Here is a guest article on valuation from Chuck Bertsch, a well-known valuation expert who has helped many of our clients:

RE: VALUATIONS IN HARD TIMES

We often use the capitalized earnings method to arrive at the value of a business. This consists of selecting an earnings level representative of future expectations for a company and, then, capitalizing these earnings with a rate which reflects investor return requirements and long-term growth expectations [A capitalization rate is the same as a price to earnings ratio expressed as a decimal; e.g., a P/E ratio of 6 is equal to a capitalization rate of .167].

The capitalization rate is the company’s weighted average cost of capital (“WACC”). If a business is appropriately capitalized with all equity the capitalization rate, or WACC, is determined by reference to Ibbotson (now Morningstar) long-term equity returns, plus an allowance for specific risk. Alternative approaches exist.

Some companies, of course, can be financed with a mix of debt and equity. In these cases, a judgment is made as to the appropriate mix of capital inputs. A WACC which reflects the returns demanded by suppliers of both types of capital is then computed.

Suppose, for example, we have a company with $15 million of equity capital, no debt, and $3 million of net income. Using the Ibbotson procedure, we might come up with an equity return requirement of 20%. The $3 million of net income, capitalized with a rate of .20, yields $15 million as the value of the company.

If, however, we were to judge the company could be financed 40% with debt yielding 7% the calculation would be different. In this case we would compute a WACC of .148 (60% equity at a rate of .20, plus 40% debt at a rate of .07). The $3 million of net income, capitalized with a rate of .148, yields $20.3 million as the value of the company, a 35% increase from the all equity case.

Two years ago, or perhaps only six months ago, an assumption of 40% debt financing in a company’s capital structure might have been unremarkable. Today this is far less likely to be true. As we read on a daily basis, credit markets are closed to many borrowers or prohibitive in terms of cost (junk bonds have been priced to yield 18% to 20% in recent months). If we conclude that the company in our example can best be financed with only 20% debt (at rates higher than 7%), or no debt, the effect on WACC and value is obvious.

In the second paragraph above, we mentioned “specific risk.” In our view, specific risk premiums have escalated significantly over the last six months. This is partly because historical long-term rates of return do not reflect requirements in today’s exceedingly risk-averse environment; it also is because the vast majority of businesses confront much greater volatility in their earnings prospects (and, hence, more risk) than has been the case in past times.

The impact of these two factors, changes in WACC’s and specific risk premiums, mean that over the last six months most companies have suffered material declines in value even in cases where earnings have resisted the general downtrend.

Frederick C. “Chuck” Bertsch III, MBA, ASA

F.C. Bertsch & Co., Inc.

416 Roundhill

St. Davids, PA 19087

610-964-1800
610-964-1801 (fax)

fcb@fcbertsch.com

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F.C. Bertsch & Co.’s valuation practice focuses on ownership interests in closely-held businesses, partnerships, and limited liability companies. Chuck Bertsch has been valuing business interests for 30 years. He belongs to the American Society of Appraisers (where he is an Accredited Senior Appraiser) and the Philadelphia, Delaware County and Chester County Estate Planning Councils. He has served as CFO of two companies (one NYSE listed) and is a graduate of Wharton (MBA in Finance) and Wesleyan University