ABZs of Solid Valuation Conclusions and Reports
I wrote a memo, titled “ABZs of Solid Valuation Conclusions and Reports,” for Mercer Capital’s analytical staff in 1989. The introduction and conclusion to this memo were written for its republication in Valuing Financial Institutions, my first book, published in 1992. The memo is reproduced as written with the exception of a few [explanatory comments].
I would only ask that readers realize that the memo was written almost 30 years ago, a time before Al Gore invented the internet, when FedEx was Federal Express, and when microprocessor technology was considerably less advanced than today.
Nevertheless, I believe that this 1989 memo is worth the time to read or reread as we think about developing solid valuation conclusions and reports in 2018.
Introduction [from 1992]
A couple of years ago , I prepared an internal training memo on “the ABZs” of reaching solid conclusions and preparing well-documented reports. That memo fits nicely into the progression of this chapter [in Valuing Financial Institutions] and serves to summarize much of the analytical discussion of the earlier chapters.
Because it was written in the second person, we will depart briefly from the basic writing style of this book. Although the memo did not relate specifically to banks, it is applicable to bank valuations almost in its entirety. With no apologies for any redundancies, the ABZs go like this:
The ABZs of Business Valuation
- Get command of the numbers. Read your spreads [financial statement spreadsheet analyses] to be sure they make sense. If things seem out of line or unusual, verify to source documents or raise questions for answering in interviews.
- Make sure you have considered all the obvious income statement adjustments (nonrecurring items, owner compensation, accelerated versus straight-line depreciation, LIFO to FIFO, etc.). Lay them all out on a valuation worksheet for consideration before eliminating them. Whether you use them or not, you must know what they are! If there are NOLs [these used to be more important than they are today] available that may shelter income in the future, be sure you get an immediate handle on the amounts and expirations. Be sure your investigation picks up the adjustments that are less than obvious. Ask the necessary questions to find the potential adjustments.
- Make sure you have considered all the obvious balance sheet adjustments (LIFO reserve, appreciated real estate or other assets, appreciated investments, condition of receivables and inventory, in tangible assets, etc.), and the appropriate tax-effecting of these adjustments. If you see early on that there are appreciated assets for consideration, initiate steps to get more information (appraisals, management estimates of value, etc.). As with the income statement, be sure to ask the questions that will reveal balance sheet adjustments that are not so obvious. Remember the other asset of $5,267 on a client’s balance sheet that turned out to be the cost of shares of Wal-Mart stock purchased shortly after the initial public offering, which had a market value, after splits, of nearly $800,000 in 1989!
- If there is a budget or business plan, be sure it is considered in the valuation worksheet, and be sure you have an opinion about its reasonableness or achievability.
- Be sure you come to grips early on with the comparable group [guideline public companies used to be called “comparables”] and that you have an opinion about the subject case in relation to the comparable group. Immediately begin to form your opinion about the appropriate capitalization rate(s) in light of the comparable data.
- If there is no comparable group, immediately begin to form your own opinion about an appropriate capitalization rate by an alternative method. Get the appropriate data for a build-up rate, or devise some other method that seems reasonable to you (and at least two more of us).
- Be sure you know everything there is to know about actual transactions in a company’s stock. The financial statements often provide evidence of transactions (related to treasury transactions, ESOPs, buy-sell agreements, stock options, etc.) if they have occurred. Be absolutely persistent in getting transactions data in detail from clients.
- If you realize there is information from an unusual source that can help solve a valuation problem, move heaven and earth to get it ASAP. Don’t wait until your back is to the wall when you know the answer is out there. Go get it! [Remember, the internet did not exist for business in 1989!]
- Be sure you know the particulars of state corporate tax rates or other tax considerations affecting the company.
- Regarding information, be sure you know what you have and what you need. Figure this out when information comes in, so if there are shortfalls, you can call or write [no Google!] for what is missing. Don’t put yourself in the position of being short on critical data at the time you have to commit to a conclusion or finish a report.
- When valuing multi-company holding companies, always be sure to obtain consolidating statements! These statements provide clues regarding intercompany relationships, show how a company is really financed, and provide a parent company only statement that is necessary to come to an opinion of consolidated value.
- Immediately after a client visit (whether or not you went on the visit), initiate all necessary follow-up to ensure that what you will need is available when you will need it.
- Immediately after a client visit, force yourself to value the company. If you have all the necessary information, you can reach a preliminary conclusion. Otherwise, attempting to reach a conclusion should force you to recognize any information shortfalls or issues that need to be addressed.
- When you start to value a company, never stop until you have a conclusion or know what you need to get to a conclusion!
- If a company’s numbers are “moving around,” be sure you understand why. If you go on the interview, be sure to ask why. If you don’t go, be sure to specify the questions for the interviewer and have the answers recorded. If, after the interview, you still do not know the answers, immediately get back in touch with the company to have them help you figure out what’s going on. You cannot value a company until you understand the numbers. Document your answers in a workpaper to save the rest of us from the problem if we later have to look into the file.
- Outline your draft before you begin to write. Get a clear mental picture of what you are trying to say at the outset, and you will save hours every time. If you do not make conscious decisions about drafting, skeletons [we now call these templates] may force you into spending hours that have no impact on your conclusion, add nothing to the quality of the final report, and have little to do with what you consider really important in the case.
- Read your draft with a pencil in hand before you ask someone else to read it. If possible, allow yourself time to set a draft aside for a couple of days or more, and then review your own work. Not only will you catch most of your obvious mistakes, you will learn how to draft better on the first try – if you habitually read your own work! You cannot improve your analytical thinking or your writing skills by hoping someone else will catch your problems and fix them for you. While the firm’s credibility is on the line when the report goes out the door, your personal credibility is on the line internally.
- Outline your draft before you begin to write. Read your outline to see if it makes sense in light of your knowledge of the case, the budget, the deadline, and the product we have promised to the client.
- Force yourself to come to your own conclusions (opinions) before asking someone else. Then you are testing, validating, affirming, and learning. You gain confidence in reaching conclusions by practice, not by asking someone else what he or she thinks.
- If you come to a valuation committee meeting [we still have to “sell” our conclusions to others] with a valuation conclusion, present the conclusion with confidence. If you don’t do that, aggressive people like Mercer (or clients) will realize you lack confidence and proceed immediately to develop their own conclusions – in which they have confidence. If you have followed the steps above, there is no reason you and others should not have confidence in your conclusions.
- If a conclusion other than yours is suggested, do not allow the change unless you understand why and are convinced of its superiority. Changes can result from finding errors of fact, omission, overemphasis, underemphasis, interpretation, mathematics, judgment, etc. Now is the time – before your report is finalized and out the door – to catch these problems and to internalize the process by which they were identified.
- Force yourself to draft each report immediately after the client visit. Our collective knowledge is seldom enhanced by the passage of time; in fact, it tends to dim with time unless we are actively working on the file over an extended period. So don’t wait until you or the visiting analyst cannot remember details. Draft immediately according to your outline!
- Be sure to stay in regular touch with the client(s) during the course of an engagement. Clients desire and deserve to have the perception of substantial effort on their behalf during the course of an engagement. Regular contact is the only way to ensure the reality and, therefore, the possibility of the perception. Clients do not generally become disturbed if problems (whether involving data, interpretations of documents, or issues) arise during the course of an engagement; they become disturbed if we ignore them when these problems arise and then surprise them with their impact on the engagement!
- If you will have to use an acquisition model or a discounted future earnings model, either as a validation of a valuation conclusion or as a primary methodology, be doubly sure you have command of the historical numbers as well as any projections available from the client. Do not wait until the last minute to get these methods set up. Templates can provide the structure for many models, but you must supply the command of the numbers and the critical link between historical and forecasted results.
- Outline your report before you start [repetition is, well, repetition]. It is an investment of time that will save you time every time and will improve the quality of your writing.
- Always keep client deadlines in mind when you work on a report. We promise drafts to clients within 30 days of our on-site visit in most of our engagement letters. That means you should have the draft done within about three weeks to allow for review, redrafting, or any other problems that might spring up at the end, as well as delivery time to the client [which was not available via pdf and email!].
The topic of this chapter is developing and presenting a valuation conclusion. This section suggests that the bank analyst should develop a command of a subject bank’s numbers and other information, ask the questions necessary to clarify issues raised by the information, and focus analytical attention on the process of valuation.
The analyst should also outline the report to ensure not only the inclusion of appropriate information in the draft, but also the logical and orderly progression of its presentation, and then draft (write) the report accordingly. After a reasonable wait, the analyst should then review (i.e., critically edit and make the necessary changes or corrections) to his or her own work. By following this procedure, chances are that the report is off to a good start.
Most valuation firms then have additional review procedures which check for quality, completeness, reasonableness and conformity with applicable appraisal standards. (For example, see Exhibit 15-2 [of Valuing Financial Institutions])
The ABZs focus analytical attention and encourage clear thinking about valuation issues. They provide a good start toward developing and presenting valuation conclusions. By avoiding common errors in report presentation, the analyst can increase the probability of having a well-written, well-organized, understandable, and reasonable valuation opinion.
Still pretty good advice today…
Hope you enjoyed this walk down memory lane.
New Book on Buy-Sell Agreements
The drafting of a new book on buy-sell agreements is almost complete. The working title is Buy-Sell Agreement Handbook for Attorneys. I am not an attorney. As always, I write based on my experience as a businessman and valuation guy.
My previous books on buy-sell agreements have been written from the perspective of business owners as in the title of the most recent book: Buy-Sell Agreements for Closely Held and Family Business Owners. Attorneys were, thankfully, one of the bigger markets for this book.
Many times, however, attorneys have said to me, in effect, “Chris, we like the ideas in your book. Do you have some template language to help us implement them?”
Until now, unfortunately, the answer was a “Not yet.” Now, this new book will contain detailed template language for several valuation processes for buy-sell agreements. I’m excited to get it to the point of making it available to attorneys, business appraisers, financial planners and, yes, business owners.
If you want to be notified when Buy-Sell Agreement Handbook for Attorneys becomes available, give me a quick email and we will put you on the list at firstname.lastname@example.org.