Michael S. Blake, CFA, ASADirector of Valuation ServicesHabif, Arogeti & Wynne, LLPmichael.blake@hawcpa.com@unblakeablewww.unblakeable.com

Topics in Valuation that Nobody is Talking About – Predictions of Future

Hot Topics

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.

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.

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

WHAT HAPPENED TO THE MARKET APPROACH?

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

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

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

SAS 73: WHAT DOES IT REALLY MEAN?

What Reviewers Need to Do is Clear

Perform tests of the data Assess valuation

methodologies in terms of acceptability

Validate qualifications of the specialist

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

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

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”

HOW THE FED IS MESSING WITH THE M&A MARKET

The Fed Punishes Savers

2008-08

2008-11

2009-02

2009-05

2009-08

2009-11

2010-02

2010-05

2010-08

2010-11

2011-02

2011-05

2011-08

2011-11

2012-02

2012-050.00.51.01.52.02.53.03.54.04.55.0

20-year Treasury Yield (%)

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

Where Fair Value Meets Alternate Reality

Fair Value – Buyer and Seller Agree

Investment Value – Seller – Low return on funds received.

Investment Value – Buyer – Low return on funds invested

Bid-ask spread

Do Owners Have to Sell?

Myth Aging owners must sell Foreign competition will

scare owners out of business

Banks calling loans will force sales

Owners will adjust to the new normal and capitulate

Buyers can wait owners out

Reality They can work longer and are getting better at succession See Clint Eastwood and Halftime for America Owners are winning games of chicken with the banks Entrepreneurs are by definition hopeless optimists Buyers only make money if they actually buy the business

Activity in Small M&A on Decline

2007 2008 2009 2010 2011 20120

200400600800

100012001400160018002000

16261730

10811219

1001

32

Number of Closed Transactions*

*2012 data through 4/24/12

Closing Time

2007 2008 2009 2010 2011 20120

50

100

150

200

250

201225 219 229 226

160

Average Days to Transaction Close

Money on the Table

2007 2008 2009 2010 2011 20120%

10%

20%

30%

40%

50%

60%

70%

80%

90%

69%74% 71%

78% 79%

64%

% Cash Down at Closing

A Buyer’s Market

2007 2008 2009 2010 2011 20120%

10%20%30%40%50%60%70%80%90%

100%

73%

85% 86% 84% 82%88%

% of Sales as Asset Sales

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

BLACK-SCHOLES DOESN’T WORK

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

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

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

APPRAISERS AND ACCOUNTANTS PLAYING NICELY

Mars and Venus

Accounting Profession is externally

regulated and licensed Highly rules-driven Math is limited to

arithmetic Views BV as a necessary

evil Right vs. wrong relatively

defined

Business Valuation Profession is largely self-

policing Heavily reliant upon

judgment Unlimited complexity to

math Views CPAs as referral

source Hard to be definitively

“wrong”

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

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

Thanks! Questions?