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Significance of Value
It's always hard to value things. In some cases, you don't have enough information. In other cases, you don't want to know the truth.
āDonald Brownstein (1972ā), American investor
SINCE THE BEGINNING OF TIME, some form of valuation has been involved in estimating the worth or price of each item in every exchange between trading parties. Whether through barter, cash, or some other medium, assets have been exchanged constantly in personal, business, and taxation transactions on some agreed-on basis. Before money and banks, payments often consisted of sheep, goats, or bushels of grain; in each case, an implicit value was involved. As a result, based on the earliest known records, from around 5000 B.C. at Jericho in Israel, some consider valuation to be the world's fifth oldest profession, after hunters, farmers, merchants, and priests.
BUSINESS USES FOR VALUATION
When considering a substantial business deal, whether a major expansion, significant acquisition, plant closure, or considerable divestiture, management will eventually reach a tipping point. A go/no-go decision has to be made, based on a bottom line calculated from inadequate information. The key questions are: How much value will be created, and for whom? The answers can be elusive; the process is rather like trying to distinguish a black sock from a blue one when dressing in the dark. Often, many of the assets involved can't be seen and aren't recorded anywhere, but are still real.
Many readers, be they lawyers, accountants, teachers, bankers, judges, investors, analysts, or managers, will have had some involvement with the valuation process. They will know how challenging it is to determine the value of a business asset. But some may not realize the difficulties and may still look at traditional accounting statements to show how much a company or even an asset is worth. Please don't! Those figures are generally based on historical costs, after some amortization, and reflect the past, not the present.
In reality, value is about the future; it is also about many more assets than the traditional itemsāreceivables; inventory; property, plant & equipmentābeloved of bankers, that we all can touch and feel. Much of the value of any company, as seen by purchasers and investors, lies in its unrecorded, usually internally generated, intangible assetsābrands, licenses, contracts, workforce expertise, and so forth. Some authorities place the figure for the United States at over 70%, as shown by the Standard & Poor's (S&P) 500 index. The existence of intangible assets makes the art of the deal somewhat like trying to put a key in the front door lock when the porch light is off.
When a business buys a building for $2 million, it shows the same amount as an asset on its balance sheet and has it available as collateral for borrowing. If it hires an employee who is brilliant and can generate an additional $3 million in sales, with a guaranteed bonus of $300,000, the firm not only cannot record an asset, but must show the guaranteed payment as a liability. Yet the purchase of the building is likely to add less to the fair value of the firm than the additional profits and cash flows generated by the hiring.
MERGERS AND ACQUISITIONS
The most obvious need for valuators in business comes when a merger or an acquisition is undertaken. If the buyer is strategic, its managers often wonder how much of that very intangible asset popularly known as synergy will be generated by the transaction. What effect should it have on the price they are willing to pay? There is obvious value, perhaps a significant amount, in immediately being able to use otherwise idle productive capacity or to have direct access to new products or markets. However, there are also always risks and costs involved, sometimes considerable ones. Both the advantages and the risks are things management must question and a valuator has to quantify. For the increasing number of financial buyers, valuation is even more important. What can be paid often depends on which noncore assets can be sold and for how much.
FINANCIAL REPORTING
Since the 2008ā2009 worldwide financial crisis, when many financial markets ceased to function effectively, and the resulting recession, more and more attention is being paid to corporate financial reporting. International Financial Reporting Standards (IFRS) have been or are being adopted by over 100 countries, representing more than half of the market capitalization of every stock market in the world. The main holdout is the United States, which has always believed in the sanctity of its own highly developed Generally Accepted Accounting Principles (GAAP). However, their custodian, the Financial Accounting Standards Board (FASB), is continuing to work with the International Accounting Standards Board (IASB), creators of IFRS, to harmonize the two regimes. Happily, the integration of the two accounting languages is not likely to lead to a mishmash franglais, as exemplified by āDonnez-moi les cornflakesāāāPass me the cornflakes.ā The major impact will likely be a level playing field around the financial world, with more assets being reported at fair values as against historical costs.
During the first decade of the 2000s there were significant changes in financial reporting in the United States. One major improvement was a change in accounting for acquisitions and the attendant introduction of goodwill impairment testing. Under both GAAP and IFRS it is now mandatory for all acquirers to allocate the purchase price of a target among the various assets acquiredāfinancial, physical, and intangibleāas well as the liabilities assumed, in keeping with their fair values. In general, all long-lived assets, except goodwill, which is an unamortized residual that is only tested for impairment, have to be amortized, thus impacting earnings.
Intangible Assets
To be recognized as an asset, an intangible must satisfy one of two criteria: it must be either contractual in nature or salable. As the purchase price allocation (PPA) process is critical to most transactions (see Chapter 13), valuators have gradually taken on a more strategic role in the acquisition process. They help identify potential intangible assets that may be owned by the target, and develop preliminary views as to their values during the planning, regulatory approval, and due diligence phases. Although any residual is booked as goodwill and not amortized, it, together with all long-lived physical and intangible assets, has to be annually tested for impairment. This is done to determine whether any reductions of carrying amounts are required as a result of changed circumstances. While only purchased intangible assets are recorded, the key Step 2 of the GAAP goodwill impairment test that determines the amount of any write-off does not differentiate between them and similar internally generated items.
Fair Value Measurement
In plain language, fair value is a broad concept; a thesaurus gives 47 synonyms for fair, including candid, equitable, honest, impartial, just, lawful, plain, reasonable, sincere, and upright. Without the modifier market, fair value can be seen as a āvalueā that is āfair.ā Accordingly, there is wide latitude as to what it might be. Depending on circumstances, the fair value of an asset could be its market, intrinsic, or investment value and might represent either a liquidation or a going-concern amount. Fortunately, FASB and IASB have developed a fixed definition, which is discussed in Chapter 2, and a related framework to estimate it, described in Chapter 3.
Fair Market Value
The term fair market value, which can be traced back to United States v. Fourteen Packages of Pins, an 1832 federal court tariff case, has become well defined and fully established in legal, tax, and accounting settings. It now relates to finding the value that an asset would have on a market that is fair, in the context of a real or hypothetical sale.
From the mid-nineteenth century onward, with the development of national and then international markets, the need for business valuation in most Western countries has been driven principally by insurance and tax/tariff requirements. In recent years the focus has moved to fair value for financial reporting. In the United States the term was used, interchangeably with fair market value, during the 1920s to record assets on balance sheets. In 1933, the newly minted Securities and Exchange Commission (SEC), due to the excessive share price declines since 1929, prohibited any write-ups of assets over their original cost.
At the same time, the SEC switched the emphasis among the financial statements from the balance sheet (statement of financial position) to that for profit and loss (income statement or statement of operations); we are now seeing a form of āback to the futureā as the emphasis is gradually returning to assets and liabilities from revenues and expensesābut that is another story.
Relevant Documents
Fast-forward 20 years to 1953; the Depression is long over, prosperity is back, and fair value returns. In that year, Accounting Research Bulletin (ARB) 43 stated that from then on, fair value was to be the basis for recording all assets acquired in a purchase; however, the term was not defined, nor were any procedures prescribed to estimate it.
The 1970s, in the aftermath of some so-called "dirty pooling" scandals, saw the issuance of Accounting Principles Board (APB) Opinions 16 and 17. Under them, fair value was again required to be used in recording assets acquired other than in a pooling of interests. They also established the notion of identifying and recording purchased intangible assets, apart from goodwill; for fair value, this was the beginning of the modern era. As none of those terms were defined, the tradition arose of using the same fair market values for recognizing assets on the financial statements as were shown on the tax returns; any unallocated balance went to goodwill, which was amortized over a period of up to 40 years.
Then came the booming 1990s, when economic changes forced a new look at accounting policies. In that decade, there were numerous, sometimes enormous, acquisitions fueled by new technologies and the apparent strength of firms' intangible assets and intellectual property. The latter is an important subset of intangible assets (patents, trademarks, copyrights, designs, trade secrets, etc.) that are granted specific legal protection.
The average price-to-book ratio of the S&P 500 index is considered a useful proxy for the unrecorded intangible assets owned by American industry. This rose from about 1.1 times in 1982, the start of the last major bull market in shares, to close to 5.0 times at the peak in 1999; it has since dropped to around 3.0 times in 2010.
In that so-called Goldilocks era (1990ā2005), when growth of the U.S. economy was not too big, but not too small, a significant number of FASB documents dealt with value, measurement methods, and present value techniques. Of the 32 Statements of Financial Accounting Standards (SFAS) issued in th...