Presentation to
Experienced Business Appraiser Group
IPCPL
Ko=FCFF/P+g
“In the land of the blind the one eyed man is king”
Erasmus of Rotterdam, circa 1510
By: Peter Butler and Bob Dohmeyer
February 19, 2013
IPCPL
Ko=FCFF/P+g
“In the land of the blind the one eyed man is king”
Erasmus of Rotterdam, circa 1510
Agenda
 Review Flaws of Build-up
 Review Fatal Flaws of Build-up
 Description of IPCPL
 IPCPL Restaurant Valuation Example
IPCPL Housekeeping Items
•
IPCPL Very Recently Developed
o
o
o
At this Point, use as a Diagnostic Tool for Litigation to Adjust and Test Other Models
Use IPCPL to Test Opposing Expert Ko for Bias/Error
For Non-Litigation or Preliminary Litigation Analysis use as Primary or Independently
•
IPCPL = Substantial Improvement over Current (Blind) Models
•
IPCPL Like All Models is Not Perfect
•
Discussion is for Control Interest of a Small Privately Held Business ($5Million FMV and Less)
•
Dr. Damodaran Quotes
•
More Info: Biz-app-solutions.com.
o
IPCPL model Download
Why Should I Use The IPCPL?
•
Dr. Damodaran calls the build-up method “a recipe for disaster”
•
“In a galaxy far far away, where unicorns prance on the back of the Loch Ness
monster and privately-held companies have access to public equity markets,
appraisers estimate cost of capital by ...(using returns of publicly traded equity
securities)”
•
In a recent Pepperdine survey, 78% of respondents did not feel comfortable with
our industry’s current cost of capital methods, using returns on publicly traded
equity securities
Why Should I Use The IPCPL?
Gesoff v. IIC Industries:
“This court has also explained that we have been understandably suspicious of expert
valuations offered at trial that incorporate subjective measures of company-specific risk
premia, as subjective measures may easily be employed as a means to smuggle improper
risk assumptions into the discount rate so as to affect dramatically the expert’s ultimate
opinion on value.”
Court of Chancery of Delaware, New Castle County 902 A.2d 1130 (2006).
Why Should I Use The IPCPL?
• IPCPL solves the following problems:
o What Tax Rate? - PTE Taxes
o Liquidity Adjustment
o Equity Risk Premium ERP
o Higher & Priced Unsystematic Risk
o Higher Systematic Risk
o Extrapolation of “Small” Stock Premium
o Cash Add-Back
o Unlevering / Relevering Beta
Finance PhD & Cost of Capital
Guru on the IPCPL
“I have not had time to circle back and really study and fully understand the IPCPL
and take the time to go over with Bob, but the basic concept and approach is
sound.
I think it provides a far more objective and empirical basis for deriving private cost
of capital given the issues Bob just noted above.
As with all implied cost of capital calculations (including Damodaran's) the devil is
in the details of the assumptions used to derive them but the results conform to
our own internal observations and unpublished work on this issue.”
What Tax Rate?
•
Marginal Investor: Asset Sale to PTE / Owner Operator vs. Public C-Corp
o FMV Independence of Seller Tax, etc. Attributes.
•
'Valuation of Pass-Through Entities: Looking at the Bigger Picture'
Keith F. Sellers and Nancy J. Fannon
From the Paper:
"Where private market valuation today treats shareholder taxes as directly correlated to value,
such treatment is a very far leap from that which is demonstrated by empirical research. At the
very least, this should indicate to private market analysts the need to carefully consider offsets and
other associated risks when different tax schemes than that which exists in the public market
return are assumed. Like all risks that affect value, this can be demonstrated perhaps most
effectively through the cost of capital."
Low Liquidity Adjustment
Dr. Damodaran Defines Liquidity as:
“When you buy a stock, bond, real asset or a business, you sometimes face
buyer’s remorse, where you want to reverse your decision and sell what
you just bought. The cost of illiquidity is the cost of this remorse. In the
case of publicly traded stock in a heavily traded company, this cost should
be small. It will be larger for stock in a small, over-the counter
stock
and
will escalate for a private business, where there are
relatively few potential buyers.”
Low Liquidity Adjustment
Dr. Damodaran Continued:
•
“One way of capturing the cost of illiquidity is through transactions costs, with less liquid
assets bearing higher transactions costs (as a percent of asset value) than more liquid
assets. ”
•
“The trading costs associated with buying and selling a private business can range from
substantial to prohibitive, depending upon the size of the business, the composition of its
assets and its profitability. There are relatively few potential buyers and the search costs
(associated with finding these buyers) will be high. In fact, if the investor buying it from you
builds in a similar estimate of transactions cost she will face when she sells it, the value of the
asset today should reflect the expected value of all future transactions cost to all future
holders of the asset. ”
Low Liquidity Adjustment
Dr. Damodaran continued:
•
“In conventional valuation, there is little scope for showing the effect of illiquidity. The cash flows are
expected cash flows, the discount rate is usually reflective of the risk in the cash flows and the present
value we obtain is the value for a liquid business. With publicly traded firms, we then use this value,
making the implicit assumption that illiquidity is not a large enough problem to factor into valuation.
In
private company
valuations, analysts have been less willing (with good reason) to make this
assumption. The standard practice in many private company valuations is to apply an illiquidity discount
to this value. But how large should this discount be and how can we best estimate it? This is a very
difficult question to answer empirically because the discount in private company valuations itself cannot
be observed.”
Higher Systematic Risk
• Lower Margins
• The Intertemporal Flaw of CAPM
“While it would
be foolhardy to attribute all of the well documented excess returns that have been
associated with owning small market capitalization and low price to book stocks to illiquidity, smaller
and more distressed companies (which tend to trade at low price to book ratios) are more illiquid than the
rest of the market”
(Dr. Damodaran)
• The Value / Distress Premium - Fama French Three Factor Model
“Small” Stock Premium
“Small” Stock Premium
•
Approximately ½ of companies in smallest percentiles lose money
•
“Small” companies tend to be small(er) because they are disproportionately distressed
•
“The key is to avoid double counting the cost of illiquidity since some of the small stock premium may
be compensation for the illiquidity of small cap companies.” DD
•
“While it would be foolhardy to attribute all of the well documented excess returns that have been
associated with owning small market capitalization and low price to book stocks to illiquidity, smaller
and more distressed companies (which tend to trade at low price to book ratios) are more illiquid
than the rest of the market.” DD
•
Liquidity and or Intertemporal Flaw of CAPM
Higher & Priced Unsystematic Risk
•
Publicly Traded vs. Small Privately Held Business
•
Diversification
•
# Products
•
# Regions
•
Depth of Management
•
Current Practice = Guess
•
“(Total Beta) theoretically applies if you have an investor who is completely undiversified, but you
never have that kind of buyer in the real world. At the other end of the spectrum, ‘beta’ applies for
totally diversified investors. Investors in private companies are somewhere in between.” (Dr.
Damodaran)
•
Typical small privately held business TB = 3.0 Approx. vs. ERP S&P 500 1.0
Current Build-Up Practice Reliability
Dr. Damodaran’s “Recipe for Disaster”:
Valuation of Company With Typical Risks - Same $6 mil Company, Two Appraisers
PTE
-1.0%
AVG CSR
4.0%
Liquidity
2.0%
Both assume same EVERYTHING, but:
Appraiser A = 21.0% = $2.1Million
Appraiser B = 11.2% = $4.5Million
FCFF G magnifies discrepancy
IPCPL (empirically tethered to reality)
Both Appraisers: same empirical estimate of
FMV
“Small” Stock
6.0%
“Small” Stock
4.0%
ERP
6.0%
RF
4.0%
PTE
-2.0%
AVG CSR
2.0%
ERP
5.0%
Judge/Jury/
Executioner
RF
2.2%
What Would Dr. Damodaran Do? WWDDD
• 100% of Kristin Kandy ($3million in Revenue)
• Dr. Damodaran does not use a small stock premium or Company Specific
Risk (CSR) adjustment
• Uses ERP, TB and Liquidity Adjustment
o No “Small” Stock premium
o No CSR Adjustment
What Would Dr. Damodaran Do? WWDDD
“…..(Total beta)….., Professor Aswath Damodaran (NYU Stern School of Business) acknowledged during his day-long presentation at the 26th annual
Valuation Roundtable of San Francisco held last Friday in Berkeley, Calif. “It theoretically applies if you have an investor who is completely
undiversified, but you never have that kind of buyer in the real world. At the other end of the spectrum, ‘beta’ applies for totally diversified investors.
Investors in private companies are somewhere in between.”
Damodaran also freely allowed that there are “dark” and difficult areas in the field of private company valuation that even he has not yet explored.
Liquidity? Marketability? Discounts? Premiums? “Fundamentally, these qualitative factors must at some point show up quantitatively in the cash flows
because there are no qualitative dollars,” he reminded attendees, “only quantitative dollars.”
“But how large should this (liquidity) discount be and how can we best estimate it? This is a very difficult question to answer empirically because the
discount in private company valuations itself cannot be observed.”
•
The Land of the Blind

Unsystematic Risk : “(diversification) somewhere in between”

Illiquidity: “(very significant but) cannot be observed”

Taxes
Market Approach
Completed Transactions
 Pratt Stats/BizComps – Market Approach No problem for:
o What Tax Rate?
o Liquidity Adjustment
o Equity Risk Premium
o Priced & Higher Unsystematic risk
o Higher Systematic risk
o “Small” Stock Premium Extrapolation / Double Counting
o Unlevering and Relevering Beta
 Cash Add-Back
 No Problem Because They are Truly Comparable – Size etc
IPCPL = Ko= FCFF /P + g
•
“The IPCPL aggregates 500 small private company transactions and directly
estimates the aggregate pre-tax IRR.
This IRR aka “ex ante” approach
is fundamentally the same as Dr. Damodaran’s equity risk premium approach.”
•
“By using prices paid (FMV) for small privately held companies, all of the above
public security return extrapolation issues are rendered moot. Effects of
Liquidity, unsystematic risk, taxes etc. are reflected in the (FMV) clearing prices
paid for the businesses”
IRR Aggregation of the IPCPL 500
( $ Millions - 500 Private Company Transactions Combined)
Revenue
$2,943
TTM
Operating Income
%Revenue
239
8%
$1,439
49%
Operating Book Capital TTM (2)
586
20%
Aggregate Revenue Growth (3)
2.44%
Fair Market Value
TTM
To (1)
Holding above relationships constant:
o FCFFT1 = $239 * 1.0244 - ($586 * 2.44%) = $230
o Ko (4) = FCFF1/P + g = $230/$1,439 + 2.44% = 18.4% = IRR
Transaction Data Reliability
IPCPL - The Line (Curve)
• Point 1 – $5.9 Million Using Above Private Co. Aggregate IRR
• Point 2– $150 Million ETF IWC Comp (Using Fama French/CAPM)
Adjusted for Costs of Going & Staying Public
• Point 1 & Point 2 Connected Using “No-Arbitrage” Rule
o Based on Double Lehman Formula Curve Shape – Proxy for Liquidity
and Unsystematic effect consistent with Dr. Damodaran’s Liquidity
discussions
IPCPL
19.8%
18.8%
18.3%
17.8%
17.3%
16.8%
16.3%
$2
$12
$22
$32
$42
$52
$62
$72
$82
$92
$102
Revenue $Millions
6.6
Operating Income Multiple
Pre - Tax Ko
19.3%
6.4
6.2
6.0
5.8
5.6
5.4
5.2
$2
$12
$22
$32
$42
$52
$62
Revenue $Millions
$72
$82
$92
$102
Restaurant Example
 Kristin’s Grill - Medium/high price restaurant bar. Revenue $6 Million
•
Ibbotson Industry Risk Premium – Negative
•
Assume Typical Liquidity for Similar Size
•
If Typical Risk for Same Size (stop at IPCPL)
•
Algorithm on regressions
IPCPL Point
Risk Analysis