VALUING CLOSELY HELD COMPANIES
Perspectives from a Former Wall Street Analyst
David C. Childe, CFA
To the Family Law Section of the Memphis Bar Association
November 19th, 2014
Methods chosen normally fall within three categories per Blasingame v. American Materials Inc. These are (1) the market value method, (2) the asset value method, and (3) the earnings value or capitalization of earnings method. The most appropriate valuation method depends on the unique circumstances of each business, says the Court.
There is no paucity of available valuation methodologies. Examples of (1) include multiples of revenue, multiples of pretax cash flow, multiples of net income, multiples of book value, comparison to valuations of publicly traded companies, and comparable transactions. Examples of (2) include liquidation value and adjusted net asset value; examples of (3) include discounted cash flow and return on investment;
Our courts regularly use IRS Rule 59-60 as a guidepost. These nine factors include: The nature of the business and the history of the enterprise from its inception; the economic outlook in general and the condition of the specific industry in particular; the book value of the stock and the financial condition of the business; the earning capacity of the company; the dividend-paying capacity; whether or not the enterprise has goodwill or other intangible value; sales of the stock and the size of the block of stock to be valued; the market price of stocks of corporations engaged in the same or similar line of business having their stocks actively traded in a free and open market either on an exchange or over-the-counter.
Much analytical emphasis gets placed on superficial, standard industry valuation parameters. Common multiples include 30-50% of sales, 2-4x owners cash flow, 3-5x net income, or 1-2x book value. A commonly used variant is to use multiples of similar publicly traded companies (which could be quite different from standard at that time) and then discount the results by 25-50% because of the smaller size and illiquidity of the private company being valued. Our courts are not generally fond of these techniques.
Yet these standards may not be the most useful for an advocate. They make for fine baselines if the company does not possess unusual features and can be squeezed into a rigid industry segment; however, the oftentimes more helpful (and analytically sound) technique is discounted cash flow. Utilizing this method requires more of the analyst: Forecasting ability – fused with a deep analysis of risk premiums, industry economics, competitive strategy, company structure, and accounting vagaries.
The components of discounted cash flow analysis:
1) Free cash flow: This is calculated annually over a ten year time horizon. It is defined as aftertax earnings of the company stripped of all accounting vagaries and adjusted for working capital and capital expenditure needs. The higher the potential free cash flow growth . . . the more valuable the company.
2) Discount rate: This figure reflects the expected return on the investment (which is a function of risk) vis-a-vis other opportunities. Historically, a risk-free government T-bill has averaged a 3% annual return, a low-risk long term government bond 6%, the higher-risk stock market 9%, and a very high risk venture capital portfolio 20%. A small business lies at the apex of the risk scale, so a starting point for any analysis would be a discount rate of 20% and possibly as high as 50%. The lower the discount rate . . . the more valuable the company
Factors influencing the discount rate. Perhaps the single most important factor is the confidence in the cash flow forecast (as measured by past earnings predictability). A close second is the company’s return on capital. The risk profile of the potential buyer will come into play as well; an entrepreneur who plans to invest the bulk of his savings will invariably pay less than a corporation or a buy-out firm.
Takeaway1: A company is worth the discounted value of free cash flows over a 10-year period.
Takeaway2: High growth, steady and predictable cash flow, high returns on capital, and potential for a strategic buyer are the major factors that increase value
Takeaway3: DCF is the most sophisticated valuation method but can still be used with the others; yet it may not be appropriate for situations that are extremely difficult to forecast or for sole practitioners
APPLICABLE CASE LAW
Blasingame v. American Materials Inc., 654 S.W.2d 659, 666 (Tenn.1983)
Brown v. Brown, E2013-01706-COA-R3-CV (Tenn. Ct. App. May 12, 2014)
-recognized three acceptable valuation methods: (1) the market value method, (2) the asset value method, and (3) the earnings value or capitalization of earnings method. The choice of the proper method or combination of methods depends upon the unique circumstances of each business entity.
-it is improper to use the market value method to directly compare with publicly traded corporations
-any valuation of earnings that does not take into consideration a minimum of three years corporate earnings experience should be rejected, unless the expert opinion clearly and convincingly establishes the validity of a lesser period.
-“Delaware Rule” must be used to determine the value of dissenting minority shareholder’s shares, although it has not decreed that this is the only acceptable way to arrive at the value of the parties’ interest in a closely held corporation in a divorce proceeding.
Wallace v. Wallace, 733 S.W.2d 102, 107 (Tenn. Ct. App. 1987).
Powell v. Powell, 124 SW 3d 100 (Tenn. Ct. App. 2003)
Brown v. Brown, E2013-01706-COA-R3-CV (Tenn. Ct. App. May 12, 2014)
-determining the value of a closely held corporation is not an exact science
-trial court is free to place value of asset anywhere within range of evidence presented
-courts not bound by IRS 59-60 yet can be used as standard guidelines for valuations
Harmon v. Harmon, 25 TAM 15-22 (W.S., Tenn. App. 2000)
-buy-sell agreements are not controlling to determine valuation but, may be considered as a factor.
Holbrook v. Holbrook, 103 Wis. 2d 327, 309 N.W.2d 343 (Ct. App. 1981).
Smith v. Smith, 709 S.W. 2d 588 (Tenn. App. 1985)
Hazard v. Hazard, 833 S.W. 2d 911 (Tenn. App. 1991)
Eberting v. Eberting, No. E2010-02471-COA-R3-CV (Tenn. Ct. App. Nov. 8, 2011)
Hartline v. Hartline, No. E2012-02593-COA-R3-CV (Tenn. Ct. App. Sep. 16, 2013)
-the reputation and goodwill of a licensed sole practitioner is not a separate property interest
-the value of net assets is the key variable to be used to value a sole practitioner
-yet the amount paid for the practice can also be taken into consideration
Koch v. Koch, 874 SW2d 571, 576 (Tenn.Ct. App.1993)
-sole proprietorship in other professions are treated the same way – no separate property interest
Witt v. Witt, No. 01-A-019110CH00360, 1992 WL 52746 (Tenn.Ct. App.1992)
York v. York, No. 01-A-01-9104-CV00131, 1992 WL 181710 (Tenn. Ct. App. 1992)
-allowed for enterprise goodwill; enterprise goodwill is marital, personal is not
-differentiating factors include business line beyond that of sole practitioner, whether there are additional partners, and nature of existing contracts in place
-applies to professional practices that do not solely depend on reputation of one practitioner
INDUSTRY GROWTH AND STABILITY FACTORS
Growth of the industry. The U.S. economy grows on average by about 3% year, so any industry with recent historical and projected growth above that gives the companies within it a fighting chance to deliver solid growth rates. The most valuable industry sectors tend to be those on the cutting edge of a major consumer or business trend that could last for a decade or more and have overcome the initial growing pains of the first few years.
- Whole Foods Market and other natural foods retailers are a classic example of companies riding a longer-term trend – in this case towards conscious capitalism, healthier eating, better informed food choices, higher quality food, and products that do minimal harm to the environment. Depending on the researcher, the organic/natural foods market has grown 10-15% per annum over the last twenty years, well above the low single digits of the overall food and beverage industry. Whole Foods Market’s sales growth has comfortably exceeded 20% over this period, with profits growing even more rapidly
- Another example, within your realm, was the growth of the jury consultant industry. In the mid-1980’s, led by leading behavioral research academics, boutique firms came up with the then-novel idea to conduct mock trials, run focus groups, and monitor trials real time with groups selected to mirror the actual jurors. The demonstrated success of these techniques spurred this industry on a twenty-plus year run of above-average growth in both sales and profits.
- Now for a contra example: the overall legal industry today, unfortunately comes to mind. Demand for legal services has been flat-to-down since 2009, after growing in the mid-to-high single digit rates for decades. Given trends such as increased in-house counsel responsibility, more billable hour rate scrutiny, and commoditization of many legal services – an established law firm will find it difficult to grow meaningfully without acquisition.
Extremely rapid industry growth is not the be-all end-all. Wall Street is littered with myriad examples of high growth industries that perpetually excited investors yet ended up being minefields. Here’s a quote from Warren Buffett on the airline industry:
“If a capitalist had been present at Kitty Hawk back in the early 1900s, he should have shot Orville Wright. He would have saved his progeny money. But seriously, the airline business has been extraordinary. It has eaten up capital over the past century like almost no other business because people seem to keep coming back to it and putting fresh money in. You’ve got huge fixed costs, you’ve got strong labor unions and you’ve got commodity pricing. That is not a great recipe for success.”
The PC industry is another classic example of a high growth industry that investors like Buffett rightly shied away from. Although the industry grew by 30%-plus rates for more than two decades starting in the early 1980s, profitability was oftentimes elusive. From a consumer standpoint, the PC manufacturers added almost no value. The critical, value-added areas were the operating systems, other software, and chipsets – areas dominated mainly by Intel and Microsoft, who accordingly captured the lion’s share of the profits in the channel. A major shake-out occurred in 1991. Dell is about the only player left from that era. As can be seen in the industry stability factors section below, this industry falls short on every one.
Growth driven by government subsidy/contract can be particularly problematic. General political pressures, unpredictable regulatory tides, major lobbying efforts, severe scrutiny by the press and watchdog groups, and changes in political party dominance all can serve to change the dynamics of an industry on a dime. This is true of most industries with a strong regulatory angle. Yet those that are almost entirely funded by government are obviously at the most risk.
- The for profit colleges experienced explosive growth yet have recently suffered a spate of bankruptcies. The schools have aggressive (and oftentimes deceptive) marketing programs, comprising as much as 20% of revenue. 94% of their students obtain student loans. Only 22% graduate, and when they do they are stuck with mountains of debt. An alarmingly high percentage of students make zero payments on their loans. So it should come as little surprise when the Obama administration and Congress recently got involved in an effort to more highly regulate this industry and shut down loans to the companies with the highest defaults and lowest rates of graduation.
- The private prison industry is entirely driven by government contracts. Corrections Corporation of America, the leading industry player, grew its operation from one prison in 1983 to 59 in 2003. Yet the company almost went bankrupt in the early 2000s owing mainly to its being an increasingly controversial private company in an industry where the profit motive can be viewed as counterproductive to society. Critics pointed to unseemly lobbying efforts towards three strike and onerous drug laws and contract procurement. Numerous high-profile escapes and wrongful death suits plagued the company. These issues are not uncommon with public prisons, yet resulted in much negative publicity for Corrections Corporation because of its position as privately run.
Beware of highly cyclical industries. These are industries whose sales fluctuate wildly based on even minor changes in overall economic conditions. The products sold are usually industrial commodities like oil, lumber, steel, and chemicals – or expensive consumer products such as automobiles. Expensive consumer service industries such as those notorious airlines are also highly cyclical. Cash flows from these sectors are notoriously hard to predict; furthermore, a steep downturn in one year can be enough to wipe out companies that are not well capitalized, particularly the smaller ones
Most companies in newly developed industries go out of business. Rarely do the early movers end up being the dominant players over time. In fact, later entrants who learn from the early companies’ mistakes typically end up being the dominant ones. Pioneers oftentimes end up with arrows in their backs.
- The automobile industry provides an example. There were hundreds of companies in the early 1920s, yet only three by the end of the decade. Ford, Chrysler, and GM then prospered mightily through the 1960s, but it would have been extremely difficult to predict the ultimate winners.
- PC operating systems are another good example. Microsoft’s MS-DOS was just one of many systems in the late 1970s and competed against Xerox and Digital Research, among others. IBM only chose them as the OS supplier to its industry-dominant PC line when negotiations broke down with its number one choice.
- Wal-Mart is the king of discount retailing today but its emergence was less-than-assured in the 1960s/1970s. Many embryonic discounters – including Kmart, Target, Woolco, Two Guys, Korvettes, and Zayles – shared that retail space. Kmart was the first to become national and was viewed as the clear industry leader. Sam Walton launched myriad retailing innovations over his career but, initially, borrowed many of WalMart’s initial operating strategies from other discounters.
Inflection point in industry. Few secular industry trends seem to last more than twenty years (and usually considerably less) in this country owing to rapidly changing consumer tastes, the availability of capital, strong supply of entrepreneurial talent, and our history of dynamic capitalism. Identifying a secular industry slowdown in its early stages is a critical analytical talent. It isn’t easy, because virtually every industry player and industry association has a vested interest in deceiving the public with reams of bullish-oriented propaganda as to why the slowdown is only temporary.
- The cruise industry’s growth skyrocketed in the 1980s by offering the vacationer an entirely different, fun, often booze-soaked experience and by offering very high incentives to travel agents. Although passenger growth continued strong, overall revenue growth began to gradually slow in the mid-to-late 1990s – a key inflection point was reached but it was not entirely obvious because of the continuation of passenger growth trends. They key analytical variable was that the easy growth of 3-4 day cruises in the upper Caribbean was over because the standard port stops could not support more ships. So companies had to move into the lower Caribbean, Alaska, and the Mediterranean to keep growth going. These markets were not as profitable, because they required more fuel expense and longer cruises that did not generate the same levels of daily onboard customer spending.
- Consumer electronics retailing’s selling and profitability modus operandi was upended when Best Buy launched a format in 1989 that did away with commissioned salespeople whose main job seemed to be foisting overpriced extended warranties on the consumer. In most cases, these retailers were getting over 100% of their operating profits from these warranties sold by a commissioned force. It took 5-10 years for Best Buy to expand this format nationally but, once it did, its primary competitors began to hemorrhage money and eventually the larger ones like Circuit City all went out of business 10-15 years the first non-commissioned Best Buy store was launched. Yet the inflection point would have been known much earlier by those analysts who knew how important extended warranties were to the industry and who knew that the upheaval would not happen overnight.
Barriers to entry in the industry. This subject is a whole discipline onto itself but, simply put, it comes down to whether or not the rate of growth of new companies into the industry will outstrip that of the overall industry. If this is the case, pricing pressure is inevitable and profits will not keep pace with sales growth. So what are some of the factors that determine how competitive an industry could become:
o Economies of scale (advertising, R&D, fixed cost allocation)
o Start-up capital required
o Brand equity of the leading players
o Presence of significant intellectual property
o Extensive distribution networks
o Nature of government regulation
o Customer switching costs
High barriers to entry are not always a panacea in themselves (to wit: the auto and airline industries), but are a strong positive factor all else being the same. In the case of some industries, like pharmaceuticals, they combine with other factors to result the highest profitability of all major industries.
Stability of the industry. Another subject that can be a whole discipline onto itself, but there are basic things to look for. The airline industry for most of the last thirty years is an example of an industry that fails on most of these counts, with predictable results for those who study industry structure closely.
o The top three players enjoy significant market share, not too narrowly defined
o Most of the companies in the industry are healthy
o Pricing power exceeds the rate of inflation
o The product is not a commodity; leading companies have solid brands
o Companies have settled into well-defined market niches
o Companies have ability to quickly adjust capacity
o Suppliers are diverse and don’t have significant market power
Is the company gaining market share and can this continue. This comes down to whether the company indeed has a distinct competitive advantage or whether it is merely going along for the ride. These so-called “stuck in the middle” companies – with neither a cost advantage nor a differentiated product or service – may grow for a period of time but are prime candidates to eventually go out of business. Sources of competitive advantage include:
o Superior product and ongoing product development
o Superior manufacturing process in a complex area
o Cultural emphasis on marketing
o Superior customer service
o Broad distribution
o Strong brand franchise
o History of innovation
o Low cost production
o Top notch management and human capital
o Ownership of intellectual property
A dream company in a dream industry?! The industry is growing fairly rapidly, the industry is not in its early stages with significant growing pains, the industry has fairly high barriers to entry, stability among the top players is evident, and the company you are analyzing is gaining market share within that industry. Some examples of this wonderful confluence include:
o Whole Foods Market (natural foods retail; 1990-today)
o Oracle (enterprise software; 1980-2005)
o Amgen (pharmaceuticals; 1990-today)
o Wal Mart (discount retail; 1970-2005)
CHARACTERISTICS OF HIGH-QUALITY COMPANIES
Must be something unique about the franchise: Lowest cost producer in a commodity industry; differentiated brand; differentiated by employee talent; strong new product flow; highly service-oriented; or patent protected.
A longer-term orientation: As evidenced by high level of R&D expenditures, sales/marketing expenditures, employee training outlays, and infrastructure investments; doesn’t live-or-die by monthly or quarterly numbers.
Unwavering focus on a central mission. Acts only within its distinctive competence and doesn’t grow the company merely just to get large; focused on growing the value of the company; understands that the most important factors in managing a business are employee satisfaction, customer satisfaction, and cash flow.
Solid market share. A company with a competitive advantage inevitably achieves some type of significant market presence. Could just be a niche area within a certain geographic market, but that still counts.
Sales grow at at least 10% annually and margins steadily expand: Good companies never stagnate; they are constantly finding new ways to please their customers and find new ones. Smart top line growth almost always results in expanding profit margins as well.
High level of recurring revenue. Selling to a new customer can be as much as 10 times more expensive than to an existing customer. The best businesses rarely lose customers and are constantly working on ways to sell more to these existing customers.
Loyal, diverse customer base. Heavy customer concentration can be a kiss of death, as they will have all the leverage and the company will have little-to-no pricing power. Consumer goods companies that sell mainly to Wal-Mart are particularly vulnerable.
Diverse base of products that need to be regularly replaced or upgraded. This minimizes risk of any one product having problems or slowing down appreciably. Beware of companies that sell just one or a few expensive products that the customer almost never replaces.
Diverse base of suppliers. Reliance on just a few can create dependency. In most cases, the top three suppliers should be well under 50% of a company’s business.
Strong cash flow and returns on capital. If strong accounting earnings are not translating into strong cash flow, then something is invariably wrong. No matter what the industry, strong cash flow and returns on capital should be the financial residual of a solid business model. Always!
Manageable debt levels. Well managed businesses try and avoid large increases in debt. New investments are steadily made along with the growth of the business, minimizing the need for large debt infusions. If a one-time shot of debt is needed, an overriding focus is on paying it down quickly.
Promotion from within, well-paid employees, low management and employee turnover. Employee satisfaction is either the first or second most important factor in a business – coupled with a good business franchise it leads to most of the other desired factors.
Conservative accounting policies that don’t change
APPENDIX – RED FLAGS
The company is in a fast-growing industry, yet capacity is being added in the industry faster than the overall industry is growing. This is common in many technology sectors, and results in gross margin erosion despite seemingly healthy growth rates
Other companies in the sector – or upstream or downstream companies – are experiencing difficulty, yet the subject company pronounces itself immune to these problems.
The company announces a major step-up in expansion pace without making plans to improve its infrastructure commensurately. This issue often plagues retailers and restaurant chains.
A major new competitor recently entered or is planning to enter the company’s primary market.
A single product or customer accounts for over 40% of the company’s sales. This is particularly negative if it is an expensive product that is prone to long sales cycles.
A significant portion of the company’s growth must come from entirely new product areas.
Management issues: Resignation of any member of top management; a non-sole proprietorship is a one-man show at the executive level; historically high turnover levels
Accounting issues (revenue): Slow revenue growth yet large increase in margins; the percentage of unbilled-to-total revenue is increasing; higher percentage of revenues coming from “other.; significant portion of revenue recorded before product shipment or service completion; transactions involving significant financing of customers; customers enjoy liberal return policies.
Accounting issues (other income statement): Expenses such as marketing are capitalized rather than put on income statement; depreciation and pension plan assumptions are more liberal than most companies; a major inventory reduction program allows selling of lower cost layers in the future
Accounting issues (balance sheet): Significantly rising receivables or inventory; rising prepaid expenses; declining levels of deferred revenue; payables/inventory declining with commensurate increase in bank debt; a major investment in a customer; major investments in unintelligible partnerships.