Implications of the Outside-In Valuation Perspective

Following up on my previous post on the “outside in” perspective on valuation, here are some recommendations to consider:

  1. Use as many approaches, methods, and techniques as you can, subject to limitations imposed by the sufficiency and reliability of the requisite data, the ability to delimit a reasonable range for required assumptions, consistency with generally accepted appraisal practice and professional standards, and your competency.

For example, in a typical financial projection, the long-term sustainable growth rate of revenue cannot exceed that of the economy as a whole (based on population growth and inflation).  That suggests a reasonable range in the low single digits.  A range of 0% to 10% is too wide (not reasonable), and one of 4% to 5% could be too narrow.

Similarly, do not try to use advanced statistical techniques such as multivariate regression (e.g. estimating sale price as a function of sales and earnings) unless you are aware of their potential pitfalls (multicollinearity being a prime example).

2. Clearly separate your scientific (logical range-narrowing) conclusions from your artistic (subjective and judgmental) conclusions.

In estimating a LOMD, various methods may narrow the reasonable range to (say) 30% to 40%.  If you select (say) 35%, state that this is a judgment inside the reasonable range, and rationalize it as best you can (perhaps you feel any discount in the reasonable range is equally probable, so the 35% midpoint was selected).

3. Defend your scientific conclusions to the death, but be willing to be flexible on your artistic conclusions.

Having said that, it is unreasonable for someone to push you to concede that every artistic conclusion should be adjusted in a manner that lowers or raises value.  If all your subjective values in the reasonable ranges are equally probable, it is highly improbable that all of them should be so adjusted, and much more probable that any subjective judgment differences would offset in such a way as to not change the value greatly.

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Inside Out versus Outside In

A propos of my previous post on valuing notes receivable, yesterday I participated in a conference call with my American Business Appraisers National Network colleagues on that very subject.  One theme of the discussion was the uncertainty (for example, of estimating the discount rate for notes with missed payments and uncertain prospects for future payments) and necessity for due diligence and subjectivity to mitigate that.  Another theme was the various technical means of developing the discount rate (using a build-up approach with a risk-free rate or a corporate rate, or using various databases on bond prices and yields).

Underlying the whole discussion was a fundamental concept: appraised value is a range under any standard of value.  The central appraisal task is to estimate, express, and support value either as a point estimate (as in tax valuations) or as a range estimate (in transactions).

The challenge appraisers confront is that we cannot estimate value with full confidence.  This can arise because of lack of data (no or too few guidelines), imperfect data (unaudited financials), inconsistent data (guidelines with a wide range of indicated pricing multiples), uncertain assumptions (the company-specific equity cash flow discount rate), conflicting premises (going concern versus liquidation), and / or inconsistent results (different value indications derived from different approaches and methods).

Appraised (estimated) value is thus inherently uncertain.

This poses two problems.  First, it is easy for appraisers to forget this.  If we rush into our calculations without consideration of the underlying uncertainties, we may come up with a value that is wide of the mark.  We find out about this when the IRS challenges our results, when we are cross-examined, or otherwise challenged.  Second, others may not realize how uncertain our estimates are.  A value conclusion of $36,814 looks very precise, when in fact there could be great uncertainty associated with it.

If we apply just one method and set of assumptions, we have an “inside out” perspective on value.  To use an archery analogy, we are shooting rather blindly at the target, assuming we will hit the bull’s-eye.  Sometimes this can be done with ease and high confidence.  For example, it does not take much work to value marketable public securities.

If, however, the securities are held in a FLP and we have to appraise the LOMD for a limited interest, the inside out approach is highly risky.  If we blithely select a LOMD, we may miss the bull’s-eye, let alone the entire target, by a considerable amount.  This is why professional standards require us to support our conclusions.  In any event, we will probably not be very confident of our blithe LOMD guess.

Enter the “outside in” perspective on value.  We start by asking a basic question: what is the maximum and minimum possible LOMD?  (Gee, let me think…ummm)…100% to 0%!
That might seem dumb and obvious, but look what we have accomplished: we narrowed the range of possible LOMDs from -∞ to +∞ with 100% confidence.  (That is why we earn the big bucks!)  In the archery analogy, we have clearly separated the target (0% to 100% LOMD) from the vacant space around it.  Next, we employ as many methods, data sets, and assumptions (with reasonable ranges) as we can to develop reasonable ranges for the LOMD.  We do not have perfect confidence about any of them, but we certainly have a fair amount.  Next, we combine the ranges, albeit with some subjective judgment, to narrow the ultimate range even more.  We then select a final value from somewhere in the range, again subjectively.  Each step of narrowing the range involved logic and (increasing amounts of subjective) judgment, but the result is something we can be confident above, much more so that our confidence with our inside out blithe guess.

When I teach valuation, I illustrate the inside out and outside in perspectives with a class exercise.  Using only information they previously knew and information they can obtain by looking out the window (but not going outside, and without a thermometer), estimate the current outside temperature (in Fahrenheit).

With a pure inside out perspective, most students guess the temperature and are relatively unconfident about their guesses.  In addition, they have no support for them other than “judgment” (in appraisal reports, this is often stated as “in my professional opinion”).

With a pure outside in perspective, students often make better and more confident guesses (estimates).  For example, as this is written (September in Cleveland), I look outside and see the sun shining, no ice or snow on the ground, and people walking around dressed in long-sleeve shirts and light jackets, but not winter coats or gloves.  The first cut at the temperature estimate is that it is not freezing so the temperature is above 32 degrees.  The temperature almost never exceeds 100 degrees here, so my first estimate of the temperature range, which has very high confidence, is 32 to 100 degrees.  The second cut is that, based on what people are wearing, the temperature is probably above 45 degrees (no winter garb) and below 65 degrees (jackets and long sleeves).  I am fairly confident of this refined range of 45 to 65 degrees.  If I have to be more specific, I will estimate (guess with subjectivity) a 55 degree temperature, but be willing to concede that, say, 50 or 50 is equally probable (reasonable).

To summarize, the inside out perspective – a blithe guess using one (or no) method might be tempting at first because it seems reasonable, but we have little confidence in it because of lack of empirical and logical support, and lack of disclosure of a reasoned, reasonable range.  The outside in perspective, by contrast, progressively limits the range, first with facts and logic, and second with subjective judgment.  The result is much more strongly defensible than that of the inside out approach.

Do you see the valuation analogy with respect to the LOMD?  Value (the estimated LOMD) is a range.  The scientific part of appraisal is narrowing the range with (case) facts and (sound appraisal methodology) logic.  The artistic part is narrowing it further and selecting a point estimate (conclusion) with common sense, informed judgment, and reasonability…the considerations enumerated in Revenue Ruling 59-60.

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Valuing Notes Receivable

I have received several inquiries regarding valuation of notes receivable.  Here are some basic thoughts about how to do it.  There is a lot more to it than I have summarized here, but this will give you a general idea.

Assume we are appraising the fair market value of a note receivable for estate tax purposes.  The three approaches to valuation: Market, Asset, and Income, are all candidates.

The Market Approach is problematic because comparables are hard, if not impossible, to find.  Even if we find some, we cannot often determine all of their features (interest rates, interest and principal payment schedules, and other features relevant to value), and that lack of data hamstrings this approach.  I rarely use it.

The Asset Approach applies if the debtor is / could be illiquid or insolvent.  If so, we determine the fair market value of the relevant assets (pledged as collateral or other possible sources of funds), deduct liabilities senior to the note, and determine to what extent it can be repaid on a liquidated basis.  I use it in cases of illiquidity and insolvency.

If the debtor entity or individual is / will be liquid and solvent, we use the Income Approach, Multi-Period Discounting Method.  The relevant cash flows are the principal and interest payments (pretax).  Assume they are stipulated by the note agreement.  What discount rate do we use?

We can explore this with a simple case.  The estate holds a note receivable with a principal amount of $50,000 due in full in 5 years (“balloon maturity”).  The interest rate is 5%.  Interest is due at the end of each year (“in arrears”).  Annual interest is $2,500.  These are the pretax cash flows: $2,500 at the end of years 1 through 4 (interest) and $52,500 at the end of year 5 (interest and principal).

The debtor is a tenured (very high job security) college professor, 50 years old, in good health (long life and earning expectancy, low risk of passing away before the note is due) earning $200,000 annually, saving $25,000 per year, and with a liquid net worth (cash equivalent assets less senior liabilities other than the note) of $300,000.  On these facts, we conclude that there is no risk of the debtor defaulting on any of the payments.  We discount the cash flows at the (pretax, matching the pretax cash flows) risk-free 5-year T-Bond rate (assume it is 4%) and calculate a present value of $52,226.  That is the fair market value of the note.  It is greater than the principal amount because the discount rate is less than the note interest rate.  On the same facts, with a 6% risk-free rate, the note is worth $47,894, less than the principal amount because the discount rate exceeds the note interest rate.

That was easy!

There are many potential complications, all of which involve uncertainty with regard to the magnitude and timing of the relevant cash flows.  The most common ones I have run into include:

  1. The note is a “demand note” with an undefined maturity
  2. There are principal prepayment or deferral options (perhaps with penalties)
  3. The interest rate varies with market rates or other conditions
  4. The note is subordinated to senior obligations
  5. There is risk of default on interest or principal payments because of problems with the debtor’s income or net worth.

The first two can be handled by developing different cash flow scenarios based on case facts and weighting them (subjectively).  The third can be handled with a credible interest rate forecast.  The last two are the hardest, because they require you to add a premium to the risk-free rate to reflect the additional risk of not receiving the expected cash flows (magnitude and timing).  One way to estimate this is to look at the spread between T-Bonds and so-called “junk bonds” (which have higher interest rates because of higher risk of default).  This would be good for a debtor that is a corporate entity.  For individuals, consult a banker for help on the appropriate rates and spreads.  The last two involve credit analysis, something a banker can help you with, and you need it because appraisers are not qualified to do it!

Finally, some notes may have transfer restrictions.  This leads to a discount for lack of marketability, which I appraise the same way I appraise them for private equity.

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Learn From My Goofs!

If I wrote a book called “My Appraisal Goofs,” it would probably run several hundred pages!  The key, of course, is to learn from each one.  Based on that, I hold a PhD in “Goofology!”  (Well, I am an ABD – all but dissertation.)

My latest goof / learning involved rounding.  A very careful accountant was checking my calculations, using the numbers in my hard copy report.  He got results close to but different from mine.

The differences arose only because I did not round intermediate values in my spreadsheet.  For example, a lack of marketability discount calculated in the spreadsheet as 25.6% was displayed in it and the hard copy report as 26%.

I learned from this to use the Excel rounding function to round all intermediate results (such as the discount rate and valuation discounts) in the spreadsheet to their displayed values.  Now, someone checking my hard copy results will come up with the same numbers as calculated in my spreadsheet and as displayed in my report.

Learn from my goofs!

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Crunching the Numbers

This post is about the nitty-gritty task of crunching numbers, specifically calculations not built into your valuation spreadsheets.  Here are two examples to illustrate what I have in mind:

  1. Comparing current valuation calculations to those of a previous report to reconcile differences
  2. Listing reported values, adjustments, and adjusted values of assets and liabilities in a holding entity


Chances are you need to put these calculations in your report.  Why hand write them (or enter them into a calculator) when you have to reenter them in a spreadsheet?  It is much easier to start with a blank spreadsheet, enter the numbers, check them, and create the necessary arithmetic formulas, and format the table.

I realized this about two months ago, and since then have forced myself to do it, saving time and improving accuracy!

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Defining Engagement Parameters

This post gets back to fundamentals: defining the parameters of a valuation engagement.  These include the purpose / use of the appraisal, the valuation date, standard of value, level of value, and premise of value.

In my experience, the first two are almost never an issue.  In some divorces, there is uncertainty about the valuation date (Separation date?  Trial date?  Most recent reporting period?).  By nagging the attorneys, I am able to get that resolved.

Most parameter issues involve the last two: the level of value (relevance of fractional interest discounts / premiums) and the premise of value (e.g. going concern or liquidation).  Until these are agreed, it is impossible to finish the job.  They usually arise in the context of valuations for divorce, dissenting shareholder matters, or actual transactions involving vague (or the absence of) buy-sell agreements.

I have found that there are three criteria that help resolve these two issues: legality, fairness, and economics.  I am not an attorney, and I never opine on legal matters, except that I had an attorney do legal research on my nickel that confirmed that in the State of Ohio, dissenting shareholder matters allow for the application of valuation discounts for lack of control and marketability.  I do not opine on fairness, but sometimes, in draft reports, I will make suggestions about it for the parties to consider.  By economics, I mean consideration of the potential cost of litigation.  For example, if a partner is to be bought out (with no buy-sell agreement in existence) and the combined discount for lack of control and marketability is, say $10,000, then it is probably worth it for the buyer to ignore that discount, pay the $10,000 to the seller, and save on legal fees.  As with fairness, I only suggest, and do not opine.

I hope that this helps you out sometime when you are having trouble defining an engagement’s parameters!

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On BV Designations

I have been appraising private businesses for almost thirty years.  The practitioner debate about the merits of the various BV designations one may earn has been ongoing.  Can we reframe it?

Laws, regulations, and professional standards require that appraisers be qualified to do the required work.  Anyone with a designation (and the required technical knowledge) is deemed qualified by those laws, regulations, standards, and, most importantly, by the vast majority of report users (clients, advisors, auditors, regulators, and the courts).  Few of them know how the designations differ, and (in my opinion and experience), most do not care which one is held, as long as there is one!  Do you really care where your doctor went to medical school or did their internship and residency?  I think you care more about their experience with your particular medical conditions!

One of the worst things appraisers do is to belittle each other’s designations.  Everyone loses when we tear at each other.  Users have accepted us as being qualified.  Mutual denigration just annoys them.

As IBA Founder Ray Miles famously and aptly stated, “the proof of an appraiser’s competence is in their work product.”  AMEN!  In my years as an IBA Qualifications Review Committee member, peer reviewing appraisal reports for CBA applicants, as well as in my private practice, I have read many high quality reports prepared by individuals with no designations, and many low quality reports prepared by individuals holding multiple designations.  Designations do not guarantee competence, only qualification.

If we put these two ideas together – designations are necessary for qualification but not sufficient for competence, and one’s work product proves the latter, then the debate about designation merits becomes moot.  The real question is: what designation(s) will help us provide high quality work products!

The answer depends on your situation: your current skills and needs, and the kinds of appraisals you do (or seek).  This turns the whole debate about designations into something each of us can control!

If you are valuing very large private companies that comparable to public ones, and / or you do a great deal of financial reporting compliance work, the ASA designation and training are invaluable.  The courses are well written and the instructors are top notch.  No other professional appraisal organization’s courses can match ASA’s in those areas.  I earned and held ASA’s in BV and Appraisal Review and Management, but I gave them up last year because I do not serve large private company clients and do relatively little financial reporting work (except for option-related valuations).

If you value medium and smaller sized private companies and have a keen desire to improve your skills (and a masochistic streak), pursue IBA’s CBA.  In my opinion, this offers you advanced training from great instructors, mentoring by experts, and strict peer review that will improve not only your ability but also your confidence.

I hold no other designations, so I am not qualified (!) to discuss them.  I suggest that you take careful inventory of your skills and needs, practice areas and plans, and then be a smart shopper for the designations that make the most sense.  Learn about the course offerings, instructors, and peer reviews, and talk to those who hold the designations you seek.

Just because we should not criticize another’s designations (or qualifications) does not mean others – mainly cross-examiners – should not do so.  That is what Daubert is all about.  I leave that to the attorneys.  I do not participate in it.

We are certainly free to criticize another appraiser’s work product, but we should do so in a constructive manner.  Why unnecessarily inflame passions and make enemies who might turn the tables on you some day?

If another appraiser has made an error of omission or commission, gently point it out and attempt to correct them using case facts, logic, and good appraisal technique.  You know how to do this.

For areas of subjective disagreement (say, the size of the company-specific equity risk premium), recognize and state that appraisals involve judgment and reasonable people can have legitimately different opinions.  Does the difference make a big difference in the ultimate value conclusion?  If not, why argue about it?

For non-appraisal issues (such as the interpretation of poorly drafted buy-sell agreements), it is not our job to resolve them.  Identify the alternatives and present value conclusions for each one, stating that you take no position on them.  If instructed to take a certain position, so state in your report, including who instructed you.

In the end, it is always ultimately about the quality of the work product.  Focus on that for your and other’s work, be constructive, and you will do just fine!

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Pigs Do Well…

We are appraising a minority interest for gift taxation (a family member owns 100% of the business).  Assume liquidated enterprise value is $300 per share and going concern minority marketable value is $100 per share (based on cash flow to the minority shareholder).

Would you apply a lack of control discount to the $100 per share value?

I probably would not.  There is already a 67% discount for lack of control over liquidation implicit in the comparative values that is unarguable since the minority owner cannot force liquidation (without a costly, risky lawsuit), assuming there are no plans by the control owner to liquidate.

I would not argue against a very small (maybe 5%) additional discount for lack of control if there is potential for, say, the control owner to increase their salary at the expense of the minority owner.  I would argue against using Pratt Mergerstat implied lack of control discounts (which can be much larger) because, in my opinion, the discount for lack of control over liquidation is already included in them.

My overarching reason for not applying the additional discount is that pigs do well, but hogs get slaughtered!

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Rules of Thumb

There are many valuation rules of thumb for different industries.  One is that service businesses are worth 1X revenues.  The problem with rules of thumb is that no two thumbs are necessarily alike!  They implicitly assume a relationship between the valuation metric (revenues, in my example) and equity cash flow.  That assumption can be fatal if the subject business differs greatly from the implicitly assumed relationship; i.e. the monetization of the metric to equity cash flow is atypical compared to the rule of thumb due to company-specific risks.

Careful application of the Income Approach explicitly relates the rule of thumb metric to equity cash flow and accounts for company-specific risks in the discount or capitalization rate.  This may lead to a value that is far different from that of the rule of thumb.

Astute readers like you will argue that the Direct Market Data Method routinely uses revenue as a valuation metric, and that Ray Miles says, “the best data on the market comes from the market.”  That is true, provided we have a sample size sufficient for statistical confidence and that there has been no material change in the industry that invalidates historical price / sales multiples.

A strong appraisal will include both an Income Approach and a Market Approach value indication (the latter using rules of thumb and / or guideline sales transactions) and explain (reconcile) the difference in terms of company-specific risks.

Extremely astute readers like you will argue that some businesses, mostly small buy-a-job ones, do not provide equity cash flow to their owners.  True again: here the Income Approach just demonstrates that the business, purchased for the indicated amount, will provide them a fair market salary and be able to service acquisition (and assumed) debt.  Equity cash flow is not relevant.

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Rummy’s Rules and Business Appraisal

One can criticize Donald Rumsfeld for many things, but I think his characterization of information is apt for business appraisal: there are known knowns, known unknowns, unknown knowns, and unknown knowns.

A known known is something like a company’s historical yearend cash balances: an accepted fact.

A known unknown is something like a financial forecast: we understand and accept its uncertainty.

An unknown known is something like ignoring past transactions in a company’s stock: an error on our part.

An unknown unknown is something like whether the business owner will be hit by a bus.  We cannot worry about these.

Thinking further about this, it strikes me that just about every business appraisal has known unknowns…and its accuracy is constrained by them!

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