Illustrative Discounted Cashflow Analysis ($ Millions) Year 1 Year 2 Year 3 Year 4 Year 5 revenues less: Cost of Goods Sold

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1 FInAnCIAL VALuATIOn - The Income Approach terminal value: A Look at Some Key Issues Take a look at the illustrative discounted cash flow (DCF) model, below. It looks pretty typical profitable and both top line and net operating profit after taxes (NOPAT) growing strongly, with a much lower long-term growth rate. Note that fully 70 percent of the invested capital value is in the terminal value calculation. Not surprising, since the company appears to be making some larger capital expenditures (CapX) investments early on that will support the expected growth. So it is important to the value indication that the terminal value calculations are supportable and make sense. But look closely; do you see the obvious error in the terminal value calculation? While the focus of this article is on terminal value, the issues outlined are just as relevant to a single period capitalization valuation model. After all, as discussed later, a terminal value is merely a single period capitalization WILLIAM quackenbush, MBA, ASA, MCBA, ABAR Advent Valuation Advisors, LLC Montgomery, NY bill@adventvalue.com model applied in a DCF analysis once economic benefit stability is reached. The fact is, there are a lot of mov- Illustrative Discounted Cashflow Analysis ($ Millions) Year 1 Year 2 Year 3 Year 4 Year 5 revenues less: Cost of Goods Sold Gross Profit less: Operating Expenses Operating Income less: Taxes 40% nopat plus: Depreciation Gross Cash Flow to Invested Capital (15) (19) (23) (24) (25) (10) (13) (15) (17) (18) (10) (12) (15) (17) (18) less: net Changes in working less: Capital Expenditures net Cash Flow to Invested Capital wacc 12% PV (3) (4) (5) (6) (6) (15) (4) (3) (3) (3) PV of Years 1-5( a ): 68.5 Terminal Value Calculation: Terminal Cash Flow: 23 Growth rate: 3.0% 23.7 Capitalization rate: 9.0% PV Factor Terminal Value ( b ): Indicated Value of Invested Capital ( a + b ): FVLE Issue 46 December 2013/January 2014 Page 10

2 ing parts in a discounted cash flow model. In developing a DCF we need to address the discrete forecast period growth, operating margins, and tax issues. We need to determine the balance sheet impacts on cash flow, including CapX, working capital, and in an equity model, financing debt, both in and out (see illustration on page 13). Then there s the development of the WACC. And all these factors, plus an estimate of long-term sustainable growth, play into the development of the terminal value calculation. So what are the key components to focus on in a terminal value calculation? STABILIzED ECONOMIC BENEFIT TO THE INTEREST VALUED We hear stories or read case law where in some venues the trier of fact refuses to consider a discounted cash flow model because it is a prognostication of the future, which nobody really can know. Instead, the trier of fact is much more comfortable with a single period capitalization model using some sort of average of past performance. Maybe the trier of fact wants to see something simple, something that can be easily understood. So, if we assume some average of the past and constant growth rate into perpetuity (even if zero), the relatively simple single period capitalization valuation formula is as follows: Value = Cash flow 1 k g I hate to disappoint you, your honor, but a single period capitalization model is just as much a prognostication of the future as a DCF model is, and maybe with more unreasonable assumptions too. The single period capitalization model is nothing more than a discounted cash flow model that can be mathematically simplified when constant growth is assumed. Let s go back to basic theory. If the expected cash flows are variable and continue forever, the discounted cash flow formula looks like the following: Value = CF 1 + CF 2 + CF CF (1+k) (1+k) 2 (1+k) 3 (1+k) The formula assumes we are forecasting discrete cash flows each and every year, and separately converting each year to present value and summing the results to get a value indication. Variable growth in discrete forecasts can have significant impacts on several value metrics, including operating margin. In real life, profit margin is rarely constant in a strong growth environment. Economies of scale, changes in productivity levels, the proportion of fixed versus variable expenses, and capital expenditures significant enough to support significant blocks of accelerated growth subsequent to the CapX investment, impact margin and cash flow, as do the more qualitative issues of management depth and competency, industry and market capacity, and response to growth. However, since we all know it is impractical (and unrealistic) to forecast variable cash flow into perpetuity, a more reasonable approach is to forecast cash flows for a period of time until variances in cash flow from year to year diminish. Why do these variances diminish? First, as we forecast farther and farther out, we have less justification for specific variances so we make reasoned assumptions regarding constant change rather than variable change. Second, the impact of variances on the present value of those far-distant forecasts become immaterial to the analysis and value indication. Since the business will still generate returns beyond the end of the forecast period, we estimate a terminal value, i.e., the company s value at the end of the forecast period. The terminal value is a single period capitalization model invoked when we can no longer empirically support a discrete year-to-year forecast and assume constant growth. As we mentioned earlier, the single period capitalization model assumes constant growth. Illustratively, the formula with a three-year discrete period forecast is as follows: CF 4 Value = CF 1 + CF 2 + CF 3 + k - g (1+k) 1 (1+k) 2 (1+k) 3 (1+k) 3 So the discrete period forecast should continue out as long as specific variances in economic benefit are known or can be forecast with an acceptable reasonableness of clarity (I hesitate to use the word, assurance). Once stabilized net cash flow has been reached or assumed, then the balance of the forecast can be captured in the single period capitalization model (the terminal value). Implement the terminal value calculation too soon and you may miss known or predictable variances in cash flow that will impact the value indication. Implement it too late, and the supportability of the discrete projections diminishes. DEPRECIATION AND CAPX Generally, we value the economic benefit to the subject interest, not the accounting benefit, so we focus on cash flow rather than income. That is why we consider adjustments for non-cash expenses such as depreciation and amortization. We also consider the balance sheet impacts on economic benefit, including capital expenditures and working capital needs, particularly when driven by growth. Additionally, when valuing equity directly, we also consider the impact of changes in financing debt levels from year to year both repayments of existing debt FVLE Issue 46 December 2013/January 2014 Page 11

3 and acquisition of additional financing debt. Did you find the obvious error in the terminal value calculation portion of the DCF model illustration? It is the relationship between CapX and depreciation expense. For the terminal year, CapX is forecasted to be $3 million, and growing into perpetuity by the long-term sustainable growth rate. Depreciation is forecasted to be $5 million and growing into perpetuity by the long-term sustainable growth rate. How can that be? The answer is: It can t. We cannot have more deprecation on an ongoing basis than we have in CapX. If we did, the implication is that the company will have significant negative fixed assets on its balance sheet, as accumulated depreciation growth outstrips the growth in the cost basis of fixed assets purchased. The terminal year must show the proper perpetual relationship between CapX and depreciation expense. In our DCF illustration this error causes a misstatement of value of 10 percent or more. Some will make the simplifying assumption that CapX, over the long run, will equal depreciation expense and that might work for small companies under certain scenarios. For example, on a cash flow basis, small businesses get a substantial tax break on tax-based depreciation expense under U.S. tax law through Section 179 expensing. So on a cash basis, as long a CapX is less than the limits of Section 179, then depreciation and CapX may indeed be equivalent. However, this happens only with a small set of given circumstances such as above for small companies or if no long-term sustainable growth is forecasted. For the rest we must develop an assumption as to the relationship between CapX and depreciation. The tables above illustrate one way to develop such a relationship assumption. Given expectations regarding depreciation schedules and long-term sustainable growth, we can forecast out future CapX and the related depreciation. In the first table we Initial Cap X: 1,000 ltgr: 4.0% # Years Depr: 7 Year: CapX: 1, , , , , , , Annual Dep: assume a seven-year straight-line depreciation term and a four percent long-term sustainable growth rate (LTGR). Year seven s depreciation expense is the sum of one year s depreciation of each of the last seven year s CapX. Dividing the depreciation by the CapX in year seven yields a relationship of 0.892:1 as between depreciation and CapX. This makes intuitive sense. If we assume constant growth and we are depreciating prior period, less expensive CapX, then the sum of the depreciation has to be less than the last year s CapX. Now look at the second table. We have now assumed a 2.5 percent LTGR and a five-year depreciation schedule. The relationship between depreciation to CapX is now 0.952:1. The fact that the relationship is closer to 1:1 in the second table makes sense. With a lower growth rate and a shorter depreciation schedule, the compounding effect of growth has less impact. So now we have a way to develop our terminal year impact of both CapX and depreciation expense on value that can be empirically support- Compounded CapX in Year 7: 1, Total Depreciation in Year 7: 1, Depreciation to Capx Ratio: 89.2% Capx to Depreciation Ratio: 112.1% Initial Cap X: 1,000 ltgr: 2.5% # Years Depr: 5 Year: CapX: 1, , , , Annual Dep: Compounded CapX in Year 5: 1, Total Depreciation in Year 5: 1, Depreciation to Capx Ratio: 95.2% Capx to Depreciation Ratio: 105.0% ed. For additional information about the relationship between CapX and depreciation, see FVLE Issue 8, Aug./Sept. 2007, The Ratio of Depreciation and Capital Expenditures in DCF Terminal Values by M. Mark Lee. WORKING CAPITAL A lot of DCF modeling that we see is focused on EBITDA. Those models not only ignore the investment in operating assets and their impacts on cash flow, but also ignore the working capital needed to fund forecasted growth. If the equity discount rate or WACC that is employed is developed from traditional BV sources, the developed required return relates to net cash flow on equity or invested capital, respectively. Ignoring the impact of working capital causes a mismatch between the economic benefit and the discounting rate, as working capital is a component of the net cash flow returns to equity and invested capital. And unless our client provides us with a cash burn forecast and that is typical only for startups either seek- FVLE Issue 46 December 2013/January 2014 Page 12

4 ing, or just receiving capital, the projections we get typically only address the income statement, and only rarely the balance sheet. Even in the latter case, the balance sheet projection is typically focused on cash balances and debt balances. But future working capital needs can have a dramatic impact on value, not only in the typically higher growth, discrete forecast years, but also in the terminal value calculation. One way to forecast working capital needs when the client does not, or cannot, provide them, is to expand the income statement projections into balance sheet projections. This not only helps quantify CapX and debt issues, but also working capital issues, and provides a sanity check to the income statement projections, particularly when comparing the forecast to historical metrics. In my nearly forty years of banking, financial consulting and valuation work, the two most common errors I see in financial projections are overstated margins and an understatement of CapX necessary to support the expected growth. Both of these errors cause an excessive forecasted buildup of cash, which hides the need for working capital required to make the projections a reality. Expanding income statement projections to balance sheet and cash flows also provides an opportunity for us to discuss more realistic expectations with management and develop an integrated forecast of working capital. Another way to forecast working capital needs is by using industry or peer group working capital turnover rates to estimate the subject company s working capital needs. Either way, you will have to come to a decision as to how much working capital will be needed on an ongoing basis in your terminal value model. In our earlier DCF illustration, working capital growth accounts for a 20 percent adjustment to terminal cash flow a significant impact on value. Invested Capital Net Cash Flow Revenue less Cost of sales less Operating expense = Operating Income (EBIT) less Taxes on EBIT = Net operating profit after tax (NOPAT) plus Depreciation & amortization = Gross cash flow less Increase in working capital less Capital expenditures = Invested Capital Net cash flow TERMINAL VALUE ON AN EqUITY BASIS WHAT TO DO WITH DEBT? Valuing equity directly by applying a DCF model to equity cash flow returns rather than invested capital cash flow returns requires the consideration of the impact of debt financing on equity cash flows both on the income statement in the form of interest expense, and the balance sheet in terms of debt service and new debt acquisition. Certainly the terminal year cash flow to equity cannot show a reduction in debt levels. As a perpetuity, that would imply decreasing debt forever, and you cannot get past zero. We could show no net changes in debt in the terminal year, but that implies an everchanging debt-to-equity ratio, as company equity grows over time while debt remains constant. Rather, if the subject company consistently avails itself of debt, then debt levels are likely to grow over time in support of growing operating assets and a net increase in debt in the terminal year may be appropriate. These complications compound when applying a DCF directly to a minority equity interest that cannot impact either the WACC or the use (or nonuse) of debt. With the exception of applying a DCF model to some sort of minority dividend payment stream, limiting the use of a DCF model to value invested capital with a market-weighted WACC and subtracting debt from invested capital to derive the value of equity quite nicely deals with these issues. EXIT MULTIPLES? In application, an exit multiple rather than a terminal value calculation is more often seen in M&A transactionrelated valuations, in the investment banking world, and for larger private company valuations where relevant publicly traded company multiples can be more easily derived. A terminal value is derived with an exit multiple by developing a pricing multiple from current market evidence and applying that multiple to the operating metric of the subject company as of the (in the future) terminal value date. Certainly an exit multiple may be more appropriate than a terminal value calculation when there is a planned exit or liquidating event in the subject company s future. But what about when there is a long-term or perpetual hold expected? In the situation when no liquidity event is expected and an exit multiple is employed, the reader of our report has to get by the intellectual hump of applying today s market-evidenced multiple to a metric that may or may not occur sometime off in the future, typically five or more years away. Essentially an exit multiple is a guideline public company method FVLE Issue 46 December 2013/January 2014 Page 13

5 Kick off your CPE for the new year with this great webinar! New Year BV Update The new Concepts, Data, Models and Methods from 2013 That You need to know and Understand wednesday, January 8, 2014 Are you way behind in your reading in 2013? Is your new year s resolution to wade through that stack of publications on your desk? This webinar will help you keep that resolution and clear that clutter! we will only present what we believe to be some of the most important pieces of BV information from This will include only new concepts, data, models and methods in such areas as cost of capital, discounts for lack of marketability, excess compensation, S corps, BV standards and BV mistakes in tax court. JIM HITCHNER, CPA/ABV/Cff, ASA HAROLD MARTIN, CPA/ABV/Cff, ASA, CfE Managing Director, Financial Valuation Advisors Partner in Charge, Valuation and Forensic CEO, Valuation Products and Services Services, keiter President, The Financial Consulting Group Coauthor, Financial Valuation Applications Coauthor, Financial Valuation Applications and Models, 3rd edition and Models, 3rd edition Panel of Experts, Financial Valuation and Coauthor, PPC s Guide to Business litigation Expert Valuations, 23rd edition Adjunct faculty member, The College of Former member of the AICPA BV Standards william and Mary writing Task Force ASA richmond Chapter, former president, AICPA Business Valuation Volunteer of the vice president, and treasurer Year Award, two-time recipient AICPA Business Valuation Volunteer of the Inductee in the AICPA BV hall of Fame Year Award, two-time recipient Inductee in the AICPA BV hall of Fame Handouts: VPS webinar PowerPoint slides Articles webinar transcript Publication citations learning Objectives: The participant will learn what two of the leaders in the valuation profession think are some of the most important things that happened in 2013 The participant will be updated on the uses of Ibbotson and Duff & Phelps data in the build up model and the modified capital asset pricing model The participant will learn about the Implied Private Company Pricing line (IPCPl) for cost of capital (based on Pratt s Stats) The participant will be updated on the Private Cost of Capital Model (PCOC) and the Pepperdine private capital markets project (based on survey data) The participant will learn about new techniques and research in discounts for lack of marketability The participant will learn about a new technique to adjust for excess compensation The participant will learn how state and local taxes affect the valuation of S Corps The participant will gain new insight into the use of calculation engagements and calculation reports including USPAP-compliant calculations The participant will learn about mistakes to avoid in business valuation based on tax court decisions Special Addition Polling data on what s being done in important areas of business valuation for details or to register, CLICK HERE or go to quackenbush, continued used as the terminal value, although in practice we often find a much less rigorous development of the multiple, which can be problematic. We ran across a DCF valuation that applied an exit multiple to year six metrics that derived a DCF value indication that was materially less than the value indication derived by applying the same multiple to current company metrics. A pricing multiple is simply the inverse of the cap rate related to the operating metric a price-to-earnings multiple of 12.5 times is an 8 percent earnings cap rate, for example. So if a pricing multiple is used, it is not too hard to sanity check the implied cap rate from that multiple to the implied cap rate from our cash flow discount rate (or WACC), recognizing the differences in the two types of cap rates (earnings vs. cash flow). You can also check the implied growth rate embedded in the exit multiple. See FVLE Issue 44, Aug./Sept. 2103, Business Valuation Mistakes: How to Avoid Them: Income and Cash Flow, DCF and Terminal-Year Exit Multiples. SUMMARY Occasionally there is a tendency to focus more time and effort on certain parts of our valuation exercise than on others. Some have been accused of spending an inordinate amount of time developing an appropriate equity discount rate down to the tenth or hundredth of a percent only to whack the concluded value with a 35 percent discount for lack of marketability without much support. So, too, can we be guilty of developing sophisticated forecast modeling, only to go lax on the terminal value. These suggestions can help us avoid that valuation faux pas. c experttip A single period capitalization model is just as much a prognostication of the future as a DCF model is, and maybe with more unreasonable assumptions too. FVLE Issue 46 December 2013/January 2014 Page 14