MARKET EVIDENCE IN BUSINESS VALUATION

A Practical Guide to Using Market Evidence to Value a Business

In Partnership With

New York Law Journal Seminar Series

Jeffrey L. Baliban Partner, Citrin Cooperman

Gregory Horowitz Partner, Kramer Levin

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MARKET EVIDENCE IN BUSINESS VALUATION

The Market Approach Methodology

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Fair Market Value—Revenue Ruling 59/60

The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.

See also United States v Cartwright, 411 U.S. 546 (1973)

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Fair Market Value—Revenue Ruling 59/60

The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.

Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property. (Emphasis added)

Investment Vs Intrinsic Value

• Investment value – reflects a subjective relationship between a particular investment and a given investor.

• Intrinsic value – analytic judgment of value based on the perceived characteristics inherent in the investment.

Johnson & Johnson v GuidantResCap

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Fair Market Value—SSVS-1

The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.

The Business Lawyer Debate

• Michael Schwartz & David Bryan, Campbell, Iridium, and the Future of Valuation Litigation, 67 Bus. Lawyer 939 (Aug. 2012)

• Robert Stark, Anders Maxwell & Jack Williams, Market Evidence, Expert Opinion, and the Adjudicated Value of Distressed Businesses, 68 Bus. Lawyer 1039 (Aug. 2013)

• Gregory Horowitz, A Further Comment on the Complexities of Market

Evidence in Valuation Litigation, 68 Bus. Lawyer 1071 (Aug. 2013):

Definition of Market Evidence

• My definition: The use of actual transactions to draw reasoned conclusions as to the value of a target asset.

• Usually but not always transactions in an asset other than the target.• Can include transactions in claims of the target.• Occasionally includes total enterprise transactions for the target itself – e.g.,

Johnson & Johnson v. Guidant; In re Boston Generating LLC, 440 B.R. 302 (Bankr. S.D.N.Y. 2010)

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General Valuation Approaches for Operating Companies

• Income approach• Guideline public company (“GPC”) approach• Guideline merged and acquired company (“M&A transactions”) approach

Published standards typically require business valuation analysts to consider all three approaches

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Disparate Results

Approach Results

Income $10,000,000

GPC $6,865,000

M&A transactions $4,500,000

Average $7,121,667

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Disparate Results

Approach Results Weights Value

Income $10,000,000 60% $6,000,000

GPC $6,865,000 30% $2,059,500

M&A transactions $4,500,000 10% $450,000

AverageWeighted average

$7,121,667$8,509,500

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Factors to Consider Per Revenue Ruling 59/60

• Have to understand the markets in which the subject business operates as well as have a considerable insight into how the business itself operates.

Nature of the business Economic outlook Book value & financial condition Earning capacity, dividend-paying capacity Goodwill or intangible value Previous sales of shares Market price of comparable companies

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Factors to Consider—SSVS-1

• Statement on Standards of Valuation Services adds several other factors

• The valuation expert’s workpapers and report should reflect what s/he did with respect to analysis of these factors

THE MARKET APPROACH METHODOLOGY

GPC & M&A Transactions Approaches

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Market Approach Methodology

• Calculate price multiples A valuation multiple is usually a multiple computed by dividing the price of the guideline

company’s stock by some relevant economic variable (Pratt, Valuing a Business, Fifth ed, 2008)

• Analyze the fundamentals of the subject company• Search for and choose comparable companies

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Pricing Multiples

• Price-to-Revenues• Price-to-Earnings before interest, taxes, depreciation, and amortization

(EBITDA)• Price-to-Earnings before interest and taxes (EBIT)• Price-to-Earnings before interest, taxes, depreciation, amortization and rental

costs (EBITDAR)• Price-to Net cash flow to invested capital• Industry specific metrics

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Factors To Determine Comparability

• Nature of the business;• Economic outlook;• Book value & financial condition;• Earning capacity, dividend-paying

capacity;• Goodwill or intangible value; • Previous sales of shares;• Market price of comparable companies;• Facilities;• Organizational structure;• Management team (which may include

officers, directors, and key employees);

• Classes of equity ownership interests and rights;

• Products or services (or both);• Economic environment;• Geographical markets;• Industry markets;• Key customers and suppliers• Competition;• Business risks;• Strategy and future plans; and• The governmental or regulatory

environment

Financial Condition of Subject Company— Key Financial Ratios

Liquidity Solvency

Activity Profitability

Current AssetsCurrent Liabilities

Net Current AssetsCurrent Liabilities

Short-term DebtTotal Debt

Short-term DebtEquity

DebtEquity

DebtTotal Assets

SalesInventory

Accounts ReceivableAverage Daily Sales

Operating ProfitTotal Assets

Operating ProfitEquity

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Where to find guideline public companies

• Lots of companies on traded exchanges• Lots of data on these companies• SEC filings• EDGAR• Compustat• Thompson Reuters

Public stock data typically represents marketable minority interest level of value.

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NAICS Codes

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NAICS Code Detail

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Levels of Value

Marketable minority interest

Marketable controlling interest

Non-marketable minority interest

Non-marketable controlling interest

Levels of Value

Control value

Marketable Minority Value

Nonmarketable Minority Value

Control premium Minority interest discount

Marketability discount

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Guideline Merged and Acquired Companies

• Historical transactions of actual businesses• Advantages• Disadvantages

This data represents control level of value, and may be marketable (if publicly traded) or non-marketable (if transaction is between privately held companies)

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Choosing Guideline Companies

• Size• Historical growth rates• Activity and other ratios• Profitability & cash flow• Profit margins• Capital structure• Other value drivers and metrics

Financial Condition Of Company—Key Financial Ratios

Liquidity Solvency

Activity Profitability

Current AssetsCurrent Liabilities

Net Current AssetsCurrent Liabilities

Short-term DebtTotal Debt

Short-term DebtEquity

DebtEquity

DebtTotal Assets

SalesInventory

Accounts ReceivableAverage Daily Sales

Operating ProfitTotal Assets

Operating ProfitEquity

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If The Guidelines Don’t Fit…

• Normalization adjustments:For ownership characteristics (control vs minority)For GAAP differences, extraordinary and nonrecurring or unusual itemsFor non-operating assets and related income & expenseFor taxesFor synergies from mergers and acquisition

Market evidence in income approach

• Data used in discount rates• Capital structure assumptions• Terminal values based on multiples

Discount Rate

Basic Capital Asset Pricing Model Discount Rate

ERi = Rf + β(Rm – Rf) + RPs + RPu

Where:ERi = Expected rate of return on the asset being valuedRf = Risk-free rate of returnβ = Beta or systematic risk(Rm – Rf) = Equity risk premiumRPs = Risk premium for sizeRPu = Unsystematic (company-specific) risk

Summary So Far…

• Market evidence of value is as strong as the degree of comparability between the subject company and the guideline companies;

• Identify assumptions and uses of expert’s judgment;• Thoroughly explore bases of guideline company choices (what he/she picked

and what he/she discarded;• Understand the nature and amount of adjustments made to financial

statements of both guideline companies and the subject company in order to reach comparability

• Multiple(s) selected; and• Comparison with other valuation methodology results

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Definition of Intrinsic Value

• “We believe that every asset has an intrinsic value and we try to estimate that intrinsic value by looking at an asset’s fundamentals. What is intrinsic value? Consider it the value that would be attached to an asset by an all-knowing analyst with access to all information available right now and a perfect [DCF] valuation model.” Aswath Damodoran, Damodoran on Valuation, at 10 (2d ed. 2006).

Relationship Between Fair Market Value and Intrinsic Value

• Efficient Market Hypothesis (strong version) holds that in an efficient marketplace there should be no difference: securities prices will perfectly impound and reflect all material information

• Courts relying on market evidence often cite EMH and find the existence of an efficient market as a predicate

• When one needs to discount market evidence, authorities may be found to question validity of the EMH, either for the period in question or in general

Do You Need to Show an Efficient Market to Rely on Market Evidence?

• Common misconception based on misreading of Basic, Inc. v. Levinson, 485 U.S. 224 (1988)

• Basic merely stands for proposition that an efficient market is necessary to “fraud on the market” presumption of class-wide reliance

• While FMV conditions must be met for market evidence to be reliable, this does not require the existence of a liquid market with any threshold of trading volume, etc. (Cammer Factors)

• So long as FMV conditions are met, even a single trade can be strong evidence

Schizophrenic Judicial Attitudes Towards Market Evidence

Courts can love market evidence:• Bank of America Nat’l Trust and Savings Ass’n v. 203 North LaSalle Street

Partnership, 526 U.S. 434 (1999): Requiring market test for new value plans.• VFB LLC v. Campbell Soup Co., 482 F.3d 624, 634 (3d Cir. 2007): Using

market evidence to find solvency. • In re Iridium Operating, LLC,, 373 B.R. 283, 291 (Bankr. S.D.N.Y. 2007):

Using market evidence to find solvency.• In re TOUSA, Inc., 422 B.R. 783 (Bankr, S.D. Fla 2009): Using market

evidence tom find insolvency.

Schizophrenic Judicial Attitudes Towards Market Evidence

Courts can distrust market evidence• Till v. SCS Credit Corp., 541 U.S. 465, 477 (2004): rejects market approach

to cram-down rates.• In re Emerging Commc’ns, Inc. S’holders litig., 2004 Del. Ch. LEXIS 70, at

*83-84 (May 3, 2004) (Del. S. Ct. Justice Jacobs sitting by designation): Market price not always indicative of value.  

• In re Spansion, Inc., 426 B.R. 114, 130 (D. Del. 2010): rejecting trading price for debtor claims as evidence of value.

• LaSalle Talman Bank, F.S.B. v United States, 45 Fed. Cl. 64, 81-82 (1999): rejecting market approach to contract damages.

Situations Where FMV is Not the Controlling Standard

• Dissenting shareholder appraisal rights and minority oppression actions • State “fair value” standards often exclude discounts for minority interest, lack

of control, illiquidity, key person.• Bankruptcy “best interests” valuation – hypothetical liquidation value• Bankruptcy adequate protection valuations – basis for petition date valuation

is debatable• Breach of contract cases, potentially -- Guidant

Situations Where Market Evidence Can Be Discounted or Ignored

• Generally, where FMV conditions can be disproven:• False or misleading information• Lack of material information• “Fire sale” transactions• Possibly, existence of material facts nobody knew about.

Official Committee of Asbestos Personal Injury Claimants et al. v. Sealed Air Corporation, et al. (In re W.R. Grace), 281 B.R. 852 (D. Del. 2002): Court found insolvency for FC purposes based on yet-to-be-discovered asbestos injuries.

• Market manipulation (note transactions may technically satisfy FMV conditions)

• Market “inefficiencies” – e.g., boom or bust cycles

QUESTIONS & ANSWERS

Presenter Contact Information

Jeffrey Baliban, PartnerCITRIN COOPERMAN & COMPANY212-697-1000 x6303529 Fifth AvenueNew York, NY 10017(347) 505-6303jbaliban@citrincoopermna.com

Gregory Horowitz, PartnerKRAMER LEVIN NAFTALIS & FRANKEL LLP1177 Avenue of the AmericasNew York, NY 10036(212) 715-9571ghorowitz@kramerlevin.com