Evaluating a Valuation

When an intangible asset, usually a business ownership interest such as stock, is valued, the report will necessarily reflect the professional judgment of the appraiser. Evaluating the report will be facilitated by the application of rules or principles that are supplied by relevant professional standards.

By Jeff Compton and Kennedell Amoo-Gottfried
September 28, 2016
Originally published in Texas Lawyer.

When an intangible asset, usually a business ownership interest such as stock, is valued, the report will necessarily reflect the professional judgment of the appraiser. Evaluating the report will be facilitated by the application of rules or principles which are supplied by relevant professional standards.

Depending upon the credentials of the appraiser, the relevant standards will come from the American Institute of Certified Public Accountants (for the CPA credential), the Appraisal Foundation and the American Society of Appraisers (for the ASA credential) or the National Association of Certified Valuators and Analysts (for the CVA credential).

The discussion here deals with the AICPA standard because the Texas State Board of Public Accountancy requires compliance with these standards by a CPA practicing in Texas. The AICPA standard is substantially similar to the Appraisal Foundation and NACVA standards. The following discussion sets out the elements of a valuation engagement according to the AICPA standard, providing a guide to a valuation report.

Evaluating a valuation report starts with considering what should be covered then moves to how well it is covered.

Exception From the Standard

While multiple exceptions exist in the AICPA standard, the most relevant for attorneys has to do with excluding engagements solely for the purpose of determining economic damages in the form of lost profits. This exception does not apply to an engagement that estimates the diminished value of equity ownership.

A Framework to Evaluate a Report

A written report is not required for litigation or other valuation engagements. Regardless whether the report is written, the appraiser’s work must comply with the same standards as a written report.

At a lesser level of rigor than a valuation engagement, the CPA may perform a calculation engagement that represents the application of limited steps to determine value. The use of a calculation of value as opposed to a conclusion of value in litigation presents problems in terms of reasonable certainty that should be addressed

Defining the Engagement

Valuation engagements must be defined by reference not only to the specific interest being valued (“1 percent of the membership interest of ABC LLC”) and the specific date of valuation but also by reference to which standard of value (fair market value, fair value, investment or intrinsic value among others). Further, the premise of value must be defined (going concern or liquidation among others).

Data and Information

Valuing a business requires the person expressing the opinion to understand it and the industry in which it operates as well as relevant economic conditions. While not a valuation standard, the five-forces analysis suggests how to consider the environment.

As available and applicable, the following nonfinancial factors should be considered:

  • Nature, background, and history
  • Facilities
  • Organizational structure
  • Management team (which may include officers, directors, and key employees)
  • Classes of equity ownership interests and rights attached thereto
  • Products or services, or both
  • Economic environment
  • Geographical markets
  • Industry markets
  • Key customers and suppliers
  • Competition
  • Business risks
  • Strategy and future plans
  • Governmental or regulatory environment

(From AICPA VS Section 100)

Likewise, the valuation professional must understand the nature of the interest, for example more than one class of equity may exist with different rights such as preferred stock which will affect its value.

Because value is generally defined as the present value of expected future economic benefits, analyzing historical financial information in order to project future benefits is a critical component of the valuation. Where applicable and available, the valuation analyst should consider:

  • Historical financial information (including annual and interim financial statements and key financial statement ratios and statistics) for an appropriate number of years
  • Prospective financial information (for example, budgets, forecasts, and projections).
  • Comparative summaries of financial statements or information covering a relevant time period.
  • Comparative common size financial statements for the subject entity for an appropriate number of years.
  • Comparative common size industry financial information for a relevant time period.
  • Income tax returns for an appropriate number of years.
  • Information on compensation for owners including benefits and personal expenses.
  • Information on key man or officers’ life insurance.
  • Management’s response to inquiry regarding the following:
  • Advantageous or disadvantageous contracts.
  • Contingent or off-balance-sheet assets or liabilities.
  • Information on prior sales of company stock.

(From AICPA VS Section 100)

Approaches to Estimating Value

The basic, accepted methodologies to arrive at estimates of value are the income approach, the market approach and the asset approach. All should be considered in any valuation engagement although usually less than all are applicable.

To consider the income approach, the process by which revenues and costs are projected, as well as the development of the discount rate to be applied to those projections, represent the most important analysis.

When evaluating the market approach, correct analysis of the comparability between the subject interest and the guideline company must occur because the market approach is based on the principle of substitution. The report should explain why a hypothetical investor would be indifferent between choosing the subject company and the guideline company.

Under the asset approach, the market value or cost of specific assets less related liabilities sum to the estimated value. This approach is typically applied to controlling interests. Ownership shares which do not have the ability to cause a sale (i.e. minority interests) might not be able to realize the asset values.

Adjustments to Value

After determining the appropriate value estimate from one or more of the methodologies above, a discount for lack of marketability will be applied, especially to less than controlling interests. The practice of describing a broad range of potential discounts without relating one to the facts of the subject interest has been criticized by courts.

An additional discount may also be applied for a lack of control based on the inverse of control premiums from tender offers or by adjustments to cash flows. However, the acquirer may have synergies not available to investors as a whole and thus comparability of the hypothetical buyer to the buyer in the control premium transaction should be established.

Further adjustments may be needed to address excess or deficient working capital, usually by reference to industry norms.

The framework of the standards described above should help evaluate a valuation.