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NQLA Conference 25 May 2011 Valuing Businesses and Property after Matrimonial Breakdown What is Valuation? Purpose of Valuation Is a Valuation necessary? The Valuation process Types of methodologies How business Valuer conducts process Issues to take into consideration for matrimonial breakdown Issues for Valuers The application of retrospectivity (Kizbeau case) Summary for Lawyers Appendix 1 – 41 factors affecting a Business Valuation What is valuation? “Valuation can be described as estimating a fair price for the parties to exchange an asset having regard to the risk and the expected return of the asset” Concept of risk and return – key to valuation Purpose of a valuation Why are valuations conducted: “to arrive at a value as a reference point for a transaction” Purpose of a valuation A valuation must have regard for: - Expected returns - Risk free rate - Comparable returns of similar assets or classes of assets - Risks of the returns - Other variables Market value “the price that would be negotiated between an knowledgeable and willing but not anxious buyer and a knowledgeable and willing but not anxious seller acting at arm’s length within a reasonable time frame.” (Lonergan, 2003) Alternatives to Market value definition Intrinsic value Fair market value Realisable value Going concern value (primarily for businesses) Present value or net present value Investment Deprival value Intrinsic Value Intrinsic Value of a business is defined as being the value “inherent” therein, “belonging to”, or “arising from” its “true or fundamental nature”. Thus, the Intrinsic Value of a business equates to its value, to the owner, in its present form, independent on the amount for which it can be sold. Intrinsic Value and Market Value “Intrinsic Value” and “Market Value” cannot be one and the same, because the value of a business, “in its current operating state”, includes assets and liabilities that are not transferred to a purchaser, in a sale thereof. It may be described as “true value” inherent in the object of the valuation. This may not be a reflection of current market price or realisable value, but is rather an assessment of value computed on true worth, irrespective of any other considerations. Intrinsic values change less frequently, as a rule, than market values. Intrinsic Value Assets Assets included in the “Intrinsic Value” of a business, not transferred to a buyer of the business, i.e., excluded from its “Market Value”, include: Cash at Bank Trade Debtors Utilities Deposits Intrinsic Value Liabilities Liabilities accounted for in establishing the “Intrinsic Value” of a business, not transferred to a buyer of the business i.e., excluded from its “Market Value”, include: Trade Creditors Employee PAYG Tax Deducted Employer Superannuation Contributions Intrinsic Value and Market Value Nevertheless, for “a knowledgeable and willing, but not anxious buyer and a knowledgeable and willing, but not anxious seller, acting at arms length, within a reasonable time frame”, “Market Value” would normally equate to “Intrinsic Value”, adjusted for the above exclusions. Price v value “Price is what you pay, value is what you get” (Kilpatrick 2006) Price: - is the amount realised in a transaction - Price is objective Value: - is an estimate at what price should be - Value is subjective In a going concern business no two Valuers are going to agree exactly on a value Conceptual framework Valuation is built around the concepts of risk and return Put simply, the value of an asset (Business) is the present value of the future cash flows of that asset This applies to businesses and property What is being valued? Business Shares To value the shares you need to value the business Is a Valuation necessary? Is it profitable after deduction of owners wages and other adjustments Has it been incurring losses Is it solvent Is it a going concern Is it only worth in situ plant and equipment value Does one of the parties have specific expertise Is there any goodwill Is business saleable Small business – is the profit no more than the business owners wage “Buying a job” Maybe pertinent to just value plant and equipment The valuation process 1. Understanding the business, its risks and industry 2. Selecting the relevant methodology 3. Determining the variables 4. Determine the result 5. Review the result 1. Understand the company’s business PORTER MODEL – introduced in 1980’s Understanding the business, its risks and industry, including: - Barriers to entry - Quality of management - Company’s competitive position - Industry and outlook - Competition Porters 5 forces 2. Select relevant methodology Standalone value / value to acquirer Methodologies: - DCF - Capitalisation multiples Which methodology to use Depends on information available and circumstances Quite a number of issues are considered before determining the methodology for valuation Terms of premises occupancy can determine the appropriate method for valuing a business E.g. If business is expected to have a limited life span business should be valued by DCF method only Types of methodologies 1. Relative Capitalisation of Future Maintainable Earnings. Aka Industry Peer Comparison. Apply an appropriate multiple to anticipated future earnings to derive a valuation. E.g.: EBITDA, EBIT, PE, multiples 2. Intrinsic Discounted Cash flow (DCF) approach. Involves the calculation of Net Present Value by applying a discount rate to projected cash flows. 3. Contingent Claims Real Options. Views investment decisions as options which acknowledge the value of flexibility in businesses. Involves valuing growth/deferral/ abandonment options. 4. Others e.g. Industry-specific rules of thumb, asset value comparable sales method Capitalisation multiples Capitalisation Multiples: Surrogates for DCF Less reliable Capture growth and risk in multiple Requires comparable companies Issues with each method: - EBITDA (Earnings before interest tax depreciation and amortisation) - EBITA (Earnings before interest tax amortisation) - EBIT (Earnings before interest tax) - PE Discounted cash flow DCF is theoretically the best methodology However it is not always practical Therefore it is mainly used for: - Lumpy cash flows - Start ups - Resource projects - Finite timeframes Capitalisation multiples - Advantages Easy to understand and extensively used in practice Inputs (published financials, short-term forecast, comparable multiples) are widely available Ability to benchmark against industry Works well for stable established business Capitalisation multiples - Drawbacks Seen as less rigorous/simplistic Inconsistency in accounting practices; depreciation, amortisation, tax outstanding Small sample size and sample reliability Range of multiples are often wide and outliers exists Uneven cash flows – start-ups, and turnarounds 3. Determining the variables DCF - Discount rate / WACC (weighted average cost of capital) - Cash flow variables e.g. foreign exchange Capitalisation multiples - Earnings to be multiplied - Earnings multiple based on comparable companies Other detailed research 4. Determining the result What is the result of the DCF of multiple valuation? Sensitivities around key assumptions 5. Review the result Cross check to other methodologies, i.e. what multiples does the DCF valuation provide? Check for reasonableness Stand back and look at result - Does it make sense? - Should the company be worth more or less? - Do the assumptions need revision? Selection of appropriate maintainable profits figure “The selection of an appropriate maintainable profits figure is a matter of judgment depending on the circumstances. For example, a company may be in a position of short term decline, as a result of industry pressures, or internal management problems. In such a situation, it is important to adopt a longer term view so as to discount any short term irregularities in the company’s profitability.” (Lonergan) Intrinsic value established by capitalisation of future maintainable earnings (FME) method Quite common for small business operators not to prepare estimates of future net cash flows Reasons for this include: a) do not believe they can be reliably predicted b) simply do not have any idea about their future net cash flow c) not willing to incur the cost of professional assistance to prepare them Method preferred by small business operators CAP FME method, an Earnings before Interest AFTER TAX Capitalisation Rate is applied to expected FME Criticisms of future maintainable earnings methodology “Too many FMP based valuations are flawed in that they automatically employ historical profits as a proxy for FMP without undertaking sufficient critical examination of past performance and likely future events. An understanding of the future of a business is essential for an accurate valuation, yet is omitted when historical profits are used in isolation.” Lonergan Noted American valuation text author, Shannnon P. Pratt, also endorses that view: “There is a mind set that can be described as the ‘mechanistic mentality’, for lack of a better expression. It mechanically relies on past data, without considering whether adjustments should be made, or whether it is reasonable to expect future results to conform to past results. Rules of thumb market value methods Criticism is rules of thumb do not provide a real value of a business in terms of the earnings derived from the net assets employed How does Business Valuer conduct process? Obtain last 3 - 5 years financials (tax returns preferable) Review profit and loss for last 3 - 5 years Establish whether future cash flow forecasts have been undertaken and if so review same Ascertain if owners wages have been paid and commercial rent charged Determine if any other applicable adjustments Take into account inflation Calculate adjusted net profit Review assets and liabilities Review Balance Sheet Land and buildings – consult Property Valuer (not to be included in net tangible assets calculation) Plant & equipment/vehicles – obtain specialist valuer of plant and equipment/vehicles Stock – determine obsolete stock Debtors – ascertain collectability Review assets and liabilities Work in progress – ascertain position Directors loan accounts Review other assets: and adjust for non business assets - below market value Review liabilities: - normally bank borrowings, (not to be included in net tangible assets calculation) trade creditors, ATO payable Have any assets been omitted? Most obvious – Goodwill May be patents or trademarks (intellectual property) Goodwill definition The High Court of Australia provides a definition of Goodwill, from a legal perspective: “For legal purposes, goodwill is the attractive force that brings in custom and adds to the value of the business. It may be site, personality, service, price or habit that obtains custom.” Valuing Goodwill or other tangible assets component of the value of a business Whether business valued by DCF, CAP FME or combination DCF and terminal value method, value of goodwill or other intangible assets therein calculated by total value of business Minus The value of the tangible assets How does Business Valuer conduct process? Alternatively described as price earnings ratio method i.e. A Price Earnings Ratio (PER) is applied to expected FME to establish the value of the business so that: e.g. A PER of 5 is equivalent to a Capitalisation rate of 20% most small business PER 2-5 (i.e. Multiples of 2-5) Applies multiplier How does Business Valuer conduct process? All Business Valuations, whether by the: Discounted Future Net Cash Flows Method, Capitalisation of Future Maintainable Profits Method, or the Combination Discounted Future Net Cash Flows and Terminal Value Method should be based on After Tax Figures! Calculation of Goodwill E.g. Calculated FME to be $200,000 after adjustments using a multiplier of say 4 (25%) $800,000 if tangible assets liabilities Net tangible assets Goodwill $700,000 $300,000 $400,000 $400,000 Continuing businesses with no Goodwill Value of business may be less than the value of net tangible assets Therefore no goodwill and value is tangible assets less value of liabilities Businesses discontinuing or closing down Value represented by value realised on disposal Issues to take into consideration for Matrimonial Breakdown Saleability of business Age of respective parties (is retirement looming) Succession planning Parties particular skill set Whether business will be continuing Issues for Valuers Can only use figures they have been provided with Does not undertake an audit of the business Difficulties re cash economy (cannot have your cake and eat it) Important for valuer to clearly articulate their assumptions Necessary to comply with Valuation Standard Apes 225 – Valuation Services Issues for Valuers - continued Expert witness if appointed by court their overriding duty is to assist court Expert witness is not an advocate for a party Combine service trusts and other entities The application of retrospectivity for valuing the interests of an exiting equity holder Pertinent to divorce settlements where the interest of one of the parties is to be transferred to the other party who will continue to conduct the business Not a hypothetical sale of a business to a hypothetical seller Interest not available for sale on open market Interest – intrinsic value method Rather, Profits derived, subsequent to the exiting date, which may not be ascertainable, until some time later, may be adopted as the Future Maintainable Profits of the Business, by applying the principle expounded in Kizbeau’s case: “Although the value is assessed, as at the date of the acquisition, subsequent events may be looked at, in so far as they illuminate the value of the thing, as at that date.” Kizbeau Pty Ltd v W G B Pty Ltd McLean [1995] HCA 4; (1995) 69 ALJR 787; (1995) 131 ALR 363; (1995) 184 CLR 281 (11 October 1995) [100%] (From High Court of Australia; 11 October 1995; 50 KB) Summary for Lawyers 1. Is a valuation required? 2. Establish clearly what is to be valued and instruct accordingly 3. Review methodology and assumptions used 4. If applicable query/challenge the valuation Some incorrect assumptions or an overly generous multiplier can have a significant effect on the end result for your client e.g. If multiplier should be 3 and 4 is used and entity generated $300,000 difference in the value is $300,000 Appendix 1 Factors Affecting a Business Valuation Factors affecting a business valuation Business History Business Reputation Market Share Potential for growth Industry conditions Superiority Vulnerability Political and economic outlook Cash flow Management / staff competency Reliance / non-reliance on founder Factors affecting a business valuation Production capacity (if applicable) Ability to increase revenues Cost competitiveness Ability to reduce costs Business’s use of technology Comparable businesses Comparable industries Product / service quality and competitiveness Encumbrances (if any) Assets for sale – their condition, their remaining useful life Factors affecting a business valuation Prevailing legal issues (if any) Ease of operation Attractiveness of the industry – competitive forces, power of suppliers, power of customers, risk of new entrants and risk of substitutes Rate of return Potential to improve customer relationships Ability to borrow against business or assets Performance results and ratios Location Presentation of premises Factors affecting a business valuation Existing relationships with suppliers and customers Intellectual property Intangibles including relationships and contacts Goodwill Condition of books and records Computerisation Tax implications Alternative opportunities Affordability Working conditions (including hours and days) Property lease conditions and landlord Please note that this is an incomplete list of just some of the factors that can influence the valuation of a business.