BVR Logo 6 August 2019 | Issue 5-1

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Free download: What increases the asset value of a customer?

Valuing customer relations requires quantitative and qualitative judgments. Yet, little guidance on valuing this increasingly important intangible asset is available while most BVWire—UK readers are facing this issue more frequently in an economy that is migrating toward desirable long-term relations.

Perhaps the best available summary of customer value factors is now available from a new BVR webcast, Using Asset Attrition to Determine Useful Life, with Ray Rath (GlobalView Advisors). Rath’s presentation can be downloaded here.  Rath has done as much research and teaching on valuing customer relationships as anyone in the BV profession.

The analyst needs to understand that two elements are required to define a customer relationship. First, the entity must have information about the customer. Second, the customer must be able to directly contact the entity. These two conditions eliminate the value of walk-in customers, which are normally valued elsewhere in an analysis.

Some factors that increase the value of a customer relationship include:

  • Lower rates of attrition or ‘customer churn’;
  • Longer customer relationships;
  • Higher product differentiation that creates barriers to entry by new and existing competitors;
  • Higher switching costs and quality of alternatives;
  • Better business health or profitability, which suggest lower attrition rates; and
  • More stable customer types (business customers may have more value than individual customers).

Rath suggests that analysts begin with at least two years of customer and termination data. He recommends that analysts review the data by anticipated revenue rather than by customer counts. Importantly, ‘different subgroups perform differently,’ so make sure that the data are segmented as needed. ‘You don’t want to treat a £1 million customer the same as a £100 customer, because the lower value attrition rate is not as important to the business.’ Business reporting units may have different attrition rates, and geography or the type of customer often make a difference.

Rath says that customer groups behave differently, and analysts need to understand whether the constant attrition rate method or the variable attrition rate method best matches the entity. Another complexity occurs if clients are concentrated. ‘If 10 customers account for almost all the revenues, you won’t have enough data to calculate a constant attrition rate. More qualitative analysis is required,’ Rath says. If most of the revenue comes from one major public company, an attrition study will be undependable.

The presence of customer contracts may eliminate the need for an attrition analysis, Rath observes, since the business valuator can value each contract individually. Another factor analysts must address is how to remove growth from new customer revenues, since this growth may be valued elsewhere. Multiple years of revenue by customer can improve the defensibility of these analyses.


Nearly 5% of estates now fall under HMRC's inheritance tax rules (IHT)

BVWire—UK estimates that 28,000 estates fall into the inheritance tax (IHT) rules this year, an increase from 24,500 in 2015/2016. Treasury does well with this tax, having collected £5.36 billion in 2018/19.

All estates valued at £325,000 or above must pay IHT. The increase in filings continues primarily because this threshold has not increased since 2008.

Since most estates in the low end of the IHT filings are comprised primarily of real property, many commentators noted that the residence nil rate band (RNRB), a £150,000 tax-free allowance on the main residential home, might reduce HMRC collections. This has not been the case.

The growth in IHT filings has contributed to keeping fiscal valuators busy the last few years, particularly with small and medium enterprise (SME) business valuations. In addition, a larger group of small-business owners have engaged in lifetime gifting of income, real, and business assets, and other tax planning provisions, in the hopes of reducing their family liability upon death. Even an economic downturn is unlikely to slow the increase in IHT filers, and, while rumours persist, no review of fiscal policy around inheritance taxes is predicted.

Do UK business valuators struggle to explain themselves? Perhaps it's because of '18 topics badly explained by many finance professors'

The confusion resulting from many finance practices isn’t your fault, says Pablo Fernandez (professor of finance, IESE Business School in Madrid) in a new and highly readable essay. BVWire—UK recommends this analysis to anyone who (sometimes) struggles to explain their conclusions to end-users (or their friends and family).

Many of the topics have to do with the weighted average cost of capital (WACC), which Fernandez points out simply ‘is not actually a cost.’ Others have to do with betas and problems with risk analysis and market or portfolio returns. (One item on Fernandez’s list explains why you shouldn’t sell hair tonic to balding men.)

However, the equity risk premium (also called market risk premium, market premium, equity premium, and risk premium) dominates the confusion. ‘Textbooks, professors, analysts and practitioners differ a lot on their recommendations.’

‘The term “equity premium” is used to designate four different concepts,’ says Fernandez:

  1. Historical equity premium (HEP): historical differential return of the stock market over treasuries;
  1. Expected equity premium (EEP): expected differential return of the stock market over treasuries;
  1. Required equity premium (REP): incremental return of a diversified portfolio (the market) over the risk-free rate required by an investor. It is used for calculating the required return to equity; and
  1. Implied equity premium (IEP): the required equity premium that arises from assuming that the market price is correct.

‘Although the HEP is equal for all investors, the REP, the EEP and the IEP are different for different investors,’ which adds to the confusion, Fernandez observes. Different values derived from different investor perspectives creates ‘a kind of schizophrenic approach to valuation.’

To make matters worse, ‘textbooks differ a lot on their recommendations regarding the equity premium,’ the professor writes in another analysis called “The Equity Premium in 150 Textbooks,” in which he reviews 150 textbooks on corporate finance and valuation published between 1979 and 2009 by authors such as Brealey, Myers, Copeland, Merton, Ross, Bruner, Bodie, Penman, Arzac, and Damodaran. ‘Their recommendations regarding the equity premium ranged from 3% to 10%,’ he finds. Worse still, 51 of the 150 books use different equity premia in different pages.

Looking to reduce the confusion? For those 150 authors, the average was 6.5%.

Fernandez realizes his list of 18 confusing finance topics is only a start: ‘I already discuss all 18 every semester with my students,’ but, if BVWire—UK readers come up with more, ‘I will do my best to badly explain those as well.’

CFA Institute ponders how to make their CFA exam 'more accessible'

Some UK business valuators hold the CFA in addition to their other professional designations. Those CFAs will be particularly interested to learn that a fifth of CFA test-takers (22%) failed to even turn up to the difficult exams so far this year. This number has remained stable despite the CFA Institute’s (CFAI) various efforts to bring it down. If you think this is a small problem, note that more than 55,000 of the 250,000 students due to sit for the exams in June were no-shows, the CFAI reports. CFAI does not release country-specific information, but most UK CFAs and others in the finance and accountancy professions assume about 10% of all CFAs reside here.

So, for those approximately 20,000 UK CFA test-takers who actually sat for the exam, and who are set to receive their results this week, good wishes. You’re joining a group where historically only about half of the candidates sitting each level usually pass—another statistic that’s stayed steady since the early years of the CFA.

BVR joins the IVSC

In keeping with the theme of aligning with top BV players around the world, BVR is now a member of the IVSC:

Business Valuation Resources, LLC (BVR) has been appointed a member of the International Valuation Standards Council (IVSC), the global not‐for‐profit organisation responsible for setting International Valuation Standards (IVS) and developing the valuation profession worldwide.

You can learn more here.

As a member of the IVSC, BVR will work with leading valuation organisations throughout the world to strengthen the body of knowledge and ensure international standards enhance the reliability and transparency of valuation data. ‘It is an erudite and talented community,’ says BVR President Lucretia Lyons. ‘We are now even more committed to playing an active role in the remarkable ongoing success of global valuation initiatives, and especially eager to contribute to the expansion of best practices, data sets and other business valuation resources.’

‘Consistent standards improve transparency and stability of financial markets, contribute to the growth of stronger economies and lead to improved confidence for all users of valuation data,” says Sir David Tweedie, chair of the IVSC board of trustees.

What do you do when you can't buy the Deutsche Boerse for £22 billion?

Having been blocked by the EU regulators in 2016-17, The London Stock Exchange Group (LSEG) has turned from Deutsche to Refinitiv, the financial product portions of Thomson Reuters carved out by Blackstone last year (LSEG was also blocked in their efforts to buy the Toronto Stock Exchange in 2011).

All the analysts seem to agree that the deal would make LSEG a global exchanges and data powerhouse. LSEG’s stock offer (which they say will grant 37% of the shares and 30% of the votes to Refinitiv shareholders such as Blackstone and the Canadian Pension Plan Investment Board) somehow suggests the expression about ‘not letting foxes guard the proverbial henhouse.’ Certainly, the deal puts LSEG on relative par as an international financial information provider with Bloomberg and SPGI (of CapIQ fame).

Most of the British financial media feel this deal will pass muster with the regulators, unlike the Deutsche and TMX efforts earlier. The London Stock Exchange is currently the seventh largest market exchange in the world.

Are business valuations of public and private firms becoming more similar?

Writing last week as a contributor for Forbes, Paul-Noël Guély suggests that ‘distinctions between public and private markets have been gradually diminishing.’ While business valuators recognize that different methods, and public market data adjustments, are still essential, ‘in recent years, liquidity has been shifting towards private capital,’ Guély argues, changing many valuation assumptions.

Guély is the London-based founder and managing partner of Arma Partners, an independent M&A and corporate finance advisory firm with offices in London, New York, and Palo Alto, Calif.

‘There is a clear trend globally of companies staying private for longer,’ he says, which affects risk-free rate and other cost of equity assumptions. The trend is most apparent, as we all know, in technology and the wider digital economy, ‘resulting in sizeable private companies with multibillion-dollar valuations.’

More private debt and equity means lower costs of capital for private companies, Guély states. This is allowing private-market shareholders to exit before traditional options (IPO or sale)—and it offers many more financing opportunities for the growing businesses.

Lower cost of capital draws more diverse investors —and higher business valuations: Guély notes that investors ‘might now comprise a broad variety of alternative asset managers, mutual funds, hedge funds, wealth-management clients, corporates, sovereign wealth funds, venture and growth funds and other forms of non-traditional institutional capital.’

As a result of this liquidity, business analysts may find that private-company balance sheets begin to look more similar to—or even richer than—those of listed companies with larger R&D, capex, divisional startup losses, and innovation funds than their listed peer group. And the private-market companies may be now equally well positioned to withstand the risks of international business expansion or acquisitions, BVWire—UK notes.

Private capital markets account for an estimated 6% of the value of corporate equity and credit issuance, so significant room for further expansion and similarities remains. ‘The emergence of deeper and more liquid private capital markets looks to be an irreversible trend,’ for both investors and business valuators, Guély concludes.

Dates for your business valuation diary

ICAEW Practical Business Valuation, 11 and 25 September and 11 and 25 November, London

IVSC Annual General Meeting and IVAS/IVSC Business Valuation Conference, 7-9 October, Singapore

ACG UK Chapter Trends in Alternative Capital, 15 October, London

ICAEW Excel Modelling—Investment Appraisal, Valuation and Business Cases, 18 October or 15 November, London

ICAEW Annual Business Valuation Conference, 23 October, London

ICAS Corporate Insolvency Rules for Scotland Course, 31 October, Glasgow; 1 November, Aberdeen; 7 November, Edinburgh; 15 November, Perth

ICAEW Forensic and Expert Witness Conference, 7 November, London

UK200 Group (the network of independent law and accounting firms) Annual Conference—13-15 November, Liverpool

Stay current with the latest 'movers' in the business valuation profession

People: Alexandra Altinger, who was chief executive of Mayfair-based Sandaire Investment Office until 2017, will move to JO Hambro as chief executive next month.

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