Math for Lawyers: Valuation Theory and Practice 101

Math for Lawyers:

Valuation Theory and

Practice 101

April 27, 2010

Introduction

Presentation

Jeff Litvak, FTI Forensic and Litigation Consulting

Kenneth Mathieu, FTI Forensic and Litigation Consulting

Questions and Answers ― (anonymous)

Slides ― now available on front page of Securities Docket

> www.securitiesdocket.com

Wrap-up

Agenda

Series of webcasts ― every other week

www.securitiesdocket.com/webcasts

Next: May 11―White Collar Criminal and SEC Cases

– New Issues and Challenges

Webcast Series

Panel

Bruce Carton

Jeff Litvak

Ken Mathieu

Business Valuation (BV) Theory and

Principles for Attorneys

Jeff Litvak, CPA/ABV/CFF, ASA Ken Mathieu, CPA/ABV/CFF

Senior Managing Director Managing Director

312.252.9323 312.252.9383

[email protected] [email protected]

mailto:[email protected]

Business Valuation (BV) Overview

Introduction

Standards of Value

Premises of Value

BV Standards

BV Approaches / Methodologies

Discounts and Premiums

Financial Statement Analysis

Case Study/Conclusion of Value

6

Introduction

Standards of Value

Premises of Value

BV Standards






7

I. Introduction: What is Business Valuation?

Business Valuation:

The act or process of determining the VALUE of a

business, business ownership interest, security, or

intangible asset.

8

I. Introduction: What is Value?

• Is value an absolute or relative measure?

• Is value inherent in the asset being valued or is it

impacted by perception?

• Can there be more than one value for a certain asset

at a particular point in time? If so, why?

• Is the concept of value time-dependant?

9

I. Introduction: Concept of Value

Due to factors such as opportunity costs and

inflation:

10

A dollar today…

. . . is worth more than

a dollar tomorrow

I. Introduction: Concept of Value (cont.)

Value is an economic concept; as such

• it is an OPINION of the worth of an asset

• at a given time

• in accordance with the specific definition of value.

Source: Uniform Standards of Professional Appraisal Practice11

I. Introduction: What Creates Value?

Investors assign value based on the FUTURE

ECONOMIC BENEFITS

The value of a cash flow stream is a function of:

• The timing of cash receipts

• The risk that less cash than expected will be received

12

I. Introduction: When is Valuation Needed?

• Litigation

o Bankruptcy

o Marital Dissolution

o Damages caused to business

• Compliance

o Determination of Estate & Gift taxes

o Employee Stock Ownership Plans (ESOPs)

o Purchase Price Allocation

o Goodwill Impairment Testing

• Strategic

o Purchase/Sale of business or shares

o Fairness Opinions

13

CASE STUDY

14

Subject Company: Dunder Muffler Paper Company

Industry: Paper Manufacturing

Valuation Date: December 31, 2009

Interest Valued: 40% (Minority)

Premise of Value: Going Concern

Standard of Value: Fair Value

Purpose of Valuation: Shareholder Dispute

Introduction

Standards of Value

Premises of Value

BV Standards






15

II. Standards of Value

16

1. Fair Market Value

2. Investment Value

3. Intrinsic Value

4. Fair Value

II. Standards of Value (cont.)

• The PRICE, expressed in terms of cash equivalents, at which

property would change hands between

• a hypothetical willing and able buyer

• a hypothetical willing and able seller

• acting at arms length

• knowledge of the relevant facts. 17

1. Fair Market Value:


Value to a PARTICULAR INVESTOR based on individual

investment requirements and expectations.

18

2. Investment Value:


The value that a prudent investor considers to be the

“true” or “real” value that will become the market value.

19

3. Intrinsic Value:


Fair Value (State Rights) - minority interest (i.e., not a

“willing” seller)

Fair Value (Financial Reporting) - SFAS 141R, SFAS

142, and SFAS 157

SFAS 157 defines Fair Value as:

“The price that would be received to sell an asset or paid to transfer a

liability in an orderly transaction between market participants at

the measurement date.”

20

4. Fair Value (two types):


Introduction

Standards of Value

Premises of Value

BV Standards




Case Study/ Conclusion of Value

21

III. Premises of Value

Premise of value refers to the appropriate

CONTEXT or set of circumstances to consider

with respect to the valuation, including:

• Going concern value

• Liquidation value

22


Introduction

Standards of Value

Premises of Value

BV Standards





23

IV. BV Standards

The U.S. professional associations that publish business

valuation standards are:

• American Institute of Certified Public Accountants (AICPA)

• American Society of Appraisers (ASA)

• Institute of Business Appraisers (IBA)

• National Association of Certified Valuation Analysts (NACVA)

• The Appraisal Foundation (TAF)

24

IV. BV Standards: AICPA

SSVS1 – Stmt. on Standards for Valuation Services No. 1

AICPA members will be required to follow this standard when they

perform engagements to estimate value that culminate in the

expression of a conclusion of value or a calculated value.

Exception from this Statement:

This Statement is not applicable to engagements that are

exclusively for the purpose of determining ECONOMIC DAMAGES

(for example, lost profits) unless those determinations include an

engagement to estimate value.

25

IV. BV Standards: ASA

I. General Requirements for Developing a Business Valuation

II. Financial Statement Adjustments

III. Asset-Based Approach to Business Valuation

IV. Income Approach to Business Valuation

V. Market Approach to Business Valuation

VI. Reaching a Conclusion of Value

VII. Valuation Discount and Premiums

VIII. Comprehensive Written Business Valuation Report

IX. Intangible Asset Valuation

26

IV. BV Standards: ASA (cont.)

SBVS-1 The guideline company valuation method

SBVS-2 Merger and acquisition method

• Advisory Opinions (AO) - Asset-Based Approach to Business

Valuation

• Procedural Guidelines (PG) – Litigation support: Role of the

independent financial expert

27

IV. BV Standards: IBA

Standard One Professional Conduct & Ethics

Standard Two Oral Appraisal Reports

Standard Three Expert Testimony

Standard Four Letter Form Written Appraisal Reports

Standard Five Formal Written Appraisal Reports

Standard Six Preliminary Reports

Standard Seven Conducting A Business Appraisal Assignment

28

IV. BV Standards: USPAP

Standard No. 9 Business Appraisal, Development

Standard No. 10 Business Appraisal, Reporting

29

IV. BV Standards: Revenue Ruling 59-60

Nature and history of the

business

Economic and industry

outlook

Financial condition

Earning capacity

Dividend-paying capacity

Intangible value

Sales of the stock

Market price of stocks of

comparable corporations

30

Introduction

Standards of Value

Premises of Value

BV Standards






31

VI. BV Approaches

Three basic approaches to determining value:

Asset Approach (also, Cost Approach)

Market Approach

Income Approach

Under each approach, there are multiple “methods.”

The use of one or several approaches (or methods)

may be appropriate.

32

VI. BV Approaches: Asset Approach (cont.)

Primary Method:

Adjusted Net Asset Value (NAV) Method – The

balance sheet is restated from historical cost to

market/fair value

o NAV = market value of assets LESS market value of liabilities

33

VI. BV Approaches: Market Approach

Overview:

• Bases on the principal of SUBSTITUTION

• A buyer would pay no more than the cost to

acquire a substitute property with the same utility

• Can be used for both control and minority level

valuations

34

VI. BV Approaches: Market Approach (cont.)

Two primary methods:

Guideline Public Company Methodo Based on sales of similar publicly traded company shares

o May require adjustments for small and medium sized companies

due to size, capital structure, and other differences

Merger and Acquisition Transaction Data Methodo Based on acquisition of similar privately held or publicly traded

companies

o Consider aspects of companies involved in the comparable

transactions

35


Example: Dunder Muffler Paper Company

Comparable Transaction Database:

SIC Filing Date Purchaser Company Name MVIC/EBITDA

2631 6/6/2000 Smurfit-Stone Container Corporation St. Laurent Paperboard, Inc. 9.8

2621 6/27/2000 Nashua Corporation Rittenhouse Paper Company 12.5

2671 10/30/2000 Pechiney SA JPS Packaging Company 12.2

2676 11/6/2000 Cascades, Inc. Wyant Corporation 4.8

2621 10/26/2001 Bowater, Inc. Alliance Forest Products, Inc. 8.2

2676 12/27/2001 Tyco International, Ltd. Paragon Trade Brands, Inc. 9.3

2631 3/8/2002 Westvaco Corporation Mead Corporation 8.3

2621 5/15/2002 MeadWestvaco Corporation Westvaco Corporation 7.9

2621 5/15/2002 Weyerhaeuser Company Willametter Industries, Inc. 11.1

2671 10/23/2002 Alcoa, Inc. Ivex Packaging Corporation 7.8

2653 3/20/2003 Temple-Inland, Inc. Gaylord Container Corporation 8.9

Average 9.2

Median 8.9

36


Example: Dunder Muffler Paper Company (cont.)

Dunder Muffler TTM EBITDA $27.6 million

Earnings Multiple x 9.0

Market Approach Value $248.4 million

37

VI. BV Approaches: Income Approach

Overview:

• Based on the PRESENT

VALUE of expected future

benefits

• Discounted or capitalized cash

flow methods

• Used for both control and

minority level valuations38

Two primary methods:

Discounted Cash Flow (DCF) Methodo Projects future cash flows for a number of years

o Terminal value

Capitalized Income Methodo Estimated future cash flow is capitalized

o Often used for companies with stable growth rates

VI. BV Approaches: Income Approach (cont.)

Year 0 Year 2 Year 3Year 1 Year 4 Year 5 Terminal

Annual Cash Flow

Net Present Value

$ $ $ $ $ $$$

Discount to Present Value

39


Discounted Cash Flow Method

• Cash flows included in projections

o Cash flow to equity

o Cash flow to market value of invested capital (MVIC)

• Normalized cash flows for terminal value calculation

• Long-term growth rate

• Cost of capital

40

TERMINAL Value = Normalized CF/(WACC – g)

• Capitalization of NORMALIZED cash flows

• GDP, inflation, or industry long-term expected growth

• Capitalization Rate = Discount Rate – Long-term growth

rate


41


Terminal Value Using Exit Multiple:

TERMINAL Value = Normalized CF x Exit Multiple

• Determine the NORMALIZED EBITDA or EBIT for the final

year of the explicit forecast period

• Apply the appropriate EBITDA or EBIT multiple

42


Example: Dunder Muffler Paper Company

For the years ended December 31 2010 2011 2012 2013 2014 Terminal

Operating income 20,887$ 21,514$ 22,159$ 22,824$ 23,509$

Depreciation 11,272 11,272 11,272 11,272 11,272

Amortization 178 178 178 178 178

EBITDA 32,337 32,964 33,609 34,274 34,959

Income tax expense ($2,048) ($2,109) ($2,172) ($2,238) ($2,305)

Capex ($9,000) ($9,000) ($9,000) ($9,000) ($9,000)

WC ($3,000) ($3,000) ($3,000) ($3,000) ($3,000)

Free Cash Flow $18,290 $18,855 $19,437 $20,037 $20,654 $287,872

Discount Factor 0.9518 0.8622 0.7810 0.7075 0.6409 0.6100

Discounted Cash Flow $17,408 $16,256 $15,181 $14,176 $13,238 $175,610

Net Present Value $251,870

(in thousands)

Cash Flow Projections

Dunder Muffler Paper Company

43

VI. BV Approaches

44

Primary valuation approaches by asset type:

Asset Type Asset Approach Market Approach Income Approach

Business

Real Property

Machinery &

Equipment

Intangible Assets

Financial Assets

Introduction

Standards of Value

Premises of Value

BV Standards






45


• Some of the common discounts and premiums are:

o Control premium – An amount by which the pro rata value of acontrolling interests exceeds a noncontrolling interest.

o Discount for lack of control (or, minority discount) (“DLOC”) – Anamount deducted from the pro rata share value of 100% interestto reflect the absence of the power of control.

o Discount for lack of marketability (“DLOM”) - An amountdeducted from the pro rata share value of 100% interest to reflectthe relative absence of marketability.

• Valuation discounts and premiums are supported byempirical market studies.

46

Introduction

Standards of Value

Premises of Value

BV Standards






47

VIII. Financial Statement Analysis (cont.)

Basic analytical techniques:

• Growth/Trend analysis

• Common size analysis

• Examine Cash Flow from

Operations section of items that

reconcile financial accounting

and cash flow

• Compare cash flows to income

statement

48


Some things to look for in historical financials:

• Increasing/decreasing profitability

• Increasing/decreasing financial leverage

• Increasing/decreasing capital expenditures or R&D

• Increasing/decreasing net working capital items

• Increasing/decreasing other assets/liabilities

• Related income statement and balance sheet items

growing at significantly different rates

49


Consider how historical trends will affect the

future cash flows:

• Is revenue growth sustainable?

• Given operational leverage, how will COGS react to revenue

increases?

• Are SG&A expenses fixed or variable?

• Is the debt burden manageable? Will debt covenants be met?

• Is company collecting on its sales?

• Is the company continuing to invest in growth?

• How much of revenue increase is lost in increased net working

capital?

50


Ratio analysis can allow an analyst to:

• Spot historical trends

• Compare one company to another (guideline company

benchmarking)

• Review public analyst reports

In practice:

• Ratios are commonly used by lenders to determine how much to

lend and to set covenants

• Equity analysts use ratios to predict target stock prices

• Multiples are nothing more than ratios of value

51


Four major types of ratios:

• LIQUIDITY ratios – measure an

entity’s short-run ability to pay its

maturing obligations

• ACTIVITY ratios – measure how

effective the enterprise is using the

assets employed

• PROFITABILITY ratios – measure

the financial performance of an entity

over a period of time

• LEVERAGE/COVERAGE ratios –

measure the degree of protection for

long-term creditors and investors

52


Examples of LIQUIDITY ratios:

Current ratio: current assets

current liabilities

Quick test: cash, marketable securities, AR

current liabilities

53


Examples of PROFITABILITY ratios:

EBITDA margin on sales: EBITDA

net sales

Return on assets: net income

average total assets

Return on common equity: net income – preferred dividends


54


Examples of ACTIVITY ratios:

Receivable turnover: net sales

average trade receivables

Inventory turnover: COGS

average inventory

Asset turnover: net sales


55


Examples of LEVERAGE/COVERAGE ratios:

Debt to total equity: debt

total equity

Times interest earned: EBIT

interest expense

56

VIII. Rationale Behind Ratio Analysis

Ratio and Financial AnalysesWhy is it important?

Financial analysis tools and techniques can:

• Isolate trends (positive and negative)

• Help identify strengths and weaknesses

Basic financial analysis tools include:

• Common size financial statements

• Ratio analysis

• Trend analysis of common size statements and ratios

57

Introduction

Standards of Value

Premises of Value

BV Standards






58

X. Conclusion of Value

In arriving at the conclusion:

• Reconcile valuation approaches

• Reliability of the results under the different approaches

• Determine whether the conclusion of value should reflect the results of

o One approach or method or

o A combination of the results of one or more approaches and methods

59

X. Conclusion of Value: CASE STUDY

60

Subject Company: Dunder Muffler Paper Company

Industry: Paper Manufacturing

Valuation Date: December 31, 2009

Interest Valued: 40% (Minority)

Premise of Value: Going Concern

Standard of Value: Fair Value

Purpose of Valuation: Shareholder Dispute

X. Conclusion of Value: CASE STUDY (cont.)

Historical Financial Performance

61

For the years ended December 31 2005 2006 2007 2008 2009

Total revenues 307,500$ 293,231$ 338,615$ 369,911$ 397,627$

Costs and expenses:

Cost of products sold 256,490 249,079 293,269 320,061 344,470

SG&A 27,843 28,968 30,797 30,871 32,464

Research and development 191 529 262 238 180

Other expenses 744 356 227 109 4,375

Total costs and expenses 285,268 278,932 324,555 351,279 381,489

Operating income 22,232 14,299 14,060 18,632 16,138

Interest income 73 57 47 101 128

Interest expense (169) (296) (233) (215) (238)

Income before income taxes 22,136 14,060 13,874 18,518 16,028

Net Income 22,095$ 13,962$ 13,033$ 17,241$ 14,514$

(in thousands)

Combined Statements of Income



Forecasted Financial Performance

62

For the years ended December 31 2010F 2011F 2012F 2013F 2014F

Total revenues 409,556$ 421,842$ 434,498$ 447,533$ 460,959$

Costs and expenses:

Cost of products sold 352,218 362,785 373,668 384,878 396,424

SG&A 34,812 35,857 36,932 38,040 39,181

Research and development 410 422 434 448 461

Other expenses 1,229 1,266 1,303 1,343 1,383

Total costs and expenses 388,668 400,329 412,338 424,709 437,450

Operating income 20,887 21,514 22,159 22,824 23,509

Interest income 132 136 140 144 148

Interest expense (410) (422) (434) (448) (461)

Income before income taxes 20,610 21,228 21,865 22,521 23,196

Net Income 18,562$ 19,119$ 19,692$ 20,283$ 20,892$

(in thousands)

Combined Statements of Income



Income Approach: Discount Rate (Build Up Method)

63

Risk Free 4.6%

ERP 5.0%

Size Premium 4.0%

Industry Premium 1.0%

Company Specific Risk 2.0%

Cost of Equity 16.6%

Cost of Debt 7.0%

Tax Rate 40.0%

After Tax Cost of Debt 4.2%

Percent Debt 50.0%

Percent Equity 50.0%

WACC 10.4%


Income Approach: Cash Flow Projections

64

For the years ended December 31 2010 2011 2012 2013 2014 Terminal

Operating income 20,887$ 21,514$ 22,159$ 22,824$ 23,509$

Depreciation 11,272 11,272 11,272 11,272 11,272

Amortization 178 178 178 178 178

EBITDA 32,337 32,964 33,609 34,274 34,959

Income tax expense ($2,048) ($2,109) ($2,172) ($2,238) ($2,305)

Capex ($9,000) ($9,000) ($9,000) ($9,000) ($9,000)

WC ($3,000) ($3,000) ($3,000) ($3,000) ($3,000)

Free Cash Flow $18,290 $18,855 $19,437 $20,037 $20,654 $287,872

Discount Factor 0.9518 0.8622 0.7810 0.7075 0.6409 0.6100

Discounted Cash Flow $17,408 $16,256 $15,181 $14,176 $13,238 $175,610

Net Present Value $251,870

(in thousands)

Cash Flow Projections



Market Approach:

$27.6 million EBITDA x 9.0 = $248.4 million

65

SIC Filing Date Purchaser Company Name MVIC/EBITDA

2631 6/6/2000 Smurfit-Stone Container Corporation St. Laurent Paperboard, Inc. 9.8

2621 6/27/2000 Nashua Corporation Rittenhouse Paper Company 12.5

2671 10/30/2000 Pechiney SA JPS Packaging Company 12.2

2676 11/6/2000 Cascades, Inc. Wyant Corporation 4.8

2621 10/26/2001 Bowater, Inc. Alliance Forest Products, Inc. 8.2

2676 12/27/2001 Tyco International, Ltd. Paragon Trade Brands, Inc. 9.3

2631 3/8/2002 Westvaco Corporation Mead Corporation 8.3

2621 5/15/2002 MeadWestvaco Corporation Westvaco Corporation 7.9

2621 5/15/2002 Weyerhaeuser Company Willametter Industries, Inc. 11.1

2671 10/23/2002 Alcoa, Inc. Ivex Packaging Corporation 7.8

2653 3/20/2003 Temple-Inland, Inc. Gaylord Container Corporation 8.9

Average 9.2

Median 8.9


Conclusion of Value: 40% Interest in Dunder Muffler

66

Value

(in millions) Weight

Market Approach $248.4 30%

Income Approach 251.9 70%

Invested Capital Value 250.9

Debt (10.2)

Indicated Value of 100% Controlling Interest 240.7

Fair Value of 40% Minority Equity Interest $96.3

67

ConclusionBasic Valuation Process

Define subject of Valuation

Valuation Date

Purpose of Valuation

Historical Financial Analysis

Financial Forecast

Comparable Company Analysis

Valuation using all three approaches

Conclusion of Value

68

Questions

Questions?

Thank You

Thank you for attending this webcast.

Math for Lawyers: Valuation Theory and Practice 101

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