Income statement adjustments (normalizing and control) are critically important in providing estimates of earnings for capitalization using methods under either the income or market approaches to valuation, as well as for providing a base level of earnings from which to forecast when using discounted future benefits methods.
Appraiser judgment is obviously required in the assessment of potential income statement adjustments.
Hopefully, the vocabulary and analysis outlined in this series on statutory fair value, are beginning to highlight the importance of income statement adjustments and the judgments made in developing them.
Each level of adjusted earnings is capitalized using a pre-tax multiple of 5.0x. As previously discussed, we assume for now that the enterprise discount rate does not change across categories of investors. We also assume a common outlook for expected growth in earnings for purposes of this illustrative discussion.
Enterprise-level values are developed at the respective levels of value and premiums or discounts to the marketable minority value are presented. Marketability discounts are applied to the “as reported” and normalized marketable minority values.
We make the following observations from the figure:
- If the objective of an appraisal is to develop an indication at the nonmarketable minority level of value, appraisers who fail to normalize in situations similar to the above have little chance to develop a reasonable indication of value. In the present case, the capitalization of reported operating income yields a result that is 20% of the appropriate nonmarketable minority value ($1,500,000 vs. $7,500,000). In other words, failure to normalize earnings suggests that nonmarketable minority investors will be burdened by the identified agency costs indefinitely.
- The application of typical marketability discounts based on benchmark analysis only exacerbates the problem noted above.
- The example illustrates that it is quite possible for different types of buyers to see different income potential – to them – when examining the same company.
- It is important to distinguish between the types of adjustments in order to understand the level of the income stream being developed. For example, if it is unlikely that there are any strategic buyers for a particular company, including strategic control adjustments would overstate value.
- A corollary to the above is that the blind application of a so-called typical control premium of 40% or so to an indication of value derived using a normalized income stream would tend to result in overvaluation if no competition among strategic buyers is expected for the property.
- Wide variations in value indications can result between appraisers at the nonmarketable minority level based on assumptions made regarding appropriate normalizing and control adjustments to enterprise earnings.
- It is inappropriate to apply a control premium to a value indication that considers financial or strategic control adjustments – such a premium is already embedded in the capitalized value. The application of a control premium in cases where no control adjustments are made implies that such benefits do exist and that, in the case of fair market value, typical buyers are willing to pay for them. The blind application of a control premium simply cries out for the kind of analysis suggested in these posts to determine the appropriate earnings at the appropriate level of value for each appraisal. For example, the strategic control value of $10,500,000 could be developed as indicated or by applying a 40% control premium to the marketable minority value of $7,500,000. In either cases, there is an assumption that a total of $600,000 in combined financial and strategic control adjustments is available.
- Further when using discounted future benefits methods, no control premium is applicable to value indications developed based on forecasts that included financial or strategic control adjustments. If the forecast does not include control adjustments to income, it may be proper to consider the application of an appropriate control premium. However, that premium should relate to the expectation of benefits that buyers would pay for – else, it could lead to overvaluation (or undervaluation).
Control Premiums and Fair (Market) Value
Combining the practical analysis of our discussion to date with the conceptual analysis of the the levels of value chart, we now consider several questions business appraisers should ponder when developing controlling interest value indications under the standard of fair market value. Recall that statutory fair value is usually defined as the functional equivalent of fair market value at a particular level of value.
Are the typical buyers financial buyers?
- The appraiser may need to evaluate the market for similar enterprises to ascertain the nature of the so-called typical buyers in a fair market value determination.
- Financial buyers may believe they can improve the earnings stream, and this belief may be reflected in the pricing.
- If there are no cash flow improvements available, there may be little or no premium to the marketable minority value (i.e., to the value developed using normalized cash flows).
Are the typical buyers strategic buyers?
- Again, the appraiser may need to evaluate the market for similar enterprises to ascertain the nature of typical buyers.
- Strategic buyers may believe they can alter and improve the earnings stream, and may reflect this belief in pricing, particularly if there are other strategic buyers who may be in competition for the same property.
- Strategic buyers may pay a premium in excess of that available to typical financial buyers, however, as previously noted, a rational strategic buyer will willingly pay no more than necessary to win the deal from the next most capable strategic buyer.
- Consideration of strategic buyers may be irrelevant in the context of fair market value determinations. For example, if there are no strategic buyers in a particular market, it would likely not be appropriate to consider a control premium based on strategic cash flows incorporating the effect of strategic control adjustments. Alternatively, if the likely buyers are strategic, for example, in consolidating industries, it may be appropriate to consider potential strategic control adjustments in the context of a fair market value determination. Once again, appraisers must make appropriate judgments in the context of their overall analysis of a subject enterprise and the likely market for the subject enterprise.
What accounts for control premiums?
- The appraiser may consider appropriate premiums over marketable minority value, but such control premiums are not automatic. Appraisers must make appropriate judgments in the context of fair market value appraisals.
- A buyer’s desire to “get a deal done” can cause the price offered to increase, resulting in a larger observed premium. If this occurs, there may be elements of compulsion involved in establishing the price limiting the relevance of such transactions in the determination of fair market value.
- Irrational buyers can pay any price that they can afford to pay, but this provides poor support for assessing fair market value.
- The first element above relates to fair market value determinations; however, elements of compulsion and irrationality should not be considered in fair market value determinations according to the very definition of fair market value.
Appraisers have their work cut out for them in developing opinions of statutory fair value or fair market value. With this discussion of normalizing and control adjustments, and a first look at the relationship between control premiums and such adjustments, we will return to the development of the integrated theory in the context of the levels of value that was begun in Statutory Fair Value: #7 An Introduction to an Integrated Theory of Business Valuation.