MARKET EVIDENCE IN BUSINESS VALUATION
A Practical Guide to Using Market Evidence to Value a Business
In Partnership With
New York Law Journal Seminar Series
Jeffrey L. Baliban Partner, Citrin Cooperman
Gregory Horowitz Partner, Kramer Levin
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MARKET EVIDENCE IN BUSINESS VALUATION
The Market Approach Methodology
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Fair Market Value—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 relevant facts.
See also United States v Cartwright, 411 U.S. 546 (1973)
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Fair Market Value—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 relevant facts.
Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property. (Emphasis added)
Investment Vs Intrinsic Value
• Investment value – reflects a subjective relationship between a particular investment and a given investor.
• Intrinsic value – analytic judgment of value based on the perceived characteristics inherent in the investment.
Johnson & Johnson v GuidantResCap
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Fair Market Value—SSVS-1
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 compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.
The Business Lawyer Debate
• Michael Schwartz & David Bryan, Campbell, Iridium, and the Future of Valuation Litigation, 67 Bus. Lawyer 939 (Aug. 2012)
• Robert Stark, Anders Maxwell & Jack Williams, Market Evidence, Expert Opinion, and the Adjudicated Value of Distressed Businesses, 68 Bus. Lawyer 1039 (Aug. 2013)
• Gregory Horowitz, A Further Comment on the Complexities of Market
Evidence in Valuation Litigation, 68 Bus. Lawyer 1071 (Aug. 2013):
Definition of Market Evidence
• My definition: The use of actual transactions to draw reasoned conclusions as to the value of a target asset.
• Usually but not always transactions in an asset other than the target.• Can include transactions in claims of the target.• Occasionally includes total enterprise transactions for the target itself – e.g.,
Johnson & Johnson v. Guidant; In re Boston Generating LLC, 440 B.R. 302 (Bankr. S.D.N.Y. 2010)
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General Valuation Approaches for Operating Companies
• Income approach• Guideline public company (“GPC”) approach• Guideline merged and acquired company (“M&A transactions”) approach
Published standards typically require business valuation analysts to consider all three approaches
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Disparate Results
Approach Results
Income $10,000,000
GPC $6,865,000
M&A transactions $4,500,000
Average $7,121,667
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Disparate Results
Approach Results Weights Value
Income $10,000,000 60% $6,000,000
GPC $6,865,000 30% $2,059,500
M&A transactions $4,500,000 10% $450,000
AverageWeighted average
$7,121,667$8,509,500
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Factors to Consider Per Revenue Ruling 59/60
• Have to understand the markets in which the subject business operates as well as have a considerable insight into how the business itself operates.
Nature of the business Economic outlook Book value & financial condition Earning capacity, dividend-paying capacity Goodwill or intangible value Previous sales of shares Market price of comparable companies
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Factors to Consider—SSVS-1
• Statement on Standards of Valuation Services adds several other factors
• The valuation expert’s workpapers and report should reflect what s/he did with respect to analysis of these factors
THE MARKET APPROACH METHODOLOGY
GPC & M&A Transactions Approaches
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Market Approach Methodology
• Calculate price multiples A valuation multiple is usually a multiple computed by dividing the price of the guideline
company’s stock by some relevant economic variable (Pratt, Valuing a Business, Fifth ed, 2008)
• Analyze the fundamentals of the subject company• Search for and choose comparable companies
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Pricing Multiples
• Price-to-Revenues• Price-to-Earnings before interest, taxes, depreciation, and amortization
(EBITDA)• Price-to-Earnings before interest and taxes (EBIT)• Price-to-Earnings before interest, taxes, depreciation, amortization and rental
costs (EBITDAR)• Price-to Net cash flow to invested capital• Industry specific metrics
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Factors To Determine Comparability
• Nature of the business;• Economic outlook;• Book value & financial condition;• Earning capacity, dividend-paying
capacity;• Goodwill or intangible value; • Previous sales of shares;• Market price of comparable companies;• Facilities;• Organizational structure;• Management team (which may include
officers, directors, and key employees);
• Classes of equity ownership interests and rights;
• Products or services (or both);• Economic environment;• Geographical markets;• Industry markets;• Key customers and suppliers• Competition;• Business risks;• Strategy and future plans; and• The governmental or regulatory
environment
Financial Condition of Subject Company— Key Financial Ratios
Liquidity Solvency
Activity Profitability
Current AssetsCurrent Liabilities
Net Current AssetsCurrent Liabilities
Short-term DebtTotal Debt
Short-term DebtEquity
DebtEquity
DebtTotal Assets
SalesInventory
Accounts ReceivableAverage Daily Sales
Operating ProfitTotal Assets
Operating ProfitEquity
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Where to find guideline public companies
• Lots of companies on traded exchanges• Lots of data on these companies• SEC filings• EDGAR• Compustat• Thompson Reuters
Public stock data typically represents marketable minority interest level of value.
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NAICS Codes
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NAICS Code Detail
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Levels of Value
Marketable minority interest
Marketable controlling interest
Non-marketable minority interest
Non-marketable controlling interest
Levels of Value
Control value
Marketable Minority Value
Nonmarketable Minority Value
Control premium Minority interest discount
Marketability discount
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Guideline Merged and Acquired Companies
• Historical transactions of actual businesses• Advantages• Disadvantages
This data represents control level of value, and may be marketable (if publicly traded) or non-marketable (if transaction is between privately held companies)
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Choosing Guideline Companies
• Size• Historical growth rates• Activity and other ratios• Profitability & cash flow• Profit margins• Capital structure• Other value drivers and metrics
Financial Condition Of Company—Key Financial Ratios
Liquidity Solvency
Activity Profitability
Current AssetsCurrent Liabilities
Net Current AssetsCurrent Liabilities
Short-term DebtTotal Debt
Short-term DebtEquity
DebtEquity
DebtTotal Assets
SalesInventory
Accounts ReceivableAverage Daily Sales
Operating ProfitTotal Assets
Operating ProfitEquity
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If The Guidelines Don’t Fit…
• Normalization adjustments:For ownership characteristics (control vs minority)For GAAP differences, extraordinary and nonrecurring or unusual itemsFor non-operating assets and related income & expenseFor taxesFor synergies from mergers and acquisition
Market evidence in income approach
• Data used in discount rates• Capital structure assumptions• Terminal values based on multiples
Discount Rate
Basic Capital Asset Pricing Model Discount Rate
ERi = Rf + β(Rm – Rf) + RPs + RPu
Where:ERi = Expected rate of return on the asset being valuedRf = Risk-free rate of returnβ = Beta or systematic risk(Rm – Rf) = Equity risk premiumRPs = Risk premium for sizeRPu = Unsystematic (company-specific) risk
Summary So Far…
• Market evidence of value is as strong as the degree of comparability between the subject company and the guideline companies;
• Identify assumptions and uses of expert’s judgment;• Thoroughly explore bases of guideline company choices (what he/she picked
and what he/she discarded;• Understand the nature and amount of adjustments made to financial
statements of both guideline companies and the subject company in order to reach comparability
• Multiple(s) selected; and• Comparison with other valuation methodology results
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Definition of Intrinsic Value
• “We believe that every asset has an intrinsic value and we try to estimate that intrinsic value by looking at an asset’s fundamentals. What is intrinsic value? Consider it the value that would be attached to an asset by an all-knowing analyst with access to all information available right now and a perfect [DCF] valuation model.” Aswath Damodoran, Damodoran on Valuation, at 10 (2d ed. 2006).
Relationship Between Fair Market Value and Intrinsic Value
• Efficient Market Hypothesis (strong version) holds that in an efficient marketplace there should be no difference: securities prices will perfectly impound and reflect all material information
• Courts relying on market evidence often cite EMH and find the existence of an efficient market as a predicate
• When one needs to discount market evidence, authorities may be found to question validity of the EMH, either for the period in question or in general
Do You Need to Show an Efficient Market to Rely on Market Evidence?
• Common misconception based on misreading of Basic, Inc. v. Levinson, 485 U.S. 224 (1988)
• Basic merely stands for proposition that an efficient market is necessary to “fraud on the market” presumption of class-wide reliance
• While FMV conditions must be met for market evidence to be reliable, this does not require the existence of a liquid market with any threshold of trading volume, etc. (Cammer Factors)
• So long as FMV conditions are met, even a single trade can be strong evidence
Schizophrenic Judicial Attitudes Towards Market Evidence
Courts can love market evidence:• Bank of America Nat’l Trust and Savings Ass’n v. 203 North LaSalle Street
Partnership, 526 U.S. 434 (1999): Requiring market test for new value plans.• VFB LLC v. Campbell Soup Co., 482 F.3d 624, 634 (3d Cir. 2007): Using
market evidence to find solvency. • In re Iridium Operating, LLC,, 373 B.R. 283, 291 (Bankr. S.D.N.Y. 2007):
Using market evidence to find solvency.• In re TOUSA, Inc., 422 B.R. 783 (Bankr, S.D. Fla 2009): Using market
evidence tom find insolvency.
Schizophrenic Judicial Attitudes Towards Market Evidence
Courts can distrust market evidence• Till v. SCS Credit Corp., 541 U.S. 465, 477 (2004): rejects market approach
to cram-down rates.• In re Emerging Commc’ns, Inc. S’holders litig., 2004 Del. Ch. LEXIS 70, at
*83-84 (May 3, 2004) (Del. S. Ct. Justice Jacobs sitting by designation): Market price not always indicative of value.
• In re Spansion, Inc., 426 B.R. 114, 130 (D. Del. 2010): rejecting trading price for debtor claims as evidence of value.
• LaSalle Talman Bank, F.S.B. v United States, 45 Fed. Cl. 64, 81-82 (1999): rejecting market approach to contract damages.
Situations Where FMV is Not the Controlling Standard
• Dissenting shareholder appraisal rights and minority oppression actions • State “fair value” standards often exclude discounts for minority interest, lack
of control, illiquidity, key person.• Bankruptcy “best interests” valuation – hypothetical liquidation value• Bankruptcy adequate protection valuations – basis for petition date valuation
is debatable• Breach of contract cases, potentially -- Guidant
Situations Where Market Evidence Can Be Discounted or Ignored
• Generally, where FMV conditions can be disproven:• False or misleading information• Lack of material information• “Fire sale” transactions• Possibly, existence of material facts nobody knew about.
Official Committee of Asbestos Personal Injury Claimants et al. v. Sealed Air Corporation, et al. (In re W.R. Grace), 281 B.R. 852 (D. Del. 2002): Court found insolvency for FC purposes based on yet-to-be-discovered asbestos injuries.
• Market manipulation (note transactions may technically satisfy FMV conditions)
• Market “inefficiencies” – e.g., boom or bust cycles
QUESTIONS & ANSWERS
Presenter Contact Information
Jeffrey Baliban, PartnerCITRIN COOPERMAN & COMPANY212-697-1000 x6303529 Fifth AvenueNew York, NY 10017(347) [email protected]
Gregory Horowitz, PartnerKRAMER LEVIN NAFTALIS & FRANKEL LLP1177 Avenue of the AmericasNew York, NY 10036(212) [email protected]