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Distinguishing Valuation Approaches and Methodologies in Divorce

DISTINGUISHING VALUATION APPROACHES AND METHODOLOGIES IN DIVORCE

Before reading this article understand that I, Eric Roy, am not a CPA and thus I am not a business valuation expert. However, understanding these concepts is integral for litigating high asset divorce cases. Thus I write this article for my own benefit and the benefit of my staff as a resource. AS counsel it is important to have a good handle on the basics of business valuation and the concepts used by CPAs in conducting their analysis. Without this understanding you cannot advise your expert with regard to how to proceed, you cannot effectively cross examine any opposing expert, and you cannot effectively direct your own expert. Thus this knowledge is integral if you as counsel are dealing with a high asset divorce case. When I say high asset divorce case I am referring to an estate valued to the tune of at least two or three million dollars and up.

This article simply provides a basic outline of what the different valuation approaches are as well as the methods and procedures that fall within those approaches are. Generally speaking, there is agreement among experts as to at least a few different "approaches" for business appraisal. In order for experts to come up with a respected report they often times will use more than one approach in their valuation. In this way they can provide greater reliability in their results. Given the specific type of entity being appraised the expert may choose to not only use more than one approach but to ascribe different weights to the different approaches used to account for the circumstances of the business as well as the context of the valuation. Within each of the different approaches there are various methods employed and within those methods there are specific procedures.

The three major approaches include the income approach, the market approach and the asset approach. The income approach looks to future income streams for valuation purposes. The market approach looks to various transactions which have occurred in the past to analyze value. The Asset-based approach looks to assets and liabilities for purposes of valuation. Understand that when various methods are employed to appraise an entity under one of these three approaches there will quite possibly be overlap among the methods employed and another method which was also employed or that was not employed but which could have been employed. The reason for this overlap is because each of the various methods employed ultimately rely on economic income and/or asset values as well as market data. Given the fact that all methods rely on this same data pool there will naturally be overlap among approaches. When an expert states that two approaches or two methods within one approach were used for purposes of enhancing reliability you should really look closely to see if the data and methods used were in fact discreet and independent of one another.

After your expert determines what approach to employ he or she will then determine what method to use within that approach. Generally there are two or three different methods accepted within the industry under each approach. Under the income approach, for instance, an expert can employ the discounting method or the capitalizing method. The discounting method takes into consideration future revenue streams and applies a discount rate to adjust for the time value of money. The capitalization method involves dividing a period's net operating income by the CAP rate.

Remember that under the market approach there are again a few different methods which can be employed. Each method takes reference of other transactions or comparable sales. For instance, under the comparable company method the analysis begins by formulating a multiple derived from stock price and financial data of a publicly traded company. Then this multiple can be applied to the particular business being valued. Similar to the comparable company method is the guideline transaction method. Here the valuation multiple is again derived by looking at price and financial data but here we look at companies which have been sold in their entirety. We then can apply this multiple to the company being valued. Another method is the past transaction method. In this method you can simply look to past transactions to create a multiple and then you can apply this multiple to the company as a whole. Similar to this, another method involves looking at buy sell agreements if they so exist. If arm's length negotiations have in fact occurred in the past then such a negotiated price can be used as evidence for purposes of valuation. Understand of course that it is important to look to see why such negotiations occurred in the past. Take into consideration the context within which the original negotiations ensued and the current context under which the business is being valued and identify similarities and differences.

Finally there is the asset approach to business valuation. Here we have two methods typically employed including the excess earnings method and then the adjusted net asset value method. Under the Excess earnings method we first subtract liabilities from the current value determination of tangible assets to receive net tangible asset value. Assumptions are then made as to how much income is needed to support these net tangible assets. If the company received income over and beyond what is needed to support these net tangible assets then take it a step further and divide this "excess income" by the capitalization rate. This will result in the value of the intangible assets (goodwill). Finally add the value of net tangible and net intangible assets together for total value. The second method which can be employed under the asset approach is that of the adjusted net asset value method. This formula is more basic in that the requirement is only to first adjust all assets and debts to current value, as you would do in the excess earnings method. And then subtract liabilities from assets to receive you value estimation.

Keep in mind that beyond approach and method lastly there are specific procedures to be employed within each method. Different procedures can be employed within any chosen methodology. For example, different procedures can be employed for the task of valuing equity. Equity can be valued directly by applying a multiple such as price over earnings. Alternatively Equity can be valued by valuing total common stock plus preferred stock and long term-debt and then subtracting out all debt out so as to arrive at a value for total common equity. I will not go into the various procedures beyond the example here as that would require more depth than this article intends. That being said it is important to understand what procedures are being used. Be mindful of the fact that there is much ambiguity in terminology both within the procedures themselves but this is in addition to the ambiguity and lack of precision in definition as it relates to difference between theory and procedure. After the business has been appraised your appraisal report should contain definition of terms. Read and understand how the appraiser defines these terms so as to be sure your understanding of a term is consistent with the appraiser's intent. For a much more thorough explanation of this material I direct you to read Shannon Pratt and Alina Niculita's literature on the subject. They are foremost experts in the field of business valuation and the source of most of my knowledge on the subject.

Categories: Family Law