Income appraisal methods are the preferred approach of most credentialed appraisers. And yet appraisers and behavioral economists know that absent any
other compelling method of determining the values of equity interests in
closely held smaller firms, buyers and sellers will rely on rules of thumb. So, if appraisers conceive of their
task as simply predicting these
exchange prices, then their task is very simple. Rules of thumb will rule.
But appraisals are not simply about predicting exchange prices. Appraisal theory and practice is concerned with stipulating what exchange prices ought to be. Users of appraisals want to know what a fair and reasonable price ought to be for a given firm. The income method explicitly recognizes the importance of this appraisal function by specifying the criterion for rational exchange value. Unfortunately, as it is currently conceived the method uses the wrong criterion for fairness. Income appraisal methods are explicitly normative and not merely descriptive. This is an important distinction in all social science. A social science theory is said to be “descriptive” if it simply describes the state of things. Such a theory is said to be “normative” if it states how things ought to be.
There are two overarching normative principles that inform all variants of income appraisal methods:
Present Value of Equity = Future Cash Flow/Risk.
In the above equation, the present value and future cash flow are measured in dollars and risk is measured as a percentage rate. To understand the income appraisal method it is important to understand the concept of present value. A present value computation is a means of converting a stream of future cash flows to a lump sum. In current appraisal practice, a future stream of cash flows from an SC is converted to a present value using a special type of rate called a discount rate. This discount rate is built up from three components: inflation, opportunity cost, and risk. Click here for a full description of how present values are developed.
There are five insurmountable practical and theoretical problems with the income appraisal approach in its current form. In order of importance:
1. The method only recognizes free cash flow as a driver of goodwill value when owner compensation is often a driver of such value.
2. The method assumes the rationality of hurdle rates. In the context of equity purchases of most closely held firms the application of hurdle rates is irrational.
3. The method assumes that one combined risk rate can accurately reflect all material sources of risk and variation of future cash flows. This is an absurdity.
4. The method makes no effort to develop realistic forecasts
of future cash flow. It relies on a formula for converting future cash flows to
a lump sum that posits that cash flows will grow forever at exactly the same
rate of growth year and year out. Another absurdity.
5. The method fails to account for risk mitigating sales terms often found in equity transfers of closely held firms.
The small size of many closely held businesses precludes the hiring of the internal and external audit staff or the professional management needed to insure that the owner's interests will not be compromised by employees. The agency problems of these businesses cannot be economically overcome without the full-time presence of an owner manager.
Because buyers of these closely held firms must devote full time to the management of the business any cash returns to them are best viewed as wages. These buyers are seeking better wages and not simply free cash flow. For many buyers of small firms, the equity investment is, in economic substance, the buying of a job. The idea that buyers of these small businesses are simply buying a job seems to many in the appraisal community as irrational.
However, investments in higher paying jobs are a widespread economic phenomenon. Individuals invest time and money in the present in order to receive higher compensation in the future. In our economy, individuals invest significant resources on post-secondary education, specialized training, and certification programs. These investments are in the form of cash, foregone wages, and lost leisure time. The expected payback for these investments is higher compensation than would be received without the investment.
Many individuals are willing to acquire equity in small closely held businesses for precisely the same reason. The potential for increased wages is a driver of value of small closely held firms. Yet the income method as currently understood only recognizes free cash flow exclusive of owner compensation as a driver of value. As a practical matter this failure to properly value owner compensation is often offset by the method’s overstating the risk of owning a small closely held firm (see below).
The expected return to investors in post-secondary education, specialized training, and certification programs is a higher wage, not free cash flow. The higher income is received only if the investor stays in the workforce. By analogy, buyers of small closely held businesses often have little or no expectation of deriving free cash flow from their investment in small closely held businesses. The investor expects to reap economic benefits only through full time, continued, active participation in the business. Such investors are driven to invest by the desire for higher compensation than they would receive if they remained non-owner employees.
The distinction between free cash flow and compensation is not merely semantic or formal. Free cash flow represents a return on capital. Compensation represents a return on labor. Generally, returns on capital are driven by macro-economic factors: money supply, inflation, and tax policy. Levels of compensation are mainly driven by microeconomic factors: the supply and demand for certain types of labor in specific industries and business sectors.
As noted above the basic stipulative premise of the
income method is that it is rational to expect and demand a higher rate of
return for riskier businesses as opposed to safer ones. The rate set in the
appraisal process is a hurdle rate. This would be a completely rational
investment criterion for investing in anything other than a closely held firms which demand that the owners have a high degree of experience and
skill. These are exactly the kinds of smaller businesses that tend to generate goodwill. For these investors
the required experience and skill constitute sunk costs for which applying a hurdle
rate is irrational. Click here for more on expertise and experience as sunk costs.
Virtually all of the appraisal effort in applying the current income method is spent trying to find the correct hurdle rate to use in discounting or capitalizing future cash flow. It is extremely foolish to think that one risk rate, no matter how well chosen, can possibly capture all the sources of risk and variation associated with the future discretionary earnings from a closely held firm. A far better and more realistic approach is to utilize computer simulations which identify each source of material risk and variation and assign probability distributions to these sources. Click here for more on computer simulations.
A fundamental and shameful truth about current income methods is that rarely is there ever a serious effort on the part of appraisers applying the technique to accurately forecast future cash flows. This despite the fact that the model explicitly recognizes that the value of the equity is directly a function of those future cash flows.
Instead of making a serious effort at accurate forecasting appraisers apply a conversion factor, called a Gordon Growth rate, to convert the future cash flows into a lump sum. This rate is applied in one of two ways. In one common approach called capitalization of earnings (or one stage approach) the appraiser develops what is called a normalized income statement which they hope is reasonably representative of future earnings. The bottom line cash flow from this income statement is divided by the risk adjusted discount rate less an expected growth rate. The resulting quotient is the supposed value of the equity before liquidity discounts.
Example. Suppose a firm has an expected average annual cash flow over the next few years of $10,000. Suppose further that we expect cash flows to grow at an annual rate of 2%. Assume further that we think the “rational” rate of return for the risk associated with this venture is 10% and the risk-free treasury rate is 3%. This gives us a risk adjusted discount rate of 13%. The capitalization rate is 11% (13%-2%). The present value of the equity is computed to be $10,000/11% = $90,909.
An alternative approach used by credentialed appraisers is to develop a hopefully more meaningful and accurate forecast of future earnings over a five-year period and then apply the above described Gordon Growth conversion factor to the fifth-year forecast cash flow to represent all future cash flows from year six forward. Then all six years are converted to a present value using the risk adjusted discount rate. This is called the two-stage approach.
Example. Suppose a firm has an expected cash flow of $10,000 in year 1, and then grows at differing rates through year five as summarized by the following table. Assume that after year five the cash flow will increase at a constant growth rate of 2%. Assume a risk adjusted discount rate is applied at 13%. The post year five income will be capitalized at 11% (13%-2%). The capitalized cash flow for years six forward is the year five cash flow divided by this capitalization rate, 11,466/.11 or $104,236. This is the value shown in year six. This value is referred to as the terminal value and it represents the present value of the future annual cash flows from year six to the end of time. This table shows the full computation.
The problem with both these approaches, in addition to trying to reduce all sources of variation and risk to one rate, is that the conversion factor is based on the mathematics of a geometric series.
In mathematics you can in effect sum an infinite series using a formula if that series grows at the same rate forever and ever and the rate of growth is between one and zero. The absurdity of using this formula in appraisals is that you have to believe that the firm will generate cash flows at the same exact level of growth forever and ever.
While forecasting future cash flow is certainly an uncertain proposition the one thing anyone can be certain of is that there never has been, nor never will be a business firm that can pull this trick off. For a detailed description of how this growth factor is derived from the sum of a geometric series click here.
What, you may ask, is wrong with assuming a firm will generate future cash flows forever? Quite a bit actually. First, most businesses (particularly smaller ones) do not last beyond twenty years. Second, the buyer of a firm is buying a bundle of assets both tangible and intangible that have finite lives. The intangible asset most frequently sought and purchased is the customer, client or patient (CCP) base. This CCP base for most firms consists of fickle and mortal human beings. CCPs relocate, die, or switch to competitor firms.
Finally, and most importantly capitalizing cash flow until the end of time violates a principle of fairness. Even if it were the case that future cash flows could realistically go on forever, no rational buyer would be willing to in effect pay the seller for all future cash flows. From the point of view of the buyer future cash flows will come from two distinct sources: cash flow from CCPs who were part of the CCP base at the time of the equity acquisition and cash flows from CCPs who will become CCPs after the acquisition. From the buyer’s standpoint it is fair to compensate the seller for cash flows derived from CCPs who were part of the CCP base at the time of acquisition, but not for cash flows from CCPs who first patronize the firm after the acquisition. Click here for more on fairness criteria.
The income method as currently applied develops risk adjusted rates from either the historic movement of publicly traded shares or from surveys of private lenders and investors. In virtually all the equity transactions upon which the data and surveys are based the buyer has the complete burden of risk in regard to future cash returns. In other words, if the buyer of an equity fails to realize their expected cash returns they do not get to adjust retroactively the price of the share.
However, when the equity involved is a small or even medium sized closely held firm, the risk is often shared between the buyer and seller. Many of these equity transfers are deferred sales where the ultimate sale price is dependent upon the realized returns to the buyer for a fixed number of years. These sales terms shift or divide the risk between the buyer and seller. Click here for a description of “earn out” sales.
The use of risk shifting sales terms often makes buying an equity interest in a small or medium sized closely held firm far less risky than the standard income method would indicate due to its reliance on rates of return from equity sales where the entire risk falls on the buyer. Historic trends for these publicly traded sales in the sub-category of small cap equities indicate that higher rates of return have been realized compared with larger cap equities. These smaller cap equities have also exhibited higher volatility than larger caps and this higher volatility is deemed to represent higher risk. Therefore, appraisers using the income method select too high a risk adjusted rate than would otherwise be warranted.
The bottom line is that any appraisal value that derives from a standard income method will yield a fair and reasonable value only by accident. The method overstates future cash flows (assuming that they will grow at a constant rate forever) but often overstates risk (by ignoring risk reducing sale terms). This pushes the value up too high due to the former error, but then pushes the value too low due to the latter method. So, it is possible by sheer luck that these systematic errors precisely offset each other and a reasonable value can be derived. But don’t bet on it. The fact is that the current income methodology is based on a completely unrealistic theory of how real-world buyers and sellers of small closely held firms operate.
Copyright 2018 Michael Sack Elmaleh