Vol18 No 1 1 Downloaded from search.informit.org/doi/10.3316/agispt.20063679. Macquarie University, on 10/09/2021 04:40 PM AEST; UTC+10:00. © Australian Family Lawyer, 2005. \ 31 AUSTRALIAN FAMILY LAWYER The NUlDerous Fallacies of ROI by Wayne Lonergan In a number of West Australian family law matters some business valuers have used a valuation method ~escribed as the return on investment (ROI) method of valuation. This method of valuation is claimed by its proponents to have become "the accepted method to value small businesses". Basically the ROI method takes the most recent year's pre-tax profit, (wrongly) adds back depreciation and proprietors remuneration, (correcdy) adds back private expenses charged to the business, (wrongly) includes interest expense as profit, (wrongly) ignores working capital and then divides the adjusted pre-tax adjusted number (as if it was a profit - which it isn't) by a return on investment percentage and arrives at a "price" for the business. There are so many conceptual flaws in the ROI method of valuation that it is little wonder that, as even its proponents admit, it is not described in any of the text books on valuations. Valuation theory in overview At its simplest level the value of any business, company or interest therein is today's value of the financial benefits that will be derived by investing in it and getting a return in future years. From a theoretical valuation perspective this is described as the present value (ie today's value) of the expected future cash flows that will be generated from the investment and is referred to as the discounted cash flow (DCF) method of valuation. Even the most simple-minded buyer of a small business knows that a dollar received in the future is worth less than a dollar in the hand today. There are three basic reasons why this is so: a) Interest - a dollar in the hand today can be invested and earn interest in the meantime, thus producing more future dollars. Wayne Lonergan is a principal of Lonergan Edwards & Associates Limited, Accountants, Sydney and author of "The Valuation of Businesses, Shares and Other Equity". b) c) Inflation - the price of most things rises over time due to inflation. Risk - you may not receive the dollar in the future if something goes wrong. Despite the conceptual arid theoretical advantages of DCF methodology; it is fair to say that in the majority of (but by no means all) situations both valuers and buyers and sellers of businesses more frequently use the capitalised earnings methodologies as a surrogate or substitute method of valuation rather than the theoretically-preferred DCF methodology. This is because, over the long term, it is widely believed1 that profits approximate cash flow. The other, more compelling reason, is the ready availability of information (for example even in the daily press) about earnings multiples and rates of return from alternative or "comparable" investment opportunities. It naturally follows that even an unsophisticated small business buyer both work.". out and compares: what will their investment cost (a relatively clear cut answer); and what will they get back; and how much better (or worse off) are they if they invest than if they dOI1~t? TIlls basic analysis is hardlfrocket science. ,<!' ROI confuses profit and cash flow The ROI valuation nibthodology adds depreciation - a cash flow - to profit, and treats depreciation as if it were a profit. This is clearly flawed for the following reasons: • Depreciation is cash flow,2 not profit. • Different multiples apply to cash flow than profit. • Cash flows from depreciation will have to be reinvested in later years in replacement plant and equipment etc. Thus under ROI the cash flow from depreciation is treated as if it was a perpetual benefit or component of profit, whereas in reality it is no more than a timing difference. That is, under ROI the need to replace worn out equipment in due course is ignored. In simple terms, ROI values the "benefit" of depreciation as if it was a profit, and ignores the fact that it will have to be paid out again to maintain or replace fixed assets. 3 A salary isn't a profit The ROI valuation methodology also adds Copyright of Full Text rests With the original owner and, except as permitted under the Copyright Act 1968, copying this copyright materialis prohibited without the permiSSion of the owner or agent or by way of a licence from Copyright Agency Limited. For mformatlOn about such licences. contact the Copyright Agency Limited on (02) 93947600 (ph) or (02) 93947601 (fax) Downloaded from search.informit.org/doi/10.3316/agispt.20063679. Macquarie University, on 10/09/2021 04:40 PM AEST; UTC+10:00. © Australian Family Lawyer, 2005. 32 AUSTRALIAN FAMILY LAWYER back the proprietor's remuneration and treats it as a profit. This too is clearly flawed for a number of reasons including: • The proprietor's actual remuneration is normally significantly influenced by tax considerations and is often only a fraction of the proprietor's true market remuneration. This is because underpaid proprietor's remuneration boosts company profits which are taxed at only 30%, leaving the proprietor control of the other $0.70 in the dollar. If proprietors draw remuneration equal to their full market worth they suffer top marginal tax rates of 48.5%, Medicare Levy 1.5%, payroll tax 6%, superannuation contribution 9% and workers' compensation insurance of between I % and 10% depending on the industry. In other words the proprietor loses $0.65 (or more) in the doIJar of the amounts drawn as salary and retains control of only $0.35 (or less) in the dollar • Failing to allow for, and expense, an appropriate notional proprietor's salary fails to distinguish between the personal goodwill of particularly capable proprietors and those of less capable proprietors. It also causes those purchasing a business in reliance on ROI methodology or ROI-based advice to pay more for the capitalised value of that difference which, under ROI, is (wrongly) portrayed as business goodwill when the simple reality is that the above-normal ROI-calculated return is really the personal goodwill of the proprietor • Even the more simple-minded purchasers of small businesses should be reluctant to payout cash for so-called goodwill under the ROI methodology when all they are really doing is generating the (same or less) return they could earn by working as an employee for a salary. ROI proponents also conveniently ignore that paying "goodwill" to generate a salary (ie "buying themselves a job") is hardly a value that is fundamentally consistent with the definition of market value (ie "a willing but not anxious purchaser"). Simply put, only an anxious buyer pays a premium to buy themselves a job which in substantial part, or in whole, is no more than a salary payment for their labour. ROI ignores the true cost of investment Proponents of ROI claim that goodwill is calculated by deducting plant, equipment and stock (presumably they mean to also include work in Vol 18 No 1 progress) from price. 4 They claim that this is because only those assets are normally sold. Firstly, in the case of the sale of company structure this is not correct. What is sold are the shares in the company, amongst whose assets are debtors and creditors. Although in the case of the sale of businesses it is common for the vendors to collect the debtors and payout the trade creditors, the ROI methodology makes no allowance for the fact that the new business owner will, on an ongoing basis, have to fund the difference between debtors (and other working capital assets) and trade creditors. Thus the value derived under ROI should be, but isn't, adjusted for the net working capital that has to be outlaid or financed by the new owner. In fact there is a "double whammy" effect under ROI for a buyer (and a double benefit to the seller). This is because the ROI value overstates the value of goodwill which is paid to the vendor and understates the net working capital investment (ie the cost) that the purchaser has to outlay or borrow from the bank. ROI proponents also ignore the often significant liabilities and provisions that are transferred with the business, and which can vary significantly from case to case. For example, employee provisions relating to long service leave and holiday pay may be very significant amounts, particularly in the service industry. A further differentiating factor ignored by ROI is whether these provisions are paid out by the vendor or transferred to the new owners. ROI confuses the cost of debt and the cost of equity It is very long-established and fundamental fact of economic and business life that the cost of debt is significantly less than the cost of equity. In simple tenus this is because interest and debt commitments rank prior to anything that the equity holder may receive. Indeed, studies of stock market returns covering periods of more than a century have shown that equity returns average some 5% to 6% after tax higher than the long term bond rate. ' As ROI calculations are made on a pre-tax basis, these stock market studies confirm that pretax equity returns are well over double (indeed closer to three times) the rate of return on debt. Notwithstanding the significant, indeed massive, difference between equity and debt rates of return, the ROI methodology adds back debt Vol18 No 1 financing costs to profits and divides the total by the same ROI percentage! Of course ROI proponents will say this is also taken into account in the ROI percentage. Given the widely different debt and equity funding structures of businesses even in the same industry, this claim is not mathematically or even logically credible. It is unnecessary to comment further on the proposition that all the wrongs in the ROI numerator are somehow magically and accurately fixed by the also wrongly calculated ROI denominator. Downloaded from search.informit.org/doi/10.3316/agispt.20063679. Macquarie University, on 10/09/2021 04:40 PM AEST; UTC+10:00. © Australian Family Lawyer, 2005. 33 AUSTRALIAN FAMILY LAWYER ROJ ignores "the trend is your friend" Some ROI proponents base their calculations only on the most recent (adjusted) profit year's result. Some average the profit results over a number of years. It is a well known saying in investment circles that "the trend is your friend". This saying is based on the following propositions: a) The value of a business or share depends on its future maintainable profits. These may differ significantly from current or even past profits. b) Profit trends are important because a business or company whose profits are in an uptrend is worth more than a business or company whose profits are in a downtrend. c) Investors pay a premium for growth. 5 d) Examining the reported results over a number of years has the effect of averaging out year end accounting cut off, estimation, accrual and prepayment errors. e) Relying on the results of one year in isolation significantly increases the risk that the results of that period have been significantly affected by one-off factors, including even contrived factors such as the release of hidden stock reserves. Litigation risks and ROJ In summary, the ROI valuation methodology is fatally flawed both conceptually and mathematically. Those relying on ROI methodology should check their professional indemnity closely as it is inevitable that one day some disaffected paliy will subject a ROI valuation to a detailed examination by the Court. The defence that this is a "practical basis without considering the theoretical reasons" and that users of ROI have historically achieved "whether by design or luck what most textbooks say they shouldn't" is unlikely to count for much courtroom when that luck runs out. ID the How should valuations be performed In today's world "near enough" (and only luck would make ROI valuations near enough) is not "good enough". There is no substitute for a carefully considered, correctly calculated conceptually sound valuation. These may be either DCF based, earnings based or (in some limited circumstances) asset based. Neither ROI, nor Rules of Thumb (the subject of another article by this author) are anywhere near being theoretically or conceptually sound or reliable valuation methodologies. To claim that ROI "relies on the same theory and principles as other capitalisation of earnings methods" is simply not true. Of course RaI proponents will argue that the any theoretical limitations of the numerator is captured in the RaJ percentage denominator. This is hardly plausible given the wide range of net working capital requirements, the different debt/equity structures, and the significantly different proprietorial skills (and hence significantly different notional proprietor's salaries) of different industries and even of different businesses in the same industry. The RaI proponents' claims are even less plausible given that reference point of RaI returns are said to be business brokers and Business Value Newsletter, the latter of which at least makes no reference to issues such as net working capital, debt/equity structures or proprietors' notional salaries. Conclusion Business brokers can play a useful role in matching buyers and sellers of businesses. However, they should not be misled into believing that RaJ based valuations are anything other than conceptually flawed. 2 3 4 S NOTES Not strictly eonectly, because part of the profits have to fund working capital increases due to inflation and growth. Technically, cash flow should be discounted, not multiplied. Obviously if plant and equipment are not maintained the resale value of the business will fall. ROI proponents generally refer to "'price" not "'value". Neither asking price nor offer pliee necessalily equate with value. By way of example, references to "'growth premium", "'growth opportunity", "'profit growth", "eamings per share growth"etc are referred to constantly in the financial press, financial analysts' reports and financial literature.