Math for Lawyers:

Valuation Theory and Practice 101

December 8, 2011

Agenda

• Introduction

• Presentation

• Questions and Answers ― (anonymous)

• Slides ― now available on front page of Securities Docket

– www.securitiesdocket.com

• Wrap-up

Webcast Series

• Approximately every other week

• December 14: “SEC Enforcement--Key Developments in 2011”

Panel

Jeff Litvak, CPA/ABV/CFF, ASA

Senior Managing Director

Forensic and Litigation Consulting, FTI Consulting

Ken Mathieu, CPA/CFF/ABV

Managing Director

Forensic and Litigation Consulting, FTI Consulting

Business Valuation (BV) Theory and

Principles for Attorneys

December 8, 2011

Jeff Litvak, CPA/ABV/CFF, ASA Ken Mathieu, CPA/ABV/CFF, MBA

Senior Managing Director Managing Director

312.252.9323 312.252.9383

jeff.litvak@fticonsulting.com ken.mathieu@fticonsulting.com

Business Valuation (BV) Overview

■ Introduction

■ Standards of Value

■ Premises of Value

■ BV Standards

■ BV Approaches / Methodologies

■ Discounts and Premiums

■ Financial Statement Analysis

■ Case Study/Conclusion of Value

− 6 −

I. Introduction:

What is Business Valuation?

What is Business Valuation

Business Valuation:

The act or process of determining the VALUE of a business,

business ownership interest, security, or intangible asset.

− 8 −

What is Value?

■ Is value an absolute or relative measure?

■ Is value inherent in the asset being valued or is it impacted

by perception?

■ Can there be more than one value for a certain asset at a

particular point in time? If so, why?

■ Is the concept of value time-dependant?

− 9 −

Concept of Value

Due to factors such as opportunity costs and inflation:

10

A dollar today…

. . . is worth more than a

dollar tomorrow

Concept of Value (cont.)

11

Source: Uniform Standards of Professional Appraisal Practice

■ Value is an economic concept; as such

■ it is an OPINION of the worth of an asset

■ at a given time

■ in accordance with the specific definition of value.

What Creates Value?

Investors assign value based on the FUTURE

ECONOMIC BENEFITS

The value of a cash flow stream is a function of:

■ The timing of cash receipts

■ The risk that less cash than expected will be received

12

When is Valuation Needed?

■ Litigation

■ Bankruptcy

■ Marital Dissolution

■ Damages caused to business

■ Compliance

■ Determination of Estate & Gift taxes

■ Employee Stock Ownership Plans (ESOPs)

■ Purchase Price Allocation

■ Goodwill Impairment Testing

■ Strategic

■ Purchase/Sale of business or shares

■ Fairness Opinions

− 13 −

Case Study

■ Subject Company: Dunder Muffler Paper Company

■ Industry: Paper Manufacturing

■ Valuation Date: December 31, 2009

■ Interest Valued: 40% (Minority)

■ Premise of Value: Going Concern

■ Standard of Value: Fair Value

■ Purpose of Valuation: Shareholder Dispute

− 14 −

II. Standards of Value

Standards of Value

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1. Fair Market Value

2. Investment Value

3. Intrinsic Value

4. Fair Value

Fair Market Value

Standards of Value (Cont.)

■ The PRICE, expressed in terms of cash equivalents, at which property

would change hands between

■ a hypothetical willing and able buyer

■ a hypothetical willing and able seller

■ acting at arms length

■ knowledge of the relevant facts.

− 17 −

Investment Value

Standards of Value (Cont.)

■ Value to a PARTICULAR INVESTOR based on individual investment

requirements and expectations.

− 18 −

Intrinsic Value

Standards of Value (Cont.)

■ The value that a prudent investor considers to be the “true” or “real”

value that will become the market value.

− 19 −

Fair Value – (Two Types):

Standards of Value (Cont.)

■ Fair Value (State Rights) - minority interest (i.e., not a “willing” seller)

■ Fair Value (Financial Reporting) - SFAS 141R, SFAS 142, and SFAS

157

SFAS 157 defines Fair Value as:

“The price that would be received to sell an asset or paid to transfer a

liability in an orderly transaction between market participants at

the measurement date.”

− 20 −

III. Premises of Value

Premises of Value

Premise of value refers to the appropriate CONTEXT or set of

circumstances to consider with respect to the valuation, including:

■ Going concern value

■ Liquidation value

− 22 −

IV. BV Standards

BV Standards

The U.S. professional associations that publish business valuation

standards are:

■ American Institute of Certified Public Accountants (AICPA)

■ American Society of Appraisers (ASA)

■ Institute of Business Appraisers (IBA)

■ National Association of Certified Valuation Analysts (NACVA)

■ The Appraisal Foundation (TAF)

24

BV Standards: AICPA

SSVS1 – Stmt. on Standards for Valuation Services No. 1

AICPA members will be required to follow this standard when they perform

engagements to estimate value that culminate in the expression of a

conclusion of value or a calculated value.

Exception from this Statement:

This Statement is not applicable to engagements that are

exclusively for the purpose of determining ECONOMIC DAMAGES (for

example, lost profits) unless those determinations include an engagement

to estimate value.

25

IV. BV Standards: ASA

I. General Requirements for Developing a Business Valuation

II. Financial Statement Adjustments

III. Asset-Based Approach to Business Valuation

IV. Income Approach to Business Valuation

V. Market Approach to Business Valuation

VI. Reaching a Conclusion of Value

VII. Valuation Discount and Premiums

VIII. Comprehensive Written Business Valuation Report

IX. Intangible Asset Valuation

26

BV Standards: ASA (cont.)

SBVS-1 The guideline company valuation method

SBVS-2 Merger and acquisition method

■ Advisory Opinions (AO) - Asset-Based Approach to Business

Valuation

■ Procedural Guidelines (PG) – Litigation support: Role of the

independent financial expert

27

BV Standards: IBA

Standard One Professional Conduct & Ethics

Standard Two Oral Appraisal Reports

Standard Three Expert Testimony

Standard Four Letter Form Written Appraisal Reports

Standard Five Formal Written Appraisal Reports

Standard Six Preliminary Reports

Standard Seven Conducting A Business Appraisal Assignment

28

BV Standards: USPAP

Standard No. 9 Business Appraisal, Development

Standard No. 10 Business Appraisal, Reporting

29

BV Standards:

Revenue Ruling 59-60

Nature and history of the

business

Economic and industry outlook

Financial condition

Earning capacity

Dividend-paying capacity

Intangible value

Sales of the stock

Market price of stocks of

comparable corporations

30

V. BV Approaches / Methodologies

BV Approaches

Three basic approaches to determining value:

Asset Approach (also, Cost Approach)

Market Approach

Income Approach

Under each approach, there are multiple “methods.” The use of one or

several approaches (or methods) may be appropriate.

32

BV Approaches: Asset Approach

Primary Method:

Adjusted Net Asset Value (NAV) Method – The balance sheet is restated

from historical cost to market/fair value

o NAV = market value of assets LESS market value of liabilities

33

BV Approaches: Market Approach

Overview:

■ Bases on the principal of SUBSTITUTION

■ A buyer would pay no more than the cost to acquire a substitute

property with the same utility

■ Can be used for both control and minority level valuations

34

BV Approaches: Market Approach

(cont.)

Two primary methods:

■ Guideline Public Company Method

■ Based on sales of similar publicly traded company shares

■ May require adjustments for small and medium sized companies due to

size, capital structure, and other differences

■ Merger and Acquisition Transaction Data Method

■ Based on acquisition of similar privately held or publicly traded

companies

■ Consider aspects of companies involved in the comparable transactions

35

BV Approaches: Market Approach

(cont.)

Example: Dunder Muffler Paper Company

Comparable Transaction Database:

36

SIC Filing Date Purchaser Company Name MVIC/EBITDA

2631 6/6/2000 Smurfit-Stone Container Corporation St. Laurent Paperboard, Inc. 9.8

2621 6/27/2000 Nashua Corporation Rittenhouse Paper Company 12.5

2671 10/30/2000 Pechiney SA JPS Packaging Company 12.2

2676 11/6/2000 Cascades, Inc. Wyant Corporation 4.8

2621 10/26/2001 Bowater, Inc. Alliance Forest Products, Inc. 8.2

2676 12/27/2001 Tyco International, Ltd. Paragon Trade Brands, Inc. 9.3

2631 3/8/2002 Westvaco Corporation Mead Corporation 8.3

2621 5/15/2002 MeadWestvaco Corporation Westvaco Corporation 7.9

2621 5/15/2002 Weyerhaeuser Company Willametter Industries, Inc. 11.1

2671 10/23/2002 Alcoa, Inc. Ivex Packaging Corporation 7.8

2653 3/20/2003 Temple-Inland, Inc. Gaylord Container Corporation 8.9

Average 9.2

Median 8.9

BV Approaches: Market Approach

(cont.)

37

Dunder Muffler TTM EBITDA $27.6 million

Earnings Multiple x 9.0

Market Approach Value $248.4 million

Example: Dunder Muffler Paper Company (cont.)

BV Approaches: Income Approach

Overview:

■ Based on the PRESENT VALUE of

expected future benefits

■ Discounted or capitalized cash flow

methods

■ Used for both control and minority

level valuations

38

Year 0 Year 2 Year 3 Year 1 Year 4 Year 5 Terminal

Annual Cash Flow

Net Present Value

$ $ $ $ $ $$$

Discount to Present Value

BV Approaches: Income Approach

(cont.)

■ Discounted Cash Flow (DCF) Method

■ Projects future cash flows for a number of years

■ Terminal value

39

■ Capitalized Income Method

■ Estimated future cash flow is capitalized

■ Often used for companies with stable growth rates

Two primary methods:

BV Approaches: Income Approach

(cont.)

Discounted Cash Flow Method

■ Cash flows included in projections

■ Cash flow to equity

■ Cash flow to market value of invested capital (MVIC)

■ Normalized cash flows for terminal value calculation

■ Long-term growth rate

■ Cost of capital

40

BV Approaches: Income Approach

(cont.)

■ Capitalization of NORMALIZED cash flows

■ GDP, inflation, or industry long-term expected growth

■ Capitalization Rate = Discount Rate – Long-term growth rate

41

TERMINAL Value = Normalized CF/(WACC – g)

BV Approaches: Income Approach

(cont.)

■ Determine the NORMALIZED EBITDA or EBIT for the final year of

the explicit forecast period

■ Apply the appropriate EBITDA or EBIT multiple

42

TERMINAL Value = Normalized CF x Exit Multiple

Terminal Value Using Exit Multiple:

BV Approaches: Income Approach

(cont.)

43

Example: Dunder Muffler Paper Company

For the years ended December 31 2010 2011 2012 2013 2014 Terminal

Operating income 20,887$ 21,514$ 22,159$ 22,824$ 23,509$

Depreciation 11,272 11,272 11,272 11,272 11,272

Amortization 178 178 178 178 178

EBITDA 32,337 32,964 33,609 34,274 34,959

Income tax expense ($2,048) ($2,109) ($2,172) ($2,238) ($2,305)

Capex ($9,000) ($9,000) ($9,000) ($9,000) ($9,000)

WC ($3,000) ($3,000) ($3,000) ($3,000) ($3,000)

Free Cash Flow $18,290 $18,855 $19,437 $20,037 $20,654 $287,872

Discount Factor 0.9518 0.8622 0.7810 0.7075 0.6409 0.6100

Discounted Cash Flow $17,408 $16,256 $15,181 $14,176 $13,238 $175,610

Net Present Value $251,870

(in thousands)

Cash Flow Projections

Dunder Muffler Paper Company

BV Approaches

Primary valuation approaches by asset type:

44

Asset Type Asset Approach Market Approach Income Approach

Business

Real Property

Machinery &

Equipment

Intangible Assets

Financial Assets

VI. Discounts and Premiums

Discounts and Premiums

46

■ Some of the common discounts and premiums are:

■ Control premium – An amount by which the pro rata value of a

controlling interests exceeds a non-controlling interest.

■ Discount for lack of control (or, minority discount) (“DLOC”) – An

amount deducted from the pro rata share value of 100% interest

to reflect the absence of the power of control.

■ Discount for lack of marketability (“DLOM”) - An amount deducted

from the pro rata share value of 100% interest to reflect the

relative absence of marketability.

■ Valuation discounts and premiums are supported by empirical

market studies.

VII. Financial Statement Analysis

Financial Statement Analysis

Basic Analytical Techniques:

■ Growth/Trend analysis

■ Common size analysis

■ Examine Cash Flow from

Operations section of items that

reconcile financial accounting and

cash flow

■ Compare cash flows to income

statement

48

Financial Statement Analysis (Cont.)

Some things to look for in historical financials:

■ Increasing/decreasing profitability

■ Increasing/decreasing financial leverage

■ Increasing/decreasing capital expenditures or R&D

■ Increasing/decreasing net working capital items

■ Increasing/decreasing other assets/liabilities

■ Related income statement and balance sheet items growing at

significantly different rates

49

Financial Statement Analysis (Cont.)

Consider how historical trends will affect the future cash flows :

■ Is revenue growth sustainable?

■ Given operational leverage, how will COGS react to revenue increases?

■ Are SG&A expenses fixed or variable?

■ Is the debt burden manageable? Will debt covenants be met?

■ Is company collecting on its sales?

■ Is the company continuing to invest in growth?

■ How much of revenue increase is lost in increased net working capital?

50

Financial Statement Analysis (Cont.)

Ratio analysis can allow an analyst to :

■ Spot historical trends

■ Compare one company to another (guideline company benchmarking)

■ Review public analyst reports

51

In Practice:

■ Ratios are commonly used by lenders to determine how much to lend and

to set covenants

■ Equity analysts use ratios to predict target stock prices

■ Multiples are nothing more than ratios of value

Financial Statement Analysis (Cont.) Four major types of ratios :

■ LIQUIDITY ratios – measure an entity’s

short-run ability to pay its maturing

obligations

■ ACTIVITY ratios – measure how effective

the enterprise is using the assets employed

■ PROFITABILITY ratios – measure the

financial performance of an entity over a

period of time

■ LEVERAGE/COVERAGE ratios – measure

the degree of protection for long-term

creditors and investors

52

Financial Statement Analysis (Cont.)

Examples of LIQUIDITY ratios:

■ LIQUIDITY ratios – measure an entity’s short-run ability to pay its

maturing obligations

Current ratio: current assets

current liabilities

Quick test: cash, marketable securities, AR

current liabilities

53

Financial Statement Analysis (Cont.)

Examples of ACTIVITY ratios:

Receivable turnover: net sales

average trade receivables

Inventory turnover: COGS

average inventory

Asset turnover: net sales

average total assets

54

Financial Statement Analysis (Cont.)

Examples of PROFITABILITY ratios:

EBITDA margin on sales: EBITDA

net sales

Return on assets: net income

average total assets

Return on common equity: net income – preferred dividends

average total assets

55

Financial Statement Analysis (Cont.)

Examples of LEVERAGE/COVERAGE ratios:

Debt to total equity: debt

total equity

Times interest earned: EBIT

interest expense

56

Rationale Behind Ratio Analysis

Ratio and Financial Analyses Why is it important?

Financial analysis tools and techniques can:

■ Isolate trends (positive and negative)

■ Help identify strengths and weaknesses

Basic financial analysis tools include:

■ Common size financial statements

■ Ratio analysis

■ Trend analysis of common size statements and ratios

57

VIII. Conclusion of Value / Case Study

Conclusion of Value

Subject Company: Dunder Muffler Paper Company

Industry: Paper Manufacturing

Valuation Date: December 31, 2009

Interest Valued: 40% (Minority)

Premise of Value: Going Concern

Standard of Value: Fair Value

Purpose of Valuation: Shareholder Dispute

59

Conclusion of Value - CASE STUDY

In arriving at the conclusion :

■ Reconcile valuation approaches

■ Reliability of the results under the different approaches

■ Determine whether the conclusion of value should reflect the

results of:

■ One approach or method or

■ A combination of the results of one or more approaches and methods

60

Conclusion of Value –

CASE STUDY (Cont.) Historical Financial Performance:

61

For the years ended December 31 2005 2006 2007 2008 2009

Total revenues 307,500$ 293,231$ 338,615$ 369,911$ 397,627$

Costs and expenses:

Cost of products sold 256,490 249,079 293,269 320,061 344,470

SG&A 27,843 28,968 30,797 30,871 32,464

Research and development 191 529 262 238 180

Other expenses 744 356 227 109 4,375

Total costs and expenses 285,268 278,932 324,555 351,279 381,489

Operating income 22,232 14,299 14,060 18,632 16,138

Interest income 73 57 47 101 128

Interest expense (169) (296) (233) (215) (238)

Income before income taxes 22,136 14,060 13,874 18,518 16,028

Net Income 22,095$ 13,962$ 13,033$ 17,241$ 14,514$

(in thousands)

Combined Statements of Income

Dunder Muffler Paper Company

Conclusion of Value –

CASE STUDY (Cont.)

Forecasted Financial Performance:

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For the years ended December 31 2010F 2011F 2012F 2013F 2014F

Total revenues 409,556$ 421,842$ 434,498$ 447,533$ 460,959$

Costs and expenses:

Cost of products sold 352,218 362,785 373,668 384,878 396,424

SG&A 34,812 35,857 36,932 38,040 39,181

Research and development 410 422 434 448 461

Other expenses 1,229 1,266 1,303 1,343 1,383

Total costs and expenses 388,668 400,329 412,338 424,709 437,450

Operating income 20,887 21,514 22,159 22,824 23,509

Interest income 132 136 140 144 148

Interest expense (410) (422) (434) (448) (461)

Income before income taxes 20,610 21,228 21,865 22,521 23,196

Net Income 18,562$ 19,119$ 19,692$ 20,283$ 20,892$

(in thousands)

Combined Statements of Income

Dunder Muffler Paper Company

Conclusion of Value –

CASE STUDY (Cont.)

Income Approach: Discount Rate (Build Up Method):

63

Risk Free 4.6%

ERP 5.0%

Size Premium 4.0%

Industry Premium 1.0%

Company Specific Risk 2.0%

Cost of Equity 16.6%

Cost of Debt 7.0%

Tax Rate 40.0%

After Tax Cost of Debt 4.2%

Percent Debt 50.0%

Percent Equity 50.0%

WACC 10.4%

Conclusion of Value –

CASE STUDY (Cont.)

Income Approach: Cash Flow Projections

64

For the years ended December 31 2010 2011 2012 2013 2014 Terminal

Operating income 20,887$ 21,514$ 22,159$ 22,824$ 23,509$

Depreciation 11,272 11,272 11,272 11,272 11,272

Amortization 178 178 178 178 178

EBITDA 32,337 32,964 33,609 34,274 34,959

Income tax expense ($2,048) ($2,109) ($2,172) ($2,238) ($2,305)

Capex ($9,000) ($9,000) ($9,000) ($9,000) ($9,000)

WC ($3,000) ($3,000) ($3,000) ($3,000) ($3,000)

Free Cash Flow $18,290 $18,855 $19,437 $20,037 $20,654 $287,872

Discount Factor 0.9518 0.8622 0.7810 0.7075 0.6409 0.6100

Discounted Cash Flow $17,408 $16,256 $15,181 $14,176 $13,238 $175,610

Net Present Value $251,870

(in thousands)

Cash Flow Projections

Dunder Muffler Paper Company

Conclusion of Value –

CASE STUDY (Cont.)

Market Approach

65

$27.6 million EBITDA x 9.0 = $248.4 million

SIC Filing Date Purchaser Company Name MVIC/EBITDA

2631 6/6/2000 Smurfit-Stone Container Corporation St. Laurent Paperboard, Inc. 9.8

2621 6/27/2000 Nashua Corporation Rittenhouse Paper Company 12.5

2671 10/30/2000 Pechiney SA JPS Packaging Company 12.2

2676 11/6/2000 Cascades, Inc. Wyant Corporation 4.8

2621 10/26/2001 Bowater, Inc. Alliance Forest Products, Inc. 8.2

2676 12/27/2001 Tyco International, Ltd. Paragon Trade Brands, Inc. 9.3

2631 3/8/2002 Westvaco Corporation Mead Corporation 8.3

2621 5/15/2002 MeadWestvaco Corporation Westvaco Corporation 7.9

2621 5/15/2002 Weyerhaeuser Company Willametter Industries, Inc. 11.1

2671 10/23/2002 Alcoa, Inc. Ivex Packaging Corporation 7.8

2653 3/20/2003 Temple-Inland, Inc. Gaylord Container Corporation 8.9

Average 9.2

Median 8.9

Conclusion of Value –

CASE STUDY (Cont.)

Conclusion of Value: 40% Interest in Dunder Muffler

66

Value

(in millions) Weight

Market Approach $248.4 30%

Income Approach 251.9 70%

Invested Capital Value 250.9

Debt (10.2)

Indicated Value of 100% Controlling Interest 240.7

Fair Value of 40% Minority Equity Interest $96.3

Conclusion

Basic Valuation Process:

Define subject of Valuation

Valuation Date

Purpose of Valuation

Historical Financial Analysis

Financial Forecast

Comparable Company Analysis

Valuation using all three approaches

Conclusion of Value

67

QUESTIONS?

Thank You for Your Time