ESOP valuations may be at a turning point

At last week’s inaugural ESOP Virtual Conference hosted by the American Society of Appraisers, the landmark Bowers case was discussed, which could represent a turning point for ESOP valuations.

Here’s the story: For over a decade, the Department of Labor has had a very aggressive enforcement stance and had not lost a major ESOP case on a valuation issue. But its winning streak ended with the Bowers case, which involved many key valuation issues that came up in prior cases as well. As in those cases, the DOL alleged that the ESOP paid more than fair market value for stock of the sponsor company. Valuation experts have long maintained that the DOL has been playing by its own valuation rules—rules that are not consistent with accepted valuation standards. But the DOL had a long track record of success using its own rules. In a stunning rebuke, the district court ruled against the DOL, stressing that the agency failed to follow standard valuation practices.

The case is “very good news” for the valuation profession, speakers at the ASA conference said, and it is “very helpful” to the ESOP community as well. The case could change the course of litigation, and it also may open the door for the DOL to finalize (at long last) regulations regarding ESOP valuations that were proposed back in 1988 (yes, 1988). Instead of finalizing the regs, the DOL has been “legislating through litigation” and through a series of settlements (process agreements) between the agency and ESOP trustees. Some of the more recent settlements have not been favorable to the DOL, speakers said, so they have not been made public.

The case is Walsh v. Bowers, 2021 U.S. Dist. LEXIS 177184 (Sept. 17, 2021), and a case analysis and the full opinion are available on the BVLaw platform.

Extra: The testifying valuation experts in the Bowers case discussed details in an article that appeared in Business Valuation Update.

Appeals court affirms modified liquidation value in shareholder dispute

In a Michigan shareholder deadlock case, a special master recommended that a sale of shares from one shareholder to the other would yield more value than if the company were dissolved. The special master used a “modified liquidation value,” which was close to the middle between the liquidation value and the fair market value of the shares. The valuation did not account for cash advance receivables, the value of noncompetition agreements, or a going-concern value. It also did not consider certain expenses that would have been incurred if the company were dissolved. The plaintiffs challenged the valuation, but the appeals court affirmed it, finding no clear error on the part of the trial court. Plus, the parties showed an initial willingness to sell their stock for the amount the valuation indicated.

The case is Pitsch v. Pitsch Holding Co., 2022 Mich. App. LEXIS 2730; 2022 WL 1508774, and a case analysis and full opinion are available on the BVLaw platform.

Butler comments on Damodaran’s ‘dynamite’ remarks regarding COE

Last weeks’ issue covered some very choice words (some of which we can’t print here) Aswath Damodaran (New York University Stern School of Business) made about various inputs some analysts use to determine the cost of equity (COE). His remarks triggered some comments from Peter J. Butler (Valtrend), who is the co-developer of the Butler Pinkerton Calculator, which offers empirical data for total cost of equity (TCOE) and company-specific risk premiums (CSRP).

“I listened to Professor Damodaran’s excellent presentation the other week titled, ‘In Search of a Steady State: Inflation, Interest Rates, and Value; The (Inflation) Genie Escapes the Bottle!’ And yes, as BVR indicates, the professor threw some dynamite on how some (but not all) appraisers develop a cost of equity for their privately held company, such as the use of:

• “A ‘normalized’ risk-free rate—whatever that is;

• “A stagnant and backward-looking historical risk premium; and

• “The alleged and dubious size premium, which he calls fiction.”

Butler continues: “He also offered some choice words over the use of the company-specific risk premium (CSRP). For what it’s worth, I have never used a CSRP either (although I have previously been lazy and called what I am actually capturing—an unsystematic risk premium—a CSRP to match, generally speaking, the BV community’s faulty nomenclature).”

“For what it’s worth, I have never added a completely qualitative CSRP to my cost of equity—to make my valuations ‘make sense,’” he says. “I have never had a subject company that is just so unique—so company-specific—that no other company in the world has the same (or at least very similar) risk profile. Rather, I have added an unsystematic risk premium in many (but not all) of my valuations for the last 15-plus years to adjust for the less-than-perfect diversification of hypothetical willing buyers and willing sellers in the private marketplace. How do I do this? ‘Simply’ with the use of total beta, which explicitly captures total risk and, therefore, implicitly captures unsystematic (and systematic) risk. Thus, there is no need to build up the rate and potentially and easily double count risk.”

Butler concludes: “If appraisers use beta in their development of the cost of equity, which I believe we all do in one form or another, it is time to start getting the full benefit of publicly traded stock returns. The only way to do that is to also use total beta.”

Extra: A full recap of Damodaran’s remarks on how to assess inflation’s impact on company valuation will be in the August issue of Business Valuation Update.

The DCF is ‘untestable,’ per new paper

The discounted cash flow method works fine for bonds but not for businesses, projects, or stocks because it is untestable, claims a new paper. “While bonds can be viewed as examples of DCF pricing, this depends on their prices often being observable and their ‘expected’ cash flows typically being bounded above by their promised cash flows,” writes the paper’s author, J.B. Heaton (One Hat Research LLC). “For capital projects, businesses, and common stocks, there is simply no way to determine whether a DCF valuation is a good representation of the causal mechanisms behind market values.” The paper, “The DCF Valuation Methodology Is Untestable,” seems to relate price to value, which valuation analysts know are two different concepts.

Date change for webinar on new Stark FMV regs

Part 1 of a two-part BVR webinar series on the new Stark FMV regs, originally scheduled for June 28, will be held on July 26. The webinar, The New Stark FMV Is a Game-Changer: Foundational Concepts and Valuation Methodology, will be conducted by Timothy R. Smith (TS Healthcare Consulting), who will provide a critical and in-depth assessment of the new definitions of fair market value under the regulations for the federal physician self-referral law commonly known as the Stark Law. Smith is the author/editor of a new book, The Complete Guide to Fair Market Value Under the Stark Regulations, which will be available soon from BVR.

Global BV News

CBV Institute’s new board reflects commitment to diversity

Almost half of the 2022-23 board of directors of the CBV Institute are female, but the organization “will not stop here,” said Dr. Christine Sawchuk, the group’s president and CEO.

“Our efforts to achieve even broader diversity will remain an ongoing focus of our governance efforts.” The full slate of new board members can be found if you click here. The new board chair is Patrick Coady, a partner at KPMG (Ottawa, ON), who praised past board chair, Anish Chopra. “I know I speak for the entire board when I say Anish’s dedication to the Institute, along with his commitment to governance excellence and the Institute’s strategic direction, is greatly appreciated. It is safe to say he left his mark.” The CBV Institute is Canada’s valuation professional organization (VPO) and standard-setter.

IVSC annual meeting in Fort Lauderdale, Fla., September 14-16