVIC/FCF to Invested Capital, MVIC/EBIT, MVIC/NOPAT, MVIC/EBITDA
Which fair value hierarchy level receives the highest priority?
Level 1