Valuation Methods Under the Income Approach
The AICPA’s Statement on Standards for Valuation Services (SSVS)-1 provides high level guidance regarding the income approach to valuation at its paragraphs 33-34 (SSVS-1, pp. 16-18).
BVS-IV Income Approach to Business Valuation of the Business Valuation Standards of the American Society of Appraisers (ASABVS) provides the initial guidance from the ASABVS (pp. 10-11). The guidance of this standard is general in nature and is applicable to businesses and interests in them. However, there is little direct guidance regarding the valuation of illiquid interests in the ASABVS. This guidance was added in Procedural Guideline 2 (PG-2 Valuation of Partial Ownership Interests).
The general guidance of BVS-IV pertains both to businesses and to business interests. It is high level in nature. We know that valuation methods under the income approach include both methods that capitalize earnings and those that discount future earnings to the present.
A. Anticipated benefits, as used in the income approach, are expressed in monetary terms. Anticipated benefits may be reasonably represented by such items as dividends or distributions,or various forms of earnings or cash flow.
B. Anticipated benefits should be estimated by considering such items as the nature, capital structure and historical performance of the related business entity, the expected future outlook for the business entity and relevant industries, and relevant economic factors.
Expected future benefits are either capitalized (at an appropriate capitalization factor that considers expected growth) or forecasted (including expected growth) and discounted to the present (at a discount rate reflective of the risks associated with their receipt.
Valuation methods for determining marketability discounts falling under the income approach include:
- Any shareholder-level discounted cash flow method, in general
- The QMDM, or Quantitative Marketability Discount Model
- The Nonmarketable Investment Company Evaluation Model (NICE)
- Option pricing models
- Any other methods that make explicit or implicit forecasts of future cash flows or dividends and discount them back to the present at a risk-appropriate discount rate
PG-2 Valuation of Partial Ownership Interests provides additional advice on the use of income methods to develop marketability discounts, including guidance regarding expected economic benefits (i.e., expected cash flows to partial, or minority, interests), the required rate of return for investing in the subject interest, and the expected holding period for an investment in the subject interest. This section focuses only on expected cash flows, risk and the expected holding period. In a later section, we will outline additional factors for consideration in the valuation of partial ownership interests found in PG-2.
Expected Holding Period
Every investment has an expected investment horizon. That horizon may be short, or long-term, but it is the horizon over which the investor reasonably expects to obtain the expected return from the investment.
Investments are made in the face of uncertainty. Holding periods are often not known with any degree of certainty. Nevertheless, investors do make investments in illiquid investments based upon their reasoned, and hopefully reasonable, assessments of the future. Investments are made without knowledge of the future, but they are made. What any investor knows is that, in the final analysis, the return on an investment will be what it turns out to be. That will be less than expectations, matching expectations, or exceeding expectations.
Procedural Guidelines in the ASABVS suggest certain procedures that may be used in the conduct of valuation engagements, but they are not binding portions of the standards. However, PG-2 does reflect the best-thinking of the American Society of Appraisers on the topic of valuing partial ownership interests to date. PG-2 does provide a roadmap for compliance with Uniform Standards of Professional Appraisal Practice (USPAP) Standards Rule 9-4(d).
Regarding the expected holding period for partial ownership interests, PG-2 enumerates a number of factors that appraisers (and investors) might consider in the process of developing a discounted cash flow model, including (ASABVS, pp. 45-46):
a. The extent to which the expected holding period may be uncertain.
b. Defined expiration or termination dates contained in the governing documents, or other external factors, that may precipitate a foreseeable liquidation or sale of the underlying entity.
c. Analysis of the age, health and other characteristics of the other owners and/or key managers, which could provide information about the possible timing of a sale or liquidation by the controlling owner(s).
d. The history of transactions (if any) involving partial (or possibly controlling) interests of the subject enterprise or asset, including recapitalizations or stock repurchases that have provided liquidity to shareholders.
e. The potential market for similar enterprises or assets (e.g., is the industry consolidating?).
f. The emerging attractiveness of the entity for equity offering, sale, merger or acquisition.
g. Provisions in the governing documents or buy-sell agreements, or under law or regulation either prohibiting, restricting or allowing transfer of the subject interest.
h. Rights and powers attributable to the subject interest that may enable a sale of the subject entity, asset or the interest itself, against the will of the other owners.
i. Historical actions of management and/or the directorate, which may provide information about their policy and intentions regarding eventual sale of the entity or asset, or receptivity to a potential sale or repurchase of partial interests.
j. The existence, depth and functioning of markets that might be available for interests similar to the subject interest.
k. The appropriateness of considering a range of expected holding periods and exit possibilities.
The expected holding period may not be known with certainty, but it can be analyzed. Reasonable expectations may call for a relatively short expected holding period, a relatively long one, or something in-between. Regardless, the valuation analyst employing discounted cash flow models to estimate the value of illiquid securities is called upon to analyze and reach a conclusion regarding the expected holding period.
This guidance amplifies guidance from the Uniform Standards of Professional Appraisal Practice that has been in the USPAP standards since 2006. Standards Rule 9-4(d) states (and the comment is part of the standard) (USPAP, p. U-74):
An appraiser must, when necessary for credible assignment results, analyze the effect on value, if any, of the extent to which the interest appraised contains elements of ownership control and is marketable and/or liquid.
Comment: An appraiser must analyze factors such as holding period, interim benefits, and the difficulty and cost of marketing the subject interest.
Equity interests in a business enterprise are not necessarily worth the pro rata share of the business enterprise interest value as a whole. Also, the value of the business enterprise is not necessarily a direct mathematical extension of the value of the fractional interests. The degree of control, marketability and/or liquidity or lack thereof depends on a broad variety of facts and circumstances that must be analyzed when applicable.
In other words, USPAP Standards Rule 9-4(d) says that, if necessary for credible results, an appraiser must consider the expected holding period of a minority investment, as well as its expected interim benefits and the risks associated with achieving them.
Expected Economic Benefits
Expected economic benefits are the driving factor for almost any investment. Expected benefits from the viewpoint of owners of a business interest or security come from anticipated dividends or distributions, as well as a terminal cash flow when the investment is expected to be sold or liquidated. PG-2 outlines the following factors for consideration with expected economic benefits (ASABVS, p. 46):
a. Expected interim dividends or distributions to the interest, which may differ from the expected benefits (cash flows) generated by the entity or asset as a whole. Interest-level benefits may be affected by such factors as:
(1) The history of dividends or distributions, including both timing and amounts.
(2) Current or expected future distribution policy.
(3) Preferential dividend claims.
(4) Enterprise-level and/or interest-level tax characteristics.
(5) The outlook for one-time and/or irregular dividends or distributions.
(6) Circumstances with controlling owners that may increase (or decrease) the likelihood of future interim benefits.
b. The expected terminal cash flow at the end of the expected holding period(s),which may be a function of such factors as:
(1) Possible future transactions involving the enterprise or asset as a whole, or transactions in the subject interest itself.
(2) Current (valuation date) value and expected growth in value of the enterprise or asset to the end of the expected holding period(s).
(3) Growth in value may be a function of expected earnings retention (distribution policy) and the amount of and effectiveness of expected reinvestment in the entity or asset.
For income-producing business interests, it would appear that some analysis of expected economic benefits and the expected holding period (or range of holding periods) should be considered if the above standards are to be observed.
Required Return for Investing in Partial Ownership Interest
The required return for investing in a partial ownership interest of a business is the discount rate that considers the risks associated with the investment, other than the risks already accounted for in the valuation of the enterprise as a whole. Factors included in the assessment of the appropriate required return include, according to PG-2 (ASABVS, p. 47):
a. The expected length and uncertainty of the holding period.
b. The likelihood of dividends or distributions (i.e., expected distribution policy).
c. The costs of due diligence efforts required to acquire the subject partial interest.
d. The costs of monitoring the investment over the expected holding period, including issues related to the expected receipt of timely and reliable information concerning the investment.
e. Required returns on similar investments or investments with similar investment specific liquidity and holding period characteristics.
f. The risk of tax liabilities from pass-through profits without guaranteed tax distributions in entities such as limited liability companies, Subchapter S corporations or partnerships.
g. The difficulty and cost of marketing the subject interest.
h. The risk of involuntary dilution when no preemptive rights are provided in the articles of incorporation or bylaws of a corporation.
i. The degree of control conveyed by the subject interest.
This post finishes our discussion of the three basic valuation approaches and the methods under them. The next post in this series on business valuation standards as they relate to marketability discounts examines additional factors in developing DLOMs.