We have previously discussed the concepts of normalizing adjustments and control adjustments to the income statement. Developing an understanding of these important adjustments that are made to the income stream is crucial in the process of conducting an appraisal – and why and when certain adjustments are appropriate or not. We learned, for example, that not making normalizing adjustments in minority interest appraisals is inconsistent with the Integrated Theory.
We now need to consider a third category of valuation adjustments, fundamental adjustments. This term is used to describe a category of adjustments employed by appraisers in the application of the guideline company method. I first posed the question about the necessity for fundamental adjustments in the 1989 ACAPM article.[1] In Valuing Financial Institutions published in 1992, we framed the issue as follows:
Business and bank appraisers face a difficult task in developing capitalization rates in situations where they are unable to identify a comparable group of public companies to use as a foundation. The ACAPM model provides some assistance in this regard.
But the analyst sometimes faces an equally imponderable task in assessing where, relative to a public comparable group, to “price” the earnings of a valuation subject. The analytical question is straightforward: How can the analyst justify a significant discount to the P/E multiples derived from public comparables even when it seems obvious that the subject should command a considerably lower multiple?
While a public company comparable group provides an objective basis for comparing a subject company’s results, either with measures of the group average (such as the mean or median) or with regard to the performance of specific companies in the group, appraisers often end up applying what amounts to a large judgmental discount to the comparable group average (e.g., …”on the order of 50 percent based on our detailed analysis”) to obtain a correct (i.e., more reasonable and realistic) valuation multiple to be applied to the subject company.[2]
Interestingly, both in the ACAPM article and in Valuing Financial Institutions, we referred to fundamental adjustments as fundamental discounts. Along the way, however, we learned that private companies can compare both favorably and unfavorably with groups of guideline companies, so we began using the term fundamental adjustments.
A brief review of the GRAPES of Value is appropriate as we begin to address the concept of fundamental adjustments.[3] We begin with “A” (alternative investment world) because of its direct correlation with the guideline company method. While the examples in the following discussion apply to the guideline (public company) method, the considerations raised are applicable to guideline transactions involving entire companies, to guideline transactions involving restricted shares of public companies, or any other relevant comparisons of private enterprises with market transactions.
A – The world of value is an alternative investment world. We value private enterprises and interests in private enterprises in relationship to alternative investments. In using the guideline company method, we look, for example, at groups of similar (or comparable) publicly traded companies to develop valuation metrics for application to private enterprises.
G – The world of value is a growth world. Investors purchase equity securities with the expectation that the underlying enterprises will grow and that their investments will grow in value. This suggests that it would be important, when comparing private enterprises with groups of guideline public companies, to examine the underlying growth prospects for each.
R – The world of value is a world in which risk is both charged for and rewarded. This would suggest that in making comparisons with guideline companies, appraisers should account for differences in the relative riskiness of subject enterprises and the guideline groups.
P – The world of value is a present value world. To the extent that one investment is riskier than another, the impact of that greater risk dampens the present value of expected future cash flows, and therefore, value.
E – The world of value is an expectational world. If it is important to understand the growth prospects of both guideline public companies and private enterprises with which they are being compared, it is also important to examine the impact on value of differences in expectations.
S – The world of value is a sane and rational world. While pockets of seeming irrationality may always exist in the public markets, on balance, the markets operate on a rational basis. It is often incumbent on the analyst to decipher the underlying rationale reflected in market transactions.
The seventh principle in the GRAPES of value is knowledge, which is the basket within which appraisers can hold their symbolic grapes. This review frames the following discussion of fundamental adjustments employed when developing valuation metrics (multiples) for private enterprises based on comparisons with public companies (or other guideline transactions).
In Chapter 3 of The Integrated Theory, we illustrated that the levels of value can be shown conceptually using the Gordon Model. The symbolic representation of the markets’ valuation of a public company was described as:
Conceptually, when we examine price/earnings multiples from guideline public companies, we are seeing the result of the capitalization of expected future cash flows or earnings based on each company’s r and expected g. Using the market approach, analysts often examine market multiples directly and do not attempt to derive either r or g specifically. There is an implicit assumption that reported public company earnings are normalized. In some cases, the analyst may actually make normalizing adjustments to individual public companies before calculating earnings multiples.
When valuing a private company, its normalized cash flows are capitalized based on the appropriate discount rate for that private enterprise (R) and its expected growth in core earnings (G). Conceptually, we define the value of a private enterprise as:
The normalized cash flows of the private company (i.e., the result of adjusting for unusual or nonrecurring items and items like excess owner compensation) are capitalized at the appropriate rate for the enterprise based on its risk profile and growth expectations. This construct works well with direct capitalization (income methods) if the analyst appropriately assesses risk and growth expectations, either with a single period capitalization of earnings or using the discounted cash flow method. In other words, if the discount rate (built-up using the Adjusted Capital Asset Pricing Model) and expected growth of cash flows are appropriately estimated, reasonable valuation indications can be developed.
However, when comparisons are made between a subject private company and public guideline companies, the objective is to compare a subject private company in appropriate ways to ascertain the appropriate discount rate or capitalization rate. Conceptually, this analysis must allow for the following range of comparisons of discount rates.
Quite often, it is the case that the subject private company is riskier than the public companies with which it is being compared. For example, it may be smaller, have key person risks, customer concentrations, or other risks not present in most or all of the selected guideline companies. Skeptical readers might suggest that the selected guideline companies were not sufficiently comparable to the private enterprise for use. However, by common practice, and judicial and client expectation, if there are publicly traded companies somewhat similar to the subject, even if somewhat larger, they will need to be considered for their valuation implications.
As discussed at length in Chapter 6 of The Integrated Theory (1st Edition) regarding the Adjusted Capital Asset Pricing Model, it is common practice when using income methods to “build up” a discount rate. Analysts routinely add a small stock premium to the base, CAPM-determined market premium to account for the greater riskiness of small companies relative to large capitalization stocks, or specify a more refined size premium based on historical rate of return data. In addition, analysts routinely estimate a specific company risk premium for private enterprises, which is added to the other components of the ACAPM or build-up discount rate.
Implicitly, analysts adjust public market return data (from Ibbotson Associates or other sources) used to develop public company return expectations to account for risks related to size and other factors. In other words, they are making fundamental adjustments in the development of discount rates. In so doing, analysts develop credible valuation indications for the subject enterprises.
Now, consider making direct comparisons between a subject enterprise and valuation metrics obtained from a guideline public group. Assume that the subject enterprise is riskier than the public companies used for comparison. Other things being equal (like expected growth in earnings), the direct application of guideline public multiples to the subject private enterprise would result in an overvaluation of the private enterprise.
Why? Because the cash flows are normalized to public equivalent basis and growth expectations are comparable. However, the lower r from the public group was applied to the normalized cash flows of the private enterprise – and the higher (relative) risk of the private enterprise was not captured.
Now, consider that the growth expectations for the subject private enterprise may be the same, greater than, or less than the growth expectations embedded in the public company multiples.
Quite often (indeed, more often), it is the case that the realistic growth expectations for the subject private enterprise are less than the growth expectations embedded in public market pricing. Familiarity with public markets is crucial when examining relative growth expectations between private and public companies.
In direct capitalization methods, analysts typically make estimates of expected future growth to convert their ACAPM or build-up discount rates into capitalization rates. Growth expectations are normally based on historical analysis and realistic expectations for future growth of earnings or cash flows. Based on personal experience, discussions with hundreds of appraisers and reviews of hundreds of appraisal reports, it is fair to say that the typical Ge, or expected growth is less than 10%. When discrete earnings forecasts are made, this observation is also true when direct capitalizations are used to develop terminal value indications.
However, the effective, long-term Ge embedded in the pricing of public companies is often 10% or a bit more. Appraisers who recognize this fact (when true) and who use lower expected growth in income methods implicitly reflect fundamental adjustments in the resulting indications of value.
Other things being equal (like risk), if valuation metrics from guideline public companies are applied directly to cash flows of private enterprises in cases where the growth expectations for the public companies exceed those of subject private enterprises, overvaluation will result. (The opposite result would be true if the private company’s growth expectations exceeded those of the publics.) Therefore, analysts should consider whether a fundamental adjustment is appropriate relative to guideline company multiples, or overvaluation (or undervaluation) will result.
Why? Because the cash flows are normalized to public equivalent basis and risks are comparable in this example. However, the higher Ge from the public group was applied to the normalized cash flows of the private enterprise – and more future cash flow than is realistically available is capitalized.
Most appraisers, even those who have never employed the term fundamental adjustment have employed the same concept in appraisals. In fact, any appraiser who has selected guideline company multiples other than the median (or perhaps, the average), whether above or below, has implicitly applied the concept of the fundamental adjustment. Based on comparisons between private companies and guideline groups of companies, appraisers often select multiples above or below the measures of central tendency for the public groups. In so doing, they are no less applying the concept of the fundamental adjustment than others who make explicit determinations of the adjustments.
As previously discussed, we introduced the concept of fundamental adjustments in the 1989 ACAPM article and in Valuing Financial Institutions in 1992. I have also discussed the concept in many speeches over the years since then. The third edition of Valuing a Business contained a brief, conceptual discussion of the concept, although the term fundamental adjustment was not used. The Pratt/Reilly/Schweihs text provides an example illustrating how to adjust for differences in expected growth and risk.
We will continue with the example where the guideline company indicated price/cash flow multiple is 8, resulting in a capitalization rate for cash flow of 12.5 percent. Let us assume the comparative risk analysis leads us to conclude the discount rate for the subject company would be five percentage points higher than for the guideline companies, which would bring the capitalization rate to 17.5 percent (12.5 + 5.0 = 17.5). On the other hand, let us assume our smaller, riskier company had two percentage points higher infinitely sustainable long-term growth prospects than the guideline companies. This offsetting factor would bring the capitalization rate back town to 15.5 percent (17.5 – 2.0 = 15.5). This, then, equates to a valuation multiple of 6.5 (1 / 15.5 = 6.5).[4]
Given that the adjusted valuation multiple above is 6.5x and the beginning guideline multiple is 8.0x, the Pratt/Reilly/Schweihs analysis implies that a fundamental discount of 19% is appropriate in their example. Unfortunately, this analysis does not appear in the fourth edition of Valuing a Business.
Richard Goeldner, ASA has also focused on the concept of fundamental adjustments. His material on this subject includes the following:
There is need for more investigation, thought, and analysis regarding fundamental adjustments in the application of the guideline company method. However, it should be clear that the concept exists and that consideration of fundamental adjustments is an integral part of the guideline company method.
We can summarize the discussion of fundamental adjustments with the following observations.
In conclusion, we hope that the methods presented here will assist appraisers as they attempt to quantify and to justify fundamental adjustments relative to guideline company multiples. Finally, we hope that this discussion of fundamental adjustments will prompt further consideration and reflection on this issue by others in the appraisal profession.
[Note to Readers: Not included in this brief article, the chapter also provides practical examples of applying fundamental adjustments using a quantitative methodology and consciously selecting valuation parameters other than the median (or average) of a guideline company group for application to private company earnings or cash flows.]
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[1] Z. Christopher Mercer, “The Adjusted Capital Asset Pricing Model for Developing Capitalization Rates: An Extension of Previous ‘Build-Up’ Methodologies Based Upon the Capital Asset Pricing Model,” Business Valuation Review, Vol. 8, No. 4 (1989): pp. 147-156. In that article, I used the term fundamental discount.
[2] Z. Christopher Mercer, “Minority Interest Valuation Methodologies,” Valuing Financial Institutions (Homewood, IL: Business One Irwin, 1992), p. 235. Now available as an e-book. See www.mercercapital.com.
[3] For a further discussion of the “Grapes of Value,” see Chapter 2 of Valuing Enterprise and Shareholder Cash Flows: The Integrated Theory of Business Valuation.
[4] Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 3rd ed. (Chicago, IL: Irwin Professional Publishing, 1996), pp. 225-226.
Reprinted from Mercer Capital’s Value Matters™ 2004-11, December 14, 2004.
