Valuation Challenge: The art and science of benchmarking

THE CHALLENGE:
During the second quarter of 2008, a private equity firm made a direct investment in a private company. The Company has continued to execute according to plan, although there are some production delays that have limited current profitability. This, coupled with the current state of the economy has convinced the private equity firm's auditors that an asset impairment should be taken just seven months after the deal closed. The private equity firm is not sure that is accurate. The opportunities ahead of the company remain strong, and the private equity firm feels that it would make the same investment today as it did seven months ago. How does the firm prove it?

OWEN DAHL'S ANSWER:
It is hard to ignore the fact that we currently face an environment of highly publicised economic failures and a consensus view that economic contraction is prevalent in the market. With this backdrop, it is not surprising that auditors are influenced to believe that asset write-downs are necessary. To prove otherwise, you need to be armed with independent, verifiable proof. An independent appraisal is one approach, but given the cost, this option is often difficult to stomach. For companies that feel capable of performing an in-house analysis, here are a few things to keep in mind.

There should be some comfort in knowing that SFAS 157 provides guidance that, if followed, can improve your analysis. First, keep in mind that contemporary transactions in the same or highly similar investments should, if available, always be the basis of your analysis. If investors continue to invest throughout the next seven months into the same financing round, you would have excellent, verifiable proof of what a “market participant” is willing to pay. This type of proof would generally trump all other valuation considerations identified in SFAS 157.

If such data is not available (generally because the fund raising activities were closed), then you will more likely than not be forced to consider one of two general valuation approaches: the Discounted Future Cash Flow analysis, or some form of the Market Approach. If you pay an appraiser, they are likely going to be looking at both approaches, and looking for “cross corroboration”, where the company's future opportunities as measured by expected cash flows are aligned by market pricing for comparable investment opportunities. The appraisal will include detailed consideration of historical operations and future opportunities, and will likely corroborate what your auditors otherwise know. The market approaches will consider the alternative investment options and discretely compare these investment options against the subject company.

Whether one or both of these approaches are ultimately useful depends on the facts at hand, but you will find a far more receptive audience if the core value factors are based on observable data. While it may be true that “EBITDA multiples of between five and seven are historically reasonable in this industry”, an analysis needs to show that comparable companies have been bought and sold at these multiples recently. This is particularly true during a market crisis, when pricing multiples are rapidly declining as stock prices fall. A six month-old data point will face certain scrutiny.

It is important to consider the valuation process for what it is. It is first and foremost an impartial judgment of the Company's operations and opportunities as of a point in time. It is also a logical process that is both auditable and repeatable. It is always based on judgment, but the judgment should never require a leap of faith from the reader. Finally, it should rely heavily on comparative analysis. Any profit expectation, pricing multiple, or volatility input should be bolstered by a broader comparison to market participants, industry analysis, or better yet, actual historical observations.

It is difficult to be impartial when preparing an internal valuation. The interesting thing is that very good entrepreneurs often make the worst appraisers. When selling the virtues of a company, an entrepreneur will forcefully assert the uniqueness of his or her company's opportunity. When it comes time to discuss valuation however, this same position is a mistake. First, it will make the valuation process very difficult. Second, it ignores the central tenant of investing: there is ALWAYS an alternative investment. By effectively suggesting that any particular investment is unique simply because its product or solution is unique has serious ramifications.

When deriving a valuation model, focus on investment benchmarking to solve the data riddle. Investment benchmarking offers a dearth of benefits to a company looking to internalise the valuation process and for companies who truly want to measure their financial performance. It is simply “best practice” for investors to find a solid group of publicly traded companies who perform in a reasonably similar market space and, if possible, track these companies from the moment a decision to invest is made. By developing your benchmark list at the beginning of the investment cycle, you will be rewarded with an impartial scorecard by which to measure value for financial reporting purposes. Remember that your benchmarks do not necessarily need to be a direct competitor (though it is always best if they are), but they should be affected by similar market dynamics and offer similar opportunities to investors. Again, don't overthink this, and keep the entrepreneurial spirit locked away for now.

Is one benchmark enough?
A common issue arises when benchmarks are either not exactly a perfect match, or when there are a very limited number of perfect matches. Our position is that a small number of perfect matches may be very relevant (even one company) but you run a serious risk that the company will cease operations twelve months from now, or will create excessive volatility in your outcomes due to irrelevant factors. To get around this issue, keep two sets of benchmarks: one for the narrow subset of companies (or company) that are considered “most comparable” and a second set that includes a broad definition of “industry”.

This may sound like more work than you want to undertake, but the internet makes this process very easy. A common website like www.moneycentral.com provides everything you need to benchmark relative performance or valuation multiples, and it is free. Take the time to set up a spreadsheet that can be updated quarterly with the new financial information like revenue growth, gross profitability, net margins, price/revenue, price/ earnings, or price/cash flow.

We look at benchmarks as a starting point. They offer a wealth of low-cost information that will be very relevant to the task of internalizing a valuation. They offer guidance regarding cash flow forecasting. They provide readily available pricing multiples that can be used to provide some of the necessary valuation evidence. They form the basis for a good volatility analysis, a necessary input for employee stock option computing. Finally, they should provide corroboration of management's overall valuation opinion.

Choosing the right valuation tool
Many finance professional agree that a forecasted cash flow method can be the best solution to valuing a particular private enterprise. There are several difficulties however, for companies trying to perform such an analysis internally. First, many of the data points needed to properly develop the correct discount rate are not available. Second, a discounted cash flow model can be misused and is generally treated with mistrust when it relies on internally generated forecasts.

This is particularly true, in our experience, for technology-based companies. Forecasts require a leap of faith when companies are currently unprofitable. A growth model in 2008 may be a serious bone of contention with your professional advisors in 2009 if the company's growth expectations are delayed. I have spoken to many auditors over the years that have grown increasingly skeptical as delays in production have caused historical forecasts to be missed.

For private companies, nothing beats a situation where a similar company is bought or sold, known commonly as the Merger & Acquisition analysis. The method is good when data is available that can be corroborated, including historical revenue and profitability, price paid in the deal, and terms associated with the transaction. More often than not, such information is unavailable without access to expensive private company databases.

In the end, a discounted cash flow analysis, merger & acquisition analysis, or some other valuation tool could be the most logical perspective on value for a given company. In our opinion, this does not reduce the value of enacting a good benchmarking program. By making a habit of benchmark corroboration, you will be able to avoid most of the common valuation difficulties we end up seeing during the review process. Your professional advisors will be more comfortable with your judgment, your auditors will be required to spend less time (and money) in the review process, and, if applicable, you are more likely to avoid red flags with the Internal Revenue Service. Finally, consider a valuation consult early on. This should help point you in the right direction as you look to navigate the land mines that are prevalent in many of the new valuation standards.