Hitchner James, Mard Michael. Financial Valuation Workbook

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formed well in the past due to such factors as loss of a key person or litigation.

The absence of those items going forward would indicate better performance.

The analysis of the historic information should also be made in light of the

local, regional, and national economy, as well as the industry outlook. All these

items can be used to support assumptions in the valuation models.

EXERCISE 15: Analysts typically spread ﬁve years of ﬁnancial statements

because:

a. Revenue Ruling 59-60 requires ﬁve years.

b. Uniform Standards of Professional Appraisal Practice requires ﬁve

years.

c. An economic cycle is often captured in ﬁve years.

d. Most business plans are based on ﬁve years of projections.

ANSWER: c. An economic cycle is often captured in ﬁve years.

There is no magic to looking at ﬁve years of data. In some industries only the

most recent year is relevant or just a few years. In other industries ﬁve to ten

years may be more appropriate. The underlying theme is that it captures

enough ﬁnancial information to indicate trends, the performance of the com-

pany and an economic cycle. Although Revenue Ruling 59-60 suggests that

ﬁve years of data be reviewed, it is not required. USPAP does not have any

requirements concerning the number of years of ﬁnancial information.

Although it may be true that many projections include ﬁve years of data, this

has no real relevance in terms of a historical review of information.

EXERCISE 16: The main drawbacks of publicly available benchmark ﬁnan-

cial ratios are:

a. There are very few SIC codes.

b. They calculate the ratios incorrectly.

c. The companies that make up the data cannot be used to determine

pricing ratios or capitalization rates.

d. The information is from public companies.

ANSWER: c. The companies that make up the data cannot be used to deter-

mine pricing ratios or capitalization rates.

Most of the national databases do have fairly extensive amounts of informa-

tion by SIC code and the ratios typically are calculated properly. Most of the

information is from closely held companies.

The main drawback of the data is that none of it is tied to pricing ratios

or valuation multiples such as price to earnings or invested capital to

EBITDA. There is also no tie to any type of discount or capitalization rate.

Therefore, some analysts believe that these types of comparisons are less

52 VALUATION CASE STUDY EXERCISES

meaningful. Alternatively, when using the guideline public company method

of the market approach, ratios can be tied to valuation multiples. You can

take a look at how the subject company compares to the various ratios of the

public companies, then make adjustments to the public company multiples to

reﬂect those differences. This cannot be done when using public benchmark

data that again have no references or ties to valuation multiplies or capital-

ization rates. However, they can help in a general risk assessment.

It is also important to recognize that many of the ratios are calculated dif-

ferently and that consistency is important when comparing the subject com-

pany being valued to the ratios in the benchmark data.

EXERCISE 17: Indicate whether you believe that LEGGO is a better or

worse performer based on the ﬁnancial ratios previously presented.

ANSWER: Although each ratio is important, some are more useful than

others. For example, proﬁt margins and leverage ratios are typically more

important than other ratios. In general, it appears that LEGGO is more liq-

uid. In terms of activity ratios, it appears that they are under-performing

based on ﬁxed assets, but this may be due to owning more of their ﬁxed assets

as opposed to leasing them. In terms of leverage, it appears that the Company

uses less debt than its industry counterparts and could add additional debt if

it chooses. The Company’s return on equity ratio and return on assets ratio

are much higher, indicating that it may be generating higher proﬁt margins

than the industry. Overall, it appears that LEGGO is outperforming its peers

based on the benchmark data presented.

EXERCISE 18: All three approaches to value must be applied in all

valuations.

a. True

b. False

ANSWER: b. False

Although it is true that all three approaches to value should be considered in

each valuation, they need not all be applied in every valuation. Most analysts

do not use the full asset approach (tangible and intangible assets) in valuing an

operating company because increases in the accuracy of the appraisal, if any,

are not worth the time and expense of having all the assets valued. The value

of all the aggregated assets, including intangible assets, is considered in the

value derived from the income and market approaches. The asset approach is

often the primary approach in valuing investment or holding companies.

Valuation Case Study Exercises 53

EXERCISE 19: In what type of valuation setting is the excess cash ﬂow

method most often used?

a. ESOPs (Employee stock ownership plans)

b. Estate tax

c. Dissenting rights

d. Marital dissolution

ANSWER: d. Marital dissolution

Although the excess cash ﬂow method can be used in any valuation, it is most

often seen in marital dissolutions. Analysts may use this method because the

court in a jurisdiction is familiar with it. In some situations, exclusion of the

excess cash ﬂow method could be perceived as an omission.

EXERCISE 20: On which Revenue Ruling is the excess cash ﬂow method

based?

a. Revenue Ruling 59-60

b. Revenue Ruling 83-120

c. Revenue Ruling 68-609

d. Revenue Ruling 77-287

ANSWER: c. Revenue Ruling 68-609

The excess cash ﬂow method, sometimes referred to as the formula method or

the excess earnings method, was ﬁrst discussed in ARM 34, which was used

to determine goodwill in breweries due to prohibition. This eventually led to

Revenue Ruling 68-609. Revenue Ruling 59-60 contains the basic tenants and

procedures for valuing closely held businesses. Revenue Ruling 83-120 deals

with valuation of preferred stock. Revenue Ruling 77-287 deals with the val-

uation of restricted securities.

EXERCISE 21: Which method(s) is(are) considered valid under the income

approach?

a. Guideline public company method

b. Discounted cash ﬂow method

c. Capitalized cash ﬂow method

d. Excess cash ﬂow method

ANSWER: b. Discounted cash ﬂow method, and

c. Capitalized cash ﬂow method

Discounted cash ﬂow and capitalized cash ﬂow are the two main methods

under the income approach. There are variations of these two methods. The

guideline public company method is a market approach, and the excess cash

ﬂow method is a hybrid of the income and asset approaches.

54 VALUATION CASE STUDY EXERCISES

EXERCISE 22: In which situation(s) would a capitalized cash ﬂow method

be most applicable?

a. When a company’s future performance is anticipated to change from

its prior performance

b. In litigation settings

c. When a single historical or pro forma amount of cash ﬂow is antici-

pated to be earned with a constant growth in the future

d. When valuing very small businesses

ANSWER: c. When a single historical or pro forma amount of cash ﬂow is

anticipated to be earned with a constant growth in the future,

and

d. When valuing very small businesses

Capitalized cash ﬂow methods are most often used when future performance

is anticipated to be at a steady rate based on either a historical ﬁgure, such as

an average or recent year, or a pro forma single ﬁgure. Discounted cash ﬂow

is most often used when future performance is anticipated to be different from

the past. Both discounted cash ﬂow and capitalized cash ﬂow methods are

used in litigation, although some analysts believe that the capitalized cash

ﬂow method is more supportable because it is easier to explain. Capitalized

cash ﬂow methods are most often seen in valuations of small businesses, since

that is how they are often bought and sold.

EXERCISE 23: List the two main bases when using the capitalized cash ﬂow

(CCF) or discounted cash ﬂow (DCF) methods of the income approach.

ANSWER: 1. Direct equity

2. Invested capital

There is much debate in the valuation community about whether to use direct

equity methods of valuation in which interest expense and debt principal are

included, or to use invested capital methods in which interest expense and

debt principal are excluded. Theoretically, the use of both models should give

you a similar result. Both methods can be used in most valuations. However,

in certain circumstances, one method may be better than the other. For exam-

ple, the invested capital method may be used in control valuations where the

capital structure of the company is anticipated to change. Alternatively, in a

minority valuation, some analysts believe that the direct equity method is

more appropriate, since the minority shareholder cannot change the capital

structure of the company. It is often a matter of preference.

EXERCISE 24: Under the direct equity basis, what are the components of

net cash ﬂow?

Valuation Case Study Exercises 55

ANSWER: Net income after tax

Plus Depreciation and noncash charges

Minus Capital expenditure requirements

Plus/minus Working capital requirements

Plus New debt principal paid in

Minus Debt principal paid out

EXERCISE 25: For the invested capital basis of the income approach, list

the components of net cash ﬂow.

ANSWER: Net income after tax

Plus Interest expense times 1 minus the tax rate

Plus Depreciation and noncash charges

Minus Capital expenditure requirements

Plus/minus Working capital requirements (debt-free)

EXERCISE 26: What is the difference between minority cash ﬂows and con-

trol cash ﬂows?

ANSWER: The difference between control cash ﬂows and minority cash

ﬂows is normalization adjustments. Normalization adjustments for control

include excess compensation and perquisites. When such amounts are added

back, it is considered a control value. When such amounts are left in as

expenses, it is considered a minority value, since the minority shareholder can-

not change the policies of the control owner.

EXERCISE 27: Which adjustment(s) are made when valuing both minority

and control cash ﬂows?

a. Nonrecurring items

b. Nonoperating assets

c. Excess compensation

d. Perquisites

e. Taxes

ANSWER: a. Nonrecurring items,

b. Nonoperating assets, and

e. Taxes

56 VALUATION CASE STUDY EXERCISES

The goal of normalizing cash ﬂows is to determine what a normalized amount

would be into perpetuity. Nonrecurring items are typically removed from the

cash ﬂows. Most analysts will also adjust the P&L for the effect of removing

nonoperating assets from the balance sheet. For example, there may be an

adjustment for interest and dividend income associated with excess marketable

securities, as is the situation here with LEGGO. Excess compensation and

perquisites are only adjusted in control cash ﬂows. When using after tax rates

of return, taxes are typically an expense in minority and control cash ﬂows.

EXERCISE 28: Assume the company does not have any control adjustments

and the company is run to the beneﬁt of all shareholders without any share-

holders taking out cash ﬂow over or above what they are entitled. Is this value

control or minority?

ANSWER: The value would clearly be control stand-alone, since the capital-

ized cash ﬂow is the cash ﬂow of the entire company reﬂecting the beneﬁts to

all shareholders. Since the current owner of the company is operating to the ben-

eﬁt of all shareholders, it becomes a minority value as well. However, it is

minority value only to the extent that the current owners continue their policies.

Policies can change and/or new owners can come in, which increases the risk

such that a discount for a lack of control or minority interest may still be appro-

priate. A possible adjustment for lack of control may be appropriate to reﬂect

the risk of potential future changes in either the owner or the policies or both.

EXERCISE 29: List some of the nonoperating/excess assets that are some-

times encountered in a business valuation.

ANSWER: Marketable securities

Cash

Inventory

Working capital

Land

Buildings

Condominiums

Boats

EXERCISE 30: In valuing a controlling interest in a corporation, most ana-

lysts agree that the nonoperating and/or excess assets of the business must be

removed out of the operating business, then added back at fair market value.

a. True

b. False

Valuation Case Study Exercises 57

ANSWER: a. True

The rate of return requirements for excess assets and/or nonoperating assets

are often less than the cost of capital of the company. As such, including the

income and expenses of the nonoperating/excess assets in the P&L, and capi-

talizing such amounts at a higher rate of return, will undervalue the company.

There are also situations where there are nonoperating assets that generate no

income. The capitalization of cash ﬂow without adjustment would result in a

zero value for those assets. This is why these types of assets are typically

removed from the balance sheet with appropriate P&L adjustments, then

added back to the operating value of the business.

EXERCISE 31: In valuing a minority interest of a company, most analysts

agree that the nonoperating and/or excess assets of the business must be

removed out of the operating business, then added back at fair market value.

a. True

b. False

ANSWER: a. True

Although this is true for most analysts, there are still differences of opinions.

Some analysts believe that the same methodology should be employed as in

valuing a controlling interest, that is, value the nonoperating or excess assets

separately and make the related P&L adjustments. They would then take a

discount for lack of control and a discount for lack of marketability from the

nonoperating asset value before they added it to the company’s discounted

operating value. Other analysts believe that a minority stockholder has no

access to these types of assets and the P&L should be as it is, reﬂecting the

way the company operates. The assets are not separately valued and added

back. Again, this can create a situation where the value of nonoperating/

excess assets may be zero.

EXERCISE 32: In the valuation of LEGGO, the analyst decided to use a

straight average of the adjusted income before income taxes for ﬁve historical

years. Besides a straight average, what other method(s) can be used to deter-

mine the appropriate cash ﬂow to be capitalized into perpetuity?

a. Weighted average

b. Most recent ﬁscal year

c. Most recent trailing 12 months

d. Trend line analysis/next year’s budget

e. DCF average of next three years

ANSWER: a. Weighted average,

b. Most recent ﬁscal year,

c. Most recent trailing 12 months, and

d. Trend line analysis/next year budget

58 VALUATION CASE STUDY EXERCISES

The ﬁrst four items can be considered in valuing and determining how cash

ﬂow should be capitalized. An example of a weighted average is (3,2,1), which

would be used for a three-year average, with the most recent year given the

weight of 3, the second year 2, and the most distant year 1. Some analysts will

use (5,4,3,2,1) for ﬁve years of data. The weighted average is typically used

when the analyst believes there may be an increasing trend but wants to reﬂect

the possibility that there could be some underperforming years. Fiscal year

end and trailing 12 months are typically used when there is anticipation that

the most recent information is indicative of the future. Some analysts will use

an estimate of next year’s budget if they believe it is more indicative of the

potential performance of the company. DCF is typically used when historical

information is not anticipated to continue. DCF and capitalized cash ﬂow

methods do not average future years, only historical years.

EXERCISE 33: Analysts will generally use a straight historical average

where the earnings and cash ﬂows are more volatile.

a. True

b. False

ANSWER: a. True

This is the situation with LEGGO. Although there is some trend upward for

LEGGO, the construction industry is fairly cyclical such that a straight his-

torical average is more appropriate here. The other methods are often more

appropriate where there is more of a trend in the historical results.

EXERCISE 34: Which situation is most appropriate when adjusting cash

ﬂows for depreciation and capital expenditures?

a. Capital expenditures should exceed depreciation.

b. Depreciation should exceed capital expenditures.

c. Depreciation and capital expenditures should be similar.

d. The actual unadjusted amounts should be capitalized.

ANSWER: c. Depreciation and capital expenditures should be similar.

A common mistake made in business valuation is to capitalize cash ﬂow into

perpetuity where the depreciation greatly exceeds the future capital expendi-

ture requirements. This is obviously an impossible situation, since future cap-

ital expenditures have to be made in order to generate future depreciation.

Many analysts will normalize depreciation and capital expenditures by mak-

ing them equal or similar. This equalization process is a simplifying assump-

tion, since capital expenditures would slightly exceed depreciation due to the

inﬂationary pressure in a stable business. However, this usually (but not

always) has a nominal effect on value. There are situations in which

Valuation Case Study Exercises 59

depreciation can exceed capital expenditures within a deﬁnite period of time.

This occurs when there is a previous purchase of a long-life asset such as a

building, or where goodwill or other intangible assets are amortized over a

longer period of time. In those situations, it would be appropriate to have

depreciation exceed capital expenditures.

EXERCISE 35: Assuming taxes are to be deducted, what two choices are

there in making the tax adjustments?

a. Tax each year historically, then determine the average.

b. Taxes should never be deducted in the value of an S corporation.

c. Make all adjustments in the historical period pretax, determine the

average, then deduct for taxes.

ANSWER: a. Tax each year historically, then determine the average, and

c. Make all adjustments in the historical period pretax, deter-

mine the average, then deduct for taxes.

Some analysts will go back and compute taxes in each of the years used in the

average income as opposed to making all the adjustments pretax, calculating

the average, then adjusting for taxes. When the tax rates are the same, this

will not have an impact. However, in C corporations, where taxes may differ

for each year due to certain types of planning, an average of ﬁve years after-

tax income may be different than the average of ﬁve years pretax, which is

aggregated with one tax amount applied to it. There may be years when the

taxes would be less than the marginal rate. As such, some analysts believe that

an average tax-affected rate is more appropriate. Other analysts believe that

the company will eventually end up paying close to the marginal rate into per-

petuity, and that would be the more appropriate rate.

EXERCISE 36: Which economic beneﬁt stream(s) can be used for cash ﬂow

in a capitalized cash ﬂow method?

a. After-tax income

b. Pretax income

c. Net cash ﬂow

d. EBITDA (Earnings before interest, taxes, depreciation, and

amortization)

e. Revenues

f. Debt-free net income

g. Debt-free cash ﬂow

ANSWER: a. After-tax income

b. Pretax income

c. Net cash ﬂow

f. Debt-free net income

g. Debt-free cash ﬂow

60 VALUATION CASE STUDY EXERCISES

Cash ﬂow is often used in many business valuations. However, there are cir-

cumstances, particularly with small businesses, when income is capitalized

both on an after-tax and a pretax basis. Debt-free net income is used in the

invested capital basis and is after-tax income with interest expense added

back. Debt-free cash ﬂow is debt-free net income with depreciation added

back. Although theoretically EBITDA could be a capitalizeable amount, it is

more often used in the market approach than the income approach. Revenues

are seldom capitalized in the income approach, although they can be capital-

ized through the market approach.

There is some debate in the valuation industry concerning the use of

either cash ﬂow or income when performing the income approach. However,

this is frequently a moot point because analysts often equalize depreciation

and capital expenditures. The only other real adjustment would be incremen-

tal working capital. Not all businesses require incremental working capital,

particularly cash businesses or businesses whose receivables are turned

quickly. As such, and particularly in small businesses, cash ﬂow and income

may be equal or similar. However, there are many businesses that require

working capital to fund growth. In those situations, working capital should

be considered as a cash outﬂow. Cash ﬂow in a growing business would typ-

ically be less than income in those businesses with working capital needs. Debt

would also have to be normalized in terms of debt principal in and debt prin-

cipal out. However, again, if they are normalized, they net out to net income.

EXERCISE 37: When using the direct equity basis instead of the invested

capital basis, assumptions of capital structure can be avoided.

a. True

b. False

ANSWER: b. False

One of the reasons often given for using the direct equity basis is that the ana-

lyst can avoid making assumptions of capital structure, that is, what percent

debt and what percent equity a company will use. However, in a direct equity

basis there needs to be assumptions of debt principal in and debt principal

out, and they need to be normalized. Anytime you normalize the amount of

debt that is used in a company, you are explicitly assuming a capital structure.

As such, debt is a consideration in using the direct equity basis.

EXERCISE 38: When using the invested capital basis to determine a control

value, you should use always an optimal capital structure in the weighted

average cost of capital.

a. True

b. False

Valuation Case Study Exercises 61