By Terry Silver
Special to the Legal
Business valuations that utilize the Income Approach judge, weigh and calculate the risk associated with the business being valued. Financial markets assess risk by the assignment of a rate of return. Low-risk investments such as U.S. Treasury bonds carry low interest rates to reflect the lower risk. Alternatively, high-risk investments reward the investor with higher returns.
In valuing a privately owned company, where public markets do not assess the risk, the assessment is determined by the valuation analyst. This assessment is one of the most significant and subjective aspects of business valuation.
The analyst must develop the discount rate, which can be thought of as a “cost of capital,” or the expected rate of return that the market requires to attract funds to a particular investment. This rate of return reflects both the time value of money and risk. The key question in the development of this discount rate is: What is an appropriate rate of return to expect if the future cash flows were purchased?
The market value of invested capital (MVIC) of a company is the total value of the company to all invested capital, not just equity stakeholders, but also debt holders. The MVIC includes the market value of all outstanding classes of stock, including long-term, interest-bearing debt. This is useful because it allows comparisons with other companies with varying capital structures.
When using the Income Approach to determine the MVIC, it is critical that the discount rate is relevant and appropriate to the economic income being discounted. In particular, the weighted average cost of capital (WACC) should be utilized when one is discounting cash flows to all capital providers. The result of this calculation gives rise to the MVIC. Said differently, it is the value of the entire investment to all stakeholders, both equity and long-term debt holders. Once the MVIC is determined, one would subtract the interest-bearing debt to arrive at the value of the company’s equity.
To determine the WACC, one needs to determine the company’s cost of equity and debt. Many analysts utilize either the Morningstar-Ibbotson Association Yearbook or the Duff & Phelps Risk Premium Report, and sometimes both. In our business valuations at Citrin Cooperman, we utilize both sources of data to assess risk. We seek to quantify market return, small stock risk and specific company risk (inclusive of macro-environmental and industry risk), using a build-up approach to arrive at the cost of equity. We then compare this result to a blending of historical equity risk indicators over a multi-year period from various business portfolios. If the multiple data sources yield comparable results, there is a higher degree of confidence in our research.
The cost of equity is converted into the WACC by weighting with the tax-impacted debt interest rate via an iterative process. The development of WACC is critical to the valuation conclusion. Care, knowledge and credible research all contribute to the WACC calculation, determined with specific company, industry and economic knowledge and information.
Terry Silver is a certified public accountant, certified valuation analyst and certified in financial forensics for Citrin Cooperman, an accounting, tax and business consulting firm in Philadelphia, where he is a partner with more than 33 years of experience as an accountant and auditor. He focuses his practice on business valuation and financial forensic services, expert testimony and matrimonial actions. He can be reached at firstname.lastname@example.org or 215-545-4800.