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.