Financial Valuation Workbook: Step-by-Step Exercises and Tests to Help You Master Financial Valuation

CHAPTER 1

Valuation Case Study Exercises

1.1 INTRODUCTION

The purpose of this chapter is to highlight and discuss important concepts in valuation through a series of exercises. These exercises have been intermittently placed in excerpts of a valuation report. You should attempt to complete these exercises as you read the report with reasoning and emphasis on an explanation of your conclusion. The authors’ solutions to these exercises can be found in Chapter 2.

The following case presents selected excerpts from a business valuation report that, in its entirety, was in full compliance with the AICPA’s Statements on Standards for Valuation Services VS Section 100 and the Uniform Standards of Professional Appraisal Practice. For more information on reports and standards compliance, see Chapters 11 and 12 of Financial Valuation Applications and Models, 4th edition. This report format is one of many that analysts can use in presenting business valuations. The schedules have been included and are referenced throughout. Some of the terms, numbers, sources, and other data have been changed for ease of presentation.

1.2 THE VALUATION REPORT

January 2, 20X6

Sherman E. Miller, Esq.

Miller & Hanson

4747 Washington Street, Suite 1740

St. Louis, Missouri 12345

Re: Fair Market Value of a 100% Equity Interest in National Fastener & Machine Co. as of September 1, 20X5

Dear Mr. Miller:

At your request XYZ Appraisal Associates LLC (XYZ) was retained to prepare a valuation analysis and appraisal (valuation engagement and conclusion of value) and detailed/comprehensive appraisal report (the report) to assist you and your client, Ms. Louise Atkins, in the determination of the fair market value of a 100 percent equity interest in National Fastener & Machine Co. (National Fastener or the Company). This interest is a controlling interest and is therefore marketable. The value conclusion is considered as a cash or cash-equivalent value. The valuation date is September 1, 20X5 (the Valuation Date). This valuation and report are to be used only as of this date and are not valid as of any other date.

EXERCISE 1   Which of the following is the as of date for valuation?

Any time within one year

As of a single point in time

As of a single point in time or six months later

Date that the report is signed

We have performed a valuation engagement and present our detailed report in conformity with the Statements on Standards for Valuation Services VS Section 100 (SSVS) of the American Institute of Certified Public Accountants (AICPA). SSVS defines a valuation engagement as an engagement to estimate value in which a valuation analyst determines an estimate of the value of a subject interest by performing appropriate procedures, as outlined in the AICPA Statements on Standards for Valuation Services, and is free to apply the valuation approaches and methods he or she deems appropriate in the circumstances. The valuation analyst expresses the results of the valuation engagement as a conclusion of value, which may be either a single amount or a range.1

SSVS addresses a detailed report as follows: "The detailed report is structured to provide sufficient information to permit intended users to understand the data, reasoning, and analyses underlying the valuation analyst’s conclusion of value."

EXERCISE 2   This is a detailed report per SSVS. What other types of reports are allowed under SSVS?

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This valuation was performed to assist in the determination of the value solely for purposes of internal operational and tax planning, and the resulting estimate of value should not be used for any other purpose, or by any other party for any purpose, without our express written consent.

EXERCISE 3   The purpose of the valuation of National Fastener is to assist management in internal operational and tax planning. What other purposes are there?

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Our analysis and report are in conformance with the 20X6–20X7 Uniform Standards of Professional Appraisal Practice (USPAP) promulgated by the Appraisal Standards Board of The Appraisal Foundation,2 and the ethics and standards of the American Society of Appraisers (ASA) and IRS business valuation development and reporting guidelines, the National Association of Certified Valuators and Analysts (NACVA), and the Institute of Business Appraisers (IBA).3

EXERCISE 4   If the analyst belongs to more than one valuation organization with standards, that analyst must comply with the standards of each organization he or she belongs to.

True

False

Our analysis is also in conformance with Revenue Ruling 59-60, which outlines the approaches, methods, and factors to be considered in valuing shares of capital stock in closely held corporations for federal tax purposes. Revenue Ruling 59-60 is often also considered as useful guidance in valuations performed for nontax purposes.

The standard of value is fair market value defined in Revenue Ruling 59-60 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. Revenue Ruling 59-60 also defines the willing buyer and seller as hypothetical as follows: Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property. Furthermore, fair market value assumes that the price is transacted in cash or cash equivalents. Revenue Ruling 59-60, while used in tax valuations, is also used in many nontax valuations.

Fair market value is also defined in a similar way in the SSVS4 as the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.

EXERCISE 5   Which of these are standards of value?

Fair market value, fair value financial reporting, investment value

Fair value investment reporting, fair value state actions, intrinsic value

Investment value, intrinsic value, equal value

Fair market value, equal value, investment value

The premise of value is going concern.5 The liquidation premise of value was considered and rejected as not applicable, as the going concern value results in a higher value for the interest than the liquidation value, whether orderly or forced.

In our conclusion of value, we considered the following relevant factors, which are specified in Revenue Ruling 59-60:

The history and nature of the business

The economic outlook of the United States and that of the specific industry in particular

The book value of the subject company’s stock and the financial condition of the business

The earning capacity of the company

The dividend-paying capacity of the company

Whether or not the firm has goodwill or other intangible value

Sales of the stock and size of the block of stock to be valued

The market price of publicly traded stocks or corporations engaged in similar industries or lines of business

Our analysis included, but was not limited to, the above-mentioned factors.

1.2.1 Understanding with the Client and Scope of Work

Per SSVS, the valuation analyst should establish an understanding with the client. The understanding with the client reduces the possibility that either the valuation analyst or the client may misinterpret the needs or expectations of the other party. The understanding should include, at a minimum, the nature, purpose, and objective of the valuation engagement, the client’s responsibilities, the valuation analyst’s responsibilities, the applicable assumptions and limiting conditions, the type of report to be issued, and the standard of value to be used.6

Furthermore, "A restriction or limitation on the scope of the valuation analyst’s work, or the data available for analysis, may be present and known to the valuation analyst at the outset of the valuation engagement or may arise during the course of a valuation engagement. Such a restriction or limitation should be disclosed in the valuation report (see paragraphs .52m, .68e, and .71n)."7

Our appraisal is in accordance with the Uniform Standards of Professional Appraisal Practice (USPAP) promulgated by the American Society of Appraisers and the Appraisal Foundation. The objective of an appraisal is to express an unambiguous opinion as to the value of a business, business ownership interest, or security, which opinion is supported by all procedures that the appraiser deems to be relevant to the valuation.8 It is based on all relevant information available to the appraiser as of the valuation date; the appraiser conducts appropriate procedures to collect and analyze all information expected to be relevant to the valuation, and the appraiser considers all conceptual approaches deemed to be relevant.9

In accordance with the Scope of Work Rule in USPAP, we must:

Identify the problem to be solved;

Determine and perform the scope of work necessary to develop credible assignment results; and

Disclose the scope of work in the report.10

To gain an understanding of the operations of National Fastener, we reviewed Company financial information as provided by management and interviewed Company management. To understand the environment in which National Fastener operates, we researched the status of and trends in the various industries that have an impact on it. We also studied economic conditions as of the valuation date and their impact on National Fastener and the industry. To understand the Company’s financial condition, we analyzed its financial statements as available.

We considered all valuation approaches and methods and applied the most appropriate methods from the income, asset, and market approaches to value to derive an opinion of value of the subject equity interest (100 percent controlling, marketable interest). Our conclusion of value reflects these findings, our judgment and knowledge of the marketplace, and our expertise in valuation.

Our valuation is set out in the report, which contains the following sections:

History and Nature of the Business

General Economic and Industry Outlook

Book Value and Financial Position

Approaches to Value

Income Approach

Market Approach

Reconciliation of Valuation Methods

Conclusion of Value

Appendixes

Appendix A—Assumptions and Limiting Conditions

Appendix B—Valuation Representation/Certification

Appendix C—Professional Qualifications of the Appraiser

Appendix D—Other Sources Consulted

Appendix E—Exhibits

In performing our work, we were provided with and/or relied upon various sources of information, including (but not limited to):

Audited financial statements for National Fastener for the fiscal years ended December 31, 20X0, through December 31, 20X4

Internal interim financial statements for National Fastener for the eight months ending August 31, 20X5, and August 31, 20X4

Tax returns for the Company for the fiscal years ended December 31, 20X0, through 20X4

Information regarding the management and shareholders of National Fastener

Information regarding the Company’s history and current operations

National Fastener’s Articles of Incorporation and Bylaws

Data from Duff & Phelps LLC, 20X5 Valuation Handbook—Guide to Cost of Capital

Federal Reserve statistical releases

Current and future economic conditions as forecast by various sources, listed in the Appendix

Miscellaneous other information

The procedures employed in valuing the subject interest in National Fastener included such steps as we considered necessary, including (but not limited to):

An analysis of National Fastener’s financial statements

An analysis of National Fastener management’s 20X5 expectations and other information supplied by management

Discussions with management

An analysis of the fastener industry, as well as the domestic automotive industry

An analysis of the general economic environment as of the valuation date, including investors’ equity and debt-return expectations

An analysis of other pertinent facts and data resulting in our conclusion of value

There were no restrictions or limitations in the scope of our work or data available for analysis.

Based on our analysis as described in this valuation report, and the facts and circumstances as of the valuation date, the estimate of value as of September 1, 20X5, of a 100 percent equity interest in National Fastener & Machine Co., on a control, marketable basis is $30,100,000.

This conclusion is subject to the Statement of Assumptions and Limiting Conditions and to the Valuation Analyst’s Representation/Certification found in Appendixes A and B of this report. We have no obligation to update this report or our conclusion of value for information that comes to our attention after the date of this report.

EXERCISE 6   Valuation conclusions can be presented as:

A range of values

A single value

An estimate of value

All of the above

EXERCISE 7   This valuation is being done on a marketable, control interest basis. It is also on a control standalone basis. Name six levels of value that are considered in a valuation.

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Distribution of this letter and report and associated results, which are to be distributed only in their entirety, is intended and restricted to you and your client, solely to assist you and your client in the determination of the fair market value of the subject interest for internal operational and tax planning purposes and is valid only as of September 1, 20X5. This letter and accompanying report are not to be used with, circulated, quoted, or otherwise referred to in whole or in part for any other purpose, or to any other party for any purpose, without our express written consent.

As is usual in appraisal practice, the approaches and methodologies used in our work did not comprise an examination or any attest service in accordance with generally accepted accounting principles, the objective of which is an expression of an opinion regarding the fair presentation of financial statements or other financial information, whether historical or prospective, presented in accordance with generally accepted accounting principles or auditing standards. We express no opinion and accept no responsibility for the accuracy and completeness of the financial information (audited, reviewed, compiled, internal, prospective, or tax returns), or other data provided to us by others, and we have not verified such information unless specifically stated in this report. We assume that the financial and other information provided to us is accurate and complete, and we have relied upon this information in performing our valuation.

If you have any questions concerning this valuation, please contact Ms. Margaret E. Smith, CPA/ABV, ASA, CVA, CBA, at (800) 000-1234.

Very truly yours,

XYZ Appraisal Associates LLC

1.3 INTRODUCTION

1.3.1 Description of the Assignment

XYZ Appraisal was retained by Mr. Sherman Miller to determine the fair market value of a 100 percent equity interest in National Fastener & Machine Co. (National Fastener or the Company) on a marketable, control basis, as of September 1, 20X5, for internal operational and tax planning purposes.

1.3.2 Summary Description and Brief History of the Company

The Company was incorporated in 1927 in the State of Missouri. National Fastener operates in two segments: fasteners and assembly equipment. The Company’s products are sold to the North American automotive industry by employees of the Company and by independent sales representatives. Revenues are primarily derived from sales to customers involved directly or indirectly in the manufacture of automobiles and automotive components. The Company is legally structured as a C corporation.

EXERCISE 8   The subject of this exercise is a C corporation, but analysts will frequently be required to value noncontrolling interests in S corporations. Valuation of S corporations is one of the most controversial issues in business valuations today. The main issue is how to tax-affect S corporation income and, if appropriate, compute an S corporation adjustment. What five models are often considered or used in valuing S corporations?

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National Fastener serves a variety of customers; however, sales to two major companies accounted for approximately 33 percent of revenues during 20X4. Sales to BI Automotive Systems, LLC, accounted for approximately 20 percent and 18 percent of the Company’s consolidated revenues in 20X4 and 20X3, respectively. Sales to Hunter & Company accounted for approximately 13 percent and 14 percent of the Company’s consolidated revenues in 20X4 and 20X3, respectively. Recently, the Company executed a manufacturing contract with a new customer, which is expected to generate significant revenue growth in the near future.

The Company maintains alternative sources for raw materials. The market is served by multiple suppliers, so prices for raw materials are generally competitive. The Company is not under any long-term contracts for raw materials. Orders are made through purchase orders based on pricing sheets negotiated biannually.

As of December 20X4, the Company had 236 full- and part-time employees. The employees are party to a collective bargaining agreement. The Company is on good terms with the union representing its employees and has recently renegotiated the union contract that now has an X-year term. There are no employment or noncompete agreements.

As of the valuation date, management and key personnel of National Fastener include the following individuals, with their titles shown in Exhibit 1.1.

EXHIBIT 1.1 Executive Management

The fastener and assembly equipment markets are characterized by active and significant competition. No single company in particular dominates the industry. The Company’s competitors include both larger and smaller manufacturers, and segments or divisions of large, diversified companies with substantial financial resources. The primary competitive factors for the Company’s products in the market are price, quality, and service. Based on discussions with management, National Fastener’s primary competitors include The Eastern Co., Twin Disc, Inc., Midwest Fasteners Corp., National Fastening Systems, and Haven Fastener, Inc.

The competitive environment has changed considerably in recent years as the Company’s customers have experienced intense international competition and pressure to reduce costs. As a result, these customers have expanded their sourcing of components beyond domestic boundaries. National Fastener’s competition now includes suppliers in other parts of the world that enjoy economic advantages, such as lower labor costs, lower health care costs, and fewer regulatory burdens.

1.3.3 Ownership and Capital Structure of the Company

The Company is legally structured as a C corporation. National Fastener is a privately held company owned by the same family that founded the company many years ago. The Company has a single class of common stock with 10,000 shares issued and outstanding. Exhibit 1.2 presents the ownership of the shares of the Company as of the valuation date:

EXHIBIT 1.2 Ownership

EXERCISE 9   We are valuing a 100 percent control interest in National Fastener. The percentage of ownership of individual shareholders is not an issue here. However, assume we are valuing the 55 percent interest of Tony Atkins as opposed to the 100 percent in National Fastener. The value of a 55 percent interest in National Fastener would be calculated as 55 percent of the 100 percent control value in National Fastener.

True

False

1.3.4 Standard of Value

The standard of value used in this report is fair market value. Fair market value is defined as:

The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy nor sell and when both have reasonable knowledge of the relevant facts.11

Among other factors, this valuation report considers elements of appraisal listed in the Internal Revenue Service’s Revenue Ruling 59-60, which outline[s] and review[s] in general the approach, methods, and factors to be considered in valuing shares of the capital stock of closely held corporations.12 Specifically, Revenue Ruling 59-60 states that the following factors should be carefully considered in a valuation of closely held stock:

EXERCISE 10   Revenue Ruling 59-60 is only applicable to estate, gift, and income tax valuations.

True

False

The nature of the business and history of the enterprise from its inception. National Fastener & Machine Co. began its history as a manufacturer of brake linings and harness rivets in 1920, under the name National Fastener & Specialty Co. In 1927, the Company was incorporated under the laws of the State of Missouri and changed its name to its current form. The Company has grown since its inception, and its customers have remained loyal.

The economic outlook in general and condition and outlook of the specific industry in particular. The consideration of the economic outlook on a national level, as well as on a regional and local level, is important in performing a valuation. How the economy is performing has a bearing in part on how the Company performs. Overall, the Company outlook is stable.

The book value of the stock and the financial condition of the business. The Company has a relatively strong balance sheet with a majority of its assets in these categories: cash, certificates of deposit, accounts receivables, inventory, and fixed assets. The fixed assets consist primarily of production equipment with some land and buildings.

The earning capacity of the Company. Revenue increased at a CAGR of 4.2 percent from fiscal 20X2 to 20X4 and 6.8 percent from 20X0 to 20X4. Growth during these periods reflects recovery of domestic auto production. Adjusted income before taxes for the year ended December 31, 20X4, was $2.9 million or 7.8 percent of revenue, down by approximately 18 percent from the income before tax of $3.5 million (9.5 percent of revenue) in the prior fiscal year. With the recovery of the automotive industry, the Company has demonstrated a good ability to generate profits.

The dividend-paying capacity of the Company. The Company has strong dividend-paying capacity. However, the Company has generally retained earnings to support capital investment requirements and internal growth.

Whether the enterprise has goodwill or other intangible value. It is generally acknowledged that goodwill is often measured by the earnings ability of an enterprise being valued. Goodwill can be broadly defined as characteristics that induce customers to continue to do business with the Company and to attract new customers. The Company has intangible assets such as long-term relationships with customers, its proprietary trademark, and assembled workforce.

Sales of the stock and size of the block to be valued. There have been no sales of stock of the Company that would provide an indication of value during the period being analyzed.

The market prices of stock of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over the counter. The market approach was considered in this valuation. A search for guideline companies that are similar in nature and size to the Company was performed.

EXERCISE 11   These are the only eight tenets of value in Revenue Ruling 59-60 that need to be considered.

True

False

1.4 NATIONAL ECONOMIC OUTLOOK13

The financial success of investments in National Fastener as of the valuation date is dependent upon conditions within the economy and financial/capital markets. A prospective investor tempers the use of historical financial statistics on the basis of anticipated general economic conditions. An analysis of these factors as of the valuation date is therefore incorporated into this valuation analysis. Certain items in the following discussion have been extracted from the cited sources and/or substantially paraphrased based upon them. In conjunction with the preparation of our opinion of fair market value, we have reviewed and analyzed the economic conditions as of September 1, 20X5, the date of valuation. This report includes summary discussions and analysis of the national economy for the second quarter of 20X5.

1.4.1 General Economic Overview

According to advance estimates released by the Department of Commerce’s Bureau of Economic Analysis (BEA), Real Gross Domestic Product (GDP), the output of goods and services produced by labor and property located in the United States, increased at an annualized rate of 2.3 percent during the second quarter of 20X5. GDP performance during the second quarter of 20X5 was slightly lower than economists’ expectations of 2.6 percent and follows increases of 2.1 percent and 0.6 percent in the fourth quarter of 20X4 and the first quarter of 20X5, respectively. GDP growth was driven largely by consumer spending, which increased 2.9 percent in the second quarter of 20X5, relative to increases of 4.3 percent and 1.8 percent in the fourth quarter of 20X4 and the first quarter of 20X5, respectively. Durable goods growth increased 7.3 percent, following an increase of 6.1 percent in the fourth quarter of 20X4 and an increase of 2.0 percent in the first quarter of 20X5. A survey of economists conducted by The Wall Street Journal reflects a consensus GDP forecast of 3.1 percent GDP in the third quarter of 20X5.

The Conference Board (TCB) reported that the Leading Economic Index (LEI), the government’s primary forecasting gauge, increased 0.6 percent in June 20X5 to 123.6, after increases of 0.6 percent and 0.8 percent in April and May, respectively. Traditionally, the index is thought to gauge economic activity six to nine months in advance. Multiple consecutive moves in the same direction are said to be indicative of the general direction of the economy. The LEI increased or remained level in each of the past 18 months. Beginning in January 20X5, the base year of the index was changed from 2004 to 2010.

Conference Board economists view the LEI’s recent movements as indicative of continuing economic growth in the second half of 20X5. According to TCB economist Ataman Ozyildirim, The upward trend in the US LEI seems to be gaining more momentum with another large increase in June pointing to continued strength in the economic outlooks for the remainder of the year. He added, Housing permits and the interest rate spread drove the latest gain in the LEI, while labor market indicators such as average workweek and initial claims remained unchanged.

Six of the LEI’s 10 leading economic indicators rose during June 20X5. The positive contributors to the LEI (largest to smallest) included the interest rate spread, building permits, average consumer expectations for business conditions, the Leading Credit Index (inverted), manufacturers’ new orders for nondefense capital goods excluding aircraft, and the ISM new orders index. Stock prices declined, and average weekly manufacturing hours, average weekly initial claims for unemployment insurance (inverted), and manufacturers’ new orders for consumer goods and materials were unchanged. The rolling six-month percentage change in LEI increased in June 20X5. In June, the Coincident Economic Index increased 0.2 percent and the Lagging Economic Index increased 0.7 percent.

1.4.2 Consumer Spending and Inflation

According to the Bureau of Labor Statistics (BLS), the Consumer Price Index (CPI) increased 0.3 percent in June 20X5 (on a seasonally adjusted basis), following increases of 0.1 percent and 0.4 percent in April and May, respectively. Over the previous 12 months, the CPI increased 0.1 percent and Core CPI increased 1.8 percent, on an unadjusted basis.

The Producer Price Index (PPI), which is generally recognized as predictive of near-term consumer inflation, increased 0.4 percent in June 20X5 (PPI for final demand, seasonally adjusted), after a decline of 0.4 percent in April and an increase of 0.5 percent in May.

1.4.3 The Financial Markets

Due to the Greek financial crisis spurring a sell-off at the end of the quarter, the Dow Jones, the S&P, and the NASDAQ experienced losses during June 20X5. The Dow Jones and the S&P also posted losses for the second quarter of 20X5, while the NASDAQ posted its 10th consecutive quarterly gain. Driven by signs of an improving economy and the anticipation of the Federal Reserve increasing rates, most U.S. Treasury yields rose during the second quarter of 20X5.

1.4.4 Interest Rates

The yield on 10-year Treasury securities set a historic low in 20X1 before falling even further in 20X2. Although 10-year yields recovered somewhat in 20X3, yields declined consistently throughout 20X4. During the second quarter of 20X5, all yields for terms greater than one year increased.

EXERCISE 12   What types of industries would most likely be affected by anticipated changes in interest rates?

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1.4.5 Unemployment

According to the Labor Department’s Bureau of Labor Statistics (BLS), the unemployment rate was 5.3 percent in June 20X5, down slightly from 5.4 percent and 5.5 percent in April and May, respectively. While the June unemployment rate is lower than rates observed over the past several years, the labor force participation rate is also lower at 62.6 percent (relative to mid- to high-60s prior to the recession). As job availability increases, the labor force could increase due to individuals reentering the workforce, which could lead to periodic increases in the unemployment rate in the foreseeable future. Economists surveyed by the Wall Street Journal anticipate an unemployment rate of 5.1 percent by year-end 20X5 and a further decline to 4.9 percent by June 20X6.

1.4.6 Summary and Outlook

Although the aptly named Great Recession reached its official end in mid-2009, economic growth continues but remains slow in some sectors. Although the housing market has strengthened, growth in the market remains modest. The unemployment rate reached pre-recession levels in December 20X4, but labor force participation remains low. Economic growth is expected to remain positive, though political uncertainty, rising interest rates, and continuing low labor force participation rates are causes for concern. GDP growth expectations from private economists surveyed by The Wall Street Journal are on the order of 3.1 percent for the third quarter of 20X5 and 3.0 percent for the fourth quarter of 20X5. Although the Federal Reserve ended its asset purchases, a significant tightening of monetary policy (via an increase in the target federal funds rate) is unlikely in the short run but increasingly likely in the coming quarters and will likely coincide with inflation stabilization. According to the Livingston Survey published on June 10, 2015, the long-term (10-year) forecast for the CPI Inflation Rate was a mean and median of 2.20 percent in a range from 1.60 percent to 2.80 percent.14 The Livingston Survey long-term (10-year) forecast for real GDP was a median 2.50 percent and mean 2.42 percent in a range from 1.80 percent to 3.10 percent.

EXERCISE 13   What two economic indicators are probably the most important in valuation?

Unemployment levels and gross domestic product (GDP)

Dow Jones Industrial Average and Producer Price Index

GDP and inflation

Inflation and unemployment levels

1.4.7 National Economic Impact on Valuation

Analyzing the national economy is an important step in performing a valuation because it helps to identify any risk that the economy may have in relation to the Company. In this case, the economy appears to be in recovery with expected slow growth.

EXERCISE 14   In valuing a small geographically concentrated business, which of these types of economic data should be considered?

International, national, regional, local

National, regional, local

Regional, local

Local only

1.5 REGIONAL ECONOMIC DATA (AS OF SEPTEMBER 1, 20X5)15

The economy remained strong in July and August, but was expanding more slowly than earlier in the year. Reports on consumer spending were mixed.

Construction activity generally was strong, despite softening on the residential side. Overall manufacturing output remained strong, but conditions were varied across industry segments. The labor markets remained much tighter than the rest of the nation, and seasonal demand put additional strain on some sectors of the market.

1.5.1 Consumer Spending

Reports on consumer spending activity were mixed. Sales of appliances, electronics, and lawn and garden goods continued to be strong. Retailers reported that inventories for most goods were in line with their planned levels. Auto dealers reported heavier floor traffic and increases in light vehicle sales. One large auto group noted that service activity was also up and that used car prices strengthened.

1.5.2 Manufacturing

The manufacturing sector generally remained strong, although activity varied by industry segment. According to most automakers, orders for light vehicles remained strong nationwide. Inventories were generally in good shape, although they were reportedly lean for select models. Despite these conditions, the pricing environment remained soft, with an increase in incentive spending noted by some analysts. Producers of agricultural and heavy construction equipment reported further softening in output in recent weeks, and most planned to reduce inventories further next year, although not as aggressively as this year. Reports expected domestic demand would be relatively soft in the coming year, while foreign demand was expected to pick up.

1.5.3 Banking and Finance

Lending activity continued to be mixed. Business lending remained robust, and most bankers suggested that growth was steady. A few reports indicated that overall asset quality on commercial loans might have deteriorated slightly, since intense competition for customers led some lenders to relax standards slightly. Some bankers appeared to be less optimistic about the near-term commercial lending outlook than they had been in recent months. Household loan demand softened further, according to most lenders, as new mortgage and refinancing activity continued to slow. Reports noted that asset quality on consumer loans improved as existing bank and store credit-card balances were paid down, delinquencies slowed, and personal bankruptcies decreased. A report from one large money center bank attributed this improvement to a lagged effect from strong refinancing activity earlier in the year, and as a result, did not expect the improvement to endure. None of the bankers contacted noted any unusual borrowing by businesses that would indicate an inventory buildup, nor was there any noticeable increase in the demand for cash by consumers.

1.5.4 Labor Markets

Labor markets remained very tight. Demand for workers in most sectors remained strong. Temporary help firms in some metro areas reported increasing demand for manufacturing workers, while there were a few reports of slackening demand for financial service professionals, partly as a result of slowing mortgage applications. On balance, reports suggested that overall wage pressures had not intensified further in recent weeks. Staffing services reports indicated that wages were increasing fastest in the administrative/clerical occupations while a slowdown in wage growth was noted for information technology professionals. Reports from a large trucking firm noted the continued shortage of drivers was especially serious during high seasonal demand for transporting goods. Most reports continued to argue that worker shortages were hampering the economic expansion.

1.5.5 Regional Economic Impact on Valuation

The regional economy should also be analyzed in performing a valuation to help to determine specific risks associated with the particular region in which the Company operates. In this instance, the regional economy is performing very well in many areas.

1.6 LOCAL ECONOMY

Anycity, Anystate was founded in 1810. It has an estimated population of 2,800,000 citizens. The economy is made up primarily of trade, services, and manufacturing. Anycity has the 12th-strongest economy in the nation, according to a 20X5 economic analysis. The analysis studied factors such as employment, per capita personal income and construction, and retail employment.

According to a 20X5 study, Anycity, Anystate was one of the top 10 metropolitan areas in the nation as a hot spot for starting and growing young companies. The survey measured the number of significant start-up firms created during the last 10 years and the number of 10-year-old firms that grew substantially during the past four years. Also, in April 20X5, a national magazine named Anycity one of the top 10 most improved cities for business in the United States. Anystate was ranked seventh based on cost of living, educational opportunities, quality of life, and business issues. Construction activity also remained good.

The local economy is another important aspect to consider when performing a business valuation. The local economy represents the immediate environment in which the Company operates. The economy of Anycity, Anystate appears to be doing very well. Thus, in our opinion, there is little risk associated with the local economy that will affect the Company.

1.7 INDUSTRY OUTLOOK: FABRICATED METAL PRODUCTS AND TRANSPORTATION EQUIPMENT

We employed Porter’s16 model of analysis to examine more closely the fastener industry defined by SIC 34, Fabricated Metal Products, Except Machinery and Transportation Equipment, and SIC 37, Transportation Equipment, specifically focusing on subcategory SIC 3714, Motor Vehicle Parts and Accessories.

1.7.1 Fabricated Metal Products Industry

The fastener industry is remarkably decentralized, with hundreds of small shops producing the majority of fasteners.17 Over the years, U.S. companies in this industry have experienced significant competition from overseas manufacturers. Manufacturers serving the automotive sector have benefited from improvement in automotive sales, but some analysts are concerned with how long the growth will continue.

1.7.2 Transportation Equipment and Auto Parts Industry

The automotive industry is the largest manufacturing sector in the United States.18 From 20X0 to 20X5 (five-year period), the automotive parts industry almost doubled.19 Original equipment production represents the majority of total automotive parts production, with the remainder being aftermarket equipment.

Demand for auto parts is directly related to automotive sales and production. Since the 2008 recession, production and sales of autos have improved dramatically in North America. In May 20X5, the annualized selling rate of light-vehicle sales was 17.8 million units, which was the highest rate since 10 years prior, July 20X5.20 Sales are expected to continue to grow as the economy improves with a positive outlook for the next few years. The average vehicle age (which is over 11 years), the number of vehicles in operation, and miles driven should also drive demand for both replacement parts and new vehicles.21

Global competition in this industry is intense, but U.S. exports are restricted in many countries by governmental regulation and tariffs. Auto manufacturers generally prefer to source parts from manufacturers located in close proximity to their production locations in order to reduce inventory through just-in-time delivery of parts. Tier 1 suppliers include large global manufacturing companies, but Tier 2 suppliers tend to be small to medium-size enterprises without export business. These businesses may see increasing price competition from foreign companies. There are more and more parts suppliers entering the market offering lower price points, quality products, and/or advanced technologies. In addition, some of these suppliers receive or have received subsidies provided by their local governments. U.S. manufacturers with aftermarket products that are easy to produce and fairly low tech will face the greatest challenges.22 To remain competitive, suppliers are focusing on new products and technologies that improve safety, enhance fuel economy, lower emissions, and support in-car connectivity.23

1.7.3 Porter’s Five Forces Analysis

1.7.3.1 Industry Competition

The domestic automotive industry is highly competitive with many independent domestic and international suppliers competing on price, quality, and service.

1.7.3.2 Threat of Substitute Products

The threat of substitute products is low, but existing products compete primarily on price, not on innovation.

1.7.3.3 Threat of New Entrants

Based on industry data, foreign companies have been entering the U.S. market, increasing competition for existing market share. As the dollar strengthens against the rest of the world currencies, pricing from foreign suppliers becomes even more attractive. Just-in-time manufacturing requiring that supplier facilities have close proximity to manufacturing facilities will somewhat limit this international competition for certain products.

1.7.3.4 Bargaining Power of Suppliers

Bargaining power of suppliers is low because of the competitive alternatives available to buyers.

1.7.3.5 Bargaining Power of Buyers

Bargaining power of buyers is very high because the smaller parts manufacturing companies are part of a chain serving very large auto manufacturers with multiple alternative sourcing options.

1.8 IMPACT ON VALUATION OF ECONOMIC AND INDUSTRY OUTLOOK

Based on analysis of the industry and economic outlook, the requirement for aging vehicles to be replaced and repaired should support stable growth for the Company, with continuing price pressures from offshore competition. The median 10-year forecast CPI and real GDP estimates from the Livingston Survey imply a combined forecast 10-year nominal GDP of 4.76 percent.24 Based on the industry and economic data, a long-term perpetuity growth rate of 4.0 percent was assumed for the Company.

EXERCISE 15   Which industry outlook factors are generally the most important in supporting valuation assumptions?

Growth rates, profit margins, and risk

Regulatory and legal issues

Unemployment figures

Minority discounts and/or control premiums

1.9 HISTORICAL FINANCIAL ANALYSIS AND OVERVIEW OF THE COMPANY

Five years of financial data are presented for the fiscal years from 20X0 through 20X4 and the 12 trailing months (TTM) ended August 31, 20X5. See Exhibits 1.3 and 1.4 for the detailed comparative income statement and balance sheet of the Company, respectively. See Exhibit 1.5 for the adjusted comparative income statement.

EXHIBIT 1.3 Comparative Income Statement

EXHIBIT 1.4 Comparative Balance Sheet

EXHIBIT 1.5 Adjusted Comparative Income Statement

EXERCISE 16   What is the most important use of historical financial data?

To determine how the company has performed

To assist in supporting anticipated performance

To highlight profitability

To determine average profits

EXERCISE 17   Analysts typically spread five years of financial statements because:

Revenue Ruling 59-60 requires five years.

USPAP and SSVS require five years.

An economic cycle is often captured in five years.

Most business plans are based on five years of projections.