Over the past twelve to eighteen months, we have heard considerable discussion about how the economic downturn has affected valuations of private companies. All of us who have 401ks understand the volatility of public company valuations. Private company values have been affected similarly. However, some valuation professionals have instituted the “smoothing” method to lessen the market volatility on business valuations.
The most obvious effect of utilizing the “smoothing” method is to sustain share values at levels which may not be realistic in a current transaction or the Fair Market Value (FMV) standard. While it may be true that this is less disruptive to ESOP participants and trustees, that may only be true in the short run. Some of the factors that may be affected by these artificially sustained values include:
- ESOP repurchase obligations
- Stock option pricing and exercise
- Stock appreciation rights (SAR) pricing and exercise
- Warrant pricing and exercise
- Company’s financial audit
- Company transactions (sales and/or acquisitions)
- Fiduciary liability
Smoothing attempts to place more emphasis on a long-term investment horizon than on what is actually happening in the marketplace today. We have heard this discussion particularly related to companies with Employee Stock Ownership Plans (ESOPs), as the plans are retirement benefit plans and, by their very nature, have long-term investment horizons. The suggestion is that because ESOP shares represent a retirement benefit their value should be viewed in a way that downplays short-term volatility so as not to overemphasize performance in a single year (which could be disruptive and confusing to participants and fiduciaries). Does this view fit into the standard of value required for ESOP valuations?
In analyzing “Fair Market Value” (FMV) a valuation analyst must consider the following:
The price, expressed in terms of cash equivalents, at which the 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, neither being under a compulsion to buy or sell and both having reasonable knowledge of relevant facts.
Essential in the concept of FMV is the idea of a transaction- a specific valuation date. In determining FMV an analyst must assume a transaction at the valuation date. That concept alone is enough to support the true application of market data, even when markets are very volatile. Transactions do not ignore volatility. Nor do they ignore market multiples.
Much discussion has centered on whether or not it is appropriate to apply market multiples to closely-held companies. Some have suggested that the values of closely-held companies are not subject to the same volatility as the broad public markets because of differences in information that is readily available for closely-held companies. Additionally, there is the belief that broad markets are partially driven by emotion and speculation, and that the mere fact that closely-held companies are not listed on an exchange makes them less subject to volatility.
According to the standard, FMV must be the price at which the interest would change hands between a hypothetical willing buyer and a hypothetical willing seller. In the real world of transactions, both of these hypothetical parties know and understand the marketplace. Both of these parties look to comparable companies and their valuations for guidance. Neither of these parties smooth results.
Smoothing is frequently instituted by simply ignoring current public company valuation multiples. In periods of high volatility, or “market divergence”, pricing multiples can fluctuate up and down dramatically. These fluctuations reflect nothing more than investors’ expectations and can all be translated into rates of return. These investors are the same investors who represent the “hypothetical” parties in the FMV standard. These “hypothetical” parties are demonstrating their tendencies and analyses every day, and the results create the very volatility that is being “smoothed” away. So wouldn’t ignoring the movements in the marketplace in favor of analysis based on some average of longer-term pricing multiples or in favor of analysis based solely on discounted future cash flows (also frequently reflecting “smoothed” results), ignore the guidelines of the standard? And if smoothing is the correct method for valuing businesses when values are falling, why was this method not implemented when we saw an extraordinary run-up in multiples a few years ago?
Clearly, it’s not appropriate to ever “over-weight” operating results from a single period. By definition, “over-weighting” in this sense means an analyst has incorrectly considered some factor. However, the standard of value certainly suggests that all factors that would be considered by the hypothetical parties on the specific valuation date must be considered in the valuation. “Under-weighting”, “smoothing”, or “normalizing” valuation multiples are just as big a departure from the FMV standard, even if the analysts’ intentions are good. We all want to “get it right” when valuing a business, but the only way to do that is to follow the standards of value that are set as guidelines.