While examining a number of valuation models and arguments by audit personnel, we found that many were overly focused on the use of sophisticated valuation tools rather than on the validity of the underlying data. The idiom "Garbage In, Garbage Out" holds true here. Like we witnessed in the Collateralized Debt Obligations (CDO) debacle on Wall Street, sophisticated valuation models with the wrong data in them or inadequate stress testing are bound to fail. Random scenario based modeling are cost effective and human judgment based discrete scenario methods are more expensive. But, should we rely on the cost-effective, random scenario calculators and ignore the human judgment-based discrete scenario computations? Rather not! The economic debacle has clearly spoken against using black box type methods.
Valuation methods and theories exist that completely define how to value companies and even privately held companies. There is really no need to keep devising newer valuation techniques or building in sophisticated volatility or stochastic models. The focus should be rather on what kinds of data go in them. Are the cash flows reliable? Are the timing of the cash flows appropriate? Are the margin calculations reasonable? Are the 3 or 5 year compounded growth rates of revenues and earnings reasonable. Is the revenue per employee or operating expense per employee reasonable for a company of a particular size, industry structure, competitive environment and financing options? Is the free cash flow to sales ratio broadly in line with industry peers? At Accuserve, we built factor models that adequately capture inputs from both qualitative and quantitative data sources, to assess the risk profile of a privately held company. This profile is then translated into a quantitative discount rate using proprietary models. Our contention is that using straight-up, vanilla Capital Asset Pricing Model or the Ibbotson Model to measure private company discount rates ar fraught with risks, and one that should not be encouraged by audit firms and especially companies that get their done overseas, who invariably employ such short cuts, to save costs and time, and are not true to the American philosophy of investigative conclusions of opinions. But should we let such philosophies creep into our mindsets here? While the private valuations are smaller and perhaps do not have the domino effect that a failed public venture may have ("too big to fail" may not apply to private companies), it is important to learn lessons from the public markets valuation debacle and apply them to private-held companies' valuations as well. That would mean we do NOT need stochastic, black box type options based models that can value thousands of companies within 1 minute, but models that force the exercise of human judgment and force the explanation of the specific economic, industry, company and customer situations that stock holders in private companies face. Valuation models should focus on verification of underlying data and applications for tests of reasonableness, more than the tools themselves. In other words, evidentiary standards on the lines of a judicial inquiry are perhaps more appropriate.
The mistakes that public companies did by outsourcing research overseas and resorting to black box models that led to failures of companies such as Long Term Capital Management (LTCM), on whose Board sat Nobel prize winning economists, says a lot about the lack of exercising subjective judgments. This country cannot afford efficiencies that come with super efficient valuation models that are totally driven by computer models and offshore analysts.
Valuation exercises that make the appraiser, the company's management and employees introspect about the nature of the businesses they are in, the future prospects, whether deployment of capital will yield more than a risk free rate creating more wealth for shareholders, is a proper mix of debt and equity used to achieve the optimal cost of capital, and whether their financial performance is in line or superior to their peers or industry are perhaps the most useful. Valuations that simply are done for the sake of regulations or done such that the cost of doing it is the lowest, with accuracy and relevancy thrown to the winds, have no meaning and should be avoided. This country cannot afford wasteful economic activities anymore, and valuation is certainly an economic activity we can ill-afford to become meaningless.
Finally, IRC 409A valuations impose a set of valuation standards, if adhered to, will surely help companies introspect and gain insights into the beneficial factors I detailed at the beginning of this paragraph. These valuations need to be used as a strategic management exercise. By treating these valuations as something purely regulatory and farming them to the lowest cost destinations perhaps makes these valuation meaningless, a cost that the country can ill-afford.
Thursday, June 24, 2010
Tuesday, June 15, 2010
Several clients ask us questions about what types of information is collected and why. You see, 409A valuations have got more to do with substantiation and evidence and less to do with valuation techniques and number crunching. One of the things we have noticed, especially, in valuation work from overseas is use of data sources, enumeration and explanation of data, and calculation methods that dont quite fit in with US Tax Court lingo or evidentiary standards. We collect information that is more appropriate to pass the evidentiary standards set out in usual IRS court cases and US GAAP standards. This also makes the audit work a breeze as most information they are looking for is set in in the manual. While working with one client, they mentioned that a company in India charges less for valuations and then when we inquired as to what they normally ask and process, the client mentioned that they use a single approach to arrive at results for all firms. Use of a single approach goes against the well established US evidentiary standard that all available approaches have to be weighed, before one or more approaches can be discarded. This "discarding" process has to be shown through calculations and comments. Cutting work short and then paying less for that defeats the evidentiary standards set out in the US. While the cost, income and market approaches are the usual methods to evaluate a firm or its assets' valuation, use of these methods have to be relevant and appropriate to how the "most advantageous transactions" market currently uses them. The valuations have to be created to reflect as if the buy or sale transaction occurred in the most advantageous market. Another thing to note that is the fact that, in the US we have something called "investment value", that widely differs from fair market value. Investment value cannot be used for 409A valuations. In reviewing valuations from overseas, we find that specific notations to which valuations are "investment" and which are "fair market", are totally missing. We are not sure how these valuations even pass US audit requirements as many of the valuations are shallow and will not stand scrutiny here, should the IRS were to scrutinize them in the future. While many of these foreign firms are presenting a quick, short valuation report, companies beware that they may not meet US evidentiary standards. We do understand the analytical strengths and cost advantages associated with doing overseas work. But cutting prices and sacrificing evidentiary standards is something we cannot advocate to any of our clients.