Valuation professionals cannot afford to ignore what is happening in the global economy, especially in light of recent events. The devaluation of the Chinese Yuan has triggered a debate on the potential impact on American businesses. Then there’s the Fed’s decision on whether or not to raise interest rates—a decision that will be made at its upcoming September meeting.
In today’s economy, it is rare for a U.S. company to be completely insulated from the rest of the world. It could be as simple as having to deal with suppliers, competitors and/or customers located abroad, but it could also extend to having physical operations in foreign countries. Exposure to other countries typically creates new sources of risk that need to be incorporated in valuations.
One of the first decisions a valuation analyst needs to make is whether to reflect country risk in the projected cash flows or in the discount rate (or a mixture of both). “While ideally one would prefer to incorporate the incremental country risks directly in the projected cash flows, the reality is that it can be very difficult to develop truly “expected” projections (i.e., probability-adjusted) in an international setting, especially when dealing with countries where lack of reliable data prevails” Carla Nunes, a senior director at Duff & Phelps, tells BVWire.
Most analysts end up adjusting the discount rate when attempting to capture country risk. Several international cost of capital models are available, but it can be challenging for practitioners to find the appropriate underlying inputs. Developing robust inputs can be time-consuming and cost prohibitive for many valuation practitioners, but simply selecting a subjective country risk premium is not likely to be a defensible alternative. “We live in an environment where adding an ad-hoc country risk premium to the discount rate is no longer acceptable,” says Duff & Phelps director Jim Harrington. Practitioners see their valuations scrutinized by auditors, the SEC, the IRS, foreign tax authorities, courts, and other regulatory bodies. “Your valuation conclusions will be more defensible if you can corroborate your estimated country risk premium with third-party sources,” he adds.
Fortunately, there are some readily-available resources, all with their own pros and cons, of course. For example, Professor Aswath Damodaran (New York University Stern School of Business) publishes country risk-adjusted equity risk premia on his website for a variety of countries. However, there are a number of caveats posted on his website about the usage of his data, and he explicitly indicates that it was never his intent for it to be used in the legal arena.
The Duff & Phelps 2015 International Valuation Handbook – Guide to Cost of Capital is a new resource providing country-level country risk premia, relative volatility factors, and equity risk premia, which can be used to estimate country-level cost of equity capital globally, for up to 188 countries, from the perspective of investors based in up to 56 countries. BVR has a webinar on how to use this annual publication, and you can access it—at no charge—if you click here.
Also look for an early-2016 Business Valuation Update article by Jim Harrington and Carla Nunes for a more detailed discussion of country risk rating sources, as well as how they can be converted into usable country risk premia information.
In recent months, one persistent rumor has circulated in the blogosphere dedicated to estate and gift tax issues. It’s that the IRS is about to eliminate or at least limit the application of discounts related to family limited partnerships and similar structures. Also, BVWire cites a recent article in The New York Times discusses the impending crackdown.
Popular tool: FLPs and their variants are a popular tool to shift significant family wealth from one generation to the next at greatly discounted value. Under a common scenario, the transferor contributes assets to an FLP and then assigns fractional limited partnership interests to the transferees. Provisions in the partnership agreement or the organizational structure may place restrictions on the fractional ownership interest, as far as concerns control, marketability and liquidity, and transferability. If the restrictions stand up to scrutiny, they can translate into significant discounts and gift and estate tax savings.
The IRS has long been concerned over depressed valuations but has had limited success litigating the issue. Recently, representatives from the IRS and the U.S. Treasury said that new regulations limiting the use of valuation discounts would be forthcoming. It’s not clear when this will be or how the language will read. But business valuators fear the worst.
Relevant law: In 1990, Congress enacted Chapter 14 of the Internal Revenue Code, particularly sections 2703 and 2704, to prevent perceived abuses of the system. Section 2704(b), which deals with restrictions affecting the ability of a partnership or corporation to liquidate, is likely to be the focal point of the threatened regulations. It says that, if there is a transfer of an interest in a corporation or partnership to a member of the transferor’s family, and immediately before the transfer the transferor and his family have control of the entity, any “applicable restrictions” are disregarded when determining the value of the transferred interest.
In a 2001 technical advice memorandum (FSA 200143004), which discusses sections 2703 and 2704, the IRS’s office of chief counsel explains how the agency may deploy the provisions in a gift tax matter. A digest of FSA 200143004 and the full text of the TAM are available at BVLaw. More on this issue is sure to follow.
In a paper published in the latest edition of the ASA’s Business Valuation Review, the author describes an empirical test he conducted of the implied private company pricing line (IPCPL). This is a new method designed to eliminate the inherent problems in comparing public and private data and to add another approach in estimating the cost of capital for a privately held business.
High marks: The author, Igor Gorshunov, a business valuation and private equity professional, conducted an empirical test of the IPCPL cost of capital and the concept of margin reversion. He describes the test: “By arranging companies in the market by their operating profit margin we could observe the market valuation line (based on the market data) and steady-state valuation line, which represents the hypothetical valuation of the company based on the IPCPL cost of capital and constant growth rate. If both IPCPL cost of capital and the margin reversion concept are correct, these two lines should intersect at the point of average margin.” For the test, the author used 840 data points on private-company transactions sourced from Pratt’s Stats. Based on the test results, the author states: “This independent test indicates that IPCPL is a reliable source for small private companies’ cost of capital.”
The developers of IPCPL are Bob Dohmeyer, Pete Butler, and Rod Burkert. “We were introduced to Igor after he wrote this paper, and we have come to know him as a well-respected economist and mathematician,” Butler tells BVWire. “We certainly appreciate Igor’s interest and this is now the second formal independent validation of our work. It is always nice to meet someone in the industry who is open to new ideas. We look forward to others taking a look at IPCPL and the feedback that will come. We are hopeful that others will find it as useful as we have.”
In his remarks, Butler is referring to a recent paper on SSRN that calls IPCPL a “significant innovation in the valuation of privately-held, small-or-medium-sized enterprises (SMEs).” (See the June 24 issue of BVWire.)
See for yourself: Appraisers should read the material on BVR’s special IPCPL Web page and develop their own conclusions. On that page, you also have complimentary access to the IPCPL-based BUM WACC calibrator tool that is updated monthly. The Gorshunov article, “IPCPL and Margin Reversion: Implications for the Valuation of Small Privately Held Companies,” will be in the September issue of Business Valuation Update.
The 2015 International Valuation Handbook – Guide to Cost of Capital includes country-level country risk premia (CRPs) and country-level equity risk premia (ERPs) that can be used to estimate country-level cost of equity capital globally, from the perspective of investors based in 55 different countries. During a recent complimentary webinar explaining how to use the book, the presenters mentioned additional sources of international equity risk premium data.
One top source is a survey that collects information about the discount rate (risk-free rate and the market risk premium) used in 2015 for 41 different countries. Pablo Fernández, Alberto Ortiz Pizarro, and Isabel Fernández Acín (all with the University of Navarra in Spain) co-authored the survey. The information is collected from professors, analysts, financial companies, and managers of nonfinancial companies.
Rate shifts: The survey found that the average risk-free rate used in 2015 was less than the one used in 2013 in 26 countries (in 11 of the countries, the difference was more than 1%). On the other hand, eight countries used an average risk-free rate in 2015 that was more than 1% higher than the one used in 2013. For the U.S., Europe, and U.K., most of the respondents use a risk-free rate that is greater than the yield for 10-year government bonds. The difference in the average market risk premium used was more than 1% for 13 countries in 2015 versus 2013.
The 2015 International Valuation Handbook – Guide to Cost of Capital, written by Duff & Phelps, is a must-have publication that includes data through March 2015 and builds on the same rigorous country-level cost of capital analysis previously published in the Morningstar/Ibbotson “international” reports.
BVWire was at the National Association of Certified Valuators and Analysts (NACVA) conference in New Orleans. Here are a few insights we picked up at the sessions.
- Keynote speaker Sam Allred, CPA, says practice development is about having a sincere desire to help people.
- One way to help clients do business with you is to accept electronic payments from them (e.g., PayPal, ACH, wire, Apple Pay).
- NACVA unveiled new standards that deal with an engagement to review another practitioner’s valuation report.
- The market approach may emerge as a more prevalent method for valuing intangible assets due to increased transactions and merchants in this space.
- “Relief from pay per click” is a new approach to measure damages due to trademark misuse over the Internet.
- When valuing family limited partnerships, make sure you read the entire document even if the lawyer says it’s a standard agreement.
- Don’t use the word “draft” to label a draft report—use “incomplete work product.”
- Pending research reveals there is significant double counting if you use a size premium and also DLOM.
- An extensive analysis of existing research reveals that shareholder taxes definitely affect value of PTEs, refuting the IRS and Tax Court position.
See more takeaways in BVWire. And there will be more details in the August issue of Business Valuation Update. Congratulations to NACVA for an excellent conference!
At the recent NACVA conference in New Orleans, former IRS manager Michael Gregory (Michael Gregory Consulting LLC) did a session on the recently released IRS job aid on reasonable compensation. Gregory worked on the job aid while he was with the agency. The IRS uses three sources of data when examining reasonable compensation: Watson Wyatt, RMA’s Annual Statement Studies and the Economic Research Institute (ERI), but ERI is used only for classification purposes, not for bottom-line numbers, according to Gregory.
In examining compensation issues, the IRS looks at ratios for red flags, he points out. For example, if a company is operating in the 25th percentile and its compensation is in the 90th percentile, the IRS is likely to “take a look.” Also, if compensation reported by a pass-through entity drops materially (without a corresponding drop in financial performance), the IRS will take note but will typically not take any action. However, if this continues in a second year, an audit could be triggered if the IRS feels the company is trying to avoid payroll taxes.
Gregory will conduct a webinar on the IRS job aid on August 6. He also has a new book, How the IRS Determines Reasonable Compensation with Job Aid Commentary by the Original IRS Champion.
At the annual business valuation conference hosted by the New York State Society of CPAs (NYSSCPA) in New York City, Nancy Fannon (Meyers, Harrison & Pia) challenged the traditional notions about the differences in value between a pass-through entity and the public-market C corporation. She presented research showing that shareholder-level taxes affect a firm’s value. The IRS and the Tax Court have refuted this conclusion, largely because the research has never been presented to support it. Fannon provides a suggestion for a new, more direct approach to pass-through entity valuation, which is included in a groundbreaking new book, Taxes and Value: The Ongoing Research and Analysis Relating to the S Corporation Valuation Puzzle, that she co-authored with Keith Sellers (University of Denver). Fannon touched on the new IRS job aid on S corp valuation (available at www.scorpvalue.com). In terms of general valuation concepts, she agrees with the job aid. But academic research does not support some substantive underlying assumptions made in the job aid, she says. One of these assumptions is that personal income taxes paid by the holder of an interest in an S corp “are not relevant” in determining the fair market value of that interest. “The academic research presented in our book presents very compelling evidence that personal-level taxes paid by the holder of an interest are very relevant to the prices paid in the marketplace,” she says.
BVWire reports on a new survey that collects information about the discount rate (risk-free rate and the market risk premium) used in 2015 for 41 different countries. Pablo Fernandez, Alberto Ortiz Pizarro, and Isabel Fernández Acín (all with the University of Navarra in Spain) co-authored the survey.
Rate changes: The survey found that the average risk-free rate used in 2015 was less than the one used in 2013 in 26 countries (in 11 of the countries the difference was more than 1%). On the other hand, eight countries used an average risk-free rate in 2015 that was more than 1% higher than the one used in 2013. For the U.S., Europe, and U.K., most of the respondents use a risk-free rate that is greater than the yield for 10-year government bonds. The difference in the average market risk premium used was more than 1% for 13 countries in 2015 versus 2013.
“I started to do surveys to prove that expectations are not homogeneous and there is no single parameter in finance—not even the risk-free rate—that is homogeneous among people,” Pablo Fernandez tells Michael Crain (Financial Valuation Group), a leading business valuation practitioner and researcher, in an exclusive interview. “People use different numbers and put different reasoning behind them. One survey I do every year is about the risk premium. This year I did the risk premium plus the risk-free rate. It’s interesting to see the variety of numbers people use and the different reasons behind the numbers they use.”
Read the full Fernandez interview in the July issue of Business Valuation Update (subscription required).
The value of a food celebrity’s restaurants may figure into his divorce case—if his estranged wife has her way, according to BVWire.
Food fight: The wife of Bobby Flay has filed legal documents to set aside their prenup to give her more of a bite out of her husband’s success. She claims the agreement should not be enforced because she’s the reason he became wildly successful, TMZ reports. The wife is also making allegations of adultery, which could bolster her case. Under the terms of their prenup, Flay, who’s worth an estimated $20 million, only has to pay wife Stephanie March $5,000 a month. Flay has a number of cooking shows on Food Network, has written several cookbooks, and owns a bunch of restaurants, including Bar Americain, Bobby Flay Steak, Bobby’s Burger Palace, Gato, and Mesa Grill.
BVR recently served up a webinar, Valuing Restaurants: A Case Study, presented by expert Lynton Kotzin (Kotzin Valuation Partners LLC). Kotzin went through a detailed numbers example of the valuation of a company that owned a group of Subway sandwich shops.
A powerhouse lineup of speakers will be at the annual business valuation conference in New York City on May 18, hosted by the New York State Society of CPAs. The speakers and topics include:
- Nancy Fannon: Withstanding a Daubert Challenge; S Corp. Tax Adjustment;
- Chris Mercer: Unlocking Private Company Wealth;
- Mark Zyla: Fair Value Measurements;
- Panel Discussion: Business Divorce and Appraisers with Sam Rosenfarb (Rosenfarb LLC) and Peter Mahler (Farrell & Fritz, P.C.);
- Valuation Issues in a New York Divorce: Jeffrey Gilbralter (Klein Leibman & Gresen LLC) and Adam J. Wolff, Esq. (Kasowitz Benson Torres Friedman LLP);
- Brian Pearson: Fairness Opinions; and
- Juli Saitz: Preparing Expert & Rebuttal Reports
This is the premier event for valuation and forensic professionals in the New York City area. For details and to register, click here.