Valuing Businesses and Property after Matrimonial Breakdown

NQLA Conference 25 May 2011

What is Valuation? Purpose of Valuation Is a Valuation necessary? The Valuation process Types of methodologies How business Valuer conducts process Issues to take into consideration for matrimonial

breakdown Issues for Valuers The application of retrospectivity (Kizbeau case) Summary for Lawyers Appendix 1 – 41 factors affecting a Business Valuation

What is valuation?

“Valuation can be described as estimating a fair price for the parties to exchange an asset having regard to the risk and the expected return of the asset”

Concept of risk and return – key to valuation

Purpose of a valuation

Why are valuations conducted:

“to arrive at a value as a reference point for a transaction”

Purpose of a valuation

A valuation must have regard for:

- Expected returns

- Risk free rate

- Comparable returns of similar assets or classes of

assets

- Risks of the returns

- Other variables

Market value

“the price that would be negotiated between an knowledgeable and willing but not anxious buyer and a knowledgeable and willing but not anxious seller acting at arm’s length within a reasonable time frame.”

(Lonergan, 2003)

Alternatives to Market value definition

Intrinsic value

Fair market value

Realisable value

Going concern value (primarily for businesses)

Present value or net present value

Investment

Deprival value

Intrinsic Value

Intrinsic Value of a business is defined as being the value

“inherent” therein, “belonging to”, or “arising from” its “true or

fundamental nature”. Thus, the Intrinsic Value of a business

equates to its value, to the owner, in its present form,

independent on the amount for which it can be sold.

Intrinsic Value and Market Value

“Intrinsic Value” and “Market Value” cannot be one and the

same, because the value of a business, “in its current operating

state”, includes assets and liabilities that are not transferred to a

purchaser, in a sale thereof.

It may be described as “true value” inherent in the object of the

valuation. This may not be a reflection of current market price

or realisable value, but is rather an assessment of value

computed on true worth, irrespective of any other considerations.

Intrinsic values change less frequently, as a rule, than market

values.

Intrinsic Value Assets

Assets included in the “Intrinsic Value” of a business, not

transferred to a buyer of the business, i.e., excluded from its

“Market Value”, include:

 Cash at Bank

Trade Debtors

Utilities Deposits

Intrinsic Value Liabilities

Liabilities accounted for in establishing the “Intrinsic Value” of

a business, not transferred to a buyer of the business i.e.,

excluded from its “Market Value”, include:

Trade Creditors

Employee PAYG Tax Deducted

Employer Superannuation Contributions

Intrinsic Value and Market Value

Nevertheless, for “a knowledgeable and willing, but not

anxious buyer and a knowledgeable and willing, but not

anxious seller, acting at arms length, within a reasonable time

frame”, “Market Value” would normally equate to “Intrinsic

Value”, adjusted for the above exclusions.

Price v value

“Price is what you pay, value is what you get”

(Kilpatrick 2006)

Price: - is the amount realised in a transaction - Price is objective Value: - is an estimate at what price should be - Value is subjective In a going concern business no two Valuers

are going to agree exactly on a value

Conceptual framework

Valuation is built around the concepts of risk and return

Put simply, the value of an asset (Business) is the present value of the future cash flows of that asset

This applies to businesses and property

What is being valued?

Business

Shares

To value the shares you need to value the business

Is a Valuation necessary? Is it profitable after deduction of owners wages and other

adjustments

Has it been incurring losses

Is it solvent

Is it a going concern

Is it only worth in situ plant and equipment value

Does one of the parties have specific expertise

Is there any goodwill

Is business saleable

Small business – is the profit no more than the business owners

wage “Buying a job”

Maybe pertinent to just value plant and equipment

The valuation process

1. Understanding the business, its risks and industry

2. Selecting the relevant methodology

3. Determining the variables

4. Determine the result

5. Review the result

1. Understand the company’s business PORTER MODEL – introduced in 1980’s

Understanding the business, its risks and industry, including:

- Barriers to entry

- Quality of management

- Company’s competitive position Porters 5 forces

- Industry and outlook

- Competition

2. Select relevant methodology

Standalone value / value to acquirer

Methodologies: - DCF - Capitalisation multiples

Which methodology to use

Depends on information available and circumstances

Quite a number of issues are considered before determining

the methodology for valuation

Terms of premises occupancy can determine the appropriate method for valuing a business

E.g. If business is expected to have a limited life span business

should be valued by DCF method only

Types of methodologies1. Relative Capitalisation of Future Maintainable Earnings.

Aka Industry Peer Comparison. Apply an appropriate multiple to anticipated future earnings to derive a valuation.E.g.: EBITDA, EBIT, PE, multiples

2. Intrinsic Discounted Cash flow (DCF) approach.Involves the calculation of Net Present Value by applying a discount rate to projected cash flows.

3. Contingent Claims

Real Options. Views investment decisions as options which acknowledge the value of flexibility in businesses. Involves valuing growth/deferral/ abandonment options.

4. Others e.g. Industry-specific rules of thumb, asset value comparable sales method

Capitalisation multiples

Capitalisation Multiples: Surrogates for DCF Less reliable Capture growth and risk in multiple Requires comparable companies Issues with each method: - EBITDA (Earnings before interest tax depreciation and

amortisation) - EBITA (Earnings before interest tax amortisation) - EBIT (Earnings before interest tax) - PE

Discounted cash flow

DCF is theoretically the best methodology

However it is not always practical

Therefore it is mainly used for:

- Lumpy cash flows

- Start ups

- Resource projects

- Finite timeframes

Capitalisation multiples - Advantages

Easy to understand and extensively used in practice

Inputs (published financials, short-term forecast, comparable multiples) are widely available

Ability to benchmark against industry

Works well for stable established business

Capitalisation multiples - Drawbacks

Seen as less rigorous/simplistic

Inconsistency in accounting practices;

depreciation, amortisation, tax outstanding

Small sample size and sample reliability

Range of multiples are often wide and outliers

exists

Uneven cash flows – start-ups, and turnarounds

3. Determining the variables

DCF

- Discount rate / WACC (weighted average cost of

capital)

- Cash flow variables e.g. foreign exchange

Capitalisation multiples

- Earnings to be multiplied

- Earnings multiple based on comparable companies

Other detailed research

4. Determining the result

What is the result of the DCF of multiple valuation?

Sensitivities around key assumptions

5. Review the result

Cross check to other methodologies, i.e.

what multiples does the DCF valuation

provide?

Check for reasonableness

Stand back and look at result

- Does it make sense?

- Should the company be worth more or less?

- Do the assumptions need revision?

Selection of appropriate maintainable profits figure

“The selection of an appropriate maintainable profits figure is a

matter of judgment depending on the circumstances. For example,

a company may be in a position of short term decline, as a result of

industry pressures, or internal management problems.

In such a situation, it is important to adopt a longer term view so as

to discount any short term irregularities in the company’s

profitability.”

(Lonergan)

Intrinsic value established by capitalisation of future maintainable earnings (FME) method Quite common for small business operators not to prepare

estimates of future net cash flows Reasons for this include:

a) do not believe they can be reliably predictedb) simply do not have any idea about their future net cash flowc) not willing to incur the cost of professional assistance to prepare them

Method preferred by small business operators CAP FME method, an Earnings before Interest AFTER TAX

Capitalisation Rate is applied to expected FME

Criticisms of future maintainable earnings methodology

“Too many FMP based valuations are flawed in that they automatically employ historical profits as a proxy for FMP without undertaking sufficient critical examination of past performance and likely future events.An understanding of the future of a business is essential for an

accurate valuation, yet is omitted when historical profits are used in isolation.” Lonergan

Noted American valuation text author, Shannnon P. Pratt, also endorses that view:“There is a mind set that can be described as the ‘mechanistic mentality’, for lack of a better expression. It mechanically relies on past data, without considering whether adjustments should be made, or whether it is reasonable to expect future results to conform to past results.

Rules of thumb market value methods

Criticism is rules of thumb do not provide a real value of a business in terms of the earnings derived from the net assets employed

How does Business Valuer conduct process? Obtain last 3 - 5 years financials (tax returns preferable)

Review profit and loss for last 3 - 5 years

Establish whether future cash flow forecasts have been

undertaken and if so review same

Ascertain if owners wages have been paid and commercial

rent charged

Determine if any other applicable adjustments

Take into account inflation

Calculate adjusted net profit

Review assets and liabilities

Review Balance Sheet

Land and buildings – consult Property Valuer (not to be included

in net tangible assets calculation)

Plant & equipment/vehicles – obtain specialist valuer of plant and

equipment/vehicles

Stock – determine obsolete stock

Debtors – ascertain collectability

Review assets and liabilities

Work in progress – ascertain position

Directors loan accounts

Review other assets: and adjust for non business assets

- below market value

Review liabilities: - normally bank borrowings, (not to be included in net tangible

assets calculation) trade creditors, ATO payable

Have any assets been omitted?

Most obvious – Goodwill

May be patents or trademarks (intellectual

property)

Goodwill definition

The High Court of Australia provides a definition of Goodwill,

from a legal perspective: “For legal purposes, goodwill is the

attractive force that brings in custom and adds to the value of

the business. It may be site, personality, service, price or habit

that obtains custom.”

Valuing Goodwill or other tangible assets component of the value of a business

Whether business valued by DCF, CAP FME or combination DCF and terminal value method, value of goodwill or other intangible assets therein calculated by total value of business

Minus

The value of the tangible assets

How does Business Valuer conduct process?

Alternatively described as price earnings ratio method

i.e. A Price Earnings Ratio (PER) is applied to expected FME

to establish the value of the business so that:

e.g. A PER of 5 is equivalent to a Capitalisation rate of 20%

most small business PER 2-5 (i.e. Multiples of 2-5)

Applies multiplier

How does Business Valuer conduct process?

All Business Valuations, whether by the:

Discounted Future Net Cash Flows Method,

Capitalisation of Future Maintainable Profits Method,

or the Combination Discounted Future Net Cash Flows

and Terminal Value Method

should be based on After Tax Figures!

Calculation of Goodwill

E.g. Calculated FME to be $200,000 after adjustments

using a multiplier of say 4 (25%) $800,000

if tangible assets $700,000

liabilities $300,000

Net tangible assets $400,000

Goodwill $400,000

Continuing businesses with no Goodwill

Value of business may be less than the value of net tangible assets

Therefore no goodwill and value is tangible assets less value of liabilities

Businesses discontinuing or closing down

Value represented by value realised on disposal

Issues to take into consideration for Matrimonial Breakdown

Saleability of business

Age of respective parties (is retirement looming)

Succession planning

Parties particular skill set

Whether business will be continuing

Issues for Valuers

Can only use figures they have been provided with

Does not undertake an audit of the business

Difficulties re cash economy (cannot have your cake and eat it)

Important for valuer to clearly articulate their assumptions

Necessary to comply with Valuation Standard Apes 225 –

Valuation Services

Issues for Valuers - continued

Expert witness if appointed by court

their overriding duty is to assist court

Expert witness is not an advocate for a

party

Combine service trusts and other

entities

The application of retrospectivity for valuing the interests of an exiting equity holder Pertinent to divorce settlements where the interest of

one of the parties is to be transferred to the other party who will continue to conduct the business

Not a hypothetical sale of a business to a hypothetical seller

Interest not available for sale on open market

Interest – intrinsic value method

Rather, Profits derived, subsequent to the exiting date, which

may not be ascertainable, until some time later, may be

adopted as the Future Maintainable Profits of the Business, by

applying the principle expounded in Kizbeau’s case:

“Although the value is assessed, as at the date of the

acquisition, subsequent events may be looked at, in so far as

they illuminate the value of the thing, as at that date.”

Kizbeau Pty Ltd v W G B Pty Ltd McLean [1995] HCA 4; (1995) 69 ALJR 787; (1995) 131 ALR 363; (1995) 184 CLR 281 (11 October 1995)

[100%](From High Court of Australia; 11 October 1995; 50 KB)

Summary for Lawyers

1. Is a valuation required?

2. Establish clearly what is to be valued and instruct accordingly

3. Review methodology and assumptions used

4. If applicable query/challenge the valuation

Some incorrect assumptions or an overly generous

multiplier can have a significant effect on the end result for

your client

e.g. If multiplier should be 3 and 4 is used and entity

generated

$300,000 difference in the value is $300,000

Appendix 1

Factors Affecting a Business Valuation

Factors affecting a business valuation Business History Business Reputation Market Share Potential for growth Industry conditions Superiority Vulnerability Political and economic outlook Cash flow Management / staff competency Reliance / non-reliance on founder

Factors affecting a business valuation Production capacity (if applicable) Ability to increase revenues Cost competitiveness Ability to reduce costs Business’s use of technology Comparable businesses Comparable industries Product / service quality and competitiveness Encumbrances (if any) Assets for sale – their condition, their remaining useful

life

Factors affecting a business valuation Prevailing legal issues (if any) Ease of operation Attractiveness of the industry – competitive forces, power

of suppliers, power of customers, risk of new entrants and risk of substitutes

Rate of return Potential to improve customer relationships Ability to borrow against business or assets Performance results and ratios Location Presentation of premises

Factors affecting a business valuation Existing relationships with suppliers and customers Intellectual property Intangibles including relationships and contacts Goodwill Condition of books and records Computerisation Tax implications Alternative opportunities Affordability Working conditions (including hours and days) Property lease conditions and landlord

Please note that this is an incomplete list of just some of the factors that can influence the valuation of a business.