Why Has The Value Changed This Year? By Barry

why has the value changed this year? by barry r. goodman, asa, cfa, cpa, abv, cba advanced valuation analytics business valuation

Why Has The Value Changed this Year?
By
Barry R. Goodman, ASA, CFA, CPA, ABV, CBA
ADVANCED VALUATION ANALYTICS
BUSINESS VALUATION CONSULTANTS
INTRODUCTION
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Among their duties, the trustees of the Employees’ Stock Ownership
Plan (“ESOP”) are charged with the fiduciary duty of monitoring any
changes in the value of the stock held by the ESOP. It is the purpose
of this article to discuss the reasons why the value might change, as
well as to explore how this change in value might be communicated to
the trustees and to the participants of the ESOP.
The causes of a change in the value of the ESOP stock can be internal
or external. Internal changes would include changes that are specific
to the sponsor/employer of the ESOP, such as changes in the nature of
the business of the sponsor, changes in key personnel, changes in
earnings, and changes in the financial position of the sponsor (such
as increased levels of debt). External factors include changes in
interest rates, changes in equity returns, changes in the economy
affecting the sponsor’s operations and changes to the specific
industry environment in which the sponsor operates.
INTERNAL FACTORS
Change in Business If the sponsor closes locations, makes
acquisitions, or simply changes the type of business that it does,
this must be considered in the valuation process. The reasons for
these business modifications, along with their expected outcomes in
terms of changes to cash flow or financial position, are also
considered. Changes in the line of business can mean a corresponding
change in the way in which the market approach to valuation is
applied.
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Change in Personnel The departure of one or more key employees can
have a significant impact on the expected cash flow of the business.
Even if the most recent year’s earnings are significantly higher and
the financial position (balance sheet) is stronger, the loss of one or
more key personnel can foreshadow substantially lower profits in the
future. A good appraiser will consider this, and may very possibly
determine that the value has declined despite the higher earnings. For
example, in the case of one corporation that our practice recently
valued, the company lost its top marketing person and one of its
manufacturing managers. These two individuals took approximately 60
percent of that company’s revenue with them, obviously a substantial
factor in the valuation.
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Change in Profits/Cash Flow The definition of value is the present
value of the expected future cash flow. In one way or another, a vast
majority of businesses will be valued using some cash flow or income
as a major factor. Regardless of the valuation methods used, a
substantial increase in a company’s cash flow capacity will normally
result in a substantial increase in the value of that company’s stock.
Similarly, a substantial decline in the cash flow capacity will
normally result in a decline in value. Cash flow capacity is sometimes
referred to as anticipated benefits. An important point to be made is
that the anticipated benefits figure is a “forward-looking” concept.
That is, historic cash flow figures are relevant in the estimation of
anticipated benefits only to the extent that they give some insight as
to the cash flow that the company is likely to generate in the future.
For example, if the current year’s cash flow has increased by 25% from
the previous year’s cash flow, this would normally point to a higher
value. If, however, next year’s earnings are expected to decline by
33%, then this 25% increase might be nullified in terms of its effect
on the anticipated benefits figure.
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Change in Financial Position The value of the company could be
significantly affected by a change in the balance sheet. The most
obvious change would be the assumption of substantial ESOP debt at the
time that the ESOP purchased company stock. Normally, the value that
is used as an adequate consideration figure, which is used to
determine whether the ESOP is overpaying for the company stock, does
not directly consider the manner in which the ESOP will finance its
purchase. For that reason, the ESOP debt will not be directly
considered at the time the transaction is completed.1 In the first
update appraisal, however, this debt will be considered in the
valuation process. For example, if the ESOP purchased all of the stock
of a company that was valued at $10 million, and used a $10 million
loan to finance that purchase, there is little question that the first
update appraisal would result in a substantially lower value.
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EXTERNAL FACTORS
================
External factors can be defined as those factors over which the
management of the company being valued has little or no control.
Changes in these factors can significantly affect the value of a
company from year to year.
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The Economy in General The general condition of the international and
national economies, as well as the economy of the region in which a
company operates, typically produces a significant impact on business
that can change value. For example, a weak economy can result in lower
sales, supply shortages, problems in servicing and securing debt and
other problems. On the other hand, aside from higher profits, a strong
economy can mean shortages of labor and higher prices to pay for
supplies and goods manufactured. Indeed, a very strong economy can be
a negative factor and a weak economy can be a positive factor for some
companies. Pawn shops, for example, typically thrive during weak
economic conditions.
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Interest Rates Aside from affecting the condition of the economy in
general, higher interest rates directly impact the value of equity
securities in theory. Equities must compete with fixed-income
investments, such as bonds and certificates of deposit, for investors.
As interest rates rise, companies must offer higher returns to
investors in order to compensate them for the additional risks that
equities involve. For example, if historic equity returns have been
13%, but interest rates have risen to the point where U.S. Treasury
notes are yielding close to 13%, investors would generally see little
attraction in equities. For that reason, those who are selling
equities, such as other investors and companies making equity
offerings to the public, would have to offer returns higher than 13%
in order to attract investors. Thus, when interest rates increase,
capitalization rates and discount rates also increase. Higher
capitalization rates and discount rates mean generally lower equity
values.
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The Stock Market Trends To what extent should a significant decline in
the general equity market translate into lower prices for the stocks
of closely held companies? The answer to this question involves some
very subjective decisions on the part of the appraiser. For example,
if the decline in the general level of the stock market has resulted
in substantially lower prices for the stocks of companies in the same
industry as the company being valued, as well as in a weaker
merger/acquisition market, then some decline in the value of the stock
of the closely held company may be called for. A 10 percent decline in
the Dow Jones Industrials, however, should not automatically translate
into a 10 percent decline in the value of the stock of a closely held
company in a niche business.
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The Industry/Competition The condition and structure of the industry
environment in which a company operates can have a significant impact
on the operations of that company. Substantially lower commodity
prices, intensifying competition, industry consolidation and other
similar factors can have quite a significant effect on the operations
of an enterprise within the industry. Industry consolidation, for
example, can mean significantly increasing competition from those
larger companies that are able to secure goods and supplies at lower
prices. On the other hand, consolidation can also mean a much stronger
merger/acquisition market if a particular company fits the profile of
a potential consolidation acquisition target.
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A deterioration in industry conditions can cause an appraiser to pay
less attention to strong historic earnings and more attention to
possibly lower earnings that the company being appraised may
experience in the future due to the worsening industry situation.
Again, some averaging of historic earnings and/or cash flow should not
automatically be used to indicate earnings or cash flow capacity for a
company being appraised.
SUMMARY AND CONCLUSIONS
=======================
The appraiser and the trustees must be prepared to communicate to the
participants why the value of the ESOP’s stock has increased or
decreased from the previous year. Clearly, the appraiser must fully
inform the trustees, taking great care to explain the factors
influencing the appraisal; it is the trustees who should then inform
the participants. Appropriate exhibits and illustrations can
frequently be of great benefit in this explanatory process.
In summation, there can be many different factors that cause the value
of the ESOP stock to increase or decrease from one year to the next.
It is part of the appraiser’s task to prepare a report that properly
communicates the reasons for these changes to the trustees, and it is
part of the task of the trustees of the ESOP to communicate the
reasons for the change in value to the participants of the ESOP.
Unfortunately, the reasons for changes in the value of the ESOP stock
cannot be simplified. A 10 percent increase in earnings, for example,
does not automatically translate into a 10 percent increase in the
value of the ESOP’s stock. Clearly understood explanations and
appropriate communication among the participants in the process are
vital if the appraiser’s task is to be successfully completed.
1See Report on Valuation Considerations for Leveraged ESOPs,
(Washington, D.C.: The ESOP Association, 1998), p. 15.
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