Dangers of Relying on a Single-Period Capitalization Mode

Frequently, matrimonial attorneys are presented with an “opinion” of marital asset value of a business equity from a CPA, appraiser or other financial professional, that seems rather basic. Following depositions, arguments often ensue as to the “reliability” of the value, how much effort was expended in the analysis, and whether the “conclusion of value” meets appropriate professional standards. The easiest model in valuation is a single-period capitalization methodology because there are few moving parts. In reality, however, the single period model encapsulates a whole variety of assumptions and estimates that are easy to manipulate but difficult to sustain. The biggest danger to matrimonial attorneys is that the valuation professional will only give this single-period model as the sole support for the opinion, seemingly ignoring other market evidence and asset/liability components. If this is the situation, the matrimonial attorney should understand how to attack the opposing expert, or seek support of his/her expert in a hearing to rehabilitate the expert following a cross-examination scrutiny.

Background

There are three approaches to valuing businesses: the income approach, market approach and asset approach. There are various methods within each of the approaches that the business appraiser can consider in performing a valuation. With perfect information, all methods will yield the “correct” value. Unfortunately, the expert's opinion of business value is necessary because of imperfect information.

A “single-period capitalization model” is one of the methods within the income approach. Under the income approach, the business appraiser can use the capitalized earnings method or the multi-period discount method, sometimes referred to as “discounted cash flow” (DCF). Each method can be prepared on the invested capital method or the equity method. The single period model shows:

[IMGCAP(1)]

In the equation, the “k ' g” is the discount rate less long-term growth, or capitalization rate. If, for example, the concluded discount rate is 23%, and long-term growth is estimated to be 3%, the capitalization rate is 20%. If the long-term stabilized annual income (or earnings, usually net cash flow to equity) in the coming years is, say, $100,000, value for all of the company becomes $500,000, or $100,000 / .20. This calculation assumes that all of the assets and liabilities within the company are necessary to produce the future income, so they are not independently added back unless the appraiser or analyst determines them to be “non-operational” in character. Generally, the capitalization method is used when earnings have stabilized while the discounted cash flow method is used when earnings are unstable. The numerator, or benefit stream estimated is a future view of profitability. The denominator, or capitalization rate, should reflect conditions in the markets as of the date of value of risk and capital markets. The growth estimate should encapsulate near term growth, intermediate growth, and long-term growth collapsed into one number.

Risks

It may sound simple, but it's not. Wide indications of value are possible by arguing that future income is higher or lower, and/or the discount rate or growth rate will vary. Matrimonial attorneys should beware of an appraisal or “conclusion of value” (from a CPA) that only uses the capitalization method and is not supported by other methods. Remember our earlier example of $100,000 / 20% = $500,000 in value? If estimated future earnings rise to $150,000 and the capitalization rate lessens to 15%, value doubles to $1 million ' 50% higher!

Earnings have not stabilized. When applying the capitalization method, one level of earnings, or cash flows, is used. Many factors can affect the future earnings level, including loss of a major customer, loss of key personnel, economic impacts, industry changes and changes in competition. All of these factors can have a dramatic change in perceived earnings levels. If the appraisal assumes earnings have stabilized and, therefore, uses one level of earnings and adjusts only for growth, it will not consider any of these other factors and could potentially overstate or understate value. One variation of this model that is popular with accountants is to divide the capitalization rate by (1 + growth) to apply against last year's historical earnings, such as 20% / (1+0.03) = 19.42%. This gives the impression of using historical performance results to estimate value in the future. Using this variation may be acceptable in a stabilized environment, but it is fraught with risk in a dynamic business environment.

Risk rate will change. The rate of risk (cost of capital) is derived from the current risk free rate and adjusted for equity risk in the stock market, size, industry and specific risk to the particular business being valued. The specific risk can include customer concentration, key person risk, supplier risk, environmental risks and other miscellaneous risks. By using the capitalized cash flow method, one rate of risk is used, forever. Considering all of the things that make up the risk rate, there is wide latitude in how risk is perceived. The proper answer should be “this is what the market says ' ” and sufficient supporting evidence is contained in the valuation analyst's report to allow a logical estimate of the rate chosen.

Normalized growth of the business will change. In applying the capitalized cash flow method, a single growth rate is assumed. In other words, the business being valued is expected to grow by the same percentage, say 3%, year after year, into perpetuity. There is no consideration for variances in growth from year to year for new product lines, increased prices, loss of customers, competition, changes in the mix of expenses, impact on the business due to economic changes or many other influences. All these variances are lumped into one estimated growth rate. Companies typically grow at three “types” of rates ' company specific, industry, and economic. Economic rates are perpetual from inflation, GDP changes, etc. and commonly are 3% to 4%. But if the subject company is growing rapidly, as in a new technology business, the long-term growth should be slightly higher to pick up the near term and intermediate years.

Debt to equity ratio will change. When using the capitalization method to determine the fair market value of invested capital (equity plus interest-bearing debt), a blended rate of risk, based on the portion of interest-bearing debt and equity, is calculated. This rate is referred to as WACC, or weighted average cost of capital. Generally, the cost of debt is much lower than the cost of equity. In other words, equity investors require a higher rate of return since their investment is not secured by the assets of the business. A simple capitalization method using only a single level of earnings to the equity holder will ignore a high-debt or low debt company. Unsophisticated analysts will often ignore debt under the guise of “this is normal debt.” In reality, companies with higher debt are worth less than otherwise identical companies with the same earnings. Unless the analyst uses a WACC model, debt will be overlooked.

For example, if the cost of equity is 20% and the cost of debt is 4% (after tax) and the interest-bearing debt and equity are each 50% of the total invested capital, the WACC rate is 12% (50%*20% plus 50%*4%). If the debt ratio changes to 75% debt and 25% equity, the WACC rate is 8% (25%*20% plus 75% of 4%). The higher the interest-bearing debt ratio to the total, the lower the risk rate and the higher the value of invested capital because the last calculation in a WACC model is to subtract the current interest-bearing debt of the company to see equity value. A wrong assumption of the percentage of interest-bearing debt to invested capital can create a significant variance in value. Keep in mind that a company can have too much debt, and value decreases accordingly.

Capital expenditures will vary. Part of projecting future-expected benefits or cash flows is determining the amount of future capital expenditures. The capitalization method assumes one amount for capital expenditures forever. Machinery and equipment can break down and need replacement; technology equipment including computers can become obsolete sooner than expected; expenses for new buildings and work spaces become necessary, and new equipment can be needed for new products. All are reasons why capital expenditures can change each year.

Working capital needs will vary. Estimating working capital needs is also a part of determining the amount of future cash flows. The capitalization method assumes one amount for working capital increases. Just like capital expenditures, there are many reasons why working capital needs will change. This too can have an impact on the business valuation. Growing companies will need to reserve cash amounts to fund inventory, receivables, and payables.

Non-operational assets and liabilities must be adjusted back. An unsophisticated appraiser or analyst will probably not take the time to investigate the asset and liability mix. Anything that is not necessary for the operation of the business ' ski chalets, airplanes and excess cash/investments are common ' should be adjusted off the earnings stream, independently valued, and added back to the capitalized value indication.

Conclusion

In summary, the income capitalization method is more sensitive to errors because of the fewer moving parts in the equation. Each must be estimated with precision because the assumptions driving the numerator and denominator can vary. The capitalized cash flow method only gives the business appraiser one chance to get expected future benefits and the rate of return right. An error in either one can distort the value.

Penny Lutocka, CPA/ABV, CFE, ASA and Rob Schlegel, FASA, MCBA (a member of this newsletters Board of Editors) are Principals with the Indianapolis, IN, office of Houlihan Valuation Advisors. The authors thank Chris Myjak, an intern.

Frequently, matrimonial attorneys are presented with an “opinion” of marital asset value of a business equity from a CPA, appraiser or other financial professional, that seems rather basic. Following depositions, arguments often ensue as to the “reliability” of the value, how much effort was expended in the analysis, and whether the “conclusion of value” meets appropriate professional standards. The easiest model in valuation is a single-period capitalization methodology because there are few moving parts. In reality, however, the single period model encapsulates a whole variety of assumptions and estimates that are easy to manipulate but difficult to sustain. The biggest danger to matrimonial attorneys is that the valuation professional will only give this single-period model as the sole support for the opinion, seemingly ignoring other market evidence and asset/liability components. If this is the situation, the matrimonial attorney should understand how to attack the opposing expert, or seek support of his/her expert in a hearing to rehabilitate the expert following a cross-examination scrutiny.

Background

There are three approaches to valuing businesses: the income approach, market approach and asset approach. There are various methods within each of the approaches that the business appraiser can consider in performing a valuation. With perfect information, all methods will yield the “correct” value. Unfortunately, the expert's opinion of business value is necessary because of imperfect information.

A “single-period capitalization model” is one of the methods within the income approach. Under the income approach, the business appraiser can use the capitalized earnings method or the multi-period discount method, sometimes referred to as “discounted cash flow” (DCF). Each method can be prepared on the invested capital method or the equity method. The single period model shows:

[IMGCAP(1)]

In the equation, the “k ' g” is the discount rate less long-term growth, or capitalization rate. If, for example, the concluded discount rate is 23%, and long-term growth is estimated to be 3%, the capitalization rate is 20%. If the long-term stabilized annual income (or earnings, usually net cash flow to equity) in the coming years is, say, $100,000, value for all of the company becomes $500,000, or $100,000 / .20. This calculation assumes that all of the assets and liabilities within the company are necessary to produce the future income, so they are not independently added back unless the appraiser or analyst determines them to be “non-operational” in character. Generally, the capitalization method is used when earnings have stabilized while the discounted cash flow method is used when earnings are unstable. The numerator, or benefit stream estimated is a future view of profitability. The denominator, or capitalization rate, should reflect conditions in the markets as of the date of value of risk and capital markets. The growth estimate should encapsulate near term growth, intermediate growth, and long-term growth collapsed into one number.

Risks

It may sound simple, but it's not. Wide indications of value are possible by arguing that future income is higher or lower, and/or the discount rate or growth rate will vary. Matrimonial attorneys should beware of an appraisal or “conclusion of value” (from a CPA) that only uses the capitalization method and is not supported by other methods. Remember our earlier example of $100,000 / 20% = $500,000 in value? If estimated future earnings rise to $150,000 and the capitalization rate lessens to 15%, value doubles to $1 million ' 50% higher!

Earnings have not stabilized. When applying the capitalization method, one level of earnings, or cash flows, is used. Many factors can affect the future earnings level, including loss of a major customer, loss of key personnel, economic impacts, industry changes and changes in competition. All of these factors can have a dramatic change in perceived earnings levels. If the appraisal assumes earnings have stabilized and, therefore, uses one level of earnings and adjusts only for growth, it will not consider any of these other factors and could potentially overstate or understate value. One variation of this model that is popular with accountants is to divide the capitalization rate by (1 + growth) to apply against last year's historical earnings, such as 20% / (1+0.03) = 19.42%. This gives the impression of using historical performance results to estimate value in the future. Using this variation may be acceptable in a stabilized environment, but it is fraught with risk in a dynamic business environment.

Risk rate will change. The rate of risk (cost of capital) is derived from the current risk free rate and adjusted for equity risk in the stock market, size, industry and specific risk to the particular business being valued. The specific risk can include customer concentration, key person risk, supplier risk, environmental risks and other miscellaneous risks. By using the capitalized cash flow method, one rate of risk is used, forever. Considering all of the things that make up the risk rate, there is wide latitude in how risk is perceived. The proper answer should be “this is what the market says ' ” and sufficient supporting evidence is contained in the valuation analyst's report to allow a logical estimate of the rate chosen.

Normalized growth of the business will change. In applying the capitalized cash flow method, a single growth rate is assumed. In other words, the business being valued is expected to grow by the same percentage, say 3%, year after year, into perpetuity. There is no consideration for variances in growth from year to year for new product lines, increased prices, loss of customers, competition, changes in the mix of expenses, impact on the business due to economic changes or many other influences. All these variances are lumped into one estimated growth rate. Companies typically grow at three “types” of rates ' company specific, industry, and economic. Economic rates are perpetual from inflation, GDP changes, etc. and commonly are 3% to 4%. But if the subject company is growing rapidly, as in a new technology business, the long-term growth should be slightly higher to pick up the near term and intermediate years.

Debt to equity ratio will change. When using the capitalization method to determine the fair market value of invested capital (equity plus interest-bearing debt), a blended rate of risk, based on the portion of interest-bearing debt and equity, is calculated. This rate is referred to as WACC, or weighted average cost of capital. Generally, the cost of debt is much lower than the cost of equity. In other words, equity investors require a higher rate of return since their investment is not secured by the assets of the business. A simple capitalization method using only a single level of earnings to the equity holder will ignore a high-debt or low debt company. Unsophisticated analysts will often ignore debt under the guise of “this is normal debt.” In reality, companies with higher debt are worth less than otherwise identical companies with the same earnings. Unless the analyst uses a WACC model, debt will be overlooked.

For example, if the cost of equity is 20% and the cost of debt is 4% (after tax) and the interest-bearing debt and equity are each 50% of the total invested capital, the WACC rate is 12% (50%*20% plus 50%*4%). If the debt ratio changes to 75% debt and 25% equity, the WACC rate is 8% (25%*20% plus 75% of 4%). The higher the interest-bearing debt ratio to the total, the lower the risk rate and the higher the value of invested capital because the last calculation in a WACC model is to subtract the current interest-bearing debt of the company to see equity value. A wrong assumption of the percentage of interest-bearing debt to invested capital can create a significant variance in value. Keep in mind that a company can have too much debt, and value decreases accordingly.

Capital expenditures will vary. Part of projecting future-expected benefits or cash flows is determining the amount of future capital expenditures. The capitalization method assumes one amount for capital expenditures forever. Machinery and equipment can break down and need replacement; technology equipment including computers can become obsolete sooner than expected; expenses for new buildings and work spaces become necessary, and new equipment can be needed for new products. All are reasons why capital expenditures can change each year.

Working capital needs will vary. Estimating working capital needs is also a part of determining the amount of future cash flows. The capitalization method assumes one amount for working capital increases. Just like capital expenditures, there are many reasons why working capital needs will change. This too can have an impact on the business valuation. Growing companies will need to reserve cash amounts to fund inventory, receivables, and payables.

Non-operational assets and liabilities must be adjusted back. An unsophisticated appraiser or analyst will probably not take the time to investigate the asset and liability mix. Anything that is not necessary for the operation of the business ' ski chalets, airplanes and excess cash/investments are common ' should be adjusted off the earnings stream, independently valued, and added back to the capitalized value indication.

Conclusion

In summary, the income capitalization method is more sensitive to errors because of the fewer moving parts in the equation. Each must be estimated with precision because the assumptions driving the numerator and denominator can vary. The capitalized cash flow method only gives the business appraiser one chance to get expected future benefits and the rate of return right. An error in either one can distort the value.

Penny Lutocka, CPA/ABV, CFE, ASA and Rob Schlegel, FASA, MCBA (a member of this newsletters Board of Editors) are Principals with the Indianapolis, IN, office of Houlihan Valuation Advisors. The authors thank Chris Myjak, an intern.