Prepare for impact
The goal of FAS 141R is to harmonize international standards with U.S. GAAP principles when accounting for business combinations, and to reduce the costs and complexity associated with the reporting process (particularly for multinational corporations that were previously required to record results using various local standards). This sounds like a step in the right direction, but what are we really getting?
In a CFO.com article titled Rule Makes Execs Think Twice About Dealmaking, Jay Hanson, National Director of Accounting for McGladrey & Pullen, LLP, was quoted saying "The most difficult part of implementing FAS 141R is coming to grips with fair-value principles that were never required before." Hanson went on to say that the new requirement to record estimated contingent consideration on the day of the sale, as opposed to when paid out, could cause potential problems. Because the difference between the fair value and that which is ultimately paid out is recorded as either a gain or a loss, tensions could arise between firms and auditors because firms may seek high estimates in the hopes of boosting earnings when the payout is made.
CFO.com’s article also included statistics from a Deloitte survey of 1,850 executives asked about the impact of FAS 141R. 40% said it would cause them to "rethink" deal strategy and affect planned deal activity, while only 4% said their companies have already finished assessing the valuation impact of the new rule.
To read the full assessment of the impact and controversy of FAS 141R by CFO.com, click here. To read the full results of Deloitte’s survey, click here.
'It’s hard to predict—especially about the future'
A multitude of reasons exist for trying to predict the future operations of a business, Jim Catty, CPA/ABV, CFA, CVA (Corporate Valuation Services, Ltd, Toronto) said during his “Are Management Forecasts Reasonable?” presentation at NACVA's Fifteenth Annual Conference in Las Vegas. “It is impossible…to be accurate, but one must strive to be effective,” Catty said, driving his point home by referencing the quote in the headline, ascribed to the immortal Yogi Berra. An appraiser needs to understand the context in which a financial projection is developed as well as the company’s past performance. However, Catty warns, there is danger in relying on the past. “The problem with relying on history is that a love of certainty and continuity often causes us to draw the wrong conclusions.” He recommends looking back at least twice as far as you plan to project – usually 10 years in the past to five in the future and advises applying a minimum of three scenarios: (1) Success (most-likely management’s optimistic view; (2) Survival (mediocre to poor performance); and (3) Status-Quo (little change, if any, from the prior year). Jim’s complete article on the topic appears in the July issue of the Business Valuation Update ™
Given the importance of—and debate around—working with management projections, BVR has collaborated with Neil Beaton and Jim Catty for an exclusive one-day workshop on Friday August 15 at the beautiful Hyatt Regency right on Lake Tahoe. Registration is limited to the first 40 people, so escape the heat, bring the family and walk away with a solid framework for management projection analysis. For more information and to register, visit The Uses and Abuses of Management Projections web page.
Avoid common errors when using the transaction databases
What are the advantages and disadvantages of using transaction data in your business appraisal? What common errors are made when using transaction databases and how can these costly mistakes be avoided? To help answer these questions, Business Valuation Resources introduces The Comprehensive Guide to the Use and Application of the Transaction Databases by Nancy Fannon ASA, CPA, ABV, MCBA and Heidi P. Walker ASA, CPA, ABV (both of Fannon Valuation, Portland, Maine). This new Guide provides analysis of the Pratt’s Stats®, BIZCOMPS®, FactSet Mergerstat Deal Report, and DoneDeals® databases and offers guidance on how to avoid common errors associated with using each.
Since each transaction database provides the information in a different format and with different definitions, using a value indication from any one database without being aware what the multiple really means may lead to a materially incorrect conclusion of value. To help avoid this, each of the databases is discussed in a detailed, consistent manner so the reader can cross-reference from one database to another in an effort to facilitate comparisons when using multiple databases.
Business Valuation Resources has posted the introductory chapter of The Comprehensive Guide to the Use and Application of the Transaction Databases to the Free Downloads page. To purchase the Guide, click here.
'Much of what’s in academic textbooks on cost of capital is behind current research'
This was a comment from Roger Grabowski ASA (Duff & Phelps, Chicago) regarding levering and unlevering Beta in his “Update on the Cost of Capital” presentation at NACVA’s Fifteenth Annual Consultants’ Conference in Las Vegas in early June. Theory tells us company risk includes operating and financial risk and that more financial risk (leverage) equates to a larger Beta. Public companies used in the guideline public company method will probably have different leverage than your subject private company—so to better match the leverages, the appraiser unlevers the guideline company and relevers the guideline company to reflect the subject company’s leverage.
The more Roger investigated unlevering and relevering Beta, the more he “was astounded to learn how much I was behind.” The Third Edition of the Cost of Capital – Applications and Examples, authored by Grabowski and Shannon Pratt CFA, FASA, MCBA, MCBC, CM&AA (Shannon Pratt Valuations, Portland, OR), includes the results of the authors’ research on the five different ways (Hamada Formula, Miles-Ezzell Formula, Harris-Pringle Formula, Practitioners’ Method Formula and the Fernandez Formula) to unlever and relever Beta. What is worse, the authors discovered that many textbooks incorrectly describe the conditions when one should use a particular formula. The book also includes a helpful table listing guidance for applying the five formulas, along with several examples.
Roger’s 110-slide presentation also included information on the criticism of subject company risk adjustments. Roger said that “the subject of company specific risk premiums is an area where BVers are most susceptible to being justifiably attacked.” If you haven’t read the Delaware Chancery’s decision in Delaware Open MRI Radiology Associates, P.A. vs. Kessler, et al., Roger said it is a must read. BVR has posted the full text of the court decision to our Free Downloads page. In that case, the judge wrote that one of the expert’s
…analysis also contains a subjective specific risk premium of 2%, the quantification of which cannot be explained by reference to objective factors…
The introduction of the Butler Pinkerton Model™ now offers appraisers the objective factors the courts seek. Roger called this new Model a “very useful tool.” To learn more about the Butler Pinkerton Model™, click here.
Monte Carlo: not just in Monaco
Bill Kennedy Ph.D., CPA/ABV (Anders Minkler & Diehl LLP in St. Louis) presented the “Use of Monte Carlo Simulation in Valuation and Litigation Support Engagements” at NACVA’s Fifteenth Annual Consultants’ Conference in Las Vegas in early June. The use of a Monte Carlo simulator can quickly and accurately help an appraiser determine value, especially when there are inputs to a valuation model that could have a range of possible values. This is a great tool to use when testing a wide range of what-ifs and when tracking the results is important.
Dr. Kennedy showed how to set up a base spreadsheet that includes the various inputs—then by using ORACLE’s Crystal Ball Monte Carlo simulator (an add-in to Microsoft Excel), he demonstrated how to set ranges on those inputs that were variable. The Monte Carlo simulator then randomly selects a value for each input variable based on the user’s criteria and runs the model hundreds or thousands of times. The result is a graph (see below for a representative graph from the ORACLE website) that shows the occurrence of each result of the calculation—with the “mean of the distribution representing the most likely outcome of the forecast, eliminating risks inherent in a single static forecast.”
Dr. Kennedy also shared several business valuation-specific scenarios where the Monte Carlo simulator would be useful, including:
- Sensitivity analysis of changing forecast assumptions when using a DCF model in a valuation
- Sales forecasting, product demand forecasting, cost estimating and other financial forecasting
- Lost profits calculations when accounting for the risks of success and failure
- Refining calculations of a lost royalty income based on forecasted sales
More BV hits available for your iPod
What are some of the challenges that are unique to valuing a very small company? To help answer this question, as well as many other questions specific to very small companies, Business Valuation Resources has posted a Free Podcast containing the highlights of the Valuing the Very Small Company teleconference, which took place on April 30, 2008. This 17-minute podcast with interviewer Stuart Weiss and speakers Gary Trugman CPA/ABV, MCBA, ASA, MVS (Trugman Valuation Associates, Plantation, FL), Ron Seigneur MBA, CVA, CPA/ABV (Seigneur Gustafson Knight LLP, Denver), and Stacy Collins CPA/ABV (Financial Research Associates, NY) focuses on the special circumstances unique to valuing a very small company. Some of the concepts covered include complying with valuation standards on a tight budget, when a calculation of value is appropriate, documentation requests, and how forensic accounting factors into the valuation.
To stream or download Valuing the Very Small Company or other podcasts, including Butler Pinkerton Model™ Specific Company Risk, S Corporations, and Valuing Community Banks, visit the Free Downloads page. To purchase the full Conference On Demand Pack, which includes the full audio recording, PDF of the transcript, presentation slides, and ancillary reading materials, click here.