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VALUATION of CLOSELY HELD BUSINESSES Richard A. Warner Principal Great Lakes Valuations 224-764-2280 [email protected] Agenda Introductory Comments Business Appraisal Concepts Approaches to Valuation Wrap-Up Selected Business Demographics Business Size by Employees Average Annual Revenues Average Number of Employees 1 to 4 $321,000 2.1 5 to 9 $792,000 6.6 10 to 19 $1,600,000 13.4 20 to 99 $5,701,000 39.2 100 to 499 $27,056,000 192.2 500 to 999 $540,467,000 688.6 Source: 1997 US Census material Why Do We Need Valuations? Mergers & Acquisitions Estate Planning and Wealth Management Family Law – Marital Dissolution Shareholder Disputes & Oppression Succession Planning/Buy-Sell Agreements ESOPs Other “Stuff” Attorney – Appraiser Roles & Relationships Objectivity & Bias Appraiser Skills, Knowledge, Certification Business Valuation Concepts Standards of Value • Fair Market Value • Investment Value • Fair Value • Intrinsic Value Premise of Value Valuation Date Present Value Would you rather have $10,000 now, or $14,025 five years from now? Future Value $14,025 2016 $10,000 2011 Present Value Investment Yield 5% ? 7% 10% Balance Sheet Basics $209,000,000 = $209,000,000 Current Assets Current Liabilities $41,500,000 $25,000,000 + + Long Term Debt (including current portion) Tangible Assets $41,000,000 + = Intangible Assets and Goodwill $34,000,000 + Equity $126,500,000 $150,000,000 Box analysis diagram ©Financial Valuation Group International Income Statement Basics Revenue: Less Cost of Goods Sold Equals: Gross Margin $6,000,000 $4,500,000 $1,500,000 Less Operating Expenses Selling Expenses General Expenses Administrative Expenses Equals: Operating Profit $450,000 $450,000 $450,000 $150,000 Plus/minus Other Income/Expenses $0 Earnings Before Taxes $150,000 Income Taxes (40%) $60,000 Net Income After Taxes $90,000 DEFINING the ENGAGEMENT Who is the client? Who is the appraiser? What is the specific interest being appraised? What is the valuation date? What is the purpose of the appraisal? What is the standard of value? What type of report is needed? Schedules? Fees? GATHERING COMPANY INFORMATION Key focus – •Estimate the stream of future benefits from the business •Estimate the risk associated with achieving those benefits •Value = Benefits/Risk ANALYZING THE INFORMATION Financial Analysis: • Common-size analysis • Comparative analysis • Trends Non-financial analysis • Management • Competition • Products & Quality • Customer/supplier concentration ESTIMATING THE VALUE Valuation Approaches • Asset Approaches • Market Approaches • Income Approaches ASSET APPROACH – WHEN TO USE Appropriate when valuing: • Marginally profitable companies (better dead than alive?) • Asset-heavy companies • Holding companies and non-profits • Controlling interests Generally not useful: • When significant intangible value exists • For valuing service companies • For valuing professional practices • When considering minority interests MARKET APPROACHES - GPTCM Guideline Publicly Traded Company Method Using information from publicly traded, similar companies, determine “multiples” to apply to the subject company’s operating results to obtain a value Completed Transactions Method Similar to GPTCM – based on sales of business interests in the market (M&A) Data Sources Institute of Business Appraisers Bizcomps© Pratt’s Stats© Mergerstat© CAPITALIZATION OF INCOME Basic capitalization formula: PV = E1/c Where: E1 = expected economic income at the end of next year c = capitalization rate Example: If E1 = $100,000 and c = 20% then PV = $500,000 DISCOUNTED CASH FLOW The value of a business is the present value of the “income” it can reasonably be expected to generate in the future… Basic DCF formula: Value Income 1 1 d 1 Income 2 1 d 2 Income 1 d 3 3 ... Income n 1 d n What about after the forecast period? nt Value Income 1 d n 1 n n Terminal Value 1 d t Where “d” is the discount rate… t DISCOUNTED CASH FLOW – TERMINAL VALUE One method is to calculate the terminal value using a capitalization of income method… E n 1 g PV kg 1 k n Where: PV = Terminal Value En = “Earnings” during last period of forecast k = discount rate (required rate of return) g = growth rate of En in perpetuity n = number of periods in the projection period DISCOUNT AND CAPITALIZATION RATES • A discount rate is a rate of return used to convert a monetary sum into a present value; also known as • opportunity cost of capital • weighted average cost of capital • required rate of return • How to determine for a closely held company? • Build-up models • CAPM DISCOUNT AND CAPITALIZATION RATES – BUILD-UP EXAMPLE Risk free rate = 5.1% General equity risk premium = 7.2% Size Premium = 9.3 Specific risk premium = 4.0% Discount rate = 25.6% DISCOUNTED CASH FLOW EXAMPLE Valuation - DCF Approach Fair market value December 31, 2010 Discount Rate Growth Rate 15.41% 5% Year 2011 2012 2013 2014 2015 Terminal Value Value of Equity as of Valuation Date Forecasted Net Cash Flow to Equity $ $ $ $ $ $ 755,696 537,746 643,674 804,113 984,646 9,931,586 Present Value Factor 0.93085 0.80656 0.69886 0.60555 0.52469 0.52469 Present Value Future Cash Flows $ $ $ $ $ $ 703,438 433,722 449,839 486,928 516,636 5,211,024 $ 7,801,587 CONTROL AND MARKETABILITY Controlling Interest Value Control Premium Minority Interest Discount Marketable Minority Interest Value (“WSJ Listed Price”) Discount for Lack of Marketability Nonmarketable Minority Interest Value Application of Discounts and Premiums Value on a control, marketable basis Less discount for lack of control (25%) Value on a minority, marketable basis $100.00 25.00 $75.00 Less marketability discount (35%) 26.25 Value of minority, non-marketable interest (51.25% discount) $48.75 A CONCLUSION OF VALUE – WHEW! Check the math… Review the facts… • Review company strengths and weaknesses • Review economic conditions • Review comparative financial analysis Subjectively weight results obtained by different valuation approaches? Did we value the right property correctly? QUESTIONS…….