ClarityBV Blog

Do you believe in the rational economic actor?

On Being Certain: Believing You Are Right Even When You’re Not provides a challenging look at human biology and the building blocks of knowledge. It asks a fundamental question, “how do we know what we know?”

Although not a business book, it provided insights relevant to business valuation by addressing issues like:

• Why do people persist in the belief that everyone should draw the same conclusion if given the same information? The author’s discussion helps explain why appraisers, given the same set of facts, often reach different conclusions about the value of a business.

• Certainty is not a biologically justifiable state of mind. The author observes that there is no isolated circuitry in the brain that can free itself from involuntary and undetectable influences.

As appraisers, our professional standards are meant to help us avoid bias. However, this book is a good reminder that we should always check the origin of our thoughts to distinguish between “felt knowledge” and testable observations and conclusions.

Automotive News just released its survey of the Top 125 Dealership Groups (pdf) in the U.S. ranked by unit sales of new vehicles in 2008.

A notable departure from the list was Bill Heard Enterprises Inc., which filed bankruptcy in 2008. (Automotive News, Sep. 2008: Heard lawyer: Dealer is ‘out of money’)

One of the biggest gainers in a difficult environment was the Ken Garff Automotive Group. An article (subscription required) in late 2007 indicated that the group planned to double revenues within 2 years. According to Automotive News, it was one of only 16 groups in the top 125 to increase revenues in 2008.

The Problem: What is the value of a 75% ownership interest in a company whose only asset is cash? Would it make a difference if I told you it was a nonvoting interest? In other words, someone else will be making all the decisions about how to invest the cash.

The Background: Under a fair market value standard, a hypothetical seller would be reluctant to accept less than dollar for dollar value. However, a hypothetical buyer would consider many investment alternatives and may require some incentive to buy a 75% nonvoting interest.

One way to analyze the problem is to make comparisons with closed-end funds, which often trade at discounts to their net asset value. These are relatively liquid investments, wherein investors give control to a third party to manage their assets.

An article in the April 2007 Journal of Finance (pdf) posed the question, “Why would investors buy a closed-end fund at its IPO, knowing that it is likely to fall to a discount, when they could instead buy an open-end fund that is guaranteed always to trade at par?” The study concludes that managerial ability may be a significant factor. However, they also note that “The inability of economists to answer this question has led many to conclude that investor irrationality is the only possible explanation.”

The Bottom Line: Even seemingly simple valuation assignments unearth all kinds of interesting issues. A dollar may not be worth a dollar when someone else controls it…

Further Reading: Forbes and Kiplinger had interesting articles last year on the topic of closed-end funds and discounts:

• Outrageous Opportunities in Closed-End Funds (Kiplinger.com; October 15, 2008)
• Closed-End Funds At Deep Discounts (Forbes.com; July 30, 2008)

It’s amazing how many valuation questions can be answered by IRS Revenue Ruling 59-60, which is available as a free download in PDF format from BVResources.com. At only six pages long, it is required reading for preparers of valuations and users of valuations for gift and estate tax reporting.

Recently, I’ve had several people ask questions along the lines of…

1. When valuing a business, do you apply as many methods as possible and average the results?
2. Is there a standard multiple of average earnings to value my business?

Revenue Ruling 59-60 succinctly addresses these questions.

1. Because valuations cannot be made on the basis of a prescribed formula, there is no means whereby the various applicable factors in a particular case can be assigned mathematical weights in deriving the fair market value. For this reason, no useful purpose is served by taking an average of several factors (for example, book value, capitalized earnings and capitalized dividends) and basing the valuation on the result. Such a process excludes active consideration of other pertinent factors, and the end result cannot be supported by a realistic application of the significant facts in the case except by mere chance. [Section 7] [Emphasis Added]
2. Prior earnings records usually are the most reliable guide as to the future expectancy, but resort to arbitrary five-or-ten-year averages without regard to current trends or future prospects will not produce a realistic valuation. [Section 4.02(d)] [Emphasis Added]

To paraphrase — appraisers should not substitute arithmetic for professional judgment!

Definitions of Dabble:

1. to be involved in an activity in a superficial way
2. to splash (one’s toes or fingers) in water [probably from Dutch dabbelen]

Two recent articles highlight the pitfalls of doing business valuation on a part-time basis.

Are you reading enough?

“Business Valuation has become so complex that most practitioners find that they must specialize in this area to keep up. It has become very difficult for an accountant to do valuation work part time and still keep abreast of all the standards, journals, and texts that must be read to be on top of the profession. That means that BV folks tend to be reading all the time!” – Eva Lang

I couldn’t agree more.

It is a challenge to keep up with the new literature in the profession – not to mention all the relevant works in the fields of accounting, economics, and finance, among many others. Valuation truly requires a multidisciplinary approach.

Creating Joint Ownership: Avoiding the Tax Traps and Other Pitfalls

“If the property is investment property, a business interest or even a personal residence, you need to be wary of those “quickie” one-page valuation reports that were commonly accepted under the old rules.” [emphasis added] - Thomas J. Stemmy

It is surprising how many accountants are still preparing proposals that do not specify under what standards a valuation will be performed. All CPA’s should be aware of and comply with the requirements of the AICPA’s Statement on Standards for Valuation Services (SSVS) No. 1.

An article in The CPA Journal contained an exhibit (pdf) that summarizes the reporting requirements under different valuation standards. If a potential appraiser is not familiar with these standards, run, don’t walk, to find one that is!