When our esteemed editor asked me to write about the 10 most common mistakes I’ve seen in valuation, my first thought was to wonder if I was giving ammunition to opposing counsel in future depositions. But with Jim’s assurance that these are presented as just my humble observations over many years and my affirmation that these are observations, not confessions, here we go.
A “valuation date” plants the flag on the specific time as of which you are establishing value and, therefore, the data sets and facts used in determining value. Using any data that was not known or knowable as of that valuation date to arrive at your conclusion is inappropriate and inconsistent with standards. This does not, however, absolve the valuer from being knowledgeable of transactions subsequent to the valuation date. Many courts have considered subsequent information to assess the reasonableness of valuation experts’ opinions and there should be a compelling reason if your concluded value is significantly different than an arm’s-length transaction occurring shortly after the valuation date.
AMBIGUITY AT THE OUTSET— NOT DEFINING VALUE, PREMISE, VALUED INTEREST, PURPOSE, ETC. (THE WHO, WHAT, WHERE, WHY, WHEN)
In my first ASA BV course, it was drilled into me that the first paragraph of my report should sound like the first paragraph of a good news article that covers the “who, what, where, when, and why. Who defines the client and recipients; what defines the specific asset or entity being valued; where covers the premise of value or where in the scope of value you are working; when covers the valuation date; and why states the purpose of the valuation, which must also cover the definition of value being applied for that particular purpose. Not providing this critical clarity at the outset will open the door for confusion, misinterpretation, ambiguity, and even litigation.
NOT CONDUCTING A SITE VISIT WHEN LOGICALLY EXPECTED DEPENDING ON THE SIZE/SCOPE OF THE ENGAGEMENT
I remember my first training session at Peat Marwick: a young audit senior was in a mock cross-examination and was asked by the GC playing prosecutor why she relied on certain client data when the company had not been operating for weeks due to a collapsed roof ? Hadn’t she seen this? Her response that she had never visited that client caused a clear defeat to her case along with potential financial liability. When available to the appraiser, and where the scope and/or size of the engagement logically require a visit to assess operational activity and management’s activities and to collect other data impacting the opinion, you should conduct a site visit. If you cannot go, one option is to have another professional you trust conduct the site visit to supplement your phone interviews with the key executives or other knowledgeable parties.
NOT APPLYING ONE OR MORE APPROACHES TO VALUE WITHOUT EXPLANATION
A USPAP comment in a prior standards book said that if information exists with which to apply an approach to value, then that approach should be applied or clearly explained why it was not. This seems pretty logical, but I have seen many reports that include just a DCF method under the income approach or just a guideline company method without any explanation as to why other approaches were not included in the report.
ACCEPTANCE OF CLIENT PROJECTIONS WITHOUT REVIEWING THE SUPPORT FOR KEY ASSUMPTIONS
This would certainly seem to be a USPAP violation. I have seen projections based on management’s mandate that “there will be 7 percent growth in revenues” and I have seen projections prepared bottom up that division managers initiated to guarantee they could beat them and earn substantial bonuses. While projections prepared by management in a format consistent with historical financial reports are typically presumed to be the most informed and reliable, there has to be a scrubbing of the key assumptions underlying the projections. The best source of help that I have found in vetting assumptions is the AICPA Guide for Prospective Financial Information and the section on determining a “Reasonably Objective Basis.”
NOT PROPERLY SUPPORTING THE GUIDELINE COMPANY SELECTION PROCESS AND INCLUDING THE VALUER’S BASIS FOR INCLUDING OR EXCLUDING POTENTIAL GUIDELINE COMPANIES
Various financial databases such as Capital IQ have made it significantly easier to identify potential guideline companies, but frequently the detail of that process fails to make it into the valuer’s report. I recommend a transparent listing of the selection criteria, and then a documented review of each potential company for inclusion or rejection in the selected sampling. Especially in testimony, it is important for the expert to have his or her fingerprints on the selection process.
IN TERMINAL VALUE, INCORPORATING A MISMATCH BETWEEN DEPRECIATION AND CAPEX
If the projected perpetual depreciation exceeds the CAPEX, then chances are the IRS might get excited and be eager to visit the company. A projection should contain a terminal CAPEX estimate that accurately reflects the fixed asset investment necessary to sup- port the long-term projected growth rate of the subject company. There are a variety of reasons that a company’s depreciation over the projection period can diverge substantially from that which would be generated by the long-term CAPEX investment and an appraiser should carefully consider whether there is a mismatch between the two assumptions.
INCOMPLETE EXPLANATION OF THE COST- OF-EQUITY CALCULATION
I have seen many instances where a report just says it “used the capital asset pricing model and, therefore, the WACC is 15 per- cent.” Of all the approaches to value, the income approach pro- vides the greatest ammunition to the IRS, to litigators, and even to audit partners to challenge your work. I’ve already covered accepting client projections without scrutiny above. The next battle lies in the assumptions used to determine the cost of equity. You need to cite which risk-free rate you are using, the basis for calculating beta, the sources of the equity risk premium and size premium, and whether and why you are applying a company-specific risk premium. It is better to put this detail in your report than to have to respond to it in a deposition or cross-examination at trial or an audit.
INCONSISTENCY BETWEEN THE INPUTS TO THE SUBJECT COMPANY’S COST OF EQUITY AND THE ADJUSTMENTS MADE TO GUIDELINE COMPANY MULTIPLES
I wrote about this several years ago in this journal. I believe that it might be inconsistent to include a company specific risk premium in the cost of equity of the income approach and not consider applying a haircut to public company medians being used in the market approach. As I said above, the bottom line on this issue is to provide a full disclosure of the sources and reasons for each input to the cost of equity in your report.
COST-OF-DEBT ASSUMPTIONS INCONSISTENT WITH THE INDUSTRY OPTIMAL CAPITAL STRUCTURE
If the premise of value is fair market value as a going concern, i.e., “what a willing buyer would pay a willing seller,” then the appraiser must consider the situation of a hypothetical buyer and the market for financing that would be available to them in a transaction as of the valuation date. Depending on the size and type of company, the industry optimal capital structure (the amount of financial leverage that maximizes the value of the business) may be estimated based on the observed levels of leverage for the guideline companies, if available and comparable. The cost-of-debt assumption should be based on this prospective capital structure. It is not uncommon to find a logical disconnect between these assumptions. These issues can arise from using a subject company’s in-place cost of debt, especially if they were in distress during the most recent funding negotiations. The valuer must also consider whether industry specific events have caused the guideline companies to have migrated in the short term away from the long-term industry optimal capital structure.
By Bruce B. Bingham, FRICS, FASA
Capstone Valuation Services, LLC New York, NY