rotkowski - income approach issues - ipt nw tax seminar

August 4, 2016~Hillsboro, Oregon

Income Approach Issuesin Valuations Prepared for Property Tax Purposes

Aaron Rotkowski, CFA, ASA, CBAWillamette Management Associates

IPT Northwest Regional Property Tax Seminar


Disclaimers

• Opinions are my own, and do not necessarily represent the opinions of my firm

• All specific examples were selected because the companies are publicly traded and have abundant data available

• For some topics, I have purposely endeavored to use examples from companies or court cases that are not represented at this conference

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Topics Covered

1. Value of intangible assets within the income approach 2. Estimating a supportable long‐term growth rate 3. Assessing the reasonableness of market data in the

income approach4. Assessing the reasonableness of normalized

depreciation expense and capital expenditures5. Internal consistency of assumptions

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Hypothetical Company – ABC Construction Machinery Manufacturing (ABC)

• Manufactures bulldozers• Began operating in 1952• One manufacturing facility • Contract with supplier to purchase raw materials at

below‐market prices• Proprietary manufacturing process that results in cost

of goods sold (COGS) that are lower than the industry average COGS

• Taxing jurisdiction doesn’t tax intangible assets

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Income Statement

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$000

Revenue 100,000 Cost of Goods Sold (70,000)Gross Profit 30,000 Operating Expenses (20,000)Operating Income 10,000 Other Income/Expense 8,000 EBIT 18,000 Interest (5,000)EBT 13,000 Income Taxes 25%Net Income 10,000


ABC Cost of Capital and Growth

• Weighted Average Cost of Capital (WACC) of 12%• ABC management expects NCF growth of 4%*

– Inflationary growth of approximately 2%– Expected real growth of approximately 2%

* Nominal growth = (1 + inflation) * (1 + real growth) ‐ 1

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Direct Capitalization Method ‐ ABC

Net Operating Cash Flow $10 millionDirect Capitalization Rate ÷ 8%Income Approach Value Conclusion: $125 million

This value represents the value of the ABC total unit of operating assets—i.e., it represents the value of the ABC tangible assets and intangible assets.

Simplifying assumptions: (1) normalized depreciation and capital expenditures offset each other and (2) no working capital requirements are projected.

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Topic 1: Intangible Assets within the Income Approach

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Intangible Assets within the Income Approach

• The concluded value from the income approach often includes value attributable to the taxpayer’s intangible assets.

• Intangible assets contribute income (by increasing revenue or decreasing expenses)

• When the $10 million of ABC business enterprise value (BEV) income is capitalized, income from intangible assets is also capitalized

• If (1) intangible assets are not properly accounted for in the unit valuation analysis and (2) only tangible assets are subject to ad valorem property taxation, then the concluded value of taxable assets may be overstated

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August 4, 2016~Hillsboro, Oregon 10

According to Guide to Intangible Asset Valuation, for an economic phenomenon to qualify as an intangible asset, it should be (1) intangible and (2) it should be an asset.

To be intangible, the economic phenomenon should derive its value from the bundle of legal rights associated with the asset, and not from the its physical characteristics.

To be an asset, the economic phenomenon should be subject to private ownership.

Defining Intangible Assets


Tangible and Intangible Assets in the Taxpayer Capital Structure

• Intangible Asset Handbook: “50% to 90% or more of a company’s value and capital structure may be represented by intangible assets”

• If market‐to‐book ratio > 1, a portion of the value of the company may be derived from intangible assets

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Company / Index Market‐to‐Book Ratio

Implied Tangible Asset Value (percent

of total value)

Implied Intangible Asset Value (percent of

total value)

S&P 500 2.81 35.6% 64.4%

Apple Inc. 4.04 24.8% 75.2%

Caterpillar Inc. 2.85 35.1% 64.9%

MPLX LP 1.19 84.0% 16.0%


Representative Intangible Assets

• Trademarks and trade names• Customer relationships (contractual and

noncontractual)• Licenses and permits• Trade secrets and patents• Databases• Trained and assembled workforce• Computer software• Contractual relationships• Goodwill

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Income from Intangible Assets in ABC Income Statement

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$000

Revenue 100,000 Cost of Goods Sold (70,000) Gross Profit 30,000 Operating Expenses (20,000) Operating Income 10,000 Other Income/Expense 8,000 EBIT 18,000 Interest (5,000) EBT 13,000 Income Taxes 25%Net Income 10,000

$1,200 cost savings associated with trade secrets$800 cost savings associated with supplier contract

Includes the contributory value from l icenses and permits and trained and assembledworkforce


Intangible Asset Extraction Issues

Industrial and commercial property owners (and their advisors) should:• determine if the concluded unit value includes the value of

intangible assets• identify the intangible assets included in the property value• value the intangible assets• extract the value of the intangible assets from the concluded

unit valueOr use summation valuation

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• Direct subtraction method: the concluded value of the taxpayer intangible assets is subtracted from the concluded taxpayer unit value. The result is the value of the tangible assets only.

• Transfer price (income allocation) method:assumes an economic rent is charged to the taxpayer intangible assets; and that “capital charge” is subtracted from the total taxpayer income

Intangible Asset Extraction Procedures

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ABC– Intangible Assets in the Income Approach

Intangible Asset IA Valuation Method Indicated Value

Trade Secrets (proprietarymanufacturing process)

Income approach – Direct capitalization method

$17 million

Favorable Contract with Supplier

Income approach – Yield capitalization method

$7 million

Trained and Assembled Workforce

Cost approach – RCNLD* method $4 million

Licenses and Permits Cost approach – RCNLD method $2 million

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The value of the ABC intangible asset was estimated at $30 million, or 24 percent of the total ABC unit value.

*RCNLD = Replacement Cost New Less Depreciation


Direct Subtraction Method Example

ABC Unit Value $125 million

‐ ABC Total IA Value ‐ $30 million

= Value of ABC Tangible Assets $95 million


Transfer Price Method Example

Cash Flow from Favorable Contract & Trade Secret $2,000

= Value of ABC Trained and Assembled Workforce and License/Permits $6,000

× Fair Rate of Return on ABC TAWF & Licenses/Permits 12%

= Annual “Capital Charge” (Cash Flow) for TAWF & Licenses/Permits $720

Concluded ABC Total Cash Flow $10,000

‐ Cash Flow from Favorable Contract & Trade Secret ($2,000)

‐ Fair Rate of Return on ABC TAWF & Licenses/Permits ($720)

= Cash Flow from ABC Tangible Assets Only $7,280

÷ Tangible Asset Direct Capitalization Rate 8%

= Concluded Value of ABC Tangible Assets $91,000


Topic 2 ‐ Estimating a Supportable Long‐Term Growth Rate

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Value Sensitivity in Direct Capitalization Method

The concluded value is very sensitive to the selected LTG rate

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Terminal Cash Flow ($millions) 10.0 10.0 10.0 10.0 10.0÷ Direct Capitalization Rate 6% 7% 8% 9% 10%= Terminal Value 167 143 125 111 100

Difference from 8% 33% 14% 0% ‐11% ‐20%Cap. Rate Assumption

Terminal Value Based onAlternative Direct Cap Rates


Terminal Value in Yield Capitalization

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Discrete Period Cash Flow ($millions): Period 1 2 3 4 5 Cash Flow 10.0 10.5 11.0 11.5 12.0Present Value Factor ‐ 12.0% WACC 0.8929 0.7972 0.7118 0.6355 0.5674 PV of Cash Flow 8.9 8.4 7.8 7.3 6.8

Terminal Value: Terminal Period Cash Flow 12.5 ÷ Direct Capitalization Rate 8% = Terminal Value 156.3 × Present Value Factor 0.5674 = Present Value of Terminal Value 88.7

PV of Discrete Period CF 39.2PV of Terminal Value 88.7Concluded Unit Value, Rounded 127.9

(30% of total) (70% of total)

Assumptions: WACC = 12.0% Growth Rate = 4.0%


What Is (Isn’t) Growing

• Growth relates to the measure of BEV income that is subject to the direct cap or yield cap analysis (i.e., the BEV income that is capitalized)

• Growth does not necessarily relate to revenue, historical growth, or near‐term projected growth

• Net income, cash flow, or some other measure?• Growth of tangible assets vs. intangible assets• One common assumption is that the net cash flow is equal

to net operating income (NOI), which assumes that depreciation expense is equal to capital expenditures (Topic 4).

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PV of Cash Flow in Years 1 through 20

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Specific Source of Growth

• Economy Growth• Industry Growth• Company‐Specific Factors

– Increasing Prices– New Products– Acquisitions & Joint Ventures

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Growth from Economic Factors

• Ibbotson SBBI Valuation Yearbook: “An example of an indefinitely sustainable growth rate is the expected long‐run growth rate of the economy.”

• “Generally, once an industry has matured, a company will grow at a steady rate that is roughly equal to the rate of nominal GDP growth.” Global GT v. Golden Telecom

• “The rate of inflation is the floor for a terminal value estimate for a solidly profitable company that does not have an identifiable risk of insolvency.” Global GT v. Golden Telecom

• “There also is considerable precedent in Delaware for adopting a terminal growth rate that is a premium, such as 100 basis points, over inflation.” Nathan Owen v. Energy Services, Inc.

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Historical Economic Growth

Min: ‐2.0%Average: 6.5%Max: 15.7%2015: 3.5%


Projected Economic Growth

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• Projected compound annual growth rates, next 10 years, according to the June 2016 Livingston Survey:– Inflation: 2.2%– Real GDP growth: 2.3%– Nominal GDP growth: 4.6%– Nominal GDP growth calculation:

((1.022)×(1.023))−1

Projected Nominal GDP Growth

DateReal

InflationNominal GDPGDP

16‐Jun 2.2 2.3 4.615‐Jun 2.5 2.2 4.814‐Jun 2.5 2.4 4.913‐Jun 2.6 2.5 5.212‐Jun 2.7 2.4 5.211‐Jun 2.7 2.4 5.210‐Jun 2.9 2.5 5.509‐Jun 2.7 2.4 5.208‐Jun 2.8 2.5 5.407‐Jun 3.0 2.4 5.506‐Jun 3.2 2.4 5.705‐Jun 3.3 2.5 5.9


Growth from Industry Factors

• An industry analysis is also important in the selection of a LTG rate

• Understand which economic factors affect the company outlook, and find projections for those factors

• Industry‐specific trade organizations and other market research firms publish data regarding industry growth rates

• Consider both real and nominal economic growth and if the subject company is expected to grow faster, slower, or similar to the growth of the U.S. economy

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Global GT v. Golden Telecom

• The court considered:– Russia projected inflation– Russia projected real GDP growth– Historical U.S. growth of telecom industry relative to U.S. economy– Stage of telecom industry in Russia

• The Point: The court considered growth in the overall economy and projected industry growth

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Company Growth Exceeding the Growth of the U.S. Economy

• NYU Finance Professor Aswath Damodaran writes:“Since no firm can grow forever at a rate greater than economy in which it operates, the constant growth rate cannot be greater than the overall growth rate of the economy.”

• In Merion Capital v. 3M Cogent, the court said:But, a terminal growth rate should not be greater than the nominal growth rate for the United States economy, because “[i]f a company is assumed to grow at a higher rate indefinitely, its cash flow would eventually exceed America's [gross national product].”

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Fast Growth Example

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• Even after 100 years of growth (8.0%) that exceeds the U.S. economy (6.5%), a company with a value of $125 million is still insignificant relative to the U.S. Gross Domestic Product

• U.S. GNP will equal $10.1 quadrillion after 100 years of 6.5% annual growth (6.5% = CAGR of GDP between 1948 and 2015)

Value Growth Value after X Number of Years($millions) Rate 5 25 50 100

ABC Company 125.0 8% 184 856 5,863 274,970ABC Company 125.0 20% 311 11,925 1,137,555 10,352,246,815

U.S. GNP 17,947,000 6.5% 24,629,385 87,357,541 425,215,354 10,074,558,266


Company‐Specific Factors

• Understand the story– ABC is operating facility at maximum production– ABC only offers one product line

• It may not be appropriate to use the same LTG rate for all companies in an industry

• Growth can come from– existing assets, both tangible & intangible– new products or services– acquisitions & JVs– capital expenditures – new intangible asset development

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Growth of Tangible Assets vs. Intangible Assets

• Tangible property depreciates• If the goal of an assignment is to value the tangible

property in place on the assessment date and positive growth is forecast, this may suggest the presence of intangible assets

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Topic 3 ‐ Assessing the Reasonableness of Market Data

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The Use of Market Data in the Income Approach

• Discount rate:– Equity risk premium– Industry risk premium– Small stock risk premium– Beta– Capital structure

• Working capital requirements• Normalizing adjustments• Control and marketability premiums/discounts

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Potential Errors Related to the use of Market Data in the Income Approach

• There are a variety of potential errors from the use of market data (and, specifically, guideline publicly traded companies, or GPTCs) in an income approach analysis.

• These errors are related to differences between the subject taxpayer and GPTCs in terms of:1. expected growth 2. marketability3. control over the underlying equity/assets4. intangible assets5. Risk of the subject property

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The Acorn or the Oak Tree

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Day 0After 200 to 300 years


Exit Multiples in Income Approach

• Use of exit pricing multiples results in a market approach (or at best a hybrid income/market approach)

• Analysts cannot avoid estimating growth by using exit pricing multiples in the terminal value

• A capitalization rate is an inverse of a pricing multiple– i.e., a 20x P/E multiple = 5% direct capitalization rate

• Pricing multiples are based on the same factors that are considered in the direct cap rate, including risk & growth

• These same issues affect the pricing multiple selection in the market approach

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P/E Multiples Example

VariableCaterpillar

Inc.Cummins

IncDeere &

CoKomatsu

LtdOshkosh Corp

Trailing P/E Multiple 11.6x 9.8x 13.2x 12.3x 13.5x

Implied Direct Cap Rate for NI 8.7% 10.2% 7.6% 8.1% 7.4%

Company Cost of Equity per Bloomberg 11.2% 9.5% 8.7% 10.1% 11.3%

Implied LTG Rate 2.5% ‐0.7% 1.1% 2.0% 3.9%

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• Many state cap rate studies calculate direct capitalization rates as the inverse of P/E pricing multiples

• Those P/E pricing multiples include assumptions about risk and growth


Security Analysts’ Growth Rates

• Projections include growth from (1) intangible assets and (2) assets not in existence as of the valuation date– The market values the oak tree, but our task is usually to value the acorn

• For these companies, real growth may come from forecast decrease in input costs, increased manufacturing capabilities, construction of new facilities, and other similar factors

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Academic Study of Analysts’ Growth Rates

• Results of a study of 2,900 publicly traded companies:1– Analysts are actively selecting company‐specific growth rates – Actual median real growth rate (3.5%) corresponds closely to real GDP

growth (3.4%)– The past is a poor predictor of the future– Analysts are overly optimistic– Informative only over short time horizons– Stock valuations do not accurately correspond to future growth– Absence of predictability

1 = “The Level and Persistence of Growth Rates,” by Lous K.C. Chan, Jason Karceski, and Josef Lakonishok, Journal of Finance, Vol. LVIII, No. 2, April 2003.

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Control

• The owner of operating assets will have operational control of these assets, while the owner of stock in a publicly traded company will not have control of the company operations

• Remedies:– Increase valuation pricing multiple– Decrease the direct capitalization rate– Increase the implied security price of the operating assets

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Marketability

• Operating assets are less marketable than comparable publicly traded securities

• Consider the process of selling ABC’s bulldozer manufacturing equipment vs. the process of selling a share of stock in Caterpillar, Inc.

• Investors will accept a discount for lack of marketability to compensate for:– The longer time involved in selling illiquid investments– The higher cost involved in selling illiquid investments

• Remedies:– Decrease valuation pricing multiple– Increase the direct capitalization rate– Decrease the implied security price of the operating assets

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Risk and Return

• Taxpayer assets have different risk and return characteristics than publicly traded securities

• Some of these reasons were just discussed: – Expected growth – Control– Marketability

• Other factors include: – Size– Geographic diversification– Product diversification– Reliance on key customers/suppliers– Others

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Topic 4 ‐ Assessing the Reasonableness of the Normalized Depreciation and Capital Expenditures

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Application by Analysts

• When asked whether depreciation expense should equal capital expenditures in growth model, in 2012:– 44 percent said yes– 29 percent said no– 27 percent said it should depend on company growth and inflation.

• When asked how they typically treat capital expenditures and deprecation expense when estimating cash flow, in 2013:– 68 percent said they made them equal or close to equal– 4 percent estimated capital expenditures < depreciation– 28 percent estimated capital expenditures > depreciation

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Growth Rate and Capital Expenditures

• If a company consistently had equal capital expenditures and depreciation expense, net fixed assets would remain unchanged.– If earnings increase & net fixed assets remain constant, ROA would continuously increase

• Projected capital expenditures should reflect the expected LTG

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• Direct capitalization method assuming depreciation = capex

• Is this a nonsensical table?

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Terminal Value in Direct Capitalization Method, Revised


Difference from 8% 33% 14% 0% ‐11% ‐20%Cap. Rate Assumption

Terminal Value Based onAlternative Direct Cap Rates


Consideration of Reinvestment

• Method #1: Capital expenditures = depreciation expense– Accepted by many courts & widely used in practice– Over long enough time horizon, depreciation expense and capital expenditures will be equal

• Method #2: Capital expenditures > depreciation expense– May be appropriate if the selected LTG rate > inflation– Plowback ratio: Reinvested CF required to achieve growth– Theory: If real growth exists, the plowback ratio > 0%– Theory: If the plowback ratio > 0%, then capex > depr.

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Calculating Capital Expenditures and Depreciation Expense

• Capital Expenditures = Initial Capex × (1 + LTG)^Life• Depr. Expense = FV(LTG, Life, (Capex ÷ Life))×(1 + (LTG ÷ 2))• Where:

– FV = future value– Initial Capex = normalized capital expenditures– Life = depreciable life of the property, plant, and equipment– LTG = long‐term growth rate of cash flow

• The ratio of normalized depreciation expense and capital expenditures is based on the results of these two formulas

• Source: James R. Hitchner, Shannon P. Pratt, and Jay E. Fishman, A Consensus View, Q&A Guide to Financial Valuation (New Jersey: Valuation Products and Services, 2016), 18‐23.

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ABC Capital Expenditures and Depr. Expense

• Inputs:– Initial cap ex: $4.0 million– Life of assets: 10 years– LTG: 4.0%

• Calculated capital expenditures: $5.9 million• Depreciation expense: $4.9 million• Depreciation expense is equal to 82.7% of capital expenditures in

perpetuity in order to sustain growth of 4.0%.

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Net Income 10.0

‐ Capital Expenditures (4.0)

+ Depreciation Expense 3.3

= Net Operating Cash Flow 9.3


Revised Terminal Value Example

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Terminal Values

Terminal Values Considering Reinvestment


Unadjusted Terminal Cash Flow 10.0 10.0 10.0 10.0 10.0Estimated LTG Rate 6% 5% 4% 3% 2%

Adjusted Terminal Cash Flow 9.0 9.2 9.3 9.5 9.6÷ Direct Capitalization Rate 6.0% 7.0% 8.0% 9.0% 10.0%= Terminal Value 150.5 130.9 116.4 105.1 96.3

Difference in Terminal Values ‐9.7% ‐8.3% ‐6.9% ‐5.4% ‐3.7%


Other Factors Impacting Depreciation and Capital Expenditures

• Capital expenditures and depreciation expense will be closer to each other when:– Inflation is lower– Assets have shorter depreciable lives

• The selected depreciation method related to the acquired assets impacts the difference between depreciation expense and capital expenditures.

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Topic 5‐ Internal Consistency in the Income Approach

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Internal Consistency in the Income Approach

• Exclude intangible assets from the unit value if such assets aren’t subject to ad valorem property taxation

• The selected LTG rate should match the income that is capitalized

• The capitalized income should reflect the selected LTG rate• The use of unadjusted market data typically results in unit

value that include intangible assets (including assets not in place on the assessment date)

• The use of unadjusted market data reflects marketable, noncontrolling securities, which is not the valuation subject

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Key Points

1. Value of intangible assets within the income approach 2. Estimating a supportable long‐term growth rate 3. Assessing the reasonableness of market data4. Assessing the reasonableness of the normalized

depreciation and capital expenditures5. Internal consistency of assumptions

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Questions and Discussion

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Aaron Rotkowski, CFA, ASA, CBAWillamette Management Associates

Vice President and Leader of Property Tax Valuation Services Practice(503) 243‐7522

[email protected]

rotkowski - income approach issues - ipt nw tax seminar

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