I’ve used the capitalization of earnings method primarily in valuing professional services firms, which lack robust projections. I’ve only used this method for tax or Fair Market Value projects. According to Pratt, Reilly and Schweihs, in their book Valuing Small Businesses and Professional Practices, the value indication provided by the capitalization of earnings method is fair market value, where the capitalized economic income, and the capitalization rate reflect the condition of the subject company on a stand-alone basis, rather than with built-in synergies peculiar to a particular investor or market participant.

For me, one of the biggest challenges in valuing a company using the capitalization of earnings method is choosing whether to value the company on an enterprise or equity basis. It’s a little easier to apply the method to free cash flows to equity. Specifically, the equity approach remains consistent with the data most often found on long-term growth assumptions, used to devise capitalization rates. Generally, the industry research we find provides long-term growth assumptions applied to growth in equity, rather than invested capital. This point is particularly relevant in calculating a capitalization rate, using a discount rate minus long-term expected growth. So what’s the best growth rate to imply, and what’s the basis for a long-term growth rate?

If I’ve got Invested Capital in the numerator, divided by the sum of the discount rate (WACC) minus a growth rate (i.e. the capitalization rate), I’ll come up with wildly different results than the output by using free cash flows to equity, divided by the sum of an equity hurdle rate minus the growth rate. In other words, the outcome is more sensitive to the growth rate applied to invested capital than applied to equity. This is true because the discount rate applied to invested capital (WACC) is lower than an equity hurdle rate.

Tax courts have generally rejected a CAPM or WACC as inappropriate in valuing closely-held businesses (Furman v. Commr., T.C. Memo 1998-157, Hendrickson v. Commr., T.C. Memo 1999-278). The Court in Furman specifically stated: “we do not believe that CAPM and WACC are the proper analytical tools to value a small, closely held corporation with little possibility of going public. CAPM is a financial model intended to explain the behavior of publicly traded securities that has been subjected to empirical validation using only historical data of the two largest U.S. stock markets.” That leaves us with a build-up method, wherein we have to consider expected inflation as an upward adjustment to the calculated discount rate, and simultaneously reduce our long-term growth rate to reflect the impact of expected inflation.

Now, we’re left some remaining challenges, like determining whether or not we’re evaluating income the investor has the ability to control; are we coming up with a control or minority interest? If it’s control we’re after, we have to normalize earnings to factor-in compensation to owners/operators. The compensation should be consistent with what we’d expect to see in the market for similar services. Now, we need to come up with a discount/capitalization rate that’s consistent with the earnings we’re evaluating. Then consider the extent to which we weight prior year earnings, for example an equally weighted average of all prior years, or a weighted average emphasizing the most recent year?

Remember, we can use a proxy of historical, current or estimated future earnings. Is the ideal data-point best represented by the most recent year’s income, or some variation of prior year earnings?

The capitalization of earnings method is not to be confused with the capitalization of excess earnings method, which is best utilized for the purpose of allocating total value between intangible and tangible assets. The capitalization of excess earnings method uses an income and an asset approach to arrive at the total value of a privately held business. This method relies on the assumption that the total value of a business is the sum of adjusted net assets, and the value of intangible assets. The capitalization of excess earnings is considered a reasonable method of valuing closely-held businesses, and is often referred to as the Treasury method or IRS method, because it was originally blessed by the Treasury Department, and later codified in Revenue Ruling 68-609.

The value computed under the capitalization of excess earnings method is generally close to the value derived by the capitalization of earnings method. The capitalization of excess earnings approach is widely criticized but used regularly in certain circumstances, such as (1) divorce cases, where personal goodwill is considered a personal rather than marital asset; (2) conversions from C corporations to S corporations; and (3) other situations where tangible and intangible values need to be recognized separately. In a nutshell an appraiser must determine:

1. Average annual earnings (adjusted for appropriate owner compensation and perquisites as above)
2. Average fair market values of the tangible and intangible assets of the business (3 to 5 years)
3. Appropriate rates of return on the various assets (tangible and intangible) of business- need to determine rate of returns separately
4. Appropriate capitalization rate to apply to “excess earnings” Normally higher than equity rate

• Subtract expected normal dollar returns on assets from total average annual earnings
• Capitalize excess earnings
• Add value of tangible assets to capitalized excess earnings for total value of business

In the first case, for tax, I looked at the equity, or Class B shares of a private subsidiary of a public parent where a purchase price was determined based on trailing EBITDA. The equity compensation (class b shares) worked like this, the Company had the right in 4 years to call the securities and the shareholder (my client, “the executive”) had the right in 4 years to put the securities back to the Company. I wasn’t exactly certain how to value these “options,” but thought Black-Scholes or Binomial model would do the trick, until I spoke with some wise colleagues, Annika Reinemann (Cogent Valuation) and Patrick McFarland (EKS&H).

My counterparts brought to my attention that these Put and Call rights weren’t options at all, but simply terms used to describe an expected transaction, or a purchase price. The so-called Put preserved the executive’s right to sell shares back to the issuing Company (his employer), and the Call enabled the Company to buy the shares from the executive (my client). However, no set exercise price had been established, rather a variable purchase price was described in the subscription agreement, which applied equally to both rights. In other words, the terms used to describe the class b shares were in fact more like a Buy/Sell Agreement, than equity compensation, per se.

The purchase price for the class b common stock was described as a function of trailing 4-year EBITDA. Rather than use an option calculation to come up with the value of options, I simply calculated the future purchase price for both the Put and Call, at some future date, based on forecasted trailing EBITDA, and discounted the purchase price back to present value using a WACC. For the value of the class b restricted shares, I split the calculated value equally between the derived put and call purchase prices.

Since these were restricted shares, I included some reference to Revenue Ruling 77-287. Specifically stating, the valuation was conducted in consideration of the guidance provided in Revenue Ruling 77-287, “Valuation of Securities Restricted from Resale,” which amplifies Revenue Ruling 59-60 by setting forth guidelines for the valuation, for Federal tax purposes, of securities that cannot be resold, because they are restricted from resale.

The second project was done for financial reporting, and it posed a bit of a challenge, because the subject company was publicly traded (OTC), and we were being asked to value non-qualified stock options, which represented a contingent liability. Our project would have fallen under ASC 718 (formerly, SFAS 123r), which is generally carved out from the definition of fair value provided in ASC 820 (formerly, SFAS 157).

Had we valued the equity under ASC 718, we would have relied exclusively on the company’s public market price. However, due to the relatively thin trading volume that had historically occurred in the subject company, we viewed the public market price as a misleading data point. For example, in one week the stock traded for $0.75 per share and later that same week for $60 per share. Fortunately, ASC 820 provides a process of estimating fair value when the volume and level of activity for an asset or liability has significantly decreased, and includes guidance for identifying circumstances that indicate a transaction is not orderly.

We examined the market for the company’s common stock to determine whether it could be appropriately categorized as active or inactive. After making the determination that the market was clearly inactive, we relied upon the most reasonable alternative inputs to develop the fair value of the common stock. Our assessment of an inactive market for the company’s common stock was made on the basis of several factors, including trading volume, price volatility, prevailing bid ask spreads, and various other impediments to market participants seeking to transact in the common stock.

Ultimately, in determining our value for the common stock, we relied upon the most reasonable alternative inputs readily available, which included the public market price, the implied value of the common stock in two recent private offering transactions, and we utilized the income method for valuing the company’s equity, based on a discounted cash flow analysis.

Our task in this matter was to value the contingent liability associated with the equity compensation. Specifically, the option grants were contingent on the company reaching certain market capitalization milestones. For example, once the company reached $100 million in market cap, the executives would receive 100 thousand common shares. After determining the equity value of the company using the Level I, Level II, and Level III inputs, as provided in ASC 820, we were able to apply a simple Black-Scholes formula to come up with the contingent liabilities associated with the company reaching its milestone events.

In running our Black-Scholes analysis, we represented the stock price with the company’s calculated equity value, and the exercise price was represented by the market capitalization hurdles provided in the subscription agreements for the contingent shares. Since our project was designed for financial reporting purposes, we applied simulation, via Crystal Ball, to all of our variables to come up with sensitivity. During the audit review process, I was told that, for the purposes of financial reporting, sensitivity is relevant for DCFs, and that’s about it. That’s an interesting point, I’d like to confirm.

For clarification, Third Quartile is the 75th percentile of all outcomes, and can be calculated in Excel using the QUARTILE function. The outcome is higher than the median, and serves as better representation of the cash flow volatility that we would expect from an early stage company, as compared with mature publicly traded counterparts.

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According to [Big 4] our method, at that time, was faulty on multiple counts: (1) because we automatically assumed all options exercised before the Company’s equity value necessarily reached a point at which any rational option holder would actually exercise their shares; (2) because we effectively double‐counted the impact of option proceeds, by first including the value in our calculation of Equity Value, and thereafter including a breakpoint where options would actually exercise; and (3) because we over‐emphasized the dilutive effect of options on common stock by including the total number of outstanding options in our denominator in the OPM, and thereby assuming that all options would, in fact, convert to common stock notwithstanding vesting schedules and other limiting factors.

As a matter of fact, [Big 4] generally approved of the basic approach we used at that time. And they wouldn’t have normally objected, but for the fact that the total number of options outstanding for this subject company far exceeded the number of outstanding common shares ‐‐ the ratio of common stock to common options was approximately .3 to 2.5. Due to the facts and circumstances of this particular case, [Big 4] requested that we treat the Company’s options on common stock in a particular manner, which we’ve implemented across the board. Or, at a minimum, in all cases where the number of options on common stock exceeds the number of common shares outstanding.

Specifically, [Big 4] asked us to make the following changes: (1) we no longer include the proceeds of hypothetically exercised options in our calculation of Equity Value; (2) we continue to add a breakpoint in our OPM for the point at which options exercise at their weighted average strike price; (3) we reduce the value of the ‘option exercise’ breakpoint, and all subsequent breakpoints, by the value derived by multiplying the total number of options outstanding, by their weighted average strike price (this implies a zero sum to option holders that choose to exercise, due to the cost of purchasing the option before exercising), also known as the Treasury method; (4) in our OPM calculation we separate common stock and options in order to derive the value of common stock independent of the options on common stock (this way we do not capture 100% of the dilutive effect of outstanding options).

[Big 4] did not have a bright line test for when the more basic, traditional approach fails. However, they generally felt that the risk of a material misstatement increases where the number of options far exceeds the number of common shares. Otherwise, our (former) approach would result in only nominal differences, which they can stomach. If you’re looking for some really strong guidance on this subject, take a look at Neil Beaton and James Herr’s October 2007 article in Business Valuation Update called “Allocation of Enterprise Value Using the OPM and Treatment of Common Stock Derivatives” (Volume 13, Number 10).

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I tend to agree with this constraint theoretically, but the challenge is – what is the required rate of return for this incremental risk? In reality, there is no market for interests like this. By that I mean, good luck finding a buyer. I think the closest we come to a market benchmark for this sort of thing is the limited partner interests in private equity vehicles trading on the secondary market. From what I understand many of these interests are trading at 40 to 60 percent discounts to their estimated face value (often the same thing as basis, i.e. invested capital).

Regardless, how does one calibrate the appropriate return for this sort of thing given there is not a robust pool of buyers readily willing to share their views on target returns? Let’s just guess for a second. Certainly an investment of this nature is riskier than a private equity investment, right?Typically private equity investors purchase controlling interests in cash flow positive companies. They have say over basically everything – management, dividends, exit, strategy, etc. Most industry sources will cite target returns in the 20 to 30 percent range for this asset class. What about a private holding company that owns minority interests in other privately held companies? 30 to 40 percent? 40 to 50 percent? Higher? I would argue higher. So what does that translate to in terms of combined discounts? Let’s say I invest in an entity that holds a risk free investment that compounds a rate of return of 5 percent over five years, at which time I get my money back with interest. If my target rate of return is 25 percent, I need to discount the face value by 58 percent. If it’s a 50 percent rate of return, I need to discount it 83 percent. So at a minimum, combined discounts should be 58 percent. That’s still way low. That’s a risk free investment! A 50 percent return for an interest in a private company that holds interests in minority stakes in other private companies doesn’t sound unreasonable, and a five year holding period with no dividends or distributions for that time period is also reasonable. So, by nature, an 83 percent discount should be acceptable. Wow. That’s huge! I understand this is overly simplified, but the reality of it is – it’s not too far from the truth, either.

Now the problem lies in the fact that while this is theoretically sound, it is also the very thing that leads attorneys to create vehicles strictly for their tax advantages – i.e. the interests were never meant to trade, but rather serve as tax advantaged vehicles for use in wealth transfer. I can understand why this upsets the IRS. However, they themselves supported the practice in my opinion with Revenue Ruling 93‐12 – the treatise on discounts and intrafamily transfers. I also know there have been some recent cases, the Astleford case, for example, that have started the movement in the greater discount direction. It certainly is interesting, given the increasing pressure on the IRS to generate incremental tax revenues given all the unfunded liabilities and entitlement programs (nevermind the current deficits). Interesting times indeed.

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At first, we figured we might have to value these “options to buy” as if they were contingent consideration, but after further consideration, we determined the step transaction was in fact two separate, discrete transactions, and our job in running the purchase price allocation, was to consider the acquisition of the initial controlling interest known to have been acquired. In this case, 70 percent of the total equity was acquired in the first step, which we were asked to evaluate, leaving 30 percent available at the option of the Buyer or the Seller. We simply imputed the purchase price derived for the 70 percent interest to the remaining 30 percent interest to assume 100 percent had been acquired. We found support for this position in ASC 805:

According to ASC 805‐20‐30, the acquirer shall measure the identifiable assets acquired, the liabilities assumed, and any non‐controlling interests in the target at their acquisition date fair values. Further, a business combination may occur when an entity acquires enough, but less than 100 percent of, voting shares to obtain control. In such cases, the acquirer recognizes in its consolidated financial statements the assets acquired, liabilities assumed, and the non‐controlling interest at 100 percent of their acquisition‐date fair values, regardless of its level of controlling interest. The FASB has indicated that once an acquirer obtains control of an entity, it controls 100 percent of its assets, not just a portion of them.

ASC 805 requires companies to record 100 percent of the fair value of assets acquired and liabilities assumed when control is obtained, even if less than 100 percent of a business is acquired. This differs from Statement 141 and its related interpretive guidance, which required that only the controlling interest’s share of the assets acquired and liabilities assumed be recognized at fair value and the remainder at book value. The FASB reasoned that once an acquirer obtains control of an entity, it controls all of an asset, not just a portion of it.

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Now don’t get me wrong – I think a set of well vetted free cash flow projections is the very best valuation data one can get in the absence of timely information of trades in the identical interest on an arm’s length basis. But the devil is in the amount of thought and diligence that has gone into constructing such projections. I think there should be a grading system for projections – with each particular kind receiving a different names – like financials, for instance.

Compiled projections – developed by management. No supporting documentation with the exception of historical financials.

Reviewed projections – developed by management. Growth, margin, and cash flow assumptions sourced from industry studies, publicly traded comparable companies, IRS tax filings in the same SIC code, etc.

Audited projections – developed by management. Revenue growth expectations independently verified by market research firm who performed a study on behalf of the company, margin and cash flow assumptions supported by granular model which provides commentary on expansion plans. When capital improvements will be required, how long are payables/receivable expected to be outstanding, etc.

I realize this seems excessive, and I also realize the practical reality that beyond one year, few companies maintain financial projections. When dealing with smaller private companies, many will ask the valuation practitioner themselves to construct the projections. Think about that for a second. Most will agree that almost 70 percent of a service company’s balance sheet value is allocated to intangible assets. And yet some individual with no operating experience whatsoever can be tasked with developing the very data set that will determine the valuation of these assets? If the accounting community ever wants fair value and intangible assets to be taken seriously – to be reliable and relevant for investors, then projections must be separately audited.

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Enter the tax alpha. Incremental savings from well devised tax strategies increases returns with zero additional risk. In finance parlance, that amounts to what is known as alpha. There is no better place to generate alpha at this point in time than in tax savings. In an environment of rising relative tax rates stemming from financial distress in the public sector and falling returns in the private sector across asset classes, wealth managers and their clients will pay increasing heed to tax strategy. As valuation practitioners ultimately responsible for quantifying tax savings, we will increasingly be called upon as the experts, synthesizing our knowledge of case law and valuation practice to assist in these endeavors. Of this I am certain. I already see it in the form of bulletins from established wealth management firms, which are solely focused on tax strategies with nary a peep about common themes such as asset allocation and investment strategies. Apparently they’ve gotten the memo too – investment alpha out, tax alpha in.

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I just came across a bunch of fixtures on a client’s balance sheet, and I was inclined to call them non‐operating assets. Ultimately, I came up with the same conclusion as proposed by Rand M. Curtiss, above, they’re operating assets.

Remember:

• Equity Value = Non‐Operating Asset Value (net) + Discounted Cash Flow Value
• Equity Value = Enterprise value + cash and marketable securities + non‐operating assets ‐ outstanding debt.
• Equity Value = Value of Operating Assets + Value of Non Operating Assets ‐ Value of Debt

Ultimately, the discounted value of free cash flows to the firm yields the value of the operating assets. The equity value can be derived by adding the value of the Non Operating Assets and deducting the value of debt from the value of the operating assets.

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Dallas – February 1, 2010 – Cogent Partners, the leading secondary sell‐side advisor to institutional investors in private equity, has released the second‐half 2009 update to its ongoing study of pricing levels in the secondary private equity market. The most recent analysis shows a dramatic increase in pricing for secondary assets, with an average high bid of 72.0% of net asset value (NAV) during the second half of 2009. The analysis also reveals that large secondary buyers returned to the market and were willing to bid on large portfolios late in 2009.

“As the public equity markets recovered throughout the year, secondary market pricing levels for limited partnership interests also recovered, up dramatically from the 39.6% of NAV pricing seen in the first half of 2009,” said Colin McGrady, Managing Director of Cogent Partners. “Ironically, despite the rising secondary market prices, the recovery in the public markets tempered institutional investors’ liquidity needs, resulting in a much lower level of overall deal flow in 2009 than originally projected by many market participants.”

This would suggest realized price to NAV discounts of between 38 and 61 percent. Huge difference. In the middle are the restricted stock studies and quantitative models (QMDM, protective puts). When doing FLP or similar type valuations where high net worth individuals have large investments in alternative investments like private equity, this delta has extremely meaningful implications from a tax perspective. I like the fact that there is increasing attention being paid to this area (as evidenced by the CFA article referenced above and market entrants like Cogent Partners serving as market makers). I think that its good for us as practitioners – the market data specifically will give us solid support for larger price to NAV discounts. I can’t wait for a data service that will cleanse that data and give us access to it for use in our analyses.

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