The opinions of testifying valuation experts can often differ substantially. This can frustrate the court, already possibly struggling with mathematical and financial concepts. But there is good reason why values can be so far apart. The value of a business can differ contingent upon: (1) the valuation date; (2) the purpose of the valuation and corresponding standard of value; and (3) the application of the valuation approaches used.
The valuation date is critical. A valuation expert is only permitted to consider information known or knowable as of the valuation date; therefore, this can have a significant impact if events impacting the value occurred at a time near the applicable valuation date. In addition, the purpose of the valuation and the associated standard of value can result in differing conclusions. For example, while estate and gift tax planning utilizes Fair Market Value, Fair Value or Fair Market Value may be used in shareholder dispute cases.
The selection of the valuation method (i.e., asset, market or income approach), and the application of such method can also impact the final value. While most experts can agree that each approach should be considered; the variations within each approach and the weighting of each approach in reconciling the final value may differ substantially. The valuation experts can have differing opinions regarding what discounts are applicable, what databases are relevant and should be used, and the assumptions that are made as a result of those choices can all have a big impact on the final value.
In utilizing the market approach, the best indication of value is usually a recent arm’s-length sale of the subject company’s stock. Absent recent transactions in the subject’s stock, experts often look to transactions involving similar companies. The direct market data method (DMDM) looks at transactions involving privately held companies by searching various databases. The guideline company method utilizes data of publicly traded companies. However, under each of these methods, finding a comparable business to the subject company is difficult. There can be qualitative and quantitative differences, including:
- Size, Growth rates
- Capital structure
- Access to capital
- Market position
- Geographic territory
- Depth of management
Adjustments made by the experts in comparing the subject company to the market transactions involve subjective judgment; therefore, experts may differ significantly in this aspect of their analysis.
Within the Income Approach, there are two common methods; the Discounted Cash Flow Method and the Capitalization of Cash Flow Method. Under each of these, estimates can vary depending on the stream of earnings used and the required rate of return. The Discounted Cash Flow Method requires determining projected normalized earnings and a discount rate. The Capitalization of Cash Flow Method requires normalizing earnings and applying a capitalization rate. Normalizing earnings requires experts to determine whether or not certain revenues and/or expenses are non-recurring, non-operating, discretionary or strategic. For example, experts often disagree on the appropriate amount to use for normalizing officer compensation or adding back personal expenses paid for by the business.
There is also controversy as to whether or not the earnings of a pass-through entity should be tax affected and to what degree.
With respect to the determination of a discount and/or capitalization rate the most subjective component is the specific company risk. Factors that are considered in determining an appropriate company risk include: nature of the business, cyclicality of the business, nature of customer relationships, length of time in business, experience of management, and competition. Experts can vary in their determination of these risk factors.
After experts have arrived at a preliminary value (e.g., the value of a controlling, marketable interest in the subject company), certain discounts may be warranted.
The application and amount of discounts for Lack of Control (DLOC) and/or discounts for Lack of Marketability (DLOM) can vary widely even among seasoned and well-credentialed experts. While DLOC’s are often applied to a non-controlling or minority interest, whether or not to utilize a DLOC is also a function of methodology used and may not always be appropriate. A DLOM is a measure of how quickly the interest can be converted to cash and may be appropriate for both minority and controlling interests. There are both qualitative and quantitative methodologies for determining both discounts; therefore, it is common for experts to disagree in their determination of discounts.
As a result of assumptions and subjective professional judgment, determining value is more of an art than a science. In addition, Courts commonly exclude expert testimony for some of the same reasons experts can have drastically different values:
- Lack of reliability, Lack of valid data, Lack of relevance.
Therefore, it is imperative that your expert adequately and thoroughly document his/her opinions and ensure that the data he/she is relying upon is valid. While experts can disagree on a number of different components to a business valuation, including normalization of income, tax effecting, and application of discounts; courts do not automatically “average” the values of opposing expert. At the end of the day, a more detailed substantiated report will carry more weight and have a better chance of being accepted by the court when there is a disagreement.
By Sheri Fiske Schultz,
Director of Litigation and Valuation Services
Fiske & Company
Offices in Fort Lauderdale, Miami, and Palm Beach
South Florida Legal Guide 2015 Edition