By Josh Shilts, CPA, ASA, ABV/CFF/CGMA, CFE
August 15, 2023
NACVA’s QuickRead
Tests of Reasonableness
Business appraisers use tests that ask whether decisions made are legitimate and designed to remedy a certain issue under the circumstances. These tests are commonly referred to in the valuation literature as tests of reasonableness. Several methods have been suggested and employed (e.g., purchase justification test), but limited literature speaks to the use of a test of reasonableness for company specific risk premia (CSRP). This article explores data sources and analyses available to appraisers to provide a “test of reasonableness” to increase the confidence level and analysis of their CSRP analysis.
Business appraisers use tests that ask whether decisions made are legitimate and designed to remedy a certain issue under the circumstances. These tests are commonly referred to in the valuation literature as tests of reasonableness. Several methods have been suggested and employed (e.g., purchase justification test), but limited literature speaks to the use of a test of reasonableness for company specific risk premia (CSRP). This article explores data sources and analyses available to appraisers to provide a “test of reasonableness” to increase the confidence level and analysis of their CSRP analysis.
“Attorneys often review business valuations which employ a capitalization of earnings approach where the earnings of the business are divided by a ‘capitalization rate’ (cap rate) to arrive at a value estimate. The cap rate has a crucial impact on the total value, so it is essential to assess its reasonableness, regardless of whether the valuation is for estate planning, the review of a challenge by the IRS, for equitable distribution, or the sale of a client’s business.”[1] Cap rates, specifically the rate developed for CSRP, are generally the topic of intense debate amongst valuation practitioners. CSRP represents the singular variable in the cap rate equation left without empirical support; thus, compelling practitioners to rely on qualitative analyses without general acceptance in the valuation profession and questioning the reasonable certainty standard. Tools, in the sense of data, are available to practitioners that choose to utilize it in their CSRP analysis from an internal and external historical perspective. Valuation professionals can utilize comparable company transaction data along with historical returns on equity to research, analyze, and support subject company CSRP rates employed.
“The CSRP is considered indirectly in the valuation market approach when (1) selecting guideline publicly traded companies and guideline merger and acquisition transactions, and (2) extracting subject interest-specific pricing multiples from the selected guideline publicly traded companies or the guideline merger and acquisition transactions.”[2] Utilizing transactional data, an appraiser can “back solve” to calculate the CSRP for that specific transaction; albeit with certain assumptions. For example, let us assume that a business with EBITDA of $250,000 recently sold for $1,000,000, thus equating to a 4x EBITDA multiple. Now, let us assume that you are valuing a similar company (for purposes of this explanation let us assume all characteristics are equal between subject and comparable) and derive a free cash flow to equity figure of $200,000. By looking up data for the risk-free rate, equity risk premia, and size premia[3] on that sales date using basic arithmetic, one can ‘extract’ the comparable company’s CSRP. Yes, the critics will question the intent of the transaction, differences in financial and other operating characteristics, and a host of other reasons why this figure is not representative of the subject assignment. But I never said this is the “end all be all” approach to calculate CSRP. Valuation standards state we should consider the utilization of all valuation approaches; the same should also hold true in this instance.
If the market data is not sufficient for the discussion, another measure is return on equity. (ROE). “ROE is considered a gauge of a corporation’s profitability and how efficient it is in generating profits. The higher the ROE, the more efficient a company’s management is at generating income and growth from its equity financing.”[4] A review of historical returns on equity from the subject company, in comparison to external and internal market events, and industry data (e.g., industry growth rates and benchmark ROE) can provide a benchmark for appraisers to assess subject company data. This baseline comparison can be used to formulate analyses on management capabilities, operating advantages, and other relevant characteristics in comparison with market comparable(s) and the industry or economy as a whole. This can serve as a “proxy” for your analysis and support CSRP determinations. By comparing the industry returns (e.g., passive) against your subject company (e.g., active) the appraiser provides a comparative analysis that not only may serve as a benchmark for CSRP but can identify a host of other relevant data.[5]
In a profession that relies on data to support conclusions and opinions, we as appraisers must take notice of the data and information available to us, and recognize that more is present than at first blush.
[1] “Critically Assessing a Business Valuation: Is the Capitalization Rate Used Reasonable?”. Hawkins, George B. Banister Financial Inc. Fair Value, Spring 1996.
[2] “Considering a Company Specific Risk Premium in the Cost of Capital Measurement”. Reilly, Robert and Thurman, Connor. Construction Accounting and Taxation. January/February 2021.
[3] I have not included industry premia. This is left for a separate discussion at another time.
[4] Definition identified via Investopedia on April 8, 2023. Site references “Rice University via OpenStax. “Principles of Accounting, Volume 1: Financial Accounting – A Financial Statement Analysis.”
[5] Active vs. passive in divorce situations.
The National Association of Certified Valuators and Analysts (NACVA) supports the users of business and intangible asset valuation services and financial forensic services, including damages determinations of all kinds and fraud detection and prevention, by training and certifying financial professionals in these disciplines.
Information contained in this article is provided for informational purposes only. It should not be misconstrued as legal or accounting advice or intended as a thorough, in-depth analysis of specific issues or a substitute for a formal opinion. It presents matters of general interest relating to business valuation, forensic accounting, and litigation support topics for educational purposes only. Shilts CPA, PLLC disclaims all liability concerning actions taken or not taken based on any or all of the contents of this article.
We would be pleased to perform the requisite research and provide a detailed written analysis. Such an engagement may be the subject of a separate engagement letter that would define the scope and limits of the desired consultation service.