< PreviousA PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 10 MAY | JUNE 2019 t h e v a l u e e x a m i n e r One important factor to consider is that floor plan debt is not a source of capital. Therefore, the interest expense related to floor plan debt should be considered an operating expense, rather than a financing expense. As such, the ongoing cash flow to invested capital should be after consideration of floor plan interest expense. Therefore, we begin with ongoing EBIT (afi)—earnings before interest and taxes after floor plan interest. When calculating ongoing depreciation and capital expenditures, it is important to consider the future requirements of the subject dealership. It is not uncommon to find that very few to no assets have been purchased in decades, resulting in no depreciation expense. Since the real estate is typically held in a separate entity and improvements are rarely made, capital expenditures are also infrequent. However, if the manufacturer requires an image upgrade, it might be necessary to make considerations for these line items. For demonstration purposes, however, we are going to assume that capital expenditures and depreciation cancel each other out over time. Once all our considerations have been made for the various factors that bring us to the ongoing cash flow to invested capital holders, we apply our multiple and arrive at an indicated market value for the invested capital holders (MVIC). In this instance, that value is $4,862,350. At this point, it is necessary to remember that we are currently only calculating the blue-sky value. If a buyer were purchasing the entirety of the dealership, this is what he or she would pay for the blue-sky. As mentioned previously, the four factors considered are the following: •Buyer is purchasing the FF&E and parts •Buyer is purchasing the blue-sky • Buyer is purchasing the vehicle inventory that is offset by floor plan, so it is a wash •Buyer is infusing its own working capital required by the manufacturer To isolate the value of the goodwill, we must reduce the MVIC by the assets that are being purchased by the buyer as well as the capital that will need to be infused. In this case, we reduce the MVIC value of $4,862,350 first by the factory required working capital investment that would need to be made as required by the manufacturer. Next, we subtract the fair market value of the net fixed assets held by the dealership. These are the only adjustments that need to be made from the list above because the cost of parts inventory is included in the working capital infusion made. The floor plan financing offsets the vehicle inventory. After each of these items has been removed, we are left with an indication of value exclusive to the blue-sky as seen in Exhibit 3. EXHIBIT 3: INDICATION OF VALUE EXCLUSIVE TO BLUE-SKY Indicated Market Value of Invested Capital (MVIC) $ 4,862,350 Less: Factory-Required Working Capital Investment (1,954,000 Less: Net Fixed Assets (311,002) Indications of Blue-Sky Value $ 2,597,348A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES t h e v a l u e e x a m i n e r MAY | JUNE 2019 11 Valuation Method Description Value Capitalization of Cash Flow method Blue-Sky $ 2,597,348 ANAV Method Net Asset Value 77,752 Conclusion of 100% Market Value of Equity $ 2,675,100 Multiple #of Vehicles Sold Average Blended Range by Company Multiple Kerrigan Report: Chevy 4.0-5.0 326 5.43 Toyota 5.0-6.375 683 Haig Report: Chevy 4.0-5.0 326 5.85 Toyota 6.0-7.0 683 DERIVING VALUE OF THE OWNERSHIP INTEREST As mentioned previously, the items bullet-pointed are the items a buyer would need to purchase or invest if the assets were purchased and a new company was created. However, we are tasked with valuing an ownership interest in the dealership as it stands, not a new entity. This being the case, we utilize the blue- sky value calculated above and add to it the net asset value of the subject company as of the date of the valuation. What this essentially does is values the entity as it stands but also considers the value that the blue-sky would bring on the open market. Exhibit 4 is an example of how this process looks: EXHIBIT 4: VALUE ON THE OPEN MARKET What you have essentially done at this point is to plug the blue-sky value into the subject company’s adjusted balance sheet as of the date of valuation. DOES IT FIT? At this point, we have derived a value for a one-hundred percent ownership interest in the subject company. Now we can compare our results to market-based multiples to see if our resulting value falls within the realm of reasonableness. Since published blue-sky multiples are based upon multiples of pretax income, we divide our calculated blue-sky value of $2,597,348 by our pretax income of $610,050 to arrive at a blue-sky multiple of 4.25. In this example, the dealership we valued was a Toyota and Chevrolet dealer. We utilized a blended multiple based upon the ratio of vehicles sold by the subject dealership to derive an average blended multiple based upon the industry multiples, as shown in Exhibit 5. EXHIBIT 5: AVERAGE BLENDED MULTIPLE BASED ON INDUSTRY MULTIPLES Based upon the blended multiples indicated above, we find that our independently calculated multiple of 4.25 falls at the bottom of the range of industry multiples. Again, it is important to keep in mind that the market multiples include investment value transactions, which naturally yield higher multiples. Also, other factors A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 12 MAY | JUNE 2019 t h e v a l u e e x a m i n e r play a significant role in where your multiple falls within the range. In this particular case, the dealer was located in a rural community approximately thirty miles from a highly populated city. This consumer market area was comprised of lower income families whose main source of income is agriculture. Neither Chevy nor Toyota are known for their heavy-duty trucks, hurting their competitiveness in this market. To compete and attract customers from the city, the dealer was forced to sell vehicles at a lower price than its big city competitors yet also found it necessary to pay its employees a higher wage to attract a quality workforce. All of these conditions factor into where an individual dealership’s blue-sky multiple falls within the range. This is why it is imperative to consider a dealer’s individual market when settling on a blue-sky multiple. WAYS APPRAISERS MANIPULATE VALUE One of the side effects we have seen with appraisers using industry published blue-sky multiples is the endless pursuit to arrive at a preconceived value. It is not uncommon to find that those who perform dealership valuations also dabble in dealership transaction work as well. This is a double-edged sword, especially when it comes to objectivity. If I were to ask anyone around my office the going price for Toyota stores located in a certain area of the country, they could quickly spout off a range based upon the transactions they have seen occur. Sometimes these estimates are spot on, but sometimes they completely miss the mark. Why is that? Mostly it is because they are speaking based on averages. Naturally, there will be those dealerships that are way above the average and those dealerships that are way below the average. The reason they miss the mark is due to their lack of consideration to the items that make a particular dealership valuable. This includes items such as dealer experience, availability of capital, geographic location, customer base, local competition, availability of a skilled workforce, demographics, and many others. It is extremely important to understand how these attributes impact the profitability of the dealership you are valuing. Is the dealer pushing through average sales numbers but having to charge less per vehicle because they are located just outside a major metropolitan city, and to attract customers, they need to offer lower prices? Do they have to pay higher wages also due to their location outside the city and a skilled workforce could earn more within the city limits? Does the dealer’s pump-in report show that a higher than the average number of sales are being given up to different dealers in different, manufacturer- specified markets? Are they losing sales because they have an insufficiently sized facility that cannot house as many vehicles, thereby reducing vehicle selection available on their lots? Do they have a service department? These are just a few of hundreds of legitimate possibilities that could cause a dealership to underperform. Some of them can be resolved by the dealer; some cannot. The important thing is that the appraiser must take the time to understand the entirety of the dealership. In some instances, we have seen appraisers utilizing various industry benchmarking guidelines to recast financial operations to what they perceive to be an obtainable industry average. These appraisers claim that a buyer would pay a premium to purchase this dealership and have the opportunity to achieve the recast cash flows. Though we do not deny that some dealers are speculative buyers, the appraiser must still be able to prove that any dealer, regardless of skillset, would be able to achieve such profitability. These adjustments should be made as cash flow adjustments, not as adjustments to the multiple as we frequently see. Also, it is imperative that benchmarking information be vetted before use. One common source we find referenced is the Annual Financial Profile of America’s Franchise New-Car Dealerships published by The National Automobile Dealers Association (NADA). What many appraisers fail to realize is that NADA’s mission statement indicates its purpose is to “promote and enhance the franchise system and effectively communicate dealer views and concerns to all branches of the federal government, to manufacturers, and the public.” At its core, NADA is a lobby organization and information published by this organization is intended to cast dealers, as an industry, in the best light, not necessarily with an unwavering commitment to fidelity. The reason these appraisers are recasting financial information comes back to the issue of preconceived notions. In certain circumstances , appraisers are not able to back into their preconceived blue-sky value based upon actual pretax earnings and still maintain a reasonable blue-sky multiple within industry norms. For example, those who participate in frequent transactions of dealers would likely tell you that they can sell a Toyota dealership for five million dollars— blue skies all day long. This reference is both based upon average experience as well as investment value, which, again, A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES t h e v a l u e e x a m i n e r MAY | JUNE 2019 13 is important to keep in mind. Since the starting point in their mind is the ending point in any valuation, they are essentially working backward to prove that their preconceived notion was correct. The issue arises when the appraiser finds that the historic operations, coupled with a reasonable multiple, do not derive their preconceived value but, rather, something significantly lower. At this point, what we have seen multiple appraisers do is to turn to industry publications that report what the industry average pretax income should be. They then take the company’s historic sales, multiply it by the industry average pretax income ratio to derive what they propose to be the dealership’s capacity, thereby bypassing everything that makes this particular dealership unique. In summary, essentially what these appraisers are doing is creating their own company and then valuing it based upon a rule of thumb. This methodology yields a value that has so many undocumented assumptions it would only be by happenstance that it came anywhere close to the true fair market value. CONCLUSION Dealership valuation is a very technical process. Without an in-depth understanding of the various ways dealers make money, it is easy to get caught in the endless maze of adjustments. Care must be taken to ensure that all factors are considered when deriving blue-sky value. Individuals who participate in dealership transactions are a source of knowledge, but that knowledge must be carefully distilled rather than blindly applied. More importantly, it is time we move beyond the method of subjectively choosing a blue- sky multiple based upon what amounts to a complete guess and move into fully supporting the multiple we feel is most appropriate for our particular subject company. Matt Stelzman, CVA, MAFF, ASA is with the firm Henderson Hutcherson & McCullough’s (HHM) Litigation and Valuation group. HHM is an accounting firm based in Chattanooga, Tennessee and has a national automotive dealership practice focusing on providing standard accounting services as well as a myriad of other consulting and valuation services to automotive dealers. While he has extensive experience across different industries, he specializes in automotive dealership valuations. E-mail: VEA PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 14 MAY | JUNE 2019 t h e v a l u e e x a m i n e r VALUATION /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// How Not to Use Duff & Phelps Data By Roger J. Grabowski, FASA; Jaime d’Almeida, ASA, CFE; and Debra Jacobs, Vice President, Duff & Phelps “In God we trust. All others must bring data.” This famous quote used to introduce this article has been attributed to various people, but it implies that when data is presented, the conclusion can be trusted. However, the Ohio District Court’s decision in Rover Pipeline, LLC v. 10.55 Acres of Land, More or Less, in Ashland County, Ohio, et al.,1 demonstrates that data is only trustworthy if it is understood and applied correctly. The case, in which the expert’s valuation report was discarded due in large part to the misuse of data, demonstrates the risk of misapplication of data in valuation reports and highlights how the misuse of data can prevent an accurate assessment of value. CASE BACKGROUND In early February 2017, Rover Pipeline, LLC (Rover) filed a civil action pursuing condemnation of approximately 700 tracks of land in the northern district of Ohio through which it intended to construct a pipeline. Rover was previously authorized by the Federal Energy Regulatory Commission to construct and maintain an interstate natural gas pipeline system traversing through West Virginia, Ohio, Pennsylvania and Michigan. The company had reached settlements with the majority of affected property owners along the route of the proposed pipeline as well as all defendants on the matter of “immediate possession.” However, it was unable to reach agreements with a few of the property owners on the issue of “just compensation” and turned to the courts to resolve the issue. Pine Tree Holding Inc. (Pine Tree) was founded in 2004 and is a tree farm company located on a tract of land totaling over 100 acres in Wayne County, Ohio. The company is organized as an S corporation with landowners Roger and Rita Dush owning one-hundred percent of its stock. Pine Tree primarily serves residents and tree suppliers with annual Christmas 1 Rover Pipeline, LLC v. 10.55 Acres of Land, More or Less, in Ashland County, Ohio, et al., United States District Court, Northern District of Ohio, Eastern Division, Case No. 5:17-cv-239 (September 14, 2018). trees and is known for its Fraser Fir trees, which are grown in only limited areas in the state. Rover was granted temporary and permanent easements on approximately 7.5 acres of the Dush’s land for the construction of its pipeline. However, Rover and the Dushs were unable to agree on just compensation for the land. According to the landowners, Fraser Fir trees are a species of evergreen that need distinct soil composition and growing conditions which existed on the property before the installation of the pipeline. Following the installation of the pipeline—and what they perceive as Rover’s insufficient remediation efforts—Rita and Roger Dush maintained: 1. The easement area was rendered useless for Fraser Fir tree production due to changes in the soil and land 2. Due to the length of the growth cycle for Christmas trees, the loss from prematurely harvesting Christmas trees that had been growing on the property was substantial Both parties engaged expert witnesses on topics related to the case, including soil, horticulture, real estate, and economics to determine just compensation, and both parties challenged the admissibility of the opposing expert opinions. VALUATION AND ANALYSIS One of the landowners’ experts was tasked with determining the value of the Christmas tree business and did so using three methodologies: The Asset Approach, the Income Approach, and the Market Approach. The Asset and Market Approach analyses indicated losses to the landowners of $167,000 and $157,000, respectively. Based on the Income Approach, however, the landowners’ expert concluded that the loss to the landowners was $888,000. The expert arrived at the Income Approach conclusion through the following steps: 1. Calculation of EBITDA cash flow before and after pipeline installationA PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES t h e v a l u e e x a m i n e r MAY | JUNE 2019 15 The expert made normalizing adjustments to Pine Tree’s historical EBITDA reflecting expensing and bonus depreciation for the 2013–2017 period. Next, she calculated a weighted average EBITDA based on Pine Tree’s historical performance to arrive at EBITDA cash flow of $114,100 before the installation of the pipeline. The expert then multiplied EBITDA cash flow by a sustainable growth rate of five percent to arrive at a calculated EBITDA cash flow of $119,805. To calculate EBITDA cash flow after the pipeline, the expert reduced revenues based on the acres affected and recalculated an EBITDA of $100,500. She applied the sustainable growth rate of five percent to arrive at a calculated EBITDA after pipeline installation of $105,525. 2. Valuation Before Pipeline Installation (December 31, 2016) The expert calculated a capitalization rate via the Build-up Method, using a normalized risk-free rate for twenty-year Treasury Bond yield of 3.5 percent and an equity risk premium of 5.5 percent, both sourced from the Duff & Phelps 2017 Valuation Handbook - U.S. Guide to Cost of Capital. She then added a size premium of one percent “due to the Company’s stable history and lack of debt.” The expert added the risk-free rate, equity risk premium, and size premium to arrive at a discount rate of ten percent. The discount rate was then converted to a capitalization rate by subtracting a sustainable growth rate of five percent, selected “because it represents a blend of the International Monetary Fund’s expected growth in the United States real gross domestic product for 2017 and growth rates in the nursery and tree production industry and profitability growth.” The expert then divided EBITDA cash flow ($119,805) by the capitalization rate of five percent to arrive at an indicated equity value for the business of $2,396,000 before the pipeline installation. 3. Valuation After Pipeline Installation (June 14, 2017) The expert repeated the procedure above to determine an equity value for the business after the pipeline installation. To determine the capitalization rate, she added the risk-free rate, equity risk premium, and size premium of 3.5 percent, 5.5 percent, and one percent above, respectively. However, she then added a company risk premium of two percent to account for “any unforeseen circumstances that could cause more damages” to arrive at a discount rate of twelve percent. Next, she subtracted the long-term sustainable growth rate of five percent from the discount rate to arrive at a capitalization rate post pipeline installation of seven percent. The expert divided EBITDA cash flow after installation ($105,525) by the capitalization rate of seven percent to arrive at an indicated equity value for the business of $1,508,000 after the pipeline installation. 4. Concluded Value The expert subtracted the equity value after pipeline installation from the value before the installation to arrive at a damages figure of approximately $888,000. While several issues surrounding the valuation methodology were disputed in the matter, for purposes of this article we focus on the incorrect use of Duff & Phelps data in the expert’s analysis and the Court’s criticism of that analysis. 1. Risk-Free Rate and Equity Risk Premium The Court questioned the expert’s use of Duff & Phelps’ guidelines for the risk-free rate and equity risk premium citing that the expert “admitted they are reserved for much larger companies worth between 2.3 and 5.6 billion.”2 However, Duff & Phelps’ risk- free rate and equity risk premium guidelines are used to calculate the cost of capital for all companies, regardless of size. “The Valuation Handbook – U.S. Guide to Cost of Capital, is designed to assist financial professionals in estimating the cost of equity capital (ke) for a subject company…The valuation data and methodology in the Valuation Handbook – U.S. Guide to Cost of Capital, can be used to develop the cost of equity capital estimates using both the Build-up Method and the capital asset pricing model (CAPM).” 3 2 Memorandum Opinion p. 20, footnote 10. 3 Duff & Phelps 2017 Valuation Handbook – U.S. Guide to Cost of Capital, A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 16 MAY | JUNE 2019 t h e v a l u e e x a m i n e r “All of the methods commonly used to estimate the cost of equity capital have the same basic framework: they start with a ‘risk-free’ rate, and then add a premium for ‘risk’…Two of the most widely used methods of estimating the cost of equity capital are the Build-up Method and the capital asset pricing model (CAPM). Both methods are predicated on this basic framework.”4 “The Build-up Method for estimating the cost of equity capital has the following five components: (1) A risk- free rate, (2) A general equity risk premium (ERP), (3) A size premium, (4) An industry adjustment factor, [and] (5) A company-specific risk adjustment…All cost of equity estimates developed using the Valuation Handbook – U.S. Guide to Cost of Capital are before the addition of any company-specific risks that the individual analyst deems appropriate.”5 Note that while the expert applied the normalized risk-free rate and Duff & Phelps recommended equity-risk premium, the spot rate, and supply-side equity risk premium have been used frequently in Delaware Chancery Court. 2. Size Premium The expert incorporates a size premium of one percent based on the company’s “stable history and lack of debt” rather than using an authoritative guide to determine a size premium. In fact, Duff & Phelps (who the expert relied on for the risk-free rate and equity risk premium) also publishes two sources to determine a size premium: the Center for Research in Securities Prices (CRSP) Deciles Size Premia Study and the Risk Premium Report Study.6 For comparison purposes, had the expert used the 10th decile in the CRSP Deciles Size Premium Study Exhibit to determine the size premium, she would Introduction, p. xv. 4 Duff & Phelps 2017 Valuation Handbook – U.S. Guide to Cost of Capital, Chapter 2, p. 2-1. 5 Ibid, p. 2-17. 6 Both of these size studies are now available through the on-line Cost of Capital Navigator; see dpcostofcapital.com have used premiums of 5.60 percent and 5.59 percent rather than one percent for the December 31, 2016, and June 14, 2017 valuations, respectively. The expert testified that she relied on unsubstantiated information presented at a continuing education class for the one percent figure rather than an authoritative guide. In fact, contrary to the expert’s testimony regarding the reason why she chose one percent, the company’s “stable history and lack of debt” are irrelevant to the size premium. Both the opposing expert and the Court criticized the expert’s use of the one percent size premium rather than Duff & Phelps’ 5.59 percent figure. The Court noted that the expert “did not explain why she used the ‘generally accepted’ Duff & Phelps numbers when they raised her valuation but ignored the guide’s suggested number when it lowered her valuation.”7 As stated in the Valuation Handbook: “The size effect is based on the empirical observation that companies of smaller size are associated with greater risk and, therefore, have a greater cost of capital. The ‘size’ of a company is one of the most important elements to consider when developing the cost of equity capital estimates for use in valuing a business simply because size is a predictor of equity returns. In other words, there is a significant (negative) relationship between size and historical equity returns—as size decreases, returns tend to increase, and vice versa.”8 Small firms have risk characteristics that differ from those of large firms, including the ability to enter the market, take market share, and respond to changes in the market. Large firms generally have more resources to weather economic downturns, spend more on advertising and R&D, hire top talent, and access capital and a larger customer base. These differences increase the rate of return, which investors require to invest in smaller firms. 7 Memorandum Opinion p. 20. 8 Duff & Phelps 2017 Valuation Handbook – U.S. Guide to Cost of Capital, Chapter 4, p. 1. Ultimate Training and Membership Subscription Unlimited Continuing Professional Education Membership Dues Recertification Fees One Monthly Fee: (multi-user options available) To simplify your professional development, we are excited to introduce the Ultimate Training and Membership Subscription where, for a flat monthly fee, NACVA members have available to them a new membership level to receive unlimited CPE with zero added or hidden costs. Designed to allow you to precisely budget your annual CPE expense and obtain 100% of your CPE from NACVA/CTI. In addition, the subscription fee covers your annual membership dues and tri-annual recertification fees. Options available for both single- and multi-users. All subscription options require a one-year commitment. 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Select courses are available 24/7 in a variety of fields of study covering ethics, accounting, auditing, and taxes. To sign up for the Ultimate Training and Membership Subscription, and address any questions, visit www.NACVA.com/Ultimate, or contact Member/Client Services at (800) 677-2009. No other association in the business valuation or financial litigation profession provides the wealth and depth of resources like NACVA. Choose the Ultimate Triple Play Subscription to receive everything included in all three other subscriptions, plus Damages Advocate calculation software. This subscription gives you access to everything we offer. Available for $625 per month for the first user. Visit www.NACVA.com/Ultimate for complete listing of what is included in each subscription level. Ultimate KeyValueData® Titanium Subscription— $250 per month for first user (access to 21 separate databases, reports, libraries, and presentations) Ultimate Software Subscription— $90 per month for first user (licenses to five valuation and report writing software packages, plus technical support) Add to your Ultimate Training and Membership Subscription:Ultimate Training and Membership Subscription Unlimited Continuing Professional Education Membership Dues Recertification Fees One Monthly Fee: (multi-user options available) To simplify your professional development, we are excited to introduce the Ultimate Training and Membership Subscription where, for a flat monthly fee, NACVA members have available to them a new membership level to receive unlimited CPE with zero added or hidden costs. Designed to allow you to precisely budget your annual CPE expense and obtain 100% of your CPE from NACVA/CTI. In addition, the subscription fee covers your annual membership dues and tri-annual recertification fees. Options available for both single- and multi-users. All subscription options require a one-year commitment. For $335 per month (for first user) you receive these benefits: Paid Practitioner membership dues Paid recertification fees Unlimited complimentary registration to all our live training events Complimentary registration to all our conferences, including the Annual Consultants’ Conference and Industry Specialty SuperConferences Unlimited complimentary registration to all live webinars Unlimited access to our CPE On-Demand library of nearly 700 webinars Complimentary self-study materials in an electronic format (nominal expense for hard copies) Access to all other paid CPE resources, including The Value Examiner® and QuickRead® quizzes, etc. Access to training in a variety of fields of study (registered with the National Association of State Boards of Accountancy) to meet your NACVA and other credential requirements, including your CPA license Surgent CPE: NASBA qualified self-study courses to meet the needs of every CPA, tax practitioner, and financial professional. Select courses are available 24/7 in a variety of fields of study covering ethics, accounting, auditing, and taxes. To sign up for the Ultimate Training and Membership Subscription, and address any questions, or contact Member/Client Services at (800) 677-2009. No other association in the business valuation or financial litigation profession provides the wealth and depth of resources like NACVA. Choose the Ultimate Triple Play Subscription to receive everything included in all three other subscriptions, plus Damages Advocate calculation software. This subscription gives you access to everything we offer. Available for $625 per month for the first user. Visit of what is included in each subscription level. Ultimate KeyValueData® Titanium Subscription— $250 per month for first user (access to 21 separate databases, reports, libraries, and presentations) Ultimate Software Subscription— $90 per month for first user (licenses to five valuation and report writing software packages, plus technical support) Add to your Ultimate Training and Membership Subscription:A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 18 MAY | JUNE 2019 t h e v a l u e e x a m i n e r Summary market statistics dating back to 1926 for CRSP NYSE/NYSE MKT and NASDAQ deciles support the Duff & Phelps 2017 recommended size premium data.9 The authors note that there are some academics and practitioners who maintain that a size premium either does not exist or has been eliminated over time. The reader is encouraged to review recent literature on this topic.10 In other words, “stable history and lack of debt” are company-specific factors rather than size factors and are not appropriate reasons to use an unsupported, reduced size premium. Additionally, both the opposing expert and the Court recommended the use of the 5.59 percent size premium from the 2017 Valuation Handbook for the December 31, 2016, and June 14, 2017 valuations. Note: While the 5.59 percent guideline in the 2017 Valuation Handbook was publicly available as of June 14, 2017, it was not available as of December 31, 2016. The correct size premium to use in the December 31, 2016 valuation is 5.60 percent, which is provided in the 2016 Valuation Handbook and which was publicly available as of the December 31, 2016 valuation date. While contemporaneous valuations typically will not suffer from these kinds of errors—retrospective valuations performed in Court can often suffer from these kinds of errors. It is important for practitioners to understand when data was made available by Duff & Phelps. 3. Company-Specific Risk Premium (C-SRP) The landowners’ expert incorporated a company- specific risk factor into the post pipeline valuation but 9 Duff & Phelps 2017 Valuation Handbook – U.S. Guide to Cost of Capital, Chapter 4, p. 2; M. S. Long and J. Zhang, “Growth Options, Unwritten Call Discounts and Valuing Small Firms”, EFA 2004 Maastricht Meetings Paper No. 4057, March 2004. 10 Clifford S. Ang, “The Absence of a Size Effect Relevant to the Cost of Equity”, Business Valuation Review, Volume 37, No. 3, Fall 2018; Roger J. Grabowski, “The Size Effect Continues to be Relevant When Estimating the Cost of Capital”, Business Valuation Review, Volume 37, No. 3, Fall 2018. did not incorporate a company-specific risk factor in the pre-pipeline valuation. The expert applied the two percent company-specific risk premium post-installation to account for any problems associated with the construction and maintenance of the pipeline on the property. However, the expert was not able to identify any literature to support a zero percent pre-installation and two percent post- installation C-SRP. As stated in the Valuation Handbook, “Different adjustments to the cost of equity capital are made in practice under the heading C-SRP. Among the adjustments labeled C-SRP are: •Adjustments for Differences in Risk: Adjustments to cost of equity capital estimates derived from a sample of guideline public companies to account for differences in risk between a subject company that is not public (e.g., a closely held business, a division, or a reporting unit) and the guideline public companies. • Adjustments for Risk in Net Cash Flows and Biased Projections: Adjustments to cost of equity capital estimates to account for risk in the net cash flows and biased projections provided for use in the valuation process. • Adjustments for Other Risk Factors: For example, adjustments to cost of equity capital estimates to account for risks accepted by investors that may not hold diversified portfolios of investments.”11 Historically, the Courts have rejected the use of unsubstantiated company-specific risk premia when offering expert testimony. “The inconsistent use of the term C-SRP has led to considerable confusion in addition to its subjective nature. Former Chancellor Strine of the Delaware Court of Chancery stated the Court’s perspective on this issue: Much more heretical to CAPM. However, the Build-up Method typically incorporates 11 Duff & Phelps 2017 Valuation Handbook – U.S. Guide to Cost of Capital, Chapter 6, p. 6-1.A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES t h e v a l u e e x a m i n e r MAY | JUNE 2019 19 heavy dollops of what is called ‘company- specific risk,’ the very sort of unsystematic risk that the CAPM believes is not rewarded by capital markets and should not be considered in calculating the cost of capital. The calculation of a company-specific risk is highly subjective and often is justified as a way of taking into account competitive and other factors that endanger the subject company’s ability to achieve projected cash flows. In other words, it is often a back-door method of reducing estimated cash flows rather than adjusting them directly…"12 Given the unsubstantiated nature of the expert’s C-SRP, the two percent C-SRP should have been avoided. The impact of the expert’s data errors is significant. When applying the correct size premium and eliminating the company-specific risk premium, damages total $147,604, in line with the Asset and Market Approach valuations. DECISION AND TAKEAWAY The District Court determined that the expert’s approach to the valuation was flawed and as a result, was inadmissible. While several issues were cited, the Court placed significant emphasis on the data used in the Income Approach that rendered it unreliable including: 1. The expert’s questionable determination of the capitalization rate 2. The expert’s rejection of the 5.59 percent Duff & Phelps recommended size premium in favor of a one percent unsupported size premium 3. The application of an unsubstantiated company-specific risk premium of two percent post-pipeline installation. The judge criticized the expert’s use of the data stating, “Given the fact that this decision resulted in a calculation that was several times what the other two valuation methods yielded, [the expert’s] inability to explain or defend her calculation adequately is decidedly troubling.”13 The decision in Rover Pipeline LLC v. 10.55 Acres of Land, et al., firmly demonstrates that the ability to defend data is essential to its credibility. The judge’s message to valuation 12 Delaware Open MRI Radiology Associates, P.A. v. Howard B. Kessler et al., (Court of Chancery of State of Delaware, Cons C.A. No. 27-N). 13 Memorandum Opinion p. 21. professionals is clear: understand, correctly apply, and substantiate data to form reliable conclusions admissible in the courtroom. Roger J. Grabowski, FASA, is a Managing Director with Duff & Phelps LLC and an Accredited Senior Appraiser and Fellow (FASA) of the American Society of Appraisers (ASA) (their highest designation), Business Valuation. He is a co-author with Shannon Pratt of Cost of Capital: Applications and Examples, 5th ed. (John Wiley & Sons, 2014); The Lawyer’s Guide to Cost of Capital (ABA, 2014); and Cost of Capital in Litigation: Applications and Examples (John Wiley & Sons, 2010). He is a co-author of the Duff & Phelps annual resources for cost of capital data: on-line Cost of Capital Navigator; Valuation Handbook - Industry Cost of Capital; International Valuation Handbook - Guide to Cost of Capital; and International Valuation Handbook - Industry Cost of Capital (Duff & Phelps). Jaime d’Almeida, ASA, CFE, is an Expert Affiliate with Duff & Phelps LLC. He has over twenty years of experience in economic and valuation analysis and consulting, and has provided both deposition and trial testimony on valuation, finance, and damages issues. He is a Lecturer in Finance at Boston University’s Questrom School of Business, and an Adjunct Lecturer at Babson College’s F.W. Olin Graduate School of Business. Debra Jacobs is a Vice President with Duff & Phelps LLC. She has over fifteen years of experience providing financial, economic, and valuation analyses for a broad range of industries. Debra has performed business and securities valuations as well as financial analysis for litigation, arbitration, financial advisory, and tax purposes. VENext >