Rebuttal Reports & Critiquing Business Valuations
In disputes and litigation, expert witnesses sometimes help attorneys prepare for hearings by drafting technical deposition and trial questions. When a case involves a privately held company, a valuation expert often performs an appraisal and provides a report outlining his findings. As we’ve explained in a prior article, a valuation expert may also prepare a rebuttal report. These documents may be used to demonstrate flaws or discrepancies in the analysis of the opposing party’s expert or to clarify ambiguities when an appraiser must defend his own analysis to the court.
Being able to identify weaknesses or inconsistencies in a valuation expert’s report can be the key to winning a favorable verdict for your client. Be mindful of the business valuation flaws discussed below when assessing the admissibility of a valuation expert’s findings.
Incorrect Valuation Methodology
There are three generally accepted business valuation approaches: the income approach, the market approach, and the asset approach. Under each approach, appraisers must select the valuation method, or combination of methods, that best apply to the subject company based on various factors, including the purpose of the valuation, the nature of the business, its historical and expected future performance, and the availability of comparative data.
Each method has advantages and disadvantages and may provide different indications of value. Valuation experts sometimes apply methods that are inappropriate based on the unique characteristics of the subject company. For example, the discounted cash flow method is expected to provide a more accurate valuation if the subject company is in the growth stage—that is, if its earnings are expected to change significantly from year to year. However, if the company has demonstrated stability and its earnings are expected to grow at a steady rate moving forward, the capitalization of earnings method would likely provide a more reliable estimate.
Valuation standards suggest that appraisers should apply multiple methods under the various approaches. According to the Uniform Standards of Professional Appraisal Practice (USPAP), “an appraiser must reconcile the indications of value resulting from the various approaches to arrive at the value conclusion.” This means that valuation experts should use their professional experience and judgment to assign a weight to each method used in order to arrive at a final estimate of value. The appraiser’s failure to justify both the use of each selected method and the weighting it was given is a common weakness in valuation reports.
Making normalizing adjustments is a necessary step in the business valuation process because it ensures that the financial information used to determine value reflects the subject company’s true operating performance and future earnings capacity. Ultimately, normalization adjustments impact the benefit stream used to derive value. When critiquing a valuation report, the valuation expert should review each adjustment and verify that proper consideration was given to common adjustment areas such as the following:
- Owner compensation and perquisites
- Related party transactions
- Extraordinary or non-recurring income and expenses
- Tax-motivated accounting methods
Numerous errors can be made in regards to inaccurate or improper normalizing adjustments. For example, appraisers sometimes make incorrect assumptions surrounding the materiality of non-operating assets and liabilities and non-operating income and expenses. Additionally, appraisers may use incorrect market data related to owner compensation or rent expense. They may also fail to recognize industry norms related to accounting practices and make adjustments that result in flawed comparisons. Errors related to these adjustments produce unreliable valuation opinions.
A common flaw in valuation reports is the lack of a clear explanation and description of each adjustment. When reviewing a report, it is important to assess the reasonableness behind any adjustments and to verify the accuracy of the information used to derive them.
Inappropriate Benefit Stream
Under the income approach, the value of a business is based on the economic benefits that it is expected to generate in the future. In a valuation report, the appraiser must identify and clearly define the economic benefit, or “benefit stream,” used to develop the selected business valuation method. Benefit streams can be expressed in various ways, but valuation professionals generally use types of cash flows such as Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE) over types of earnings. This preference is based on the fact that cash flows take into consideration the balance sheet requirements of sustaining growth.
Different benefit streams can produce different values and appraisers may commit calculation errors when deriving a particular benefit stream, which results in inconsistencies. To understand how these errors are made, and to learn how to recognize inconsistent use of a benefit stream, consider the following example involving the differences between FCFF and FCFE:
Free Cash Flow to the Firm (FCFF)
Earnings Before Interest and Taxes * (1–Taxes) + Depreciation – Capex – ΔNet Working Capital
Free Cash Flow to Equity (FCFE)
Net Income Before Taxes * (1–Taxes) + Depreciation – Capex – ΔNet Working Capital + ΔDebt
The calculations shown above help demonstrate the differences between each type of cash flow. The major difference between the two is that FCFF represents the cash flow before interest and principal payments on debt—that is, cash available to both shareholders and debt holders. FCFE represents the value only of the equity, or in other words, the cash available to shareholders after accounting for all payments to debt holders. The value derived from discounting FCFF is the enterprise value, which is relevant in acquisitions because the buyer takes over the liabilities, debt, and equity of a firm. On the other hand, discounting FCFE will give the equity value of a company, which is appropriate when determining the value of a shareholder's equity interest.
Appraisers may forget to remove interest or may not adequately account for changes in debt when deriving FCFE. Conversely, the appraiser may remove interest, but incorrectly claim to be using FCFF as the benefit stream. This creates issues when applying discount and/or capitalization rates and produces an inaccurate value.
Incorrect Discount/Capitalization Rates
The income approach involves the application of discount and capitalization rates to arrive at the present value of a company’s future benefit stream. The discount rate represents an investor’s expected rate of return given a certain level of risk. The capitalization rate is the discount rate minus the expected long-term growth rate. Both components are often disputed in litigation because the process used to develop them requires the appraiser to make crucial judgments based on subjective information. Furthermore, the slightest errors can have a significant impact on final calculations. One of the most common errors is applying a discount rate that is inconsistent with the benefit stream.
When using FCFF, the appropriate discount rate is the firm’s weighted average cost of capital (WACC). When using FCFE, the appropriate discount rate is the firm’s cost of equity. Consider a situation in which the appraiser selects FCFF as the benefit stream and makes the mistake of capitalizing the earnings by the cost of equity (instead of WACC) less a long-term growth rate. In doing so, the appraiser derives a value for the equity of the company as if it did not carry any debt. Since most companies carry debt, the resulting value would be inaccurate.
Another common error is the over/understatement of a long-term growth rate, which can significantly impact the value of a company. The long-term growth rate should not exceed the rate of inflation plus GDP growth. Ideally, the growth rate will account for qualitative factors based on management input and industry outlook. Occasionally, an appraiser may not include a growth rate when capitalizing a benefit stream, thereby producing an inaccurate value.
When developing the discount rate, an appraiser may use the "buildup method," which involves summing various elements of risk, including an industry risk premium, a size risk premium, and a company-specific risk premium. An appraiser may rely on data studies to derive industry and size risk premiums to some degree, but determining a reasonable company-risk premium requires sound judgment and experience. This opens the door to one of the most common discount rate errors: double-counting risk factors.
Companies of a similar size often share similar characteristics, such as level of accessibility to capital resources, product diversification, and management depth. Companies in the same industry also often face many of the same risks, such as those relating to cyclicality, customer concentration, regulation, and capital structure. Therefore, many of these factors may already be reflected in size and industry risk premia. Double counting typically occurs when the appraiser fails to realize that certain factors that he believes are company-specific are actually size- or industry-specific and are already accounted for.
During a report review, an expert should review the methods used to develop the discount rate and the long-term growth rate. This includes not only checking the accuracy of the appraiser's mathematics, but also evaluating the parameters used to derive these rates for consistency and reasonableness. Furthermore, the expert should verify that the opposing party's appraiser gave proper consideration to risk factors related to items such as company size, market share, cyclicality, management capabilities, location, competition, customer base, suppliers, capital structure, and contingent liabilities.
Improper Application of Valuation Discounts
Discounts may be applied in business valuations involving a minority interest in a subject company. The discount for lack of control (DLOC) and discount for lack of marketability (DLOM) are sometimes applied improperly (or not at all) due to errors in judgment or the misuse of data used to derive the value of the discount. These discounts can have an enormous impact on the value of a company.
A common misstep in the application of valuation discounts relates to the business valuation method(s) selected by the appraiser. An appraiser may assume that both a DLOC and a DLOM are necessary because the interest being valued is a minority interest.. However, each valuation method will generate an indication of value on either a controlling or non-controlling basis, as well as, on either a marketable or non-marketable basis. Consequently, it would not make sense to apply a DLOC to a non-controlling value or a DLOM to a non-marketable value. The control/marketability characteristics of value determined under various valuation approaches is an area of much debate. Appraisers are responsible for clearly explaining their assumptions and reasoning behind the application of any discounts.
The magnitude of these discounts is impacted by factors unique to the company and interest being valued. Factors such as dividend paying capacity, likely timeframe to liquidity, restrictions on transferability, and stock redemption policies impact the degree of an interest’s marketability. In determining the amount of a DLOC, appraisers should consider that minority shareholders in some companies are afforded more rights than in others, which may indicate a higher degree of control. Failure to consider these factors will likely yield an inappropriate discount.
The appraiser must clearly define the qualitative and quantitative information used to derive these discounts. Additionally, the appraiser must justify any empirical data and knowledge used in determining whether a discount was required and the amount of that discount. Unfortunately, some appraisers fail to provide this information and simply offer subjective numbers without supporting information.
Preparing the Report
Reviewing experts must not only identify and describe the discrepancies being addressed, but also correct the errors through their own calculations. In doing so, the expert can provide any supporting evidence or data that may have been missing and show how this information can yield different estimates of value. Demonstrating this through a report will discredit the work of the opposing party's expert and also build the credibility of your case.
This article describes only a few common errors found in business valuations, but the flaws discussed involve concepts that are disputed frequently in litigation. Considering that a valuation expert may overlook these issues, it is helpful to have a general understanding of common valuation flaws as you prepare your case.