The medical device manufacturing industry produces equipment designed to diagnose and treat patients within global healthcare systems. Medical devices range from simple tongue depressors and bandages, to complex programmable pacemakers and sophisticated imaging systems. Major product categories include surgical implants and instruments, medical supplies, electro-medical equipment, in-vitro diagnostic equipment and reagents, irradiation apparatuses, and dental goods.
The following outlines five structural factors and trends that influence demand and supply of medical devices and related procedures.
The aging population, driven by declining fertility rates and increasing life expectancy, represents a major demand driver for medical devices. The U.S. elderly population (persons aged 65 and above) totaled 49 million in 2016 (15% of the population). The U.S. Census Bureau estimates that the elderly will roughly double by 2060 to 95 million, representing 23% of the total population.
The elderly account for nearly one third of total healthcare consumption. Personal healthcare spending for the population segment was $19,000 per person in 2014, five times the spending per child ($3,700) and almost triple the spending per working-age person ($7,200).
According to United Nations projections, the global elderly population will rise from approximately 607 million (8.2% of world population) in 2015 to 1.8 billion (17.8% of world population) in 2060. Europe’s elderly are projected to reach approximately 29% of the population by 2060, making it the world’s oldest region. While Latin America and Asia are currently relatively young, these regions are expected to undergo drastic transformations over the next several decades, with the elderly population expected to expand from less than 8% in 2015 to more than 21% of the total population by 2060.
Demographic shifts underlie the expected growth in total U.S. healthcare expenditure from $3.5 trillion in 2017 to $6.0 trillion in 2027, an average annual growth rate of 5.5%. While this projected average annual growth rate is more modest than that of 7.0% observed from 1990 through 2007, it is more rapid than the observed rate of 4.3% between 2008 and 2017. Projected growth in annual spending for Medicare (7.9%) is expected to contribute substantially to the increase in national health expenditure over the coming decade. Healthcare spending as a percentage of GDP is expected to expand from 17.9% in 2017 to 19.4% by 2027.
Since inception, Medicare has accounted for an increasing proportion of total U.S. healthcare expenditures. Medicare currently provides healthcare benefits for an estimated 60 million elderly and disabled people, constituting approximately 15% of the federal budget in 2018. Medicare represents the largest portion of total healthcare costs, constituting 20% of total health spending in 2017. Medicare also accounts for 25% of hospital spending, 30% of retail prescription drugs sales, and 23% of physician services.
Owing to the growing influence of Medicare in aggregate healthcare consumption, legislative developments can have a potentially outsized effect on the demand and pricing for medical products and services. Net mandatory benefit outlays (gross outlays less offsetting receipts) to Medicare totaled $591 billion in 2017, and are expected to reach $1.3 trillion by 2028.
The Patient Protection and Affordable Care Act (“ACA”) of 2010 incorporated changes that are expected to constrain annual growth in Medicare spending over the next several decades, including reductions in Medicare payments to plans and providers, increased revenues, and new delivery system reforms that aim to improve efficiency and quality of patient care and reduce costs. On a per person basis, Medicare spending is projected to grow at 4.6% annually between 2017 and 2027, compared to 1.5% average annualized growth realized between 2010 and 2017, and 7.3% during the 2000s.
As part of ACA legislation, a 2.3% excise tax was imposed on certain medical devices for sales by manufacturers, producers, or importers. The tax had become effective on December 31, 2012, but met resistance from industry participants and policy makers. In late 2015, Congress passed legislation promulgating a two-year moratorium on the tax beginning January 2016. In January 2018, the moratorium suspending the medical device excise tax was extended through 2019.
The primary customers of medical device companies are physicians (and/or product approval committees at their hospitals), who select the appropriate equipment for consumers (patients). In most developed economies, the consumers themselves are one (or more) step removed from interactions with manufacturers, and therefore pricing of medical devices. Device manufacturers ultimately receive payments from insurers, who usually reimburse healthcare providers for routine procedures (rather than for specific components like the devices used). Accordingly, medical device purchasing decisions tend to be largely disconnected from price.
Third-party payors (both private and government programs) are keen to reevaluate their payment policies to constrain rising healthcare costs. Several elements of the ACA are expected to limit reimbursement growth for hospitals, which form the largest market for medical devices. Lower reimbursement growth will likely persuade hospitals to scrutinize medical purchases by adopting i) higher standards to evaluate the benefits of new procedures and devices, and ii) a more disciplined price bargaining stance.
The transition of the healthcare delivery paradigm from fee-for-service (FFS) to value models is expected to lead to fewer hospital admissions and procedures, given the focus on cost-cutting and efficiency. In 2015, the Department of Health and Human Services (HHS) announced goals to have 85% and 90% of all Medicare payments tied to quality or value by 2016 and 2018, respectively, and 30% and 50% of total Medicare payments tied to alternative payment models (APM) by the end of 2016 and 2018, respectively. A report issued by the Health Care Payment Learning & Action Network (LAN), a public-private partnership launched in March 2015 by HHS, found that 34% of payments were tied to APMs, a 5% increase from 2016 to 2017.
Some expressed concern that the shift toward value-based care would encounter difficulties with the current administration. In November 2017, the CMS partially canceled bundled payment programs for certain joint replacement and cardiac rehabilitation procedures. However, indications are that the CMS supports value-based care and wants pilot programs to accelerate. Ultimately, lower reimbursement rates and reduced procedure volume will likely limit pricing gains for medical devices and equipment.
The medical device industry faces similar reimbursement issues globally, as the EU and other jurisdictions face increasing healthcare costs, as well. A number of countries have instituted price ceilings on certain medical procedures, which could deflate the reimbursement rates of third-party payors, forcing down product prices. Industry participants are required to report manufacturing costs and medical device reimbursement rates are set potentially below those figures in certain major markets like Germany, France, Japan, Taiwan, Korea, China, and Brazil. Whether third-party payors consider certain devices medically reasonable or necessary for operations presents a hurdle that device makers and manufacturers must overcome in bringing their devices to market.
Historically, much of the growth for medical technology companies has been predicated on continual product innovations that make devices easier for doctors to use and improve health outcomes for the patients. Successful product development usually requires significant R&D outlays and a measure of luck. However, viable new devices can elevate average selling prices, market penetration, and market share.
Government regulations curb competition in two ways to foster an environment where firms may realize an acceptable level of returns on their R&D investments. First, firms that are first to the market with a new product can benefit from patents and intellectual property protection giving them a competitive advantage for a finite period. Second, regulations govern medical device design and development, preclinical and clinical testing, premarket clearance or approval, registration and listing, manufacturing, labeling, storage, advertising and promotions, sales and distribution, export and import, and post market surveillance.
In the U.S., the FDA generally oversees the implementation of the second set of regulations. Some relatively simple devices deemed to pose low risk are exempt from the FDA’s clearance requirement and can be marketed in the U.S. without prior authorization. For the remaining devices, commercial distribution requires marketing authorization from the FDA, which comes in primarily two flavors.
Pursuant to the Medical Device User Fee Modernization Act (MDUFA), the FDA collects user fees for the review of devices for marketing clearance or approval. The current iteration of the Medical Device User Fee Act (MDUFA IV) came into effect in October 2017. Under MDUFA IV, the FDA is authorized to collect almost $1 billion in user fees, an increase of more than $320 million over MDUFA III, between 2017 and 2022.
The European Union (EU), along with countries such as Japan, Canada, and Australia all operate strict regulatory regimes similar to that of the FDA, and international consensus is moving towards more stringent regulations. Stricter regulations for new devices may slow release dates and may negatively affect companies within the industry.
Medical device manufacturers face a single regulatory body across the EU. In order for a medical device to be allowed on the market, it must meet the requirements set by the EU Medical Devices Directive. Devices must receive a Conformité Européenne (CE) Mark certificate before they are allowed to be sold in that market. This CE marking verifies that a device meets all regulatory requirements, including EU safety standards. A set of different directives apply to different types of devices, potentially increasing the complexity and cost of compliance.
Emerging economies are claiming a growing share of global healthcare consumption, including medical devices and related procedures, owing to relative economic prosperity, growing medical awareness, and increasing (and increasingly aging) populations. As global health expenditure continues to increase, sales to countries outside the U.S. represent a potential avenue for growth for domestic medical device companies. According to the World Bank, all regions (except Sub-Saharan Africa and South Asia) have seen an increase in healthcare spending as a percentage of total output over the last two decades.
Global medical devices sales are estimated to increase 6.4% annually from 2016 to 2020, reaching nearly $440 billion according to the International Trade Administration. While the Americas are projected to remain the world’s largest medical device market, the Asia/Pacific and Western Europe markets are expected to expand at a quicker pace over the next several years.
Demographic shifts underlie the long-term market opportunity for medical device manufacturers. While efforts to control costs on the part of the government insurer in the U.S. may limit future pricing growth for incumbent products, a growing global market provides domestic device manufacturers with an opportunity to broaden and diversify their geographic revenue base. Developing new products and procedures is risky and usually more resource intensive compared to some other growth sectors of the economy. However, barriers to entry in the form of existing regulations provide a measure of relief from competition, especially for newly developed products.
The August 2019 Bank Watch described key considerations in analyzing the financial statements of banks. However, we did not address one crucial set of relationships – those between a bank holding company (“BHC”) and its subsidiary depository institution.
Most banks are owned by bank holding companies. While investors often state that they own an interest in a bank, this may not be legally precise. Usually, they own a share of stock in a bank holding company, which in turn owns a controlling interest in a subsidiary bank’s common stock. Where a bank holding company exists, this entity’s common stock generally is the subject of valuation analyses.
Part 3 of the Community Bank Valuation series explores important relationships between banks and their holding companies, focusing particularly on cash flow and leverage.
Compared to a bank’s balance sheet, a holding company’s balance sheet has fewer moving parts. The “left side” of its balance sheet, or its assets, usually is rather boring. The more intriguing analytical question, though, is how the bank holding company finances its investment in the bank. The following table presents a balance sheet for a BHC controlling 100% of the common stock of a bank with $500 million of total assets.
Usually, the holding company’s assets consist virtually entirely of its investment in its subsidiary bank or banks, which equals the bank’s total equity. The investment in the bank is carried at equity, meaning that it increases by the bank’s net income and decreases by dividends paid from the bank to the holding company, among other transactions. Other material assets may include:
Interestingly, BHCs can borrow from banks – just not their bank subsidiary – and other capital providers. If the funds are downstreamed into the bank, the borrowings can be transformed from an instrument not includible in the BHC’s regulatory capital into Tier 1 capital at the bank. In order of seniority these funding sources include:
A BHC’s equity usually consists almost entirely of common stock, which generally must be the principal form of capitalization under BHC regulations. However, BHCs can issue preferred stock, and regulations view most favorably non-cumulative, perpetual preferred stock.
Why do holding companies exist? First, they provide an efficient way to raise funds that can be injected as capital into the bank, thereby accommodating its organic growth. Second, they can facilitate acquisitions. Third, BHCs can more efficiently conduct shareholder transactions, such as repurchases.
By using leverage, a BHC can enhance the bank’s stand-alone return on equity (or exacerbate the ROE pressure arising from adverse financial scenarios). As indicated in Table 2, BHC leverage magnifies the subsidiary bank’s 12.0% ROE to 12.9% after considering the cost of the BHC’s debt.
As for a non-financial company, too much leverage can mean that the beneficial effect to shareholders of a higher ROE is swamped by the additional risk of financial distress. Various metrics exist to measure the holding company’s leverage, but one is the “double leverage” ratio, which is calculated as the investment in the bank subsidiary divided by the BHC’s equity. As indicated in Table 1 on page one, the BHC’s ratio is 113%, which is consistent with the median reported by all smaller BHCs at June 30, 2019 (112%, excluding some BHCs for which the BHC’s equity exceeds the bank investment).
Unfortunately, BHC regulatory filings and audited financial statements do not provide a sources and uses of funds schedule, although some cash flow data is provided. Nevertheless, understanding the BHC’s obligations, and the cash required to service those obligations, is essential.
Sources of funds consist principally of the following:
Uses of funds include the following:
Analysts should compare a bank’s ability to pay dividends, given its profitability level and need to retain earnings to fund its growth, against the BHC’s various claims on cash. Mismatches can sometimes arise due to changes in the bank’s performance or operating strategy. For example, consider a BHC that historically has paid high dividends to shareholders. If its subsidiary bank adopts a new strategic plan focused on organic growth, then the bank will need to retain earnings rather than pay dividends to the BHC and, ultimately, BHC shareholders. Additional borrowings could fund a short-term gap, but this is not a long-term solution to a BHC cash flow mismatch.
Two other special circumstances arise when analyzing BHC cash flow:
Capital requirements for BHCs vary based upon their asset size. Under current regulations, BHCs with assets below $3.0 billion are subject to the Federal Reserve’s Small Bank Holding Company Policy Statement. This regulation does not establish any specific minimum capital ratios for small BHCs; however, a debt/ equity ratio limitation exists for debt arising from acquisitions. Therefore, small BHCs have significant flexibility in managing their capital structure, although the Federal Reserve theoretically remains a check on their creativity.
Large BHCs are subject to the Basel III regulations, which involve capital ratios calculated based on Tier 1 and total capital. Tier 1 capital generally is limited to common equity, non-cumulative perpetual preferred stock, and grandfathered TruPS. In addition to the allowance for loan losses, Tier 2 capital may include subordinated debt. Large BHC management can balance these capital sources to minimize the BHC’s weighted average cost of capital, maintain flexibility for unexpected events or opportunities, and ensure compliance with regulatory expectations.
While the subsidiary bank receives most of the analytical attention, the holding company on a standalone (or parent company) basis should not be overlooked. This is particularly true if the holding company has significant obligations to service debt or pay other expenses. By understanding the linkages between the bank and holding company, analysts can better assess a BHC’s potential future returns to shareholders and risk factors posed by the BHC that could jeopardize those returns.
In last quarter’s issue of Portfolio Valuation we raised the issue as to whether public market investors are more critical (or discerning) in establishing value than private equity investors. The evidence this year largely is, yes—at least for companies where there is skepticism as to whether meaningful profitability can be achieved.
Lyft, SmileDirectClub and Uber are examples of unicorns that saw share prices marked sharply lower after the IPO (Lyft, SDC) or during the roadshow (Uber); and The We Company’s planned IPO never occurred due to pushback by investors. At the other extreme is Beyond Meat, which as of early October had risen about six-fold from its May IPO.
The We Company’s (formerly “WeWork” and will be refered to in this article as WeWork) valuation journey is interesting (maybe even fascinating).
WeWork, which was founded in 2010, is a real estate company that signs long-term leases for pricey real estate that it refurbishes then releases the space short-term. The company describes itself somewhat differently as a “community company committed to maximum global impact.”
The S-1 disclosed not only massive losses, but also significant corporate governance issues. Year-to-date revenues through June 30, 2019 doubled to $1.5 billion from the comparable period in 2018, but the operating loss also doubled to $1.4 billion. EBITDA for the six months was negative $511 million, while capex totaled $1.3 billion.
That is a big hole to fill every six months before factoring in rapid growth to be financed. Cash as of June 30 totaled $2.5 billion, while the capital structure entails a lot of debt and negative equity.
From a valuation perspective, WeWork is problematic because operating cash flows are deep in the red with little prospect of turning positive anytime soon. Nonetheless, the increase in value private equity investors placed on the company was astounding.
The company pierced the unicorn threshold in early 2014 when affiliates of JPMorgan invested $150 million in the fourth funding at a post-raise $1.5 billion valuation. T. Rowe Price and Goldman Sachs invested $434 million in late 2014, which resulted in a post raise valuation of $10 billion.
The 7th and 8th funding rounds are where the valuation really gets interesting. In August 2017 SoftBank Vision Fund invested $3.1 billion, which implied a valuation of $21 billion. SoftBank Group Corp., which sponsors the Vision Fund, invested $4.0 billion in January 2019 at an implied valuation of $47 billion.
When the underwriters were forced to pull the plug on the IPO the targeted post-raise valuation reportedly was $10 billion to $15 billion—a value the company apparently was willing to accept because it needs the cash.
We do not know exactly how private equity investors valued the company. Presumably discounted cash flow (DCF), guideline public company and guideline transaction methods were used, perhaps overlaid with a Monte Carlo simulation.
The valuation history raises an important question: how was a stupendous valuation achieved in the private markets by a cash incinerator such as WeWork? A similar question could be asked about many high-profile PE-backed investments.
The short answer is that Softbank thinks the valuation increased significantly even though the company’s fundamentals argue otherwise.
Prospective investors such as the public ones who were offered WeWork shares in an IPO could prepare their own DCF forecast to value the company. They also could examine past transactions in the company for relevant valuation information.
Likewise, they could examine capital transactions in similar companies. Both sets of data fall under the guideline transaction method.
A transaction in a privately held company infers a meaningful data point about value to investors, but there are a couple of caveats. One is an assumption that both parties are fully-informed and neither is forced to transact. Great values were realized by those willing to buy during the 2008 meltdown because there were so many forced sellers that ran the gamut from levered credit investors forced to dump bonds to the likes of Wachovia Corporation and National City Corporation. The price data was legitimate, but many sellers faced margin calls and had to dump assets into an illiquid market. Is the valuation data relevant if “normal” market conditions prevail?
The second issue relates to private equity valuation generally, but especially those where start-up losses and ongoing capital requirements can be huge. The valuation issue relates to using transaction data from investments in other money losing enterprises. Is it always valid to apply multiples paid by investors in a funding round of a money-losing business to value another money-losing business? The valuation data may be factual, but it may be nonsense when weighed against the business’ operating and financial performance.
One can question Softbank’s motives. Did Softbank need a higher valuation to offset losses in other parts of the portfolio in order to maintain investor and lender confidence? Was a higher valuation necessary to support upcoming capital raises? We do not know, but prospective public investors were dismissive of Softbank’s valuations and they appear to be dismissive of the prior two raises given how low the price talk had fallen by the time the IPO was pulled.
We at Mercer Capital respect markets and the pricing information that is conveyed. The prices at which assets transact in private and public markets are critical observations; however, so too are a subject company’s underlying fundamentals, especially the ability to produce positive operating cash flow and a return on capital that at least approximates the cost of capital provided.
Mercer Capital can assist with the valuation of your portfolio companies. We value hundreds of debt and equity securities of privately held companies every year and have been doing so for nearly four decades. Please call if we can assist in the valuation of your portfolio companies.
Originally published in Portfolio Valuation Newsletter, October 2019.
In contested divorces where one or both spouses own a business or a business interest with significant value, it is common for one or both parties to retain a business appraiser to value the marital business interest(s). It is not unusual for the valuation conclusions of the two appraisers to differ significantly, with one significantly lower/higher than the other.
What is a client, attorney, or judge to think when significantly different valuation conclusions are present? The answer to the reasonableness of one or both conclusions lies in the reasonableness of the appraisers’ assumptions. However, valuation is more than “proving” that each and every assumption is reasonable. Valuation also involves proving the overall reasonableness of an appraiser’s conclusion.
A short example will illustrate this point and then we can address the issue of individual assumptions. In the following example, we see three potential discount rates and resulting price/earnings (“P/E”) multiples. Let’s assume that for the subject company in this example, there is significant market evidence suggesting that similar companies trade at a P/E in the neighborhood of 10x earnings.
In the figure below, we look at the assumptions used by appraisers to “build” discount rates. We show differing assumptions regarding four of the components, and none of the differing assumptions seems to be too far from the others. So, we vary what are called the equity risk premium (“ERP”), the beta statistic, which is a measure of riskiness, the small stock premium (“SSP”), and company-specific risk.
The left column (showing the low discount rate of 9.6% and a high P/E multiple of 15.2x) would yield the highest valuation conclusion. The right column (showing the high discount rateof 16.6% and the low P/E of 7.4x) would yield a substantially lower conclusion. That range is substantial and results in widely differing conclusions.
However, as stated earlier, market evidence suggests that companies like our example are worth in the range of a 10x earnings. In our example, the assumptions leading to a P/E in the range of 10x are found in the middle column.
In either case, appraisers might have made a seemingly convincing argument that each of their assumptions were reasonable and, therefore, that their conclusions were reasonable. However, the proof is in the pudding. Neither the low nor the high examples yield reasonable conclusions when viewed in light of available market evidence.
So, as we discuss how to understand the reasonableness of individual valuation assumptions in divorce-related business appraisals, know also that the valuation conclusions must themselves be proven to be reasonable. That’s why we place a “test of reasonableness” in every Mercer Capital valuation report that reaches a valuation conclusion.
Now, we turn to individual assumptions.
Growth rates can impact a valuation in several ways. First, growth rates can explain historical or future changes in revenues, earnings, profitability, etc. A long-term growth rate is also a key assumption in determining a discount rate and resulting capitalization rate.
Growth rates, as a measure of historical or future change in performance, should be explained by the events that have occurred or are expected to occur. In other words, an appraiser should be able to explain the specific events that led to a certain growth rate, both in historical financial statements and also in forecasts. Companies experiencing large growth rates from one year to the next should be able to explain the trends that led to the large changes, whether it is new customers, new products being offered, loss of a competitor, an early-stage company ramping up, or other pertinent factors. Large growth rates for an extended period of time should always be questioned by the appraiser as to their sustainability at those heightened levels.
A long-term growth rate is an assumption utilized by all appraisers in a capitalization rate. The long-term growth rate should estimate the annual, sustainable growth that the company expects to achieve. Typically, this assumption is based on a long-term inflation factor plus/minus a few percentage points. Be mindful of any very small, negative, or large long-term growth rate assumptions. If confronted with one, what are the specific reasons for those extreme assumptions?
In the course of a business valuation, appraisers normally examine the financial performance of a company for a historical period of around five years, if available. Since business valuations are point-in-time estimates, the date of valuation may not always coincide with a company’s annual reporting period.
Most companies have financial software with the capability to produce a trailing twelve month (“TTM”) financial statement. A TTM financial statement allows an appraiser to examine a fullyear business cycle and is not as influenced by seasonality or cyclicality of operations and performance during partial fiscal years. The balance sheet may still reflect some seasonality or cyclicality. Note if the appraiser annualizes a short portion of a fiscal year to estimate an annual result. This practice could result in inflating or deflating expected results if there is significant seasonality or cyclicality present. At the very least, the annualized results should be compared with historical and expected future results in terms of implied margins and growth.
Depending on the industry or where the company is in its business life cycle, a forecast may be used in the valuation and the discounted cash flow method (“DCF”) may be used.
Most forecasts are provided to appraisers by company management. While appraisers do not audit financial information provided by companies, including forecasts, the results should not be blindly accepted without verification against the company’s and its industry’s performance.
During the due diligence process, appraisers should ask management if they prepare multiple versions of forecasts. They should also ask for prior years’ forecasts in order to assess how successful management has been in estimations as compared to actual financial results. Be mindful of appraisers that compile the forecasts themselves and make sure there is some discussion of the underlying assumptions.
“Divorce recession” is a term to describe a phenomenon that sometimes occurs when a business owner portrays doom and gloom in their industry and for current and future financial performance of the company. As with other assumptions, an appraiser should not blindly accept this outlook.
An appraiser should compare the performance of the company against its historical trends, future outlook, and the condition of the industry and economy, among other factors. Be cautious of an appraisal where the current year or ongoing expectations are substantially lower, or higher for that matter, than historical performance without a tangible explanation as to why.
Most formal business valuations should include a narrative describing the current and expected future conditions of the subject company’s industry. An important discussion is how those factors specifically affect the company. There could be reasons why the company’s market is experiencing things differently than the national industry. Industry conditions can provide qualitative reasons why and how the quantitative numbers for the company are changing. Look carefully at business valuations that do not discuss industry conditions or those where the industry conditions are contrary to the company’s trends.
Certain industries have specific valuation methodologies and techniques that are used in addition to general valuation methodologies. Several of these industries include auto dealers, banks, healthcare and medical practices, hotels, and holding companies. It may be difficult for a layperson reviewing a business valuation to know whether the methods employed are general or industry-specific techniques. An attorney or business owner should ask the appraiser how much experience they have performing valuations in a particular industry. Also inquire if there are industry-specific valuation techniques used and how those affect the valuation conclusion.
Risk factors are all of the qualitative and quantitative factors that affect the expected future performance of a company. Simply put, a business valuation combines the expected financial performance of the subject company (earnings and growth) and its risk factors. Risk factors show up as part of the discount rate utilized in the business valuation.
Like growth rates, there is no textbook that lists the appropriate risk factors for a particular industry or company. However, there is a reasonable range for this assumption.
Be careful of appraisals that have an extreme figure for risk factors. Make sure there is a clear explanation for the heightened risk.
Another typical component of a business valuation is the comparison and use of market multiples while utilizing the market approach. Multiples can explain value through revenues, profits, or a variety of performance measures. One critique of market multiples is the applicability of the comparable companies used to determine the multiples. Are those companies truly comparable to the subject company?
Also, how reliable is the underlying comparable company data? Is it dated? How much information on the comparable companies or transactions can be extracted from the source? This critique can be fairly subjective to the layperson.
Another critique could be the range of multiples examined and how they are applied to the subject company. As we have discussed, take note of an appraisal that applies the extreme bottom or top end of the range of multiples, or perhaps even a multiple not in the range. Be prepared to discuss the multiple selected and how the subject company compares to the comparable companies selected.
Earlier we stated that a typical appraisal provides the prior five years of the company’s financial performance, if available. Be cautious of appraisals that use a small sample size, e.g. the latest year’s results, as an estimate of the subject company’s ongoing earnings potential without explanation. The number of years examined should be discussed and an explanation as to why certain years were considered or not considered should be offered.
Some industries have multi-year cycles (further evidence of the importance of a discussion of industry conditions and consideration of recognized industry-specific techniques in the appraisal).
The examination of one year or a few years (instead of five years) can result in a much higher or lower valuation conclusion. If this is the case, it should be explained.
Business valuation is a technical analysis of methodologies used to arrive at a conclusion of value for a subject company. It can be difficult for a client, attorney, or judge to understand the impact of certain individual assumptions and whether or not those assumptions are reasonable. In addition to a review of individual assumptions, the valuation conclusion should be reasonable.
If the divorce case warrants, hire an appraiser to perform a business valuation. If the case or budget does not allow for a formal valuation, it may be helpful to hire an appraiser to review another appraiser’s business valuation at a minimum to help determine if the assumptions and conclusions are reasonable.
Originally published in Mercer Capital’s Tennessee Family Law Newsletter, Second Quarter 2019.
The June BankWatch featured the first part of a series describing key considerations in the valuation of banks and bank holding companies. While that installment provided a general overview of key concepts, this month we pivot to the analysis of bank financial statements and performance1 . Unlike many privately held, less regulated companies, banks produce reams of financial reports covering every minutia of their operations. For analytical personality types, it’s a dream.
The approach taken to analyze a bank’s performance, though, must recognize depositories’ unique nature, relative to non-financial companies. Differences between banks and non-financial companies include:
1. Close interactions between the balance sheet and income statement. Banking revenues are connected tightly to the balance sheet, unlike for nonfinancial companies. In fact, you often can estimate a bank’s net income or the growth therein solely by reviewing several years of balance sheets. Banks have an “inventory” of assets that earn interest, referred to as “earning assets,” which drive most of their revenues. Earning assets include loans, securities (usually highly-rated bonds like Treasuries or municipal securities), and shortterm liquid assets. Changes in the volume of assets and the mix of these assets, such as the relative proportions of lower yielding securities and higher yielding loans, significantly influence revenues.
2. The value of liabilities. For non-financial companies, acquisition motivations seldom revolve around obtaining the target entity’s liabilities. The effective management of working capital and debt certainly influences shareholder value for non-financial companies, but few attempt to stockpile low-cost liabilities absent other business objectives. Banks, though, periodically buy and sell branches and their related deposits. The prices (or “premiums”) paid in these transactions reveal that bank deposits, the predominate funding source for banks, have discrete value. That is, banks actually pay for the right to assume another bank’s liabilities.
Why do banks seek to acquire deposits? First, all earning assets must be funded; otherwise, the balance sheet would fail to balance. Ergo, more deposits allow for more earning assets. Second, retail deposits tend to cost less than other alternative sources of funds. Banks have access to wholesale funding sources, such as brokered deposits and Federal Home Loan Bank advances, but these generally have higher interest rates than retail deposits. Third, retail deposits are stable, due to the relationship existing between the bank and customer. This provides assurance to bank managers, investors, and regulators that a disruption to a wholesale funding source will not trigger a liquidity shortfall. Fourth, deposits provide a vehicle to generate noninterest income, such as service charges or interchange. The strength of a bank’s deposit portfolio, such as the proportion of noninterest-bearing deposits, therefore influences its overall profitability and franchise value.
3. Capital Adequacy. In addition to board and shareholder preferences, nonfinancial companies often have debt covenants that constrain leverage. Banks, though, have an entire multi-pronged regulatory structure governing their allowable leverage. Shareholders’ equity and regulatory capital are not the same; however, the computation of regulatory capital begins with shareholders’ equity. Two types of capital metrics exist – leverage metrics and risk-based metrics. The leverage metric simply divides a measure of regulatory capital by the bank’s total assets, while risk-based metrics adjust the bank’s assets for their relative risk. For example, some government agency securities have a risk weight equal to 20% of their balance, while many loans receive a risk weight equal to 100% of their balance.
Capital adequacy requirements have several influences on banks. Most importantly, failing to meet minimum capital ratios leads to severe repercussions, such as limitations on dividends and stricter regulatory oversight, and is (as you may imagine) deleterious to shareholder value. More subtly, capital requirements influence asset pricing decisions and balance sheet structure. That is, if two assets have the same interest rate but different risk weights, the value maximizing bank would seek to hold the asset with the lower risk weight. Stated differently, if a bank targets a specific return on equity, then the bank can accept a lower interest rate on an asset with a smaller risk weight and still achieve its overall return on equity objectives.
4. Regulatory structure. In exchange for receiving a bank charter and deposit insurance, all facets of a bank’s operations are tightly regulated to protect the integrity of the banking system and, ultimately, the FDIC’s Deposit Insurance Fund that covers depositors of failed banks. Banks are rated under the CAMELS system, which contains categories for Capital, Asset Quality, Management, Earnings, Liquidity, and Sensitivity to Market Risk. Separately, banks receive ratings on information technology and trust activities. While a bank’s CAMELS score is confidential, these six categories provide a useful analytical framework for both regulators and investors.
We now cover several components of a bank’s balance sheet.
1. Short-Term Liquid Assets and Securities. Banks are, by their nature, engaged in liquidity transformation, whereby funds that can be withdrawn on demand (deposits) are converted into illiquid assets (loans). Several alternatives exist to mitigate the risk associated with this liquidity transformation, but one universal approach is maintaining a portfolio of on-balance sheet liquid assets. Additionally, banks maintain securities as a source of earning assets, particularly when loan demand is relatively limited.
Liquid assets generally consist of highly-rated securities issued by the U.S. Treasury, various governmental agencies, and state and local governments, as well as various types of mortgage-backed securities. Relative to loans, banks trade off some yield for the liquidity and credit quality of securities. Key analytical considerations include:
2. Loans. A typical bank generates most of its revenue from interest income generated by the loan portfolio; further, the lending function presents significant risk in the event borrowers fail to perform under the contractual loan terms. While loans are more lucrative than securities from a yield standpoint, the cost of originating and servicing a loan portfolio – such as lender compensation – can be significant. Key analytical considerations include:
3. Allowance for Loan & Lease Losses (“ALLL”). Banks maintain reserves against loans that have defaulted or may default in the future. While a new regime for determining the ALLL will be implemented beginning for some banks in 2020, the size of the ALLL under current and future accounting standards generally varies between banks based on (a) portfolio size, (b) portfolio composition, as certain loan types inherently possess greater risk of credit loss, (c) the level of problem or impaired loans, and (d) management’s judgment as to an appropriate ALLL level. Calculating the ALLL necessarily includes some qualitative inputs, such as regarding the outlook for the economy and business conditions, and reasonable bankers can disagree about an appropriate ALLL level. Key analytical considerations regarding the ALLL and overall asset quality include:
4. Deposits. As for loans, bank financial statements distinguish several deposit types, such as demand deposits and CDs. It is useful to decompose deposits further into retail (local customers) and wholesale (institutional) deposits. Key analytical considerations include:
5. Shareholders’ Equity and Regulatory Capital. Historical changes in equity cannot be understood without an equity roll-forward showing changes due to retained earnings, share sales and redemptions, dividends, and other factors. In our opinion, it is crucial to analyze the bank’s current equity position by reference to management’s business plan, as this will reveal amounts available for use proactively to generate shareholder returns (such as dividends, share repurchases, or acquisitions). Alternatively, the analysis may reveal the necessity of either augmenting equity through a stock offering or curtailing growth objectives.
The computation of regulatory capital metrics can be obtained from a bank’s regulatory filings. Relative to shareholders’ equity, regulatory capital calculations: (a) exclude most intangible assets and certain deferred tax assets, and (b) include certain types of preferred stock and debt, as well as the ALLL, up to certain limits.
There are six primary components of the bank’s income statement:
1. Net interest income, or the difference between the income generated by earning assets and the cost of funding.
2. Noninterest income, which includes revenue from other services provided by the bank such as debit cards, trust accounts, or loans intended for sale in the secondary market. The sum of net interest income and noninterest income represents the bank’s total revenues.
3. Noninterest expenses, which principally include employee compensation, occupancy costs, data processing fees, and the like. Income after noninterest expenses commonly is referred to by investors, but not by accountants, as “pre-tax, pre-provision operating income” (or “PPOI”).
4. Loan loss provision
5. Security gains and losses
We take each component in turn:
1. Net Interest Income. The previous analysis of the balance sheet foreshadowed this net interest income discussion with one important omission – the external interest rate environment. While banks attempt to mitigate the effect on performance of uncontrollable factors like market interest rates, some influence is unavoidable. For example, steeper yield curves generally are more accommodative to net interest income, while banks struggle with flat or inverted yield curves.
Another critical financial metric is the net interest margin (“NIM”), measured as the yield on all earning assets minus the cost of funding those assets (or net interest income divided by earning assets). The NIM and net interest income are influenced by the following:
2. Noninterest Income. The sensitivity of net interest income to uncontrollable forces – i.e., market interest rates – makes noninterest income attractive to bankers and investors. Banks generate noninterest income from a panoply of sources, including:
Some sources of revenue can be even more sensitive to the interest rate environment than net interest income, such as income from residential mortgage originations. Yet other sources have their own linkages to uncontrollable market factors, such as revenues from wealth management activities tied to the market value of account assets.
Expanding noninterest income is a holy grail in the banking industry, given limited capital requirements, revenue diversification benefits, and its ability to mitigate interest rate risk while avoiding credit risk. However, many banks’ fee income dreams have foundered on the rocks of reality for several reasons. First, achieving scale is difficult. Second, cross-sales of fee income products to banking customers are challenging. Third, significant cultural differences exist between, say, wealth management and banking operations. A fulsome financial analysis considers the opportunities, challenges, and risks presented by noninterest income.
3. Noninterest Expenses. In a mature business like banking, expense control always remains a priority.
4. Loan Loss Provision. We covered this income statement component previously with respect to the ALLL.
5. Income Taxes. Banks generally report effective tax rates (or actual income tax expense divided by pre-tax income) below their marginal tax rates. This primarily reflects banks’ tax-exempt investments, such as municipal bonds; bank-owned life insurance income; and vehicles that provide for tax credits, like New Market Tax Credits. It is important to note that state tax regimes may differ for banks and non-banks. For example, some states assess taxes on deposits or equity, rather than income, and such taxes are not reported as income tax expense.
As the preceding discussion suggests, many levers exist to achieve shareholder returns. One bank can operate with lean expenses, but pay higher deposit interest rates (diminishing its NIM) and deemphasize noninterest income. Another bank may pursue a true retail banking model with low cost deposits and higher fee income, offset by the attendant operating costs. There is not necessarily a single correct strategy. Different market niches have divergent needs, and management teams have varying areas of expertise. However, we still can compare the returns on equity (or net income divided by shareholders’ equity) generated by different banks to assess their relative performance.
The figure below presents one way to decompose a bank’s return on equity relative to its peer group. This bank generates a higher return on equity than its peer group due to (a) a higher net interest margin, (b) a slightly lower loan loss provision, and (c) higher leverage (shown as the “equity multiplier” in the table).
The figure bel0w cites several common income statement metrics used by investors, as well as their strengths and shortcomings.
Banks file quarterly Call Reports, which are the launching pad for our templated financial analyses. Depending on asset size, bank holding companies file consolidated financial statements with the Federal Reserve. All bank holding companies, small and large, file parent company only financial statements, although the frequency differs. Other potentially relevant sources of information include:
1. Audited financial statements and internal financial data
2. Board packets, which often are sufficiently extensive to cover our information requirements
3. Budgets, projections, and capital plans
4. Asset quality reports, such as criticized loan listings, delinquency reports, concentration analyses, documentation regarding ALLL adequacy, and special asset reports for problem loans
5. Interest rate risk scenario analyses and inventories of the securities portfolio
6. Federal Reserve form FR Y-6 provides the composition of the holding company’s board of directors and significant shareholders’ ownership
A rigorous examination of the bank’s financial performance, both relative to its history and a relevant peer group and with due consideration of appropriate risk factors, provides a solid foundation for a valuation analysis. As we observed in June’s BankWatch, value is dependent upon a given bank’s growth opportunities and risk factors, both of which can be revealed using the techniques described in this article.
1 Given the variety of business models employed by banks, this article is inherently general. Some factors described herein will be more or less relevant (or even not relevant) to a specific bank, while it is quite possible that, for the sake of brevity, we altogether avoided mention of other factors relevant to a specific bank. Readers should therefore conduct their own analysis of a specific bank, taking into account its specific characteristics.
Originally published in Bank Watch, June 2019.
FinTech M&A continues to be top of mind for the sector as larger players seek to grow and expand while founders and early investors look to monetize their investments. This theme was evident in several larger deals already announced in 2019 including Global Payments/Total System Services (TSYS), Fidelity National Information Services, Inc./Worldpay, Inc., and Fiserv, Inc./First Data Corporation.
One important aspect of FinTech M&A is the purchase price allocation and the valuation estimates for goodwill and intangible assets as many FinTech companies have minimal physical assets and a high proportion of the purchase price is accounted for via goodwill and intangible assets. The majority of value creation for the acquirer and their shareholders will come from their investment in and future utilization of the intangibles of the FinTech target. To illustrate this point, consider that the median amount of goodwill and intangible assets was ~98% of the transaction price for FinTech transactions announced in 2018. Since such a large proportion of the transaction price paid for FinTech companies typically gets carried in the form of goodwill or intangibles on the acquirer’s balance sheet, the acquirer’s future earnings, tax expenses, and capitalization will often be impacted significantly from the depreciation and amortization expenses.
When preparing valuation estimates for a purchase price allocation for a FinTech company, one key step for acquirers is identifying the intangible assets that will need to be valued. In our experience, the identifiable intangible assets for FinTech acquisitions often include the tradename, technology (both developed and in-development), noncompete agreements, and customer relationships. Additionally, there may be a need to consider the value of an earn-out arrangement if a portion of transaction consideration is contingent on future performance as this may need to be recorded as a contingent liability.
Since the customer relationship intangible is often one of the more significant intangible assets to be recorded in FinTech acquisitions (both in $ amounts and as a % of the purchase price), we discuss how to value FinTech customer relationships in greater detail in the remainder of the article.
Firms devote significant human and financial resources in developing, maintaining and upgrading customer relationships. In some instances, customer contracts give rise to identifiable intangible assets. More broadly, however, customer-related intangible assets consist of the information gleaned from repeat transactions, with or without underlying contracts. Firms can and do lease, sell, buy or otherwise trade such information, which are generally organized as customer lists.
Since FinTech has some relatively varied niches including payments, digital lending, WealthTech, or InsurTech, the valuation of FinTech customer relationships can vary depending on the type of company and the niche that it operates in. While we do not delve into the key attributes to consider for each FinTech niche, we provide one illustration from the Payments niche.
In the Payments industry, one key aspect to understand when evaluating customer relationships is where the company is in the payment loop and whether the company operates in a B2B (business-to-business) or B2C (business-to-consumer) model. This will drive who the customer is and the economics related to valuing the cash flows from the customer relationships. For example, merchant acquirers typically have contracts with the merchants themselves and the valuable customer relationship lies with the merchant and the dollar volume of transactions processed by the merchant over time, whereas the valuable relationship with other payments companies such as a prepaid or gift card company may lie with the end-user or consumer and their spending/card usage habits over time.
Valuation involves three approaches: 1) the cost approach, 2) the market approach, and 3) the income approach. Customer relationships are typically valued based upon an income approach (i.e., a discounted cash flow method) where the cash flows that the customer relationships are expected to generate in the future are forecast and then discounted to the present at a market rate of return.
Valuation under the cost approach requires estimation of the cost to replace the subject asset, as well as opportunity costs in the form of cash flows foregone as the replacement is sought or recreated. The cost approach may not be feasible when replacement or recreation periods are long. Therefore, the cost approach is used infrequently in valuing customer-related assets.
Use of the market approach in valuing customer-related assets is generally untenable for FinTech companies because transactional data on sufficiently comparable assets are not likely to be available.
Under the income approach, customer-related assets are valued most commonly using the income approach. One method within the income approach that is often used to value FinTech customer relationships is the Multi-Period Excess Earnings Method (MPEEM). MPEEM involves the estimation of the cash flow stream attributable to a particular asset. The cash flow stream is discounted to the present to obtain an indication of fair value. The most common starting point in estimating future cash flows is the prospective financial information prepared by (or in close consultation with) the management of the subject business. The key valuation inputs are often estimates of the economic benefit of the customer relationship (i.e., the cash flow stream attributable to the relationships), customer attrition rate, and the discount rate. Three key attributes that are important when using these inputs to valuing customer relationships include:
Mercer Capital has experience providing valuation and advisory services to FinTech companies and their acquirers. We have valued customer-related and other intangible assets to the satisfaction of clients and their auditors within the FinTech industry across a multitude of niches (payments, wealth management, insurance, lending, and software). Most recently, we completed a purchase price allocation for a private equity firm that acquired a FinTech company in the Payments niche. Please contact us to explore how we can help you.
Originally published in the Value Focus: FinTech Industry Newsletter, Mid Year 2019.
Karolina Calhoun, CPA/ABV/CFF presented “Business Valuations and Quality of Earnings in M&A Transactions” at the Association for Corporate Growth (ACG) Tennessee Chapter’s monthly meeting on August 22, 2019. In this presentation, Karolina provides an overview of valuation and quality of earnings as well as when to use each, how are the two different, and how can the two overlap.
Originally presented at the Consumer Bankers Association Executive Banking School at Furman University in Greenville, South Carolina, in this session, Jeff K. Davis, CFA addresses the following objectives:
Originally presented at the Alabama Bankers Association CEO Conference in Point Clear, Alabama, in this session, Jeff K. Davis, CFA addresses the following objectives:
Through late July, M&A activity in 2019 is on pace to match the annual deal volume achieved in the last few years. Since 2014, approximately 4%-5% of banks have been absorbed each year via M&A. According to data provided by S&P Global Market Intelligence, there were 136 announced transactions in the year-to-date period, which equates to 2.5% of the 5,406 FDIC-insured institutions that existed as of year-end 2018.
In the first seven months of the year, aggregate deal volume reached $41.3 billion, which surpasses the $30.5 billion in announced deals in all of 2018 as shown in Figure 1. The increase primarily reflects the $28 billion BB&T-SunTrust merger that was announced on February 7 and represents the largest deal since the 2007-2009 financial crisis. While deal value is up, multiples are down relative to 2018 with the average P/TBV multiple declining from 174% to 161% and the median P/E multiple declining from 25.3x to 17.1x as shown in Figure 2, although the price/earnings multiples from the 2018 period may be distorted by the effects of tax reform.
The tables below provide a more detailed look at deal activity and the change in multiples in 2019 relative to 2018. For banks with assets less than $500 million, P/TBV multiples declined approximately 5%. While deal volume in the $500 million to $1 billion size group somewhat limits the meaningfulness of comparisons, it’s interesting to note that the median P/TBV multiple increased for this group relative to 2018 while the median buyer size increased from $3.1 billion in assets to $6.8 billion.
As shown in Figure 3 below, the landscape of buyers has shifted somewhat in favor of bigger banks over the last decade. Deal activity among the smallest group (buyers with assets less than $500 million) peaked in 2015 with 95 announced deals. In 2018, this group announced 56 acquisitions. In contrast, buyers with total assets between $10 billion-$50 billion announced a 10-year high, 28 deals in 2018 and are on pace to reach a similar level in 2019. In May 2018, the SIFI threshold was increased to $250 billion, providing immediate relief to banks with assets between $50 billion and $100 billion. For those with assets between $100 billion and $250 billion, regulatory relief will phase in after 18 months. This change is expected to encourage additional M&A activity among bigger players.
The theme of the story hasn’t changed; consolidation of the banking industry continues at a pace on par with the historical average. Target banks with less than $500 million in assets continue to comprise 75%-85% of total deal volume, but the composition of the buyer universe does seem to be shifting. In addition to the move towards larger buyers, another trend that appears to be gaining speed is the acquisition of commercial banks by credit unions. In 2015, three of such transactions were announced. In 2018, nine deals by credit unions were announced, and an additional ten have been announced through late July of this year.
As to be expected, pricing trends over the last few years have also further cemented the value of a stable and low-cost customer base. As shown in Figure 4 below, as interest rates increased from the end of 2015 through 2018, pricing diverged in favor of banks with the highest percentage of noninterest-bearing deposits to total deposits.
Mercer Capital has been providing transaction advisory and valuation services for over 30 years. To discuss a transaction or valuation issue in confidence, please contact us.
Originally published in Bank Watch, July 2019.
This article begins a series focused on the two issues most central to our work at Mercer Capital: What drives value for a depository institution and how are these drivers distilled into a value for a given depository institution?
We leave the more technical valuation discussion for subsequent articles. At its core, though, value is a function of a specified financial metric or metrics, growth, and risk.
Many industries have a valuation benchmark used by industry participants, although this metric does not necessarily cohere with benchmarks used by investors. In the banking industry, “book value” fills this role. In fact, there are several potential measures of book value, including:
The most commonly used book value metric is tangible book value (or TBV). Like most industry benchmarks, simplicity and commonality are reasons industry participants embrace TBV as a valuation metric. Strengths of TBV as a valuation metric include:
While TBV has its place, investors focus primarily on an institution’s earnings and the growth therein. This earnings orientation occurs because investors are forward looking, and TBV inherently is a backward-looking measure representing the sum of an institution’s common stock issuances, net income, dividends, and share redemptions since its inception. In addition to being forward-looking, investors also appreciate that earnings ultimately are the source of returns to shareholders. With earnings, the institution can do any of (or a combination of) the following:1
More bluntly, investors like growing earnings and cash returns (dividends or share repurchases), which are difficult to provide without a sustainable base of strong earnings. Investors will tolerate some near-term drag on earnings from expansion or risk mitigation strategies, but their patience is not limitless.
In many industries, earnings before interest, taxes, depreciation, and amortization (EBITDA) or a similar metric is the preferred earnings measure. However, banks derive most of their revenues from interest spreads, and EBITDA is an inappropriate metric. Instead, bank investors focus on net income and earnings per share. When credit quality is distressed, investors may consider earnings metrics calculated before the loan loss provision, such as pre-tax, pre-provision operating income (PPOI).
While earnings-based analyses generally should have valuation primacy in our opinion, TBV multiples nevertheless serves as an important test of reasonableness for a valuation analysis. It would be foolhardy to develop a valuation for a depository institution without calculating the TBV multiple implied by the concluded value. Analysts should be able to reconcile implied TBV multiples to public market or M&A market benchmarks and explain any significant discrepancies.
Occasionally, analysts cite balance sheet-based metrics beyond TBV, some of which have more analytical relevance than others. The most useful is a multiple of “core” deposits, a definition of deposits that excludes larger deposits and deposits obtained from wholesale funding markets. Core deposits are time consuming and costly to gather; thus, a multiple of core deposits aligns a bank’s value with its most attractive funding source. A less useful multiple is value as a percentage of total assets, the use of which would implicitly encourage management to stockpile assets without regard to their incremental profitability.
Investors like growth and accelerating growth even more. Without demonstrating the mathematics, higher expected growth rates produce higher valuation multiples. Further, price/earnings multiples expand at an increasing rate as growth rates increase, as indicated in the following chart. The opposite is true, too, as slowing growth reduces the price/earnings.
Banks report innumerable metrics to directors and investors, but what are the most relevant growth indicia to investors? Usually, investors focus on growth in the following:
Valuation is inherently forward-looking, and historical growth rates are useful mostly as potential predictors of future growth. Further, most investors understand that there is some tradeoff between earnings today and investing for higher earnings in the future. While some near-term pressure on earnings from an expansion strategy is acceptable, strategic investments should not continually be used to explain below average profitability. After all, a bank’s competitors likely are reinvesting as well for the future.
How does growth affect value? As a thought experiment, consider a bank with no expected growth in earnings and a 100% dividend payout ratio. Should this bank’s common equity value increase? In this admittedly extreme scenario, the answer is no. This bank’s common equity resembles a preferred stock investment, with a shareholder’s return generated by dividends. That is, for value to grow, one (or preferably more) of the preceding factors must increase.
Should a bank prioritize growth in earnings per share, dividends per share, or another metric? The answer likely depends on the bank’s shareholder base. In public markets, investors tend to be more focused on earnings per share growth. If an investor desires income, he or she can sell shares in the public market. For privately-held banks, though, investors often are keenly aware of dividend payments and emphasize the income potential of the investment. Of course, sustaining higher dividend payments requires earnings growth.
Growth creates a virtuous cycle – retained earnings lead to higher future net income, allowing for future higher dividends or additional reinvestment, and so the cycle continues. One important caveat exists, though. This virtuous cycle presumes that the retained earnings from a given year are invested in new opportunities yielding the same return on equity as the existing operations. If reinvestment occurs in lower ROE opportunities – such as liquid assets supported by excess capital beyond the level needed to operate the bank safely – then growth in value may be diminished.
This discussion of growth segues into the third key valuation factor, risk.
More than most industries, risk management is an overarching responsibility of management and the board of directors and a crucial element to long-term shareholder returns. Banks encounter the following forms of risk:
While growth rates are observable from reported financial metrics, the risk assumed to achieve that growth often is more difficult to discern – at least in the near-term. Risk can accumulate, layer upon layer, for years until a triggering event happens, such as an economic downturn. Risk also is asymmetric in the sense that a strategy creating incremental risk, such as a new lending product, can be implemented quickly, but exiting the problems resulting from that strategy may take years.
From a valuation standpoint, investors seek the highest return for the least risk. Given two banks with identical growth prospects, investors would assign a higher price/earnings multiple to the bank with the lower risk profile. Indicia of risk include:
None of the preceding factors necessarily imply higher risk vis-à-vis other banks; the key is risk management, not risk avoidance. However, if an investor believes risk is rising for any reason, then that expectation can manifest in our three pronged valuation framework as follows:
An old adage is that risk can be quantified and uncertainty cannot. This observation explains why stock prices and pricing multiples can be particularly volatile for banks in periods of economic uncertainty or distress. If investors cannot quantify a bank’s downside exposure, which often is more attributable to general economic anxieties than the quality of the bank’s financial disclosures, then they tend to react by taking a pessimistic stance. As a result, risk premiums can widen dramatically, leading to lower multiples.
This article provides an overview of the three key factors underlying bank stock valuations – financial performance, risk, and growth. While these three factors are universal to valuations, we caution that the examples, guidance, and observations in this article may not apply to every depository institution.
At Mercer Capital, valuations of clients’ securities are more than a mere quantitative exercise. Integrating a bank’s growth prospects and risk characteristics into a valuation analysis requires understanding the bank’s history, business plans, market opportunities, response to emerging technological issues, staff experience, and the like. These important influences on a valuation analysis cannot be gleaned solely from reviewing a bank’s Call Report. Future editions of this series will describe both the quantitative and qualitative considerations we use to arrive at sound, well-reasoned, and well-supported valuations.
1 In theory, a bank could accomplish the preceding without earnings, but eventually that well (i.e., the bank’s TBV) will run dry
Originally published in Bank Watch, June 2019.
On May 8-10, 2019, Chris Mercer, Scott Womack, and I attended the 2019 AAML/BVR National Divorce Conference in Las Vegas. This was the first biannual National Divorce Conference on cutting edge tax, valuation, and financial issues co-sponsored by the American Academy of Matrimonial Lawyers and Business Valuation Resources, LLC.
In attendance were family law attorneys, general practice attorneys, CPAs, business valuators, and other financial professionals. Total attendance was approximately 300 individuals, split about 50/50 between attorneys and financial professionals. Sessions covered topics including updates on standards of value, cryptocurrencies and their impact on divorce, tax law changes and their impact on family law, and how to best present your case to the courtroom, among others.
We have chosen four sessions that we thought would be of interest to this newsletter’s audience.
In “Blockchain/Crypto: Dividing Digital Assets,” Ed Kainen and Richard West provided a brief history of money– from the development of various forms of currencies and eventually to Bitcoin and other cryptocurrencies. In addition to providing a comprehensive glossary of essential terminology, the speakers also covered how Bitcoin and cryptocurrencies are transacted and explained the mechanics of Bitcoin technology upon which cryptocurrencies rely. A history of Bitcoin, as well as the benefits, determinants and consequences associated with the use of these cryptocurrencies was addressed. The session also covered how all of the foregoing impacts divorce and family law litigation, both issues of valuation and essentials of discovery, as well as the potential for malpractice pitfalls and how to avoid them.
Z. Christopher Mercer, FASA, CFA, ABAR, Founder and CEO of Mercer Capital
In “How to Present Complex Finance to Judges: K.I.S.S.,” Chris Mercer addressed the question of how to K.I.S.S. (keep it simple, stupid) in a litigation setting, as the K.I.S.S. principle is one of the key ideas of effective communication. Mr. Mercer drew on over 30 years of experience in presenting complex valuation and damages issues to judges and juries while sharing the techniques and templates necessary to communicate one’s position and the opponent’s position in such a way that judges can understand key information and why it is important.
James R. Hitchner, CPA, ABV, CFF, ASA, Managing Director of Financial Valuation Advisors
In this session, Jim Hitcher posed the question: Have you ever read a business valuation report where you knew the valuation was rigged to obtain a higher or lower value? During his session, he provided tricks of the trade to identify how some valuation analysts can manipulate the process in order to please their client and/or win at all costs. Mr. Hitchner also provided tips on how to attack biases including three areas with the most frequent biases such as multiples, growth factors, and the specific company risk premium/risk factor.
In this session, Peter Gladstone and Robert Stone provided background on equity awards and options as the increase of startups precipitated by the tech boom of the 1990s has led to increasing popularity of stock options, restricted stock units (“RSUs”), and similar types of equity-based compensation. These forms of executive compensation have become common in both privately held and publically traded companies.
Designed to both reward and retain talented employees, these benefits can be difficult to understand and value, particularly at a random moment that, while relevant to one’s divorce, might seem arbitrary in the context of a business. Just as the value of closely held businesses presents challenging issues over which business valuation experts often disagree, equity-based compensation plans and their values (or future income stream) represent ground for a divergence of opinions among forensic accountants supporting counsel on behalf of their divorce clients.
During the session, the speakers examined the various characteristics of stock options, RSUs, both vested and unvested; their tax implications; and the challenges typically encountered in valuing and equitably distributing these valuable and highly guarded assets of a marital estate.
All the sessions were well-received, and we recommend these presentations and their authors’ publications to anyone interested. We’re looking forward to next year’s event and hope to see you there.
Originally published in Mercer Capital’s Tennessee Family Law Newsletter, Second Quarter 2019.
Section 409A is a provision of the Internal Revenue Code that applies to all companies offering nonqualified deferred compensation plans to employees. Generally speaking, a deferred compensation plan is an arrangement whereby an employee (“service provider” in 409A parlance) receives compensation in a later tax year than that in which the compensation was earned. “Nonqualified” plans exclude 401(k) and other “qualified” plans.
What is interesting from a valuation perspective is that stock options and stock appreciation rights (SARs), two common forms of incentive compensation for private companies, are potentially within the scope of Section 409A. The IRS is concerned that stock options and SARs issued “in the money” are really just a form of deferred compensation, representing a shifting of current compensation to a future taxable year. So, in order to avoid being subject to 409A, employers (“service recipients”) need to demonstrate that all stock options and SARs are issued “at the money” (i.e., with the strike price equal to the fair market value of the underlying shares at the grant date). Stock options and SARs issued “out of the money” do not raise any particular problems with regard to Section 409A.
Stock options and SARs that fall under Section 409A create problems for both service recipients and service providers. Service recipients are responsible for normal withholding and reporting obligations with respect to amounts includible in the service provider’s gross income under Section 409A. Amounts includible in the service provider’s gross income are also subject to interest on prior underpayments and an additional income tax equal to 20% of the compensation required to be included in gross income. For the holder of a stock option, this can be particularly onerous as, absent exercise of the option and sale of the underlying stock, there has been no cash received with which to pay the taxes and interest.
These consequences make it critical that stock options and SARs qualify for the exemption under 409A available when the fair market value of the underlying stock does not exceed the strike price of the stock option or SAR at the grant date.
For public companies, it is easy to determine the fair market value of the underlying stock on the grant date. For private companies, fair market value cannot be simply looked up on Bloomberg. Accordingly, for such companies, the IRS regulations provide that “fair market value may be determined through the reasonable application of a reasonable valuation method.” In an attempt to clarify this clarification, the regulations proceed to state that if a method is applied reasonably and consistently, such valuations will be presumed to represent fair market value, unless shown to be grossly unreasonable. Consistency in application is assessed by reference to the valuation methods used to determine fair market value for other forms of equity-based compensation. An independent appraisal will be presumed reasonable if “the appraisal satisfies the requirements of the Code with respect to the valuation of stock held in an employee stock ownership plan.”
A reasonable valuation method is to consider the following factors:
The value of tangible and intangible assets
The present value of future cash flows
The market value of comparable businesses (both public and private)
Other relevant factors such as control premiums or discounts for lack of marketability
Whether the valuation method is used consistently for other corporate purposes
In other words, a reasonable valuation considers the cost, income, and market approaches, and considers the specific control and liquidity characteristics of the subject interest. For start-up companies, the valuation would also consider the company’s most recent financing round and the rights and preferences of any securities issued. The IRS is also concerned that the valuation of common stock for purposes of Section 409A be consistent with valuations performed for other purposes.
Fair market value is not specifically defined in Section 409A of the Code or the associated regulations. Accordingly, we look to IRS Revenue Ruling 59-60, which defines fair market value as “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”
Among the general valuation factors to be considered under a reasonable valuation method are “control premiums or discounts for lack of marketability.” In other words, if the underlying stock is illiquid, the stock should presumably be valued on a non-marketable minority interest basis.
This is not without potential confusion, however. In an Employee Stock Ownership Plan (ESOP), stock issued to participants is generally covered by a put right with respect to either the Company or the ESOP. Accordingly, valuation specialists often apply marketability discounts on the order of 0% to 10% to ESOP shares. Shares issued pursuant to a stock option plan may not have similar put rights attached, and therefore may warrant a larger marketability discount. In such cases, a company that has an annual ESOP appraisal may not have an appropriate indication of fair market value for purposes of Section 409A.
In addition to independent appraisals, formula prices may, under certain circumstances, be presumed to represent fair market value. Specifically, the formula cannot be unique to the subject stock option or SAR, but must be used for all transactions in which the issuing company buys or sells stock.
For purposes of Section 409A compliance, start-ups are defined as companies that have been in business for less than ten years, do not have publicly traded equity securities, and for which no change of control event or public offering is reasonably anticipated to occur in the next twelve months. For start-up companies, a valuation will be presumed reasonable if “made reasonably and in good faith and evidenced by a written report that takes into account the relevant factors prescribed for valuations generally under these regulations.” Further, such a valuation must be performed by someone with “significant knowledge and experience or training in performing similar valuations.”
This presumption, while presented as a separate alternative, strikes us a substantively and practically similar to the independent appraisal presumption described previously. Some commentators have suggested that the valuation of a start-up company may be performed by an employee or board member of the issuing company. We suspect that it is the rare employee or board member that is actually qualified to render the described valuation.
The bottom line is that Section 409A applies to both start-ups and mature companies.
The safe harbor presumptions of Section 409A apply only when the valuation is based upon an independent appraisal, and it is likely that a valuation prepared by an employee or board member would raise questions of independence and objectivity.
The regulations also clarify that the experience of the individual performing the valuation generally means at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending, or other comparable experience in the line of business or industry in which the service recipient operates.
In our reading of the rules, this means that the appraisal should be prepared by an individual or firm that has a thorough educational background in finance and valuation, has accrued significant professional experience preparing independent appraisals, and has received formal recognition of his or her expertise in the form of one or more professional credentials (ASA, ABV, CBA, or CFA). The valuation professionals at Mercer Capital have the depth of knowledge and breadth of experience necessary to help you navigate the potentially perilous path of Section 409A.
Originally published in the Financial Reporting Update: Equity Compensation, June 2019.
Clients frequently want to know, “How long is an equity compensation valuation good for?” We get it. You want to provide employees, contractors, and other service providers who are compensated through company stock with current information about their interests, but the time and cost required to get a valuation must also be considered.
Due to the natural business changes every company goes through, accounting and legal professionals often recommend updates at least annually if no significant change or financing has occurred. However, unique company or market characteristics often necessitate more frequent updates. Here are some of the factors to consider when determining the need for a valuation update:
Even for companies that have fairly steady operations, the effects of small business changes accumulate over time. Companies that deal with major changes relatively infrequently may be suited to regular summary updates to supplement full comprehensive reports as a way to maximize the cost-benefit analysis of equity compensation valuation.
Originally published in the Financial Reporting Update: Equity Compensation, June 2019.
Executives expend a great deal of effort to determine the optimal way to finance the operations of their businesses. This may involve bringing on outside investors, employing bank debt, or financing through cash flow. Once the money has hit the bank, they may wonder, what effect does the capitalization of my company have on the value of its equity?
A company with a simple capital structure typically has been financed through the issuance of one class of stock (usually common stock). Companies with complex capital structures, on the other hand, may include other instruments: multiple classes of stock, forms of convertible debt, options, and warrants. This is frequent in startup or venture-backed companies that receive financing through multiple channels or fundraising rounds and private equity sources.
With various types of stock on the cap table, it is important to note that all stock classes are not the same. Each class holds certain rights, preferences, and priorities of return that can confer a portion of enterprise value to the shares besides their pro rata allocation. These often come in two categories: economic rights and control rights. Economic rights bestow financial benefits while control rights grant benefits related to operations and decision making.
The value of a certain class of stock is affected both by the rights and preferences it holds as well as those held by the other share classes on the cap table. The presence of multiple preferred classes also brings up the issue of seniority as certain class privileges may be overruled by those of a more senior share class.
Complex capital structures require complex valuation models that can integrate and prioritize the special treatments of individual share classes in multi-class cap tables. As such, models such as the PWERM or OPM are better-suited for these types of circumstances.
Originally published in the Financial Reporting Update: Equity Compensation, June 2019.
When an exit event is not imminent, the appropriate models to measure the fair value of a company with a complex capital stack are the Probability Weighted Expected Return Method (PWERM), the Option Pricing Method (OPM), or some combination of the two. While the choice of the model(s) is often dictated by facts and circumstances – for example, the company’s stage of development, visibility into exit avenues, etc. – using either the PWERM or the OPM requires a number of key assumptions that may be difficult to source or support for pre-public, often pre-profitable, companies. In this context, primary or secondary transactions involving the company’s equity instruments, which may or may not be identical to common shares, can be useful in measuring fair value or evaluating overall reasonableness of valuation conclusions.
For companies granting equity-based compensation, transactions are likely to take the form of either issuances of preferred shares as part of fundraising rounds or secondary transactions of equity instruments (preferred or common shares, as part of a fundraising round or on a standalone basis). Fundraising rounds usually do not provide pricing indications for common shares (or options on common) directly. However, a backsolve exercise that calibrates the PWERM and/or the OPM to the price of the new-issue preferred shares can provide value indications for the entire enterprise and common shares. While standalone secondary transactions may involve common shares, facts and circumstances around those transactions may determine the usefulness of related pricing information for any calibration or reconciliation exercise. Calibration, when viable, provides not only comfort around the overall soundness of valuation models and assumptions, but also a platform on which future value measurements can be based.
This article presents a brief discussion on evaluating observed or prospective transactions. Not all transactions are created equal – a fair value analysis should consider the facts and circumstances around the transactions to assess whether (and the degree to which) they are useful and relevant, or not.1
ASC 718 Compensation-Stock Compensation defines fair value as “the amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.” ASC 820 Fair Value Measurement defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” While some of the finer nuances may differ slightly, both definitions make reference to the concepts of i) willing and informed buyers and sellers, and ii) orderly transactions.
Notably, ASC 820 includes the directive that “valuation techniques used to measure fair value shall maximize the use of relevant observable inputsÉand minimize the use of unobservable inputs.” We take this to mean that pricing information from transactions should be used in the measurement (valuation) process as long as they are relevant from a fair value perspective.
A fundraising round involving new investors, assuming the company is not in financial distress, tends to involve negotiations between sophisticated buyers (investors) and informed sellers (issuing companies). As such, these transactions are relevant in measuring the fair value of equity instruments, including those granted as compensation.
When a fundraising round does not involve new investors, the parties to the transaction are not necessarily independent of each other. However, such a round may still be relevant from a fair value perspective if pricing resulted from robust negotiations or was otherwise reflective of market pricing.
As they give rise to observable inputs, secondary transactions can be relevant in the measurement process if the pricing information is reflective of fair value. Pricing from transactions in an active market for an identical equity instrument would generally reflect fair value. In other cases, orderly transactions Ð those that have received adequate exposure to the appropriate market, allowed sufficient marketing activities, and were not forced or distressed Ð can give rise to transaction prices that are reconcilable with fair value. Orderly secondary transactions that are relatively larger and those that involve equity instruments similar to the subject interests are more relevant.
Some fundraising rounds involve strategic investors who may receive economic benefits beyond just the ownership interest in the company. The strategic benefits could be codified in explicit contracts like a licensing arrangement. Consideration paid for equity interests acquired in such transactions may exceed the price a market participant (with no strategic interests) would consider reasonable. However, even as the pricing indication from such a transaction may not be directly relevant, it can be a useful reference or benchmark in measuring fair value. For example, it may be possible to estimate the excess economic benefits accruing to the strategic investors. Any fair value indication obtained separately could then be compared and reconciled to the price from the strategic fundraising rounds.
In other instances, strategic rounds may result in the company and investors sharing equally in the excess economic benefits. The transaction price could then be reflective of fair value, and a backsolve analysis to calibrate to the transaction price would be viable.
A tranched preferred investment may segment the purchase of equity interests into multiple installments. Pricing for such a round is usually set before the transaction and is identical across the installments, but future cash infusions may be contingent on specified milestones. Value of a company usually increases upon achieving technical, regulatory, or financial milestones. Even when future installments are not contingent on specified milestones, value may increase over time as the company makes progress on its business plan. Pricing set before the first installment tends to reflect a premium to the value of the company at the initial transaction date as it likely includes some expectation of potential economic upside from future installments. On the other hand, the same price may reflect a discount from the value of the company at future installment dates as the investments are (only) made once the economic upside is realized. Accordingly, a reconciliation to pricing information from these fundraising rounds may require separate estimates of the expectation of future upside (for the initial transaction date) and future values implied by the initial terms of the transaction (for later installment dates).
Some fundraising rounds involve purchases of a mix of equity instruments across the capital stack (i.e. different vintages of preferred and/or common) for the same or similar stated price per share. Usually, common shares involved in mixed purchases represent secondary transactions. From a fair value perspective, the transaction could be relevant in the aggregate and provide a basis to discern prices for each class of equity involved (considering the differences in rights and preferences among the classes). In other instances, either the company or the investor may have entered into a transaction for additional strategic benefits beyond just the economics reflected in the share prices. Depending on whether the buyer or the seller expects the additional strategic benefits, reported pricing may exceed the fair value of common shares or understate the value of the preferred shares. In yet other instances, mixed purchases at the same or similar prices may indicate a high likelihood of an initial public offering (IPO) in the near future. Typically, preferred shares convert into common at IPO and only one class of share exists subsequently.
Perhaps obviously, for both secondary and primary transactions, more proximate pricing indications are generally more directly useful for fair value measurement. Older, orderly transactions involving willing and informed parties would have been reflective of fair value at the time they occurred. If a more recent pricing observation is not available, current value indications could still be reconciled with the older transactions by considering changes at the company (and general market conditions) since the transaction date.
Planned future fundraising rounds could also provide useful information. In addition to the factors already addressed, a fair value analysis at the measurement date would need to consider the risk around the closing of the transaction.
Besides the usual transactions, other events that occur subsequent to the measurement date could still have a bearing on fair value. Future events that were known or knowable to market participants at the valuation date should be considered in measuring fair value. Events that were not known or knowable, but were still quite significant, may require separate disclosures.
An example of a special event on the horizon is an impending IPO. An IPO is usually a complex process that is executed over a relatively long period. At various points during the process, the company’s board or management, or the underwriter (investment banker) may project or estimate the IPO price. These estimates may change frequently or significantly until the actual IPO price is finalized. Even the actual IPO price may be subject to specific supply and demand conditions in the market at or near the date of final pricing. Subsequent trading often occurs at prices that vary (sometimes drastically) from the IPO price. For these reasons, estimates or actual IPO prices are unlikely to be reflective of fair value for pre-IPO companies.
Setting aside the uncertainties and idiosyncrasies around the process, an IPO provides ready liquidity for investors and access to public capital markets for the company. The act of going public ameliorates the risks associated with the lack of marketability of investments in a company. Easier access to public markets generally lowers the cost of capital, which would engender higher enterprise values. Accordingly, fair value of a minority equity interest prior to an IPO is generally perceived to be meaningfully different from (estimates of) the IPO price.
Incorporating information from observed or prospective transactions can help calibrate the PWERM or the OPM (or other valuation methods), along with the underlying assumptions. However, a valuation analysis should evaluate the transactions to assess whether they are relevant. Even when they are not directly relevant, transactions can help gauge the reasonableness of valuation conclusions.
Valuation specialists are fond of thinking their craft involves a blend of technique and judgment. The specific mechanics of models and methods, and related computations, represent the technical aspect. There is certainly some judgment involved in developing or selecting the assumptions that feed into the models. Judgment plays a bigger role, perhaps, in weaving together the models, assumptions, valuation conclusions, and other facts and circumstances, including transactions, into a coherent and compelling narrative.
Contact Mercer Capital with your valuation needs. We combine technical knowledge and judgment developed over decades of practice to serve our clients.
1 The discussion presented in this article is a summary of our reading of the relevant sections in the following:
Valuation of Privately-Held-Company Equity Securities Issued as Compensation, AICPA Accounting & Valuation Guide, 2013
Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies, Working Draft of AICPA Accounting & Valuation Guide, 2018
Originally published in the Financial Reporting Update: Equity Compensation, June 2019.
Equity-based compensation has been a key part of compensation plans for years. When the equity compensation involves a publicly traded company, the current value of the stock is known and so the valuation of share-based payments is relatively straightforward. However, for private companies, the valuation of the enterprise and associated share-based compensation can be quite complex.
The AICPA Accounting & Valuation Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, describes four criteria that should be considered when selecting a method for valuing equity securities:
With these considerations in mind, let’s take a closer look at the four most common methods used to value private company equity securities.
The Current Value Method estimates the total equity value of the company on a controlling basis (assuming an immediate sale) and subtracts the value of the preferred classes based on their liquidation preferences or conversion values. The residual is then allocated to common shareholders. Because the CVM is concerned only with the value of the company on the valuation date, assumptions about future exit events and their timing are not needed. The advantage of this method is that it is easy to implement and does not require a significant number of assumptions or complex modeling.
However, because the CVM is not forward looking and does not consider the option-like payoffs of the share classes, its use is generally limited to two circumstances. First, the CVM could be employed when a liquidity event is imminent (such as a dissolution or an acquisition). The second situation might be when an early-stage company has made no material progress on its business plan, has had no significant common equity value created above the liquidation preference of the preferred shares, and for which no reasonable basis exists to estimate the amount or timing of when such value might be created in the future.
Generally speaking, once a company has raised an arm’s-length financing round (such as venture capital financing), the CVM is no longer an appropriate method.
The Probability-Weighted Expected Return Method is a multi-step process in which value is estimated based on the probability-weighted present value of various future outcomes. First, the valuation specialist works with management to determine the range of potential future outcomes for the company, such as IPO, sale, dissolution, or continued operation until a later exit date. Next, future equity value under each scenario is estimated and allocated to each share class. Each outcome and its related share values are then weighted based on the probability of the outcome occurring. The value for each share class is discounted back to the valuation date using an appropriate discount rate and divided by the number of shares outstanding in the respective class.
The primary benefit of the PWERM is its ability to directly consider the various terms of shareholder agreements, rights of each class, and the timing when those rights will be exercised. The method allows the valuation specialist to make specific assumptions about the range, timing, and outcomes from specific future events, such as higher or lower values for a strategic sale versus an IPO. The PWERM is most appropriate to use when the period of time between the valuation date and a potential liquidity event is expected to be short.
Of course, the PWERM also has limitations. PWERM models can be difficult to implement because they require detailed assumptions about future exit events and cash flows. Such assumptions may be difficult to support objectively. Further, because it considers only a specific set of outcomes (rather than a full distribution of possible outcomes), the PWERM may not be appropriate for valuing option-like payoffs like profit interests or warrants. In certain cases, analysts may also need to consider interim cash flows or the impact of future rounds of financing.
The Option Pricing Model treats each class of shares as call options on the total equity value of the company, with exercise prices based on the liquidation preferences of the preferred stock. Under this method, common shares would have material value only to the extent that residual equity value remains after satisfaction of the preferred stock’s liquidation preference at the time of a liquidity event. The OPM typically uses the Black-Scholes Option Pricing Model to price the various call options.
In contrast to the PWERM, the OPM begins with the current total equity value of the company and estimates the future distribution of outcomes using a lognormal distribution around that current value. This means that two of the critical inputs to the OPM are the current value of the firm and a volatility assumption. Current value of the firm might be estimated with a discounted cash flow method or market methods (for later-stage firms) or inferred from a recent financing transaction using the backsolve method (for early-stage firms). The volatility assumption is usually based upon the observed volatilities of comparable public companies, with potential adjustment for the subject entity’s financial leverage.
The OPM is most appropriate for situations in which specific future liquidity events are difficult to forecast. It can accommodate various terms of stockholder agreements that affect the distributions to each class of equity upon a liquidity event, such as conversion ratios, cash allocations, and dividend policy. Further, the OPM considers these factors as of the future liquidity date, rather than as of the valuation date.
The primary limitations of the OPM are its assumption that future outcomes can be modeled using a lognormal distribution and its reliance on (and sensitivity to) key assumptions like assumed volatility. The OPM also does not explicitly allow for dilution caused by additional financings or the issuance of options or warrants. The OPM can only consider a single liquidity event. As such, the method does not readily accommodate the right or ability of preferred shareholders to early-exercise (which would limit the upside for common shareholders). The potential for early-exercise might be better captured with a lattice or simulation model. For an in-depth discussion on the OPM, see our whitepaper A Layperson’s Guide to the Option Pricing Model at mer.cr/2azLnB.
The Hybrid Method is a combination of the PWERM and the OPM. It uses probability-weighted scenarios, but with an OPM to allocate value in one or more of the scenarios.
The Hybrid Method might be employed when a company has visibility regarding a particular exit path (such as a strategic sale) but uncertainties remain if that scenario falls through. In this case, a PWERM might be used to estimate the value of the shares under the strategic sale scenario, along with a probability assumption that the sale goes through. For the scenario in which the transaction does not happen, an OPM would be used to estimate the value of the shares assuming a more uncertain liquidity event at some point in the future.
The primary advantage of the Hybrid Method is that it allows for consideration of discrete future liquidity scenarios while also capturing the option-like payoffs of the various share classes. However, this method typically requires a large number of assumptions and can be difficult to implement in practice.
The methods for valuing private company equity-based compensation range from simplistic (like the CVM) to complex (like the Hybrid Method). In addition to the factors discussed above, the facts and circumstances of a particular company’s stage of development and capital structure can influence the complexity of the valuation method selected. In certain instances, a recent financing round or secondary sale of stock becomes a datapoint that needs to be reconciled to the current valuation analysis and may even prove to be indicative of the value for a particular security in the capital stack (see “Calibrating or Reconciling Valuation Models to Transactions in a Company’s Equity” on page 6). At Mercer Capital, we recommend a conversation early in the process between company management, the company’s auditors, and the valuation specialist to discuss these issues and select an appropriate methodology.
Originally published in the Financial Reporting Update: Equity Compensation, June 2019.
To the lay person, transportation may seem like the farthest end of the spectrum from the technology industry – telephone orders and paper shipment tracking. But those in the know understand just how tech-enabled the industry has become. Advancements in machine learning, artificial intelligence, and predictive technology could have the power to disrupt the way goods are transported, stored, and tracked. And investors are clearly willing to take bets on that.
Over the past few years, FreightTech has emerged as its own category of technology. The level of excitement in the space grew in 2018 as global venture capital investment increased to $2.9 billion from $1.3 billion the prior year. FreightTech is on track for another year of exponential growth in 2019, with $1.6B of funding raised in the first quarter alone.
The willingness of industry participants to adopt logistics technology is evident as well. Corporate players and major OEMs have spun up innovation departments, startup accelerators, and investment arms in order to find and fund new technology. However, it’s not only the companies that directly benefit from this technology that are investing capital in the space. Technology players recognize the potential for returns on transportation investments, too. Alphabet’s venture capital arm, Capital G, led a $185 million investment in Convoy, a tech-enabled freight matching startup, at the end of 2018. The Series C round valued Convoy at $1.0 billion and brought the company’s total capital raise to $265 million. Softbank Vision Fund, known for making big bets on disruptive technology, got in on the game too. The fund invested $1.0 billion in Flexport, a digital platform for freight forwarding and logistics, at the start of the year. The investment valued the company at $3.2 billion.
The table below shows the five largest North American FreightTech investments in the first quarter of 2019 by round size.
Investment in FreightTech has not only grown in terms of aggregate investment, but the average size of deal rounds has increased as well, mirroring the trends in the overall venture capital landscape. According to Morningstar, the average round size for a Series B round in the FreightTech industry increased 78% from $24.5 million in 2014 to $43.6 million in 2017.
The classification of transportation and logistics startups differs, but it is clear that there is growing innovation in many different facets of the industry. It is evident that technological change in the freight transportation industry is about far more than just digitizing processes that once involved paper or fax machines. The application of advanced data and analytics to the transportation and logistics industry has the potential to change the global movement of freight.
Originally published in the Value Focus: Transportation & Logistics, First Quarter 2019.
I recently attended the 2019 Spring Conference of the National Auto Dealers Counsel (NADC) in Dana Point, California. This article provides a couple of key takeaways from the day and a half sessions on the current conditions in the industry.
Car subscription services are becoming a popular alternative to leasing. Each service varies in structure and is operated by dealers, manufacturers, and third parties. Some offer reasonable traditional leases or allow customers to make monthly payments, but allow more flexibility/frequency in swapping vehicles for changing preferences and needs.
Some manufacturers are only initially offering subscription services regionally, or in specific markets (BMW and Mercedes-Benz are offering vehicle subscription services in the Nashville market).
There has been a lot of talk in the news recently about impending tariffs in the auto dealer industry. Many unknowns and questions remain—Will President Trump enact tariffs? How will they affect the auto industry?
The Center for Automotive Research Report has compiled statistics to show the likely effects of tariffs on new/ used vehicle pricing, estimated losses for dealers, and projected employment and GDP loss (as seen below). With so much at stake, the auto dealer industry will keep a close eye on monitoring any new developments.
Amid the many changes that have resulted from the recent tax reform (the Tax Cuts and Jobs Act (TCJA)), here are a few directly impacting the auto dealer industry:
Originally published in the Value Focus: Auto Dealer Industry Newsletter, Year-End 2018.
This article explains dealership metrics and performance statistics–what they mean, how to evaluate them, and where a particular store stacks up. As always, performance measures are relative. We are relying upon averages provided by NADA as well as our experience working with auto dealers.1
A few key terms help frame our discussion:
Specifically, we are relying upon information from the average dealership profile for 2017 and 2018 from NADA.2
For the average dealership profile, our experience has been that this department comprises between 50% – 60% (58% for 2017-2018 per NADA) of total gross sales. The front-end gross margin on new vehicles can vary over time and is somewhat controlled by the manufacturer. Typically, dealerships track and measure front-end gross margin on a per unit basis and can evaluate the overall performance of that figure by comparing it to prior years. Most domestic, import, or luxury dealerships experience a lower front-end gross margin on new vehicles than on used vehicles. Conversely, most high-line dealerships experience a higher front-end gross margin on new vehicles than on used vehicles.
New vehicles generally have a higher average retail selling price, lower front-end gross margins, and sell fewer units than used vehicles. These factors result in new vehicles comprising approximately 25% of total overall gross profits for an average dealership.
For the average dealership profile, our experience has been that this department comprises between 25% – 40% of total gross sales. These percentages can vary depending on franchise/dealership type and regional location. Like new vehicles, dealerships also track frontend gross profits on used vehicles on a per unit basis. Most domestic, import, or luxury dealerships experience a higher front-end gross margin on used vehicles than on new vehicles.
The sale of used vehicles should not be overlooked when assessing the value of a dealership. More often than not front-end gross margins on used vehicles will be higher than new vehicles. Additionally, the sale of both new and used vehicles put more cars in service and help drive profitability to fixed operations (to be discussed in next section). Based on our experience valuing new car dealerships, the range of used retail vehicles sold to new retail vehicles sold is 1.00 to 1.25. This figure can vary by dealership and can also be quite cyclical throughout the year. Further, our experience shows this ratio can climb to 1.5 to 1.6 when considering dealerships with successful wholesale used vehicle sales.
Used vehicles generally have a lower average retail selling price, higher front-end gross margins, and sell more units than new vehicles. These factors result in used vehicles comprising approximately 25% of total overall gross profits for an average dealership, or about even with the total overall gross profit contribution from new vehicles.
The long-term success of a dealership’s fixed operations is often tied to their effectiveness in selling new and used vehicles over time. These activities help to build brand in a market. Another critical factor in the success and level of profitability in the fixed operations is the auto industry cycle. In our last issue, we discussed the cyclicality of the industry not only in terms of certain months during the year, but also year-over-year.
Two such indicators of the auto industry life cycle are the SAAR and the average age of car. As shown on page 14 of the newsletter, the monthly SAAR began to level off in late 2018 and into the first few months of 2019 (despite a slight spike in March 2019) evidencing slower new light vehicle sales. Additionally, per our previous newsletter, the average age of cars in service was approximately ten years.
Both factors foreshadow that fixed operations of successful dealerships should experience an uptick in the short-term and mitigate the moderate/sluggish new vehicle sales. When customers hold onto their cars longer, they are less likely to spend money on a new or used vehicle, but their maintenance needs on their current vehicle will likely increase.
For the average dealership profile, our experience suggests that the service department comprises between 10% – 15% of total gross sales. However, this department is typically the most profitable in terms of a percentage of sales. The combination of much higher margins on lower sales results in the service department averaging 45% – 50% of total gross profits, or a much higher contribution level than new or used vehicles.
All dealerships are not created equally. This article is a general discussion on various dealership metrics and performance statistics. Each statistic is relative and not to be viewed in a vacuum. Hopefully, we have provided a better understanding of the various departments, including fixed vs. variable operations and their contribution to overall profitability and the eventual value of a store. A graphic display of historical profitability and other metrics are discussed later in the newsletter. For an understanding of how your dealership is performing along with an indication of what your store is worth, contact us. We are happy to discuss your needs in confidence.
1 The data and discussion are based generally on average dealership profiles and do not pertain specifically to domestic dealerships, import dealerships, ultra high-line dealerships, etc. Specific types of dealerships and their regional location could have different performance metrics and criteria.
2 It’s important to note that other national sources of Blue Sky multiple data (Haig Partners and Kerrigan Advisors) classify the categories of dealerships slightly different from NADA, so all comparisons and discussion should be done in general terms.
Originally published in the Value Focus: Auto Dealer Industry Newsletter, Year-End 2018.
Originally presented at the 2019 AAML/BVR National Divorce Conference in Las Vegas, in this session, Z. Christopher Mercer, FASA, CFA, ABAR delves into more than 30 years of experience presenting complex valuation and damages issues to judges and juries. One of the key ideas of effective communication is the KISS principle, or “keep it simple, stupid.” The question is, how can we do that? Chris provides the techniques and templates necessary to communicate your position, and your opponent’s position, in such a way that judges can hone in on and understand the most important information and why it’s important.
The trucking industry is wedged between a rock and a hard place when it comes to driver recruitment. Trucking companies are simultaneously exploring self-driving technology, while still convincing new entrants to the labor market that commercial driving is a career choice that will pay off. Punctuating the less-than-glamorous work and lifestyle conditions of the occupation, those entering the labor force realize that the career path could be upended in the near-term by the economic cycle and disrupted in the long term by the impending evolution of autonomous transportation. With several companies (like Tesla) beginning deployment of self-driving trucks, and numerous others deep in development of the technology, young workers may fear choosing a vocation that trucking companies are actively planning to automate.
Rob Sandlin, CEO of Patriot Transportation, emphasized these challenges in the company’s third quarter earnings call, “Management spends a good deal of time dealing with these issues surrounding driver shortage, including advertising, recruiting, compensation, dispatcher training and productivity among others.” With the tightening of the labor market, companies have found new ways to attract talent including investments in newer and more reliable assets, in-house training programs, incentive bonuses, and, of course, a simple increase in wages.
Executives at many of the largest trucking companies dedicated time in their third quarter investor calls and presentations to this issue. PAM identified several unique recruitment initiatives in its November corporate presentation. The company is taking advantage of temporary visitor qualifications through the B1 Visa program to increase labor capacity. This program allows commercial drivers with Mexican residence temporary entry to the United States for truck delivery. Additionally, the company’s new driver-friendly initiatives promote lifestyle and career improvements. Its “Driver Life-Cycle” program provides dedicated driver experience with a path towards ownership through a lease-to-own set up.
Patriot mentioned significant changes to its recruitment efforts, as well. “In the latter part of fiscal 2018, we implemented a significant change to our hiring process, we added [a] driver advocate position and introduced productivity-based driver pay, all in an effort to attract and retain drivers. We are encouraged by the increased number of drivers hired and in training since these implementations, and we’ll continue to monitor our progress for any needed adjustments to our plan.”
The driver shortage (which is estimated to reach 108,000 by 2026) has sparked major shifts in the way hiring and training are conducted in the industry. While this shortage will hurt shippers until autonomous technology is fully developed, the long-term problem may actually lie in another labor pool: service technicians.
As new truck designs increase the level of technology on board, those who service them will have to develop more tech-focused expertise. Additional sensors, predictive technology, and, of course, autonomy will evolve the role of the truck mechanic as they start spending more time with computers than wrenches. While technical colleges and certificate programs continue to produce a skilled workforce, the supply of service technicians has not kept pace with the increasing demand.
Trucking companies have had to adapt to the shifting labor force trends and find new ways to fulfill maintenance needs. Like driver scarcity, mechanic shortages have caused companies to seek alternatives to traditional labor sourcing, from outsourcing labor needs to developing training programs.
Overall, employment in the transportation and warehousing industry grew 3.5% from October 2017 to October 2018, adding more than 183,700 jobs. Nearly 37,000 of these jobs were in the trucking industry, which experienced a 2.5% increase in employment over the prior year. The transportation industries are adding jobs faster than the overall non-farm economy, which experienced a more modest 1.7% increase in employment.
Despite labor pressures in the industry, economic activity and transportation demand remain strong. While executives will continue to monitor driver and mechanic shortages, the outlook for trucking in 2019 appears optimistic. John Roberts III, CEO of J.B. Hunt, summed up the industry sentiment well on the company’s third quarter earnings call.
Just final comment on the people side of things. Driver hiring has been a challenge. It’s been a challenge in the past. It presented us with the challenge like we have never seen before this year. In fact, our unseated need number got as high as [it’s] ever been. In about the last 60 days, we’ve seen that number come down a little bit through a number of internal efforts. And I think overall pay in the industry is starting to catch up a little bit. And so I think more people are becoming interested. But we’re making progress there and feel confident we’ll continue to get through that. Good year, some challenges, and frankly, we’re looking forward to heading into 2019.
Originally published in the Value Focus: Transportation & Logistics, Fourth Quarter 2018.
Since Bank Watch’s last review of net interest margin (“NIM”) trends in July 2016, the Federal Open Market Committee has raised the federal funds rate eight times after what was then the first rate hike (December 2015) since mid2006. With the past two years of rate hikes and current pause in Fed actions, it’s a good vantage point to look at the effect of interest rate movements on the NIM of small and large community banks (defined as banks with $100 million to $1 billion of assets and $1 billion to $10 billion of assets).
As shown in Figure 1, NIMs crashed in the immediate aftermath of the financial crisis, primarily because asset yields fell much quicker than banks could reprice term deposits. NIMs subsequently rebounded as the asset refinancing wave subsided while banks were able to lower deposit rates. A several year period then occurred in which asset yields grinded lower at a time when deposit rates could not be reduced. This period was particularly tough for commercial banks with a high level of non-interest bearing deposits.
Since rate hikes started, the NIM for both small and large community banks have increased about 20bps through year-end 2018 before experiencing some pressure in early 2019. The nine hikes by the Fed to a target funds rate of 2.25% to 2.50% amounts to a 225bps increase.
At first pass, the expansion in the NIMs is less than might be expected; however, there are always a number of factors in bank balance sheets that will impact the NIM, including:
Recent incremental pressure on NIMs notwithstanding, community banks’ balance sheets were poised to take advantage of rising rates the past several years. The outperformance of bank stocks beginning in November 2016 reflected several factors, including an economic and regulatory backdrop that would allow the Fed to raise rates further and faster, and thereby support NIM expansion.
The underperformance of bank stocks since last fall reflects investor concern that this tailwind is ending in addition to more general concerns about what a possible economic slowdown implies for credit costs. Telltale signs include the inversion of the Treasury yield curve and yields on the two-year and five-year Treasuries that, as of the date of the drafting of this article, are below the low-end of the Fed Funds target range.
Also, the spot and forward curves for 30-day Libor imply the Fed will cut the Funds target rate and other short-term policy rates one or two times by early 2020 (or stated differently, the December rate hike was a mistake).
The Federal Funds rate, the predominant influence on short-term interest rates, has remained unchanged since year-end 2018 at a target range of 2.25%–2.50% due to concerns about lower inflation figures and what they may forewarn about future economic growth as reflected in falling U.S. Treasury yields. The FOMC reiterated its wait-and-see approach on May 1. However, the sand appears to be shifting beneath the Fed’s feet.
The Wall Street Journal’s most recent Economic Forecasting Survey revealed an increasing belief that the Fed’s next move will be to cut rates. 51% of respondents said that a rate cut would be the next move, up from 44% in April. 25.5% replied that the next rate raise would occur in 2020 or later. Fed officials have maintained their stance that a rate move in either direction will not occur soon.
As deposit costs initially lagged, but more recently moved with short-term interest rate hikes, the composition of a bank’s deposit base and funding structure has become increasingly important. As shown in Figure 4, the percentage of banks experiencing a rising cost of interest bearing deposits has steadily increased. Total funding costs have nearly doubled since year-end 2016 as depositors have reoriented funds toward accounts offering higher rates. Banks searching for funding either must engage in intense deposit competition or tap into higher-cost sources such as wholesale funding.
Going forward community banks may face a modest reduction in NIMs because the yield curve is flat and the cost of incremental funding is expensive. Some community banks will choose to slow loan growth in order to protect margins; others will accept a lower margin. The predicament demonstrates yet again why deposit franchises are a key consideration for acquirers as banks with low cost deposit franchises and excess liquidity are particularly attractive in the current market.
Originally published in Bank Watch, May 2019.
Lucas Parris, CFA, ASA-BV/IA, vice president, co-presented the session, “Employee Benefits Agency Consolidation and Valuation” with Mike Strakhov (Live Oak Bank) at the 2019 Workplace Benefits Renaissance Conference in Nashville, TN (February 20-22,2019).
A short description of the session can be found below.
Insurance agency merger and acquisition activity has been at historic levels for the past few years. Employee benefit agency transactions represent a significant number of these annually. This session will address the current state of agency consolidation including trends, who’s buying and who’s selling and the overall impact to employee benefits distribution. We’ll also identify and discuss the important characteristics that drive value of an employee benefits agency.