How should an expert explain the basics of valuation to a judge or a jury or a business owner or an attorney who needs to understand something about value for court, for personal reasons, or for clients? This post provides seven ideas to discuss the essence of business valuation in terms that have proven successful for me. I have drawn the following figures on chalkboards, wall boards, flip charts, and pieces of paper many times over many years. Assume the audience is a judge who may not have had any formal valuation training.
1. The Basic Valuation Equation
Most judges have an intuitive understanding of what I call the basic valuation equation. The equation illustrates that some measure of earnings is multiplied by a multiple to arrive at value, as follows.
The earnings in the equation is a measure of the cash flow of a business. Many people who know little or nothing about valuation are at least vaguely familiar with the idea of this equation. Writing it out either re-familiarizes them or makes them aware of the relationships between earnings and a multiple. At this point, I don’t even attempt to talk about which measure of earnings (or which multiple). This is a conceptual discussion.
I’ll often say that valuation is easy. All one has to do is to pick the right earnings measure and the right multiple and the answer is apparent. Then, of course, I say that if it were that easy, we wouldn’t be in the courtroom that day.
If cash flow is too complicated, I stick with earnings. Assume for our example that earnings, as adjusted, which we will discuss shortly, are $1.0 million.
2. The Multiple
The multiple is a number. By the time I testify, there may be several such numbers before the court. But where does the multiple come from? A little bit of basic algebra is helpful. I draw the next figure and then introduce the concepts of risk and growth.
The multiple is developed by the relationship between risk and growth. The “R” in the denominator of the equation above is the discount rate or the rate at which future benefits are “discounted” to the present. Greater risk implies lower present values, and less risk suggests greater present values.
Even children are familiar with this concept of risk. All of mine always preferred to get ice cream now rather than tomorrow. After all, ice cream now is ice cream now. Something might happen and Dad might forget and there wouldn’t be any ice cream tomorrow. And then there’s the thought that they might get ice cream now and tomorrow! The only way they can win (or not lose) is to get their ice cream today.
The “G” in the equation stands for the expected growth rate of earnings or cash flow. Higher growth creates more benefits in the future than lower growth. The more dollars there are in the future, the greater is the present value today. Most judges and juries get this one pretty quickly.
Then, we assume that the discount rate (R) is 15% and the growth rate (G) is 5%, not worrying about where these numbers came from. By the time I testify, chances are that there may be a discount rate or two and a growth rate or two that have been talked about.
3. Revised Valuation Equation
With the information so far, we can revise the basic valuation equation from two components (earnings and a multiple) to three components. The value of a business is a function of three concepts. And we have to understand something about these concepts to understand value.
The components of the revised valuation equation are:
- Cash Flows (CF) or Earnings. Let’s be clear. We are talking about expected earnings, not historical earnings.
- Growth (G) in Expected Earnings. We are really still talking about earnings here when we talk about growth, but it is helpful to make a distinction between the current level of earnings and the expected growth in those earnings.
- Risk (R) or the Discount Rate. The R-factor, or discount rate, is the value component that converts future dollars of earnings into present values.
With this discussion, I say that this revised equation is really a short-hand notation for what appraisers call the discounted cash flow valuation method (DCF). The court may already have seen a complicated and incomprehensible DCF method by this time.
I explain that the revised equation is identical to a DCF method under the assumptions that earnings grow at a constant rate of “G” into the distant future (forever), and that all earnings are reinvested in the business at the discount rate (R), which we have talked about. In other words, the revised equation is a simplified discounted cash flow method.
4. Example “Valuation”
With the information that is on the flip chart or the board (or on my PowerPoint), we can address a simple valuation.
First, we calculate the multiple, which is [1 / (R – G)], using the assumed values from above. R minus G is 15% minus 5%, or 10%. That’s simple math. We get the multiple by dividing 1 by 10% and get 10x. I then say that this multiple is like the price/earnings multiple that people talk about when they discuss publicly traded stocks. The public multiples are derived based on the consensus public opinion about a company’s risk and growth at a particular time.
This simple comparison with the price of a public company’s stock, which many judges are at least somewhat familiar with, helps bring a real-world touch to the simple discussion of valuation.
We assumed that adjusted earnings were $1.0 million above. If the multiple is 10x, then the valuation indication is $10 million. The judge may not have understood any of the valuation stuff presented to this point, but he or she has most likely understood this “valuation” so far. I liken the multiple in the picture to the price/earnings multiples that we all hear about for public companies, and suggest that public consensus regarding expected cash flow, risk and growth determines the price per share of any public company at a point in time.
The next idea is that it matters that the measure of earnings or cash flow, i.e., the $1.0 million in our example, or the actual earnings being discussed at trial, are reasonably determined. It follows, then, that the multiple must also be reasonably determined.
So far, we have boiled the essence of valuation down into three concepts, which must be reflected as actual numbers in any valuation. These are expected cash flows, the growth of cash flows, and the expected risk of achieving those cash flows in the future – from the vantage point of standing, today, at a valuation date.
5. Valuation is Based on Three Things
How do we decide what level of earnings is appropriate, or what growth rate to expect in the future, or what risks are associated with a particular company? The following figure provides a brief overview of potential discussions about these valuation elements.
In an actual presentation, I would not talk about all of the aspects of cash flow, risk and growth in the figure above. Often, by the time I come to court, there has already been a discussion of the elements that are important in a particular valuation, so I focus on those.
What adjustments are appropriate for earnings? Appraisers almost always adjust for historical items that are non-recurring or unusual like, for example, a disaster-related loss or a gain on a litigation settlement. Appraisers also make adjustments to bring owner compensation and perquisites into the range of market levels for similar positions.
When earnings are adjusted, they can be analyzed, and trends can be discussed. Are earnings rising? Falling? Volatile? These factors are relevant. How do the margins, as adjusted, compare with other, similar companies, and what is the trend in adjusted margins. It is easier to talk about these things in the “real valuation” after a conceptual discussion like the above.
What are the reasonable expectations for future growth? Past growth or the lack thereof are relevant, as is information about the local, regional, or national economy, or a company’s particular industry.
Finally, what are the particular risks associated with a particular company? We are always on the lookout for concentrations of customers, managers, suppliers, or products. One of my favorite lines is that:
Every customer relationship has a beginning, a duration and an end. It is no fun to be around when a major customer goes away, regardless of reason. So customer concentrations (and other concentrations) are risks that should be considered by appraisers.
6. A Picture of the Valuation Process
When the valuation picture has been put on the board or flip chart, I sometimes draw a little picture of the valuation process. It provides an overview of the more complicated analysis that will follow but places it into context and perspective. The picture looks like the following.
The important points from the picture are looking at the history of earnings or cash flow through the lenses of growth and risk. When appropriate, I’ll point to the equation and show why we are doing the historical analysis. Then, I’ll talk about the outlook for earnings, again through the lenses of expected growth and risk. History and future are separated by the artificial line at the valuation date.
There are a couple of other things that I mention, as well. We want to look at the balance sheet, because it may have implications for value if there are non-operating assets there, or if there is a shortage of assets (like working capital). The balance sheet may provide perspective for the riskiness of future earnings and for current value, as well.
Finally, I tell the court that we will look at historical transactions and whether they provide relevant information regarding value as of the valuation date.
7. Assumptions Matter
It should be clear from our discussion thus far that the assumptions that appraisers make matter, and they matter a great deal. The next figure summarizes the impact on valuation of positive or negative changes in the assumptions made about expected cash flow, growth and risk.
The impact of changes in assumptions, or, in actual appraisals, the levels at which they are made, can have significant impacts on valuation conclusions. It is pretty clear that increases in earnings or growth expectations will increase value indications and lower levels of assumptions will decrease value indications.
Greater assumed risk means lower value and lesser assumed risk means higher value.
And value indications are sensitive to changes in assumptions (or the level at which they are made). This brings us to the final piece of my overview discussion of the basics of business valuation.
Common Sense, Informed Judgment and Reasonableness
Frank Lloyd Wright, the famous architect, said many years ago that:
There is nothing more uncommon as common sense.
Revenue Ruling 59-60, published by the Internal Revenue Service in 1959, says that every valuation should be considered in the context of an analysis of a company, its historical performance and its outlook through the lenses of common sense, informed judgment and reasonableness. Common sense, informed judgment and reasonableness is the wrapper around the seven ideas above.
I explain to judges that appraisers have an obligation to demonstrate their common sense and informed judgment and the reasonableness, not only of their assumptions but of their value conclusions, as well. Then, I proceed to do my best to show that my analysis in the then-present valuation situation follows the basics of valuation as outlined on the board or flip chart. Further, I do my best to show that each assumption is reasonable and that, taken collectively, the assumptions lead to a conclusion that meets the final test of common sense, informed judgment and reasonableness.
These Ideas Work
Last week, I testified in court where alleged lost equity value was a large component in a damages litigation. The opposing expert failed completely to offer a cogent valuation analysis, so there was confusion by the court regarding the valuation of a company. Value was allegedly lost over a period of time, so there were questions regarding value at three separate valuation dates.
I spent a few minutes drawing the figures above on a flip chart, and discussing the valuation trilogy of expected cash flow, its growth, and risk. The entity’s balance sheet was relevant.
For each valuation date, I went back to the flip chart to look at the history of cash flow to each date, as well as the outlook for future growth. I reminded the court about the risks associated with the entity at each date. And then, I talked about the balance sheet and net asset value at each date. Further, there were some actual transactions for 100% of the stock of the entity over the relevant period, so we talked about them. Each valuation conclusion for each date was wrapped up by reference to the figures I had drawn.
While the jury is still out on this one, I know that my testimony was aided and shortened and made more convincing by the use of the seven ideas above.
New Books on the Way
- An Attorney’s Handbook for Buy-Sell Agreements (in production). This book provides guidance based on 30-plus years of dealing with buy-sell agreements. Importantly, it provides for the first time ever, anywhere, draft template language for the valuation portions of buy-sell agreements that will work for clients or companies. You will not want to miss this book!
- Business Valuation: An Integrated Theory Third Edition (with Travis Harms). The draft is due to the publisher (Wiley) shortly and will be available subject to their publication schedule. This book updates the Integrated Theory of Business Valuation and will include the Integrated Theory on an equity basis and on an enterprise (total capital) basis, as well. This book will be must reading for all business appraisers and anyone interested in business valuation.
E-mail me if you would like to be notified when these books become available.
In the meantime, be well!