Valuation formulas are subject to many influences, so it helps to periodically test them out to make sure they yield accurate results.
Many firms in the A/E industry are attracted to using a “valuation formula” to price their stock. They do this more than in any other industry I have studied in my valuation career. Over time, I have had many conversations with clients about their formulas. I thought I would share some of my insights with you.
To begin, I would like to emphasize that a formulaic approach to determine the value of a firm’s stock does not constitute fair market value as defined in Revenue Ruling 59-60. The ruling specifically addresses formulas, stating, “No formula can be devised that will be generally applicable to the multitude of different valuation issues ….” Having said that, I prefer to think of the use of formulas as a method to price stock, rather than to value it. I know it sounds like I’m being particular, and I am, with good reason.
- Case in point – A. Firm A has been using a stock formula to price shares for internal transactions for several years. Two people in the firm hold a majority of the shares, considered a block of stock, and approximately 10 others own very minority positions. Firm A engaged Zweig Group to value the shares at fair market value to test the formula in place. The result indicated that the firm was overvaluing the shares at a minority interest level due to, in our professional opinion, the formula producing a control level value. This creates a difficult problem because minority shares have been transacted at the higher price and the firm is anticipating more transactions in the near future. In addition, the two owners with a majority of the shares have discovered that their individual shares are worth less than they anticipated. So, how will this issue be resolved? Likely the firm will (1) Modify its formula to represent a pricing structure more representative of a minority interest level, (2) Modify the language in the existing shareholder agreement, (3) Value the shares of the two senior people as a control block of stock, which will require the sale of that stock as a block when they are ready to exit, and (4) Invest in a periodic formal valuation in an effort to monitor formula results and confirm that they are within a reasonable range of fair market value.
- Case in point – B. Firm B was using a formula comprised of multiples applied to net service revenue and EBIT, adding cash and subtracting debt. Within the span of one year, the formula produced a per share stock price more than 30 percent below the previous year that was not warranted, even acknowledging some changes in financial performance. Therefore, the formula had a high level of sensitivity to the metrics combined with the multipliers. So, how was this issue resolved? We revalued the firm’s stock at fair market value to provide a reasonable guideline to the shareholders to modify the formula. Besides the full-blown formula problems that we see quite frequently, there are also specific metric issues that can over- or under-influence a stock price indication.
- Case in point – C. I received an inquiry related to the issue of non-operating assets on the balance sheet, specifically excess cash. Firm C’s ownership in another company that sold produced $1 million in extra cash and the question that arose is how to deal with it in the context of Firm C’s formula. To maintain consistency from year to year, when an abnormal event influences the financial measures, such as excess cash, it is appropriate to remove the non-operating asset from the balance sheet, derive the price result from the formula, then add back the non-operating asset. This will help to maintain a certain level of stability in a stock price and account for a non-operating asset that may only be on the books temporarily.
- Case in point – D. Similar to balance sheet challenges, if a firm’s formula is using metrics derived from the income statement, careful consideration should be given to confirm that the measurement used is representative of normal operating conditions. Firm D’s formula uses earnings before taxes as one of the metrics. Historically, the company’s profitability has been relatively consistent until recently when an extraordinary event took place, costing the firm a significant amount of money that greatly diminished profitability in that year. It is my position that the extraordinary expense should be added back to the earnings before calculating the stock price to reflect normal operating conditions.
If your firm is using a formulaic process to develop a stock price it should be used with care and an in-depth understanding of multiple influencing factors. We suggest that every firm periodically test its formula by going through a formal valuation process. It is a reasonable investment to stay on top of formula pricing results that are being trusted by you and those buying into firm ownership.
Tracey Eaves, MBA, CBA, CVA, BCA, CMEA is a member of the valuation consulting team at Zweig Group. Contact Tracey at firstname.lastname@example.org or directly at 505.258.8821.