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Financial Valuation Workbook
By James R. Hitchner Michael J. Mard John Wiley & Sons
ISBN: 0-471-22083-3
Chapter One
Valuation Case Study Exercises
INTRODUCTION
The purpose of this chapter is to highlight and discuss important concepts in valuation through a series of exercises. These exercises have been intermittently placed in excerpts of a valuation report. You should attempt to complete these exercises as you read the report with reasoning and emphasis on an explanation of your conclusion. The authors' solutions to these exercises can be found in Chapter 2.
The following case presents selected excerpts from a business valuation report that, in its entirety, was in full compliance with the Uniform Standards of Professional Appraisal Practice. This report format is one of many that analysts can use in presenting business valuations. All schedules have been omitted as they are not necessary for the exercises. Some of the terms, numbers, sources, and other data have been changed for ease of presentation.
THE VALUATION REPORT
August 20, 2000
Mr. Tom Profit LEGGO Construction, Inc. 123 Builders Drive Anycity, Anystate 54321
Dear Mr. Profit:
The object of this valuation report is to estimate the fair market value of 100% of the common stock in LEGGO Construction, Inc. (LEGGO or the Company), on a nonmarketable, control interest basis, as of December 31, 1999, for management purposes and internal planning.
In our opinion, the fairmarket value of 100% of the common stock in LEGGO, on a nonmarketable, control interest basis, as of December 31, 1999, for management purposes, is (rounded):
FIVE MILLION EIGHT HUNDRED THOUSAND DOLLARS $5,800,000
The standard of value used in this appraisal report is fair market value. Fair market value is:
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.
Valuation is based on relevant facts, elements of common sense, informed judgment, and reasonableness. Our scope was unrestricted and our methodology and analysis complied with the Uniform Standards of Professional Appraisal Practice. In addition, this valuation report and the values determined herein cannot be utilized or relied on for any purpose other than for internal management planning.
The enclosed narrative valuation report, as well as all documents and schedules in our files, constitute the basis on which our opinion of fair market value was determined. Statements of fact contained in this valuation report are, to the best of our knowledge and belief, true and correct. In the event that facts or other representations relied on in the attached valuation report are revised or otherwise changed, our opinion as to the fair market value of the common stock of the Company may require updating. However, Valking LLP has no obligation to update our opinion of the fair market value of the common stock of the Company for information that comes to our attention after the date of this report.
No partner or employee of Valking LLP has any current or contemplated future interest in the Company or any other interest that might tend to prevent them from making a fair and unbiased opinion of fair market value. Compensation to Valking LLP is not contingent on the opinions or conclusions reached in this valuation report.
We wish to express our appreciation to you and the management of the Company for your cooperation in making available to us financial data and other pertinent information necessary for the preparation of the report.
Very truly yours,
Valking LLP Val Dude, CPA/ABV, ASA, CBA, CVA
INTRODUCTION
Description of the Assignment
Valking LLP was retained by Mr. Tom Profit to determine the fair market value of 100% of the common stock in LEGGO Construction, Inc. (LEGGO or the Company) on a nonmarketable, control interest basis, as of December 31, 1999, for management purposes.
Summary Description and Brief History of the Company
The Company was incorporated in 1978 in the state of Anystate. The Company is a closely held subcontractor whose revenues are predominantly earned from sewer and water-line construction, primarily in central Anystate. The Company's customers generally consist of area contractors, developers, and local governments. The Company is now legally structured as an S corporation.
The Company obtains most of its business through bidding competitively with general contractors. Management believes that customers contract with the Company due to its solid reputation and competitive bids; its customers have remained loyal. The two largest customers are XYZ General Contractors and the city of Anycity.
Employee relations have been harmonious with minimal turnover. All employees of the Company are unionized with the exception of several office workers. Currently, the economic climates in the market and industry are good. The Company has six competitors that are similar in size and nature.
Ownership and Capital Structure of the Company
The Company is legally structured as a closely held S corporation. As of the date of valuation, there were 5,000 shares of common stock outstanding, structured as follows:
Standard of Value
The standard of value used in this report is fair market value. Fair market value is defined as:
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.
Among other factors, this valuation report considers elements of appraisal listed in the Internal Revenue Service's Revenue Ruling 59-60, which "outline[s] and review[s] in general the approach, methods, and factors to be considered in valuing shares of the capital stock of closely held corporations." Specifically, Revenue Ruling 59-60 states that the following factors should be carefully considered in a valuation of closely held stock:
1. The nature of the business and history of the enterprise from its inception. The Company was incorporated in 1975. It is engaged primarily as a sewage and water-line subcontractor. The Company has grown since its inception, and its customers have remained loyal.
2. The economic outlook in general and condition and outlook of the specific industry in particular. The consideration of the economic outlook on a national level, as well as on a regional and local level, is important in performing a valuation. How the economy is performing has a bearing in part on how the Company performs. Overall, the Company outlook is positive. 3. The book value of the stock and the financial condition of the business. The Company has a relatively strong balance sheet with a majority of its assets in three categories: cash, contract receivables, and fixed assets. The fixed assets consist primarily of construction equipment and vehicles.
4. The earning capacity of the company. The Company's compound growth rate in revenues from 1995 to 1999 was approximately 5%. The Company has demonstrated a good ability to generate profits.
5. The dividend-paying capacity of the company. The Company has made distributions equal to the amount of the shareholders' respective tax liabilities in the recent past and will likely continue this trend into the future.
6. Whether the enterprise has goodwill or other intangible value. It is generally acknowledged that goodwill is often measured by the earnings ability of an enterprise being valued. Goodwill can be broadly defined as characteristics that induce customers to continue to do business with the Company and to attract new customers.
7. Sales of the stock and size of the block to be valued. There have been no sales of stock of the Company that would provide an indication of value during the period being analyzed.
8. The market prices of stock of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over the counter. The market approach was considered in this valuation. A search for guideline companies that are similar in nature and size to the Company was performed.
Sources of Information
Sources of information used in this appraisal include:
1. Audited financial statements for the years ended March 31, 1995 through December 31, 1999
2. Stocks, Bonds, Bills, and Inflation, 1999 Yearbook, published by Ibbotson Associates
3. The Federal Reserve Bank for the 20-year maturity rate on 30-year bonds as of December 31, 1999
4. 1996-1999/2000 editions of Benchmark Statistics and Ratios (fictitious)
5. The National Economic Review, published by Mercer Capital Management, Inc., for the fourth quarter of 1999
6. The Beige Book published by the Federal Reserve Bank as of December 8, 1999
7. xls.com web site for public company information
8. hoovers.com web site for public company information
9. Pratt's Stats Online Comparable Transactions Database
10. IBA Comparable Transactions Database
Valking LLP has relied on these sources, but has not provided attest services in regard to any of the sources. Val Dude, a financial analyst with Valking LLP interviewed management of the Company.
NATIONAL ECONOMIC OUTLOOK
In conjunction with the preparation of our opinion of fair market value, we have reviewed and analyzed the economic conditions as of December 31, 1999, the date of valuation. This report includes summary discussions and analysis of the national economy for the fourth quarter of 1999. These discussions are based on a review of current economic statistics, articles in the financial press, and economic reviews found in current business periodicals. The purpose of the review is to provide a representative "consensus" review of the condition of the national economy and its general outlook at the end of the fourth quarter of 1999.
General Economic Overview
According to preliminary estimates released by the Department of Commerce's Bureau of Economic Analysis (BEA) real Gross Domestic Product (GDP), the output of goods and services produced by labor and property located in the United States, increased at an annualized rate of 5.8% during the fourth quarter of 1999. Revised growth in GDP for the third quarter of 1999 was 5.7%, which is higher than the preliminary estimated annualized growth rate of 4.8%. Increases in personal consumption expenditures, government spending, inventory investment, and exports were major contributors to the increase in GDP. These components were partially offset by an increase in imports. Annual growth in GDP for 1999 was 4.0%, modestly lower than the 4.3% growth rate reported for 1998. The U.S. economy is expected to continue expanding in the year 2000 at approximately a 3% to 4% growth rate.
The Composite Index of Leading Economic Indicators (the government's primary forecasting gauge) increased 0.4% in December after rising 0.1% in October and 0.3% in November. The composit index attempts to gauge economic activity six to nine months in advance. Multiple consecutive moves in the same direction are said to be indicative of the general direction of the economy. In December, nine of the ten leading economic indicators rose. The most significant increases were money supply, interest rate spread, manufacturers' new orders of nondefense capital goods, stock prices, and manufacturers' new orders of consumer goods and materials. During the six-month span through December, the leading index rose 0.9%, and seven of the ten components advanced. According to the Conference Board's report, "the leading indicators point to a continuation of the [economic] expansion during 2000."
Stock markets ended the year at record levels. Broad market and blue chip stock indices turned in 20% to 25% annual gains, while the NASDAQ gained an unprecedented 85.6% during 1999. The Federal Reserve (the "Fed") increased the Federal funds rate in mid-November in an effort to slow economic growth and thus curb inflation. The Fed is attempting to cool the robust economic engine before it produces excessive inflationary pressure. Additional rate tightening is expected during the early part of 2000. Despite a midquarter respite in bond price declines, bond yields reached their highest levels of the year in December, with the 30-year Treasury bond averaging a yield to maturity of 6.35%.
Inflation results for 1999 reflect very low core price growth but high growth in energy prices. The Consumer Price Index (CPI) rose 2.7% for the year. Tight labor markets and strong economic activity may produce inflationary pressures, however, pricing data continue to suggest that gains in productivity and limited pricing power are keeping inflation in check. The inflation rate is expected to continue at approximately 2.5% to 3.0% in the first half of the year 2000, but increasing fuel prices are posing a significant threat to future price stability.
Consumer Spending and Inflation
According to the Bureau of Labor Statistics (BLS), the CPI was unchanged at 168.3 in December (CPI: all urban consumers, 1982-1984 = 100, before seasonal adjustment). Excluding food and energy, this rate increased at a seasonally adjusted 0.1% in December, following an increase of 0.2% in November. The seasonally adjusted annual rate of inflation for the fourth quarter was 2.2%, compared to 4.2%, 2.9%, and 1.5%, respectively, for the prior three quarters. The inflation rate for 1999 was 2.7%, higher than the 1.6% rate of 1998 which was the smallest annual increase since a 1.1% rise in 1986. The acceleration in 1999 was largely due to an upturn in petroleum-based energy prices. The energy index, which declined 8.8% in 1998, increased 13.4% in 1999. Following a 15.1% decline in 1998, petroleum-based energy costs increased 29.5% in 1999, the largest annual advance since 1990.
The Producer Price Index (PPI), generally recognized as predictive of near-term consumer inflation pressure, increased 0.3% in December (PPI for finished goods, seasonally adjusted) following a 0.2% increase in November and a 0.1% decline in October.
Continues...
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