CIRR produce company--a case study introduction to business valuation.
This case puts the student in the role of a CPA, ABV engaged in valuing a closely held family business for purposes of buying out a disenfranchised family member. Students are exposed to basic valuation research, confront the limitations of historical cost financial statements, choose an appropriate valuation method and exercise professional judgment in a variety of valuation decisions. The issues of objectivity, client conflicts of interest and business valuation accreditation are also introduced.
The case is appropriate for junior or senior level accounting or finance majors with a solid background in financial accounting. The case can be taught in one to two hours of class time and will require four to five hours of outside preparation by students.
Jess Parker, a CPA, ABV, is hired by one his former college friends to place a value on a wholesale grocery business currently owned by him, his brother and sister. Family friction has led to the brother wanting to retire and have his interest bought by the other two siblings.
Over a three week period, Jess works with his client and one of his staff members in doing the research and preliminary work. As he responds to questions from the client and his assistant, Jess explains some of the major challenges and issues involved in valuing a non-public business. Students research some common valuation methods and select the one most appropriate to the set of conditions in the grocery valuation. As students progress through the valuation and write the report they deal with limitations of traditional financial reports, the challenge of estimating proper discount and capitalization rates and the subjectivity of the valuation process.
DISCUSSION ITEM 1
Traditional GAAP-based financial statements should reflect full-accrual, primarily historical cost-based values. (Although not legally required to do so, many closely-held companies also prepare GAAP-based statements at the request of creditors.) While appropriate for the general investor and creditor trying to evaluate the firm's future earnings and cash flows, many GAAP-based amounts may not be relevant for valuation purposes. Among the reasons why GAAP standards are not always compatible with fair-value decisions are that 1) assets are reported at depreciated book value (using historical cost) and not at replacement cost or fair value; 2) revenue recognition rules may not be consistent with GAAP; 3) accounting estimates (e.g. bad debt reserves, depreciation lives, warranty provisions, pension accruals) may be overly optimistic or overly cautious;
DISCUSSION ITEM 2
The objective for this activity is for students to become familiar with some basic business valuation methods available to practitioners and discover some of the variables involved in the valuation process. Students will give a wide variety of responses depending on which particular sources are used. Students that limit their research to only those references in Appendix IV could adequately respond to Item 1 in an hour or so. Students using other resources might take an additional hour to complete this question. The following summaries are based on the sources in Appendix IV of the case that are typical of most discussions of valuation methods. It's important that students describe not only the calculation procedures but also that they have at least some appreciation of when each method is most appropriate.
Capitalized earnings approach: This is one of the most commonly used methods. It is appropriate when current earnings are presumed to be a good estimate of future earnings and will continue indefinitely. Historical earnings are first adjusted for unusual and abnormal items. Typical adjustments include removing excess owner and manager compensation and benefits and correcting for overly conservative or liberal accounting assumptions (e.g. depreciation, bad debts, and inventories). The normalized earnings are then projected into the indefinite future by dividing them by a capitalization rate. The capitalization rate is a risk-free rate of return that is adjusted for the risk inherent in the specific business situation.
Fair value of net assets method: This method is appropriate when the company's existing assets provide most of the firm's value. The appraised or estimated fair value of identifiable assets less liabilities gives the firm's equity value. This method is not appropriate when the firm's financial performance suggests that there may be a large amount of unrecorded intangible assets such as going-concern value or goodwill or the firm's value is largely dependent on earnings or cash flows.
Excess earnings method: This is one of the few methods that use both an asset and an income approach. The business is presumed to be worth the fair value of the existing net assets plus an amount for goodwill (going-concern value) based on the company's earnings in excess of a normal profit. Annual excess earnings are capitalized at an appropriate "cap" rate. The excess earnings method is appropriate when substantial going-concern value is suggested in the investigation phase of the valuation.
The excess earnings method, as presented in IRS Rev. Rul. 68-609, is a common technique but it is sometimes hard to implement in practice. It is, however, appropriate in the set of circumstances surrounding the Cirr Grocery job. In this method, a business' value is estimated as the sum of the fair value of net tangible assets plus an approximated amount of goodwill based on excess earnings ability. It requires three calculations: 1) a reasonable rate of earnings on the tangible assets, 2) the company's normalized earnings in excess of the reasonable return (excess earnings) and 3) capitalization of the excess earnings at a rate appropriate for intangible assets.
Liquidation value method: This method approximates the minimum value that a business is worth and might be used if the owners were forced to sell the business quickly. Liquation value is the estimated amount that would be left if the owner were forced to quickly liquidate all of the assets and pay off the liabilities. The quick sale would preclude getting full, market value for the assets.
DISCUSSION ITEM 3
The objective of this activity is for students to relate the general valuation methods to the Cirr Grocery valuation job by focusing on some of the key issues. Students will have to critically evaluate the approaches in Item 2 and select one as most appropriate. This activity should help students see the type of professional judgments required in placing a value on a business. Choice of method(s) is one of the most important decisions that valuators make.
Most students will complete this activity in one hour or less since the background work was done in Item 1. (In actuality, three different valuation methods were applied to the Cirr valuation. See details below.) Students should select either the capitalization of earnings or the excess earnings methods based on the following points: 1) the capitalization of earnings method seems appropriate since future operations are not likely to change in the near future after Darryl is bought out. Therefore, current normalized earnings are expected to continue; 2) the excess earnings method is appropriate since normalized earnings show substantial evidence of goodwill value (i.e. the firm is worth more than its recorded asset values); 3) the conditions are not conducive to using the other two methods. Future operations are unlikely to change substantially (due to the continuation of existing management), there is evidence of goodwill value based on successful operations and the company is not being liquidated.
DISCUSSION ITEM 4
The objective of this activity is to have students directly address some of the calculation and conceptual issues common in valuations and document their work. (Instructors may elect to have students do both of the suggested methods since this is often done in practice thereby adding realism and completeness to the case.) This section should take from two to three hours of student time.
Based on the discussion in Item 2, students have discovered that the liquidation method and the fair value of net assets method are inappropriate in these circumstances. Students will apply either (or both) the capitalized earnings or excess earnings methods. To apply these methods, normalized income statements for the five year period are required. To compute normalized earnings, students will likely propose earnings adjustments in two areas--specific adjustments based on items already presented in the case and general areas of GAAP.
The case only specifically identifies, and gives dollar amounts for adjustments related to salaries, profit sharing, personal travel costs and personal use of cars. Based on these items, the normalized income statements are presented below. For year 2001, the original amounts, adjustments and normalized amounts are shown (Table 1 and 2); for 1997-2000 only the final, normalized amounts are shown (Table 3).
Adjustments A and C: Adjust owner compensation to 2 percent of sales. In the case, Jess suggests that owner compensation should not exceed an industry average of 2 percent of sales. Therefore, officer salaries for each of the five years should be reduced to that amount (2% x Net Sales). Also, since Profit Sharing is additional owner compensation, $60,000 ($20,000 @ owner) should also be eliminated to keep owner compensation to a total of two percent of sales. [Instructor note: The RMA size category for Cirr (Sales $10-$25 million) shows average compensation of 1.7 percent of sales. Some students may want to use that as the industry average. Jess' estimate at 2 percent seems reasonable.]
Adjustment B: Remove depreciation for personal use of cars by owners and spouses. Appendix II shows that one-half of the owners' car use is personal and that the company pays all of the expenses for the spouses' cars. Depreciation expense should be reduced by $10,000 ($20,000 x 50%) for the owners' personal use and another $10,000 for the spouses' cars.
Adjustment D: Remove personal travel expenses paid by the company. Appendix II shows that Cirr pays $6,000 ($2,000 @ owner) of personal travel expenses for the shareholders. These should be eliminated since they are not typical business expenses.
Adjustment E: Adjust income taxes to 40% of normalized pre-tax income. The 40 percent rate must be determined from the tax expense data for years 1997--2001.
Students may propose a variety of other potential adjustments, such as depreciation, write-down of obsolete plant and equipment, inventory costing methods and write downs, bad debt allowances, unrecorded sales, unrecorded liabilities (e.g. potential lawsuits), and inadequate operating accruals such as interest, taxes, wages or benefits. While the GAAP basis for their choices may be worthy of consideration and class discussion, there is no direct evidence that any of these items are substantially out of line at Cirr Grocery.
[Instructor note: There are a variety of GAAP issues that might be discussed here, although most of them really aren't vital to the adjustment process. Instructors may want to use this chance to review some basic GAAP concepts such as cash versus accrual basis (is Cirr full or only partial accrual?), periodicity and cut-offs (are all revenues booked and expenses accrued?), conservatism (what amounts did they use for depreciable lives?), reliability (have these statements been audited?) and materiality (does it really matter whether we use 2 or 1.7 percent of sales?).]
Capitalized Earnings Approach
The calculations for this method are: average expected future earnings / appropriate capitalization rate. In the case, Jess suggests a 40 percent cap rate when he predicts that there will be no major changes in operations for the next two and one-half years (100% / 2 1/2 = 40%). Some students may use the three year estimate (Jess gave a 2 1/2 to 3 year range) and use a 33 1/3 percent cap rate. This is a good opportunity to discuss the use or conservatism in business valuation work. Of course, the lower the cap rate, the higher the value assigned to the assets. When in doubt, valuators like to err on the conservative side of their estimates which builds a bit more cushion for risk into the valuation numbers.
After the normalized earnings are computed for years 1997-2001, the valuator must decide which, if any, of these years are representative of future trends. In three of these years, Cirr did not have the chain store customers that now account for a large percentage of their sales. And, the year 2000 earnings are unusually high and probably not typical of long-term trends. Therefore, a conservative estimate of Cirr's value can probably best be found by capitalizing only the year 2001 earnings. This gives a value of approximately $1,168,890 ($467,556 / 40%). Students using the lower cap rate will get a value of $1,404,072 ($467,556 / 33.3 %).
In short, the business valuator is estimating that to get a 40 percent return on an investment in Cirr Grocery, one would need to pay $1,168,890.
Excess Earnings Method
The excess earning method has the following steps: 1) Determine the fair value of net assets (assets minus liabilities); 2) Compute normal earnings (fair value of assets times normal rate of return); 3) Compute excess earnings as actual average earnings minus normal earnings; 4) Capitalize the excess earnings using an appropriate capitalization rate; 5) Compute the company value as: fair value of net assets plus capitalized excess earnings.
The fair values of Cirr's net assets as of December 31, 2001, are shown in Table 4.
The calculations for the excess earnings method are: 1) The fair value of Cirr's net assets is $955,000 (Assets $2.297 M minus Liabilities $1.342 M); 2) Using Jess' imputed normal rate of return of 18 percent, normal earnings for net assets of $955,000 are $172,000 ($955,000 x 18%); 3) Cirr's normalized earnings for year 2001 are $467,556. Excess earnings are $295,556 (actual $467,556 minus normal $172,000); 4) Using Jess' estimate of two and one-half years, the capitalization rate would be 40 percent (100% / 2 1/2 years). Capitalized excess earnings are $738,890 (excess earnings $295,556 / 40% cap rate).
The company's value is approximately $1.64 M (fair value of assets $955,000 + capitalized excess earnings $738,890).
Since both methods seem appropriate, the final estimate could include both the capitalized earnings estimate of $1.17 million and the excess earnings estimate of $1.64 million. One approach is to mathematically weigh each amount equally which is the simple average of the two amounts, or $1.41 million [($1.17 + $1.64)/ 2]. Or, the valuator may use the amounts only as guidelines and select some other value based on their professional judgment. In most cases, some mathematical approach is used. Under this approach, Darryl's one-third interest is worth about $470,000 (1/3 of $1.41 million).
Not all valuators weight the amounts equally. For example, some might use a 60% weighting for the capitalized earnings method and 40% weighting for the excess earnings method. This gives an approximate business value of $1.36 million [($1.17 x 60%) + ($1.64 x 40%)]. Weighting of final values is subjective. Individual valuators consider such variables as reliability and timeliness of the data, nature of the business, past experience with different methods and other considerations. For Cirr Grocery, only substantial differences in the weighting values (e.g. 90% vs. 10%) will make a material difference in the final valuation. In the final valuation report, the mathematical precision indicated by the weighting procedure should be downplayed.
At this point, students will want to know the "right" answer. In the AICPA case study, Cirr was valued at $1,298,000 using a combination of the capitalized earnings method (weighted 60%); excess earnings method (weighted 15%); and the discounted cash flow method (weighted 25%). (Note: Details of the cash flow method calculations were not given in the case; the authors' discounted cash flow value was inserted in the solution without explanation.) Be sure to stress that this is only one of many different amounts that could be computed depending on the evaluator, the assumptions made and a variety of other variables. Regardless of the subjectivity involved, it is fair to say that most valuations would fall in the range of $1.3 to $1.6 million.
Majority/ Minority Interests
While researching the various valuation methods, students may likely discover several of the many other issues that may be relevant in small business valuations. Among these are majority interest premiums, minority interest discounts and use of sanity checks on final valuation estimates. The instructor can raise these issues on their own if time, and student interest, permit.
In the appropriate circumstances, the business valuation may require an adjustment for a majority or a minority interest. If a majority interest in the business is being acquired (or sold) the value may be greater than its true proportional share. For example, the control inherent in a 60% ownership interest would indicate that a buyer would pay a premium above 60% of the estimated company value. On the other hand, a less than proportional share might be discounted for the opposite reason (lack of control or influence). For Cirr Grocery, family ownership shares are equal before the buy-out (each owns 1/3 of the company) and will be equal after the buy-out (each will own 1/2 of the company). So, majority and minority interest adjustments are not warranted.
One final step in arriving at the final estimate is applying "sanity checks" to the calculated amounts. For example, the valuator might ask: "Based on my knowledge of the industry and competitors, is this price reasonable?" "From an investment perspective, would an outside investor be willing to pay this amount?" With sufficient experience, most valuators can detect valuation results that are substantially different from reality.
General Business Valuation Guidelines
In retrospect, the instructor might want to share with students the following valuation axioms (Zipp, page 48). Each valuation is unique with its own peculiar circumstances, functions and purposes. There are only general guidelines to valuation. Individual judgment must be applied as part of and beyond the general methods. There is no single correct value. The appraiser only hopes to get a rational and supportable value in light of the circumstances. Experts usually disagree in their judgments of value. There are generally accepted methods of business valuation that have been tested in practice and in the courts. There is a difference between value and price. A value can be determined analytically; the price paid is the result of negotiation.
The Grocery Industry
Cirr's industry, the wholesale grocery industry, is SIC Code 5141 (Groceries, General Line) and NAICS Code 4224 (Grocery and Related Products Wholesale). Inquisitive students might explore for industry information as additional background. In the case, Jess concludes that a good industry average is owner compensation of about 2% of sales. This conclusion was reached from data found in: Risk Management Association's (RMA) Annual Statement Studies, 2000, Wholesale Groceries, General Line. In 2000, Cirr's owners' compensation as a percentage of sales is 5.5% which is higher than any of the RMA categories. Since Cirr's owner compensation seems out of line, a normalization adjustment was made.
The Role of the Valuator
This is a good time to bring up the role of business valuators. Are they independent, objective appraisers (like external auditors) or advocates for their clients (like defense attorneys)? In most cases, valuators try to remain neutral and unbiased and this should be clearly understood by the client. On the Cirr engagement, Jess is actually working for all three owners, not just Dan, and will get paid by the company. Since these owners have competing agendas, Jess needs to remain objective. In other situations, however, valuators may take the advocate role. This often happens when the valuator is helping an individual client negotiate a purchase or sales price for a company.
Richard H. Fern, Eastern Kentucky University
[Data for the case is adapted from the AICPA's Course: "Developing Your Business Valuation Skills: An Engagement Approach". Copyright American Institute of Certified Public Accountants. Used with permission. All rights reserved.]
Table 1 Cirr Grocery Company Normalized Income Statement For Year Ended December 31, 2001 Normalized As Reported Adjustment Amounts Net Sales $17,037,000 $17,037,000 Cost of Sales 15,314,000 15,314,000 Gross Profit 1,723,000 1,723,000 Operating Expenses: Compensation of Officers 939,000 a (598,260) 340,740 Salaries & Wages 217,000 217,000 Bad Debts 21,000 21,000 Telephone & Utilities 73,000 73,000 Insurance 18,000 18,000 Advertising 7,000 7,000 Maintenance & Repairs 43,000 43,000 Profit Sharing Contributions 91,000 c (60,000) 31,000 Employee Benefit Programs 23,000 23,000 Depreciation 42,000 b (20,000) 22,000 Meals, Travel & Entertainment 12,000 d (6,000) 6,000 Taxes 40,000 40,000 Dues & Subs criptions 3,000 3,000 Gas & Oil 5,000 5,000 Legal & Accounting 18,000 18,000 Licenses & Permits 2,000 2,000 Supplies 18,000 18,000 Office Expense 9,000 9,000 Miscellaneous 2,000 2,000 Interest 45,000 45,000 Total Operating Expenses 1,628,000 943,740 Income (Loss) Before Taxes 95,000 779,260 Income Taxes (38,000) e (273,704) (311,704) Net Income (Loss) 57,000 410,556 467,556 Table 2 Cirr Grocery Company Normalized Income Statement--Adjustments for Year Ended December 31, 2001 A - Reduce owner compensation Sales $17,037,000 to average 2% of sales Industry Average x 2% Avg. Owner Comp. 340,740 Less: Actual Comp. -939,000 Adjustment $598,260 B - Remove depreciation for Owner Depreciation $20,000 personal use of cars Personal Use % x 50% Personal Use Depreciation 10,000 Plus: Spouse Depr. 10,000 Adjustment $20,000 C - Remover excessive owner Adjustment $60,000 contributions (3 @ $20,000) D - Remover personal travel Adjustment $6,000 expenses (3 @ $2,000) E - Income Taxes Adjusted IBIT $779,260 Tax Rate x 40 Adjusted Taxes 311,704 Taxes as reported 38,000 Adjustment $273,704 Table 3 Cirr Grocery Company Normalized Income Statement For Years Ended December 31, 1997 - 2000 Normalized Normalized Amounts Amounts 2000 1999 Net Sales $15,921,000 $11,508,000 Cost of Sales 14,129,000 10,239,000 Gross Profit 1,792,000 1,269,000 Operating Expenses: Compensation of Officers 318,420 230,160 Salaries & Wages 234,000 183,000 Bad Debts 25,000 16,000 Telephone & Utilities 75,000 71,000 Insurance 16,000 16,000 Advertising 10,000 7,000 Maintenance & Repairs 38,000 25,000 Profit Sharing Contributions 36,000 22,000 Employee Benefit Programs 19,000 14,000 Depreciation 26,000 21,000 Meals, Travel & Entertainment 6,000 5,000 Taxes 37,000 34,000 Dues & Subscriptions 3,000 3,000 Gas & Oil 5,000 5,000 Legal & Accounting 28,000 17,000 Licenses & Permits 2,000 2,000 Supplies 11,000 11,000 Office Expense 9,000 9,000 Miscellaneous 0 0 Interest 40,000 24,000 Total Operating Expenses 938,420 715,160 Income (Loss) Before Taxes 853,580 553,840 Income Taxes (341,420) (221,536) Net Income (Loss) $512,160 $332,304 Normalized Normalized Amounts Amounts 1998 1997 Net Sales $11,932,000 $10,502,000 Cost of Sales 10,721,000 9,241,000 Gross Profit 1,211,000 1,261,000 Operating Expenses: Compensation of Officers 238,640 210,040 Salaries & Wages 178,000 164,000 Bad Debts 31,000 34,000 Telephone & Utilities 78,000 71,000 Insurance 12,000 2,000 Advertising 5,000 5,000 Maintenance & Repairs 41,000 24,000 Profit Sharing Contributions 9,000 3,000 Employee Benefit Programs 13,000 12,000 Depreciation 6,000 3,000 Meals, Travel & Entertainment 7,000 3,000 Taxes 27,000 25,000 Dues & Subscriptions 3,000 2,000 Gas & Oil 7,000 6,000 Legal & Accounting 23,000 15,000 Licenses & Permits 2,000 1,000 Supplies 11,000 10,000 Office Expense 8,000 7,000 Miscellaneous 0 0 Interest 33,000 31,000 Total Operating Expenses 732,640 629,040 Income (Loss) Before Taxes 478,360 631,960 Income Taxes (191,344) (252,784) Net Income (Loss) $287,016 $379,176 Table 4 Cirr Grocery Company Fair Value of Net Assets as of December 31, 2001 FMV Market As Reported Adjustments Value ASSETS Cash $841,000 $841,000 Accounts Receivable 454,000 454,000 Inventory 230,000 230,000 Loans Receivable -- -- Prepaid Federal Tax -- -- Advances -- -- Land 20,000 44,000 64,000 Buildings 530,000 (150,000) 380,000 Machinery & Equipment 299,000 (91,000) 208,000 Furniture & Fixtures 14,000 (7,000) 7,000 Autos & Trucks 226,000 (120,000) 106,000 Less: Accumulated Depreciation (670,000) 670,000 -- Other Assets 37,000 37,000 Total Assets $1,951,000 $346,000 $2,297,000 LIABILITIES & EQUITY Accounts Payable $609,000 $609,000 Notes Payable 115,000 115,000 Accrued Payroll Taxes 1,000 1,000 Accrued Federal Taxes -- -- Long-Term Debt 617,000 617,000 Stockholders' Equity 609,000 609,000 Market Value Adjustment 346,000 346,000 Total Liabilities & Equity $1,951,000 $346,000 $2,297,000
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|Title Annotation:||CASE NOTES|
|Author:||Fern, Richard H.|
|Publication:||Journal of the International Academy for Case Studies|
|Article Type:||Case study|
|Date:||Nov 1, 2004|
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