Tuesday, April 30, 2013

Step 5 to Reviewing a Valuation Report – Cash Flow Reasonableness

Is the valuation based on a going concern income-based approach?  If so, what future cash flow assumptions are the value conclusions based upon?
 
The reasonableness of the underlying cash flow assumptions can significantly affect the integrity of the resulting value conclusions.  Under common income-based valuation approaches, the business valuator must select an operating cash flow level (or range) that he/she expects the business to generate going forward.  The cash flows may vary from year to year over a specific projection period or an ongoing maintainable level may be assumed.
 
Step 5 to reviewing a business valuation report involves assessing the reasonableness of the projected cash flow assumptions. 
 
Income-Based Approach

To recap, an income-based approach involves estimating the present value of the projected future cash flows to be generated from the business and theoretically available to the capital providers of the company.  A discount rate is then applied to the projected future cash flows to arrive at a present value. 
 
Two common income-based approaches include the discounted cash flow (DCF) approach and the capitalized cash flow (CCF) approach.  A brief discussion of each approach along with some key items to consider in assessing the reasonableness of the projected cash flow assumptions is set out below:

Discounted Cash Flow Approach (DCF)
 
The DCF approach involves estimating the present value of the projected future cash flows to be generated from the business.  A discount rate is applied to the projected future cash flows to arrive at a present value.  The cash flows are typically projected over a limited number of years (e.g. 3 to 5 years) and a terminal value is determined as at the end of the projection period based on an assumed annual cash flow at that time.
 
Items to consider in assessing the reasonableness of the projected cash flows include:
     
  • Time period – a longer period is more difficult to accurately predict
  • Revenue growth rates – supported by actual historical rates and/or industry averages?
  • Gross profit margins – consistent with past performance and/or industry averages?
  • EBITDA margins – consistent with past performance and/or industry averages?
  • Capital reinvestment – sufficient to meet revenue and cash flow growth? 
  • Working capital requirements – often overlooked but necessary to support revenue growth

Where cash flow projections are provided by management, the valuator should assess the reliability of management’s projections including the ability of management to accurately predict future cash flows.  This can be done by comparing actual historical results to management’s original projections for the same period of time.
 
Capitalized Cash Flow Approach (CCF)
 
The CCF approach involves converting an annual maintainable cash flow (e.g. discretionary cash flow, EBITDA, etc.) into a lump sum present value using a capitalization rate (or valuation multiplier) that reflects the risk profile and long-term growth prospects of the company.  Under this approach, historical results serve as a proxy for the company’s future performance.  As a result, the valuator must "normalize" the company’s historical cash flows so they provide the best representation of what the company is expected to generate going forward.
 
Items to consider in assessing the reasonableness of the projected annual maintainable cash flows include:
  • Normalization items - have all normalization items been considered and appropriately reflected?
  • Trends – has there been an increasing/decreasing trend in the past normalized cash flows?
  • Past as an indicator – is the past truly representative of the company’s future?
  • Weighting – should certain years be more heavily weighted than others?
  • Changes – have there been recent changes in business strategy, product mix, customers, contracts, suppliers, employees, etc.?

Some of the more common normalization adjustments you can expect to see include:
  • Shareholder remuneration – should be adjusted to market wages for services provided
  • Related party payments (e.g. wages, rent, etc.) – should be adjusted or imputed to market amounts for services provided
  • Personal and/or discretionary expenses - should be added back
  • Non-operating income – income from redundant assets should be deducted
  • One-time, non-recurring items – revenues should be deducted and expenses should be added back 
 
Reasonable and supportable future cash flow assumptions are critical to a reliable value conclusion.  Depending upon the scope of review, inquiries and experience level, this is an area where business valuators can differ significantly.  As a result, assessing the reasonableness of the projected future cash flows or the normalized historical cash flows and resulting selection of maintainable cash flow should be a major focus in reviewing a business valuation report. 
 
If you have any questions regarding assessing the reasonableness of cash flow assumptions or if you would like an independent business valuator to assist in your review of a business valuation report, contact us at www.vspltd.ca.

Tuesday, April 23, 2013

Step 4 to Reviewing a Valuation Report - Valuation Approach

How many different valuation approaches are there?  How does a valuator select which valuation approach to apply?  What if the valuator adopted an incorrect valuation approach?
 
The business valuator is responsible for selecting an appropriate valuation approach and for ensuring that it has been correctly applied.  Step 4 to reviewing a business valuation report involves identifying and assessing the valuation approach adopted by the valuator. 
 
In valuing a business, there are many valuation approaches to select from.  In the context of a legal dispute,

"There are many ways to approach an analysis of a loss resulting from a particular set of facts. Part of the expert’s role is to identify all of these alternatives and determine which is the most appropriate." [1]

 
There are two fundamental bases on which to determine the value of a business: going-concern and liquidation.  In the case of a company that is expected to continue operating well into the future, the prospective investor will evaluate the risks and expected returns of the investment on a going-concern basis.  If for any reason the company is likely or expected to liquidate, liquidation values for the assets, as well as costs associated with liquidation would prevail.
 
All methodologies applied to the valuation of business may be broadly classified into the asset-based, income-based or market-based approaches.  Each of these is discussed briefly below.
 
 
The asset-based approach is applicable when the underlying asset values constitute the prime determinant of corporate worth.  The application of this approach depends on the nature of the company’s operations (such as an investment or real estate holding company) and/or if the outlook for a particular company’s earnings is somewhat uncertain, or returns based on earnings are insufficient to justify the investment in assets.
 
This approach focuses on individual asset and liability values from the company’s balance sheet, which are adjusted from book values to fair market values.  The asset-based approach can also be applied in situations where liquidation is likely or expected.
 
 
The income-based approach involves estimating the present value of the projected future cash flows to be generated from the business and theoretically available to the capital providers of the company.  In general, a discount rate is applied to the projected future cash flows to arrive at a present value.  The discount rate is intended to reflect all risks of ownership and the associated risks of realizing the stream of projected future cash flows.  It can also be interpreted as the rate of return that would be required by providers of capital to the company to compensate them for the time value of their money, as well as the risk inherent in the particular investment.
 
There are different variations of the income approach.  Common income approaches include the capitalized earnings ("CE"), capitalized cash flow ("CCF"), excess earnings ("EE") and discounted cash flow ("DCF") approaches.  An income-based approach is typically the most common valuation approach adopted in the valuation of privately held operating companies.
 
Market-Based Approach

The market-based approach involves comparing the subject business to similar "guideline" companies whose securities are actively traded in public markets or which have recently been sold in a private transaction.  Certain valuation metrics (e.g. EV/EBITDA, EV/Sales, etc.) obtained from a sample of comparable public companies and/or industry transactions are applied to the subject business to arrive at a value range.  This approach is generally appropriate when the subject business is publicly traded and may also be useful for indicating what a privately held business would be worth in the public market.
 
It is dangerous, however, to blindly apply a market-based approach to a privately held company without carefully assessing the comparability of the target business to the "guideline" companies.  Certain adjustments may be required to the public company and/or industry transaction multiples (e.g. to account for differences in size, growth, control, marketability, etc.) before they can be applied to the target business.  In addition, it is very difficult if not impossible to assess the extent to which purchaser perceived synergies, relative bargaining abilities and emotional considerations influenced the price realized in an actual industry transaction. 
 
As a result, a market-based approach may not be appropriate as a primary valuation approach.  It can, however, be useful as a reasonableness check on the value otherwise determined under an income-based approach.
 
It is the valuator’s role to determine which approach is appropriate in light of the company-specific facts and circumstances and the valuator should adequately explain and justify the reasons for his/her selection. 
 
In reviewing the valuation report, the following questions should be addressed:
  1. What valuation approach was adopted?
  2. Is the valuation approach appropriate under the circumstances?
  3. Would an alternate valuation approach be more suitable?
  4. What would be the impact if a more suitable valuation approach was applied? 
  5. Would adopting an alternate valuation approach corroborate or refute the values determined under a primary approach?
In my experience, business valuators will typically agree on an appropriate valuation approach.  It is the application of the approach and/or the underlying assumptions where valuators will often differ.  However, identifying and understanding the valuation approach adopted is critical to an effective review of a valuation report.
 
If you have any questions regarding matters involving the valuation of your business or if you would like an independent business valuator to assist in your review of a business valuation report, contact us at www.vspltd.ca.

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1.  The Litigator's Guide to Expert Witnesses, Mark J. Freiman and Mark L. Berenblut, p. 87.
 

Wednesday, April 17, 2013

Step 3 to Reviewing a Business Valuation Report – Scope Limitations

How reliable is a valuation that was rendered based on a restricted or limited scope of review?  Is the quality of a valuation report affected by the extent to which the valuator was restricted from examining certain key documents and/or interviewing key parties?
 
The third step to reviewing a business valuation report involves identifying any major scope limitations, restrictions and qualifications rendered on the value conclusions.  This helps ascertain whether or not the valuator conducted sufficient work to support the value conclusion.  The extent to which the valuator’s scope of review has been restricted can seriously impact the reliability of the valuation findings.
 
A business valuation report should explicitly identify any limitations in the valuator’s scope of review.  In Canada, Chartered Business Valuators (CBVs) must follow the Practice Standards of the CICBV for Valuation Reports. In this regard, Practice Standard 110 states,

"The Valuation Report shall contain a scope of review that clearly identifies the specific information on which the Valuator relied to arrive at a conclusion.  Where the conclusion is qualified by a scope limitation, regardless of the type of Valuation Report being provided, the limitation shall be explained, setting out the reasons for the limitation."   [1]

Potential scope limitations to consider when reviewing a valuation report include:
  • Not having access to relevant information or key documentation;   
  • Not being permitted to interview key individuals;
  • Not conducting a site visit or a tour of the company’s operating facilities;
  • Not relying upon other specialists outside the valuator’s area of expertise (e.g. real estate appraiser, machinery and equipment appraiser, etc.); and
  • Not having reliable financial information (e.g. financial statements prepared internally by management and not audited or reviewed by an external accountant).
 
Where do you find scope limitations in a valuation report?

Scope limitations should be separately identified in the valuation report and may be set out in one of the following sections of the report:
  • Scope of Review & Limitations
  • Restrictions & Qualifications
  • Conclusion (e.g. immediately preceding or after the conclusions)
  • Methodology or Valuation Approach
 
Limitations in the scope of a valuator’s review can negatively impact the quality and reliability of the value conclusions.  Scope limitations are generally easy to spot as there is typically a section in the valuation report designated for their identification.  Occasionally, scope limitations may not be explicitly highlighted in the report.  They may be alluded to where the calculations are being explained or in the notes to the schedules where the valuation calculations themselves are contained.  It is, therefore, worthwhile to scrutinize the report for any indication that the valuator was limited in his/her scope of review and question what impact that limitation may have had on the valuation conclusions contained therein.
 
If you have any questions regarding matters involving the valuation of your business or if you would like an independent business valuator to assist in your review of a business valuation report, contact us at www.vspltd.ca.

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1.  CICBV Practice Standard No. 110 – Report Disclosure Standards and Recommendations (Section 12).




Wednesday, April 10, 2013

Step 2 to Reviewing a Business Valuation Report - Credentials

What qualifies someone to be an expert in business valuation?  Will the quality of a valuation report be affected by the qualifications of the valuator?  The second step to reviewing a business valuation report involves reviewing the business valuator’s credentials and qualifications.
 
The pre-eminent designation for business valuation in Canada is the Chartered Business Valuator (CBV) designation.  CBVs are highly trained, educated and experienced in the valuation of privately held business interests.  There are professional standards (e.g. regarding scope of work and report disclosures) that CBVs must follow when conducting a business valuation. 
 
Other U.S. based business valuation credentials and designations include:
  • Accredited Senior Appraiser (ASA) with the American Society of Appraisers;
  • Certified Valuation Analyst (CVA) with the National Association of Certified Valuation Analysts;
  • Certified Business Appraiser (CBA) with the Institute of Business Appraisers; and
  • Accredited in Business Valuation (ABV) with the American Institute of Certified Public Accountants.
Where a business valuation report was prepared by an independent expert in the context of a legal dispute, the Rules of Civil Procedure stipulate that it is the expert’s duty to provide opinion evidence that is related only to matters that are within the expert’s area of expertise.  As a result, a thorough review of the expert’s area of expertise should be conducted as part of the review of a business valuation report.  Obtaining and reviewing the author’s curriculum vitae, or CV, is a good place to start.
 
According to The Litigator’s Guide to Expert Witnesses,
"A critical review of the opposing expert’s resume is the most often overlooked but wonderfully useful source of cross-examination ammunition.  An expert may have carefully reviewed the available information, critically reviewed the literature in the area, meticulously arrived at his opinion and artfully drawn his conclusions, but if he padded or fudged his resume he will be destroyed on cross examination." [1]

A summary of some questions to consider when reviewing the valuator’s CV is as follows:
  1. What training and education has the author obtained?  What professional designation(s) does he/she have?  
  2. What professional standards must be followed in light of those professional designation(s)?  
  3. What experience does the author have?
  4. Has the author provided expert testimony on business valuation before?  If so, what was the outcome?
  5. What publications and/or speaking engagements has the valuator prepared/presented?  Are there any inconsistencies between his/her report and those prior writings? 
I was once retained to review a business valuation report prepared by a "professional advisor" on behalf of a majority shareholder for purposes of a potential buyout of a minority shareholder’s interest.  Although this "professional advisor" claimed to have significant experience with actual transactions involving companies operating in the industry, he did not have any formal training in business valuation or any valuation designations. 
 
This valuation report calculated the enterprise value of the business (i.e. value attributed to the capital providers of the company including both debt and equity).  Common valuation principles and practice stipulate that the equity value is determined by, among other things, deducting the value of the interest bearing debt and debt equivalents from the enterprise value.  This valuation report, however, deducted the total liabilities (including working capital accounts and deferred revenue), resulting in an understated equity value.
 
I suspect that the lack of formal valuation training and credentials may have contributed to this oversight, illustrating the importance of reviewing the valuator’s credentials and qualifications when reviewing a business valuation report. 
 
If you have any questions regarding matters involving the valuation of your business or if you would like an independent business valuator to assist in your review of a business valuation report, contact us at www.vspltd.ca.
 
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[1] The Litigator’s Guide to Expert Witnesses, Mark J. Freiman and Mark L. Berenblut, 1997, page 41.
 
 

Tuesday, April 02, 2013

Step 1 to Reviewing a Business Valuation Report – Type of Report

Is a Calculation Valuation Report appropriate for the intended purpose of the valuation?  What is a Calculation Valuation Report?  Has the valuator conducted a sufficient level of work to provide the assurance required by the intended users of the valuation?
 
Chartered Business Valuators (CBVs) in Canada must adhere to the professional practice standards of the Canadian Institute of Chartered Business Valuators (CICBV).  In this regard, there are practice standards for preparing a business valuation report (Standard 110 for Calculation, Estimate and Comprehensive Valuation Reports).  There are also practice standards for preparing a report containing comments on another valuation report (Standard 410 for Limited Critique Reports).
 
Although not bound by the professional practice standards of the CICBV, lawyers and business owners will often be in a position to review a business valuation report prepared by a CBV.  It would be prudent to involve a CBV to assist with this task.  However, it is also beneficial for non-CBV lawyers and business owners to have a process for conducting a preliminary review of the valuation report.  This is who this series is geared towards.
 
The first step to reviewing a business valuation report prepared by a CBV involves identifying the type of valuation report provided and assessing:
  1. The appropriateness of the type of report provided in a particular situation; and

  2. Whether or not the author adhered to the CICBV professional standards with respect to scope of work and report disclosure.
  3.  
According to the CICBV Practice Standard No. 110, there are three types of Valuation Reports. [1]  These reports are distinguished by the valuator’s scope of review, amount of disclosure provided and the level of assurance being provided in the conclusion, with a Comprehensive Valuation Report providing the highest assurance and a Calculation Valuation Report providing the lowest.  The three types of Valuation Reports that CBV’s provide are described as follows:
 
Calculation Valuation Report - contains a conclusion as to the value of shares, assets or an interest in a business that is based on minimal review and analysis and little or no corroboration of relevant information, and generally set out in a brief Valuation Report.
 
Estimate Valuation Report - an Estimate Valuation Report contains a conclusion as to the value of shares, assets or an interest in a business that is based on limited review, analysis and corroboration of relevant information, and generally set out in a less detailed Valuation Report.
 
Comprehensive Valuation Report – a Comprehensive Valuation Report contains a conclusion as to the value of shares, assets or an interest in a business that is based on a comprehensive review and analysis of the business, its industry and all other relevant factors, adequately corroborated and generally set out in a detailed Valuation Report.

The context for which the valuation report is being prepared and the extent to which the users will rely on the value conclusion in making a decision or taking a course of action should be considered in determining the type of valuation report that is suitable in a particular situation.  The extent to which such decisions or actions cannot be changed may influence the level of assurance that is required. [2]
 
Some relevant considerations in assessing the suitability of a particular type of valuation report include:
  1. Extent of reliance on conclusion by user(s);

  2. Significance of the matter to the user(s);

  3. Preliminary nature of the matter;

  4. Number of users of the report;

  5. Public availability;

  6. Contentious nature of the matter (or potential for being contentious); and

  7. Regulations or agreements.
Ultimately, a determination as to whether the type of valuation report is appropriate for the particular purpose is a matter of professional judgment that takes into account all of the relevant facts and circumstances.  It is worthwhile, however, for business owners and lawyers to understand and appreciate the guidelines and standards considered by CBVs in this regard.
 
If you have any questions regarding the types of valuation reports that CBV can prepare or if you would like an independent business valuator to assist in your review of a business valuation report, contact us at www.vspltd.ca.
 
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1.  https://cicbv.ca/practice-standards/
2.  https://cicbv.ca/practice-bulletins/