Deciding whether to normalize the stream of cash flows and what discount rate to use made a difference of roughly $190 million in one case.
By Shannon P. Pratt and Alina V. Niculita, Valuators
We were recently involved as consulting valuation experts in a high-stakes divorce case. The subject of the valuation was the husband’s 1% partnership interest (“Subject Partnership Interest”) in a large, privately-held professional practice organized as a partnership (“Partnership”) with about 100 partners.
The amounts in dispute were indeed high stakes:
- The Partnership valuations ranged between $8 and $10 billion;
- Several valuation experts offered values ranging from $10 million to about $200 million for the 1% Subject Partnership Interest;
Because the husband was both an employee and an owner of equity in the Partnership, he received annual amounts from the Partnership that consisted of a combination of salary, benefits, return on capital, and distributions that ranged from a few hundred thousand to tens of millions of dollars.
To estimate the value of the Subject Partnership Interest, we used the discount cash flow method of the income approach, discounting a stream of future cash flows back to the present using a discount rate based on the cost of capital.
There were several issues in dispute in this case, but two items accounted for most of the difference in the values between roughly $10 million and $200 million for the 1% Subject Partnership Interest:
- Normalization of cash flows and reasonable compensation. Whether or not to normalize the stream of cash flows forecasted to be received in the future by the husband from the Partnership by subtracting from it an annual reasonable compensation amount.
- Discount rate for the discounted cash flow method. What is the appropriate discount rate to be applied to the normalized stream of cash flows after the subtraction of a reasonable compensation amount.
Normalization of Cash Flows
In valuation literature, “normalization” is the process of adjusting the reported levels of economic income on the financial statements of the company subject to valuation. The adjustments may involve either adding back items of expenses or subtracting items of income – usually from pre-tax income, in which case the result is “adjusted pre-tax income” or “normalized pre-tax income.”
Although family law courts are generally familiar with and accept normalization within the capitalization method, the use of normalization is not restricted to the capitalization method: all valuation methods need to use properly adjusted economic income figures as inputs.
The purposes of the adjustments include:
- Providing a foundation for developing future expectations about the subject company;
- Presenting financial data on a consistent basis over time;
- Making the best estimate possible regarding the ongoing earning power of the company.
The ultimate purpose of normalization of economic income is to estimate the ongoing earning power of the subject entity or interest that is expected to prevail in the future under normal business conditions.
One of the adjustments commonly considered as part of the normalization process is the adjustment of owners’ compensation to market levels.
Depending on whether the valuation subject is a business or an interest in a business, the main reason for normalization of owners’ compensation is to estimate either:
- The true earnings of the company (as compared to the reported earnings); or
- The true return on capital (as opposed to return on labor) for owners who are also employees in the business.
The adjustment for an employee/partner’s compensation is performed in two steps:
- Determine market-level replacement compensation (also called replacement cost or reasonable compensation). This is done either using various databases or sources of comparable compensation, or by using consulting experts from the specific industry when the industry is very specialized, and there is not a lot of public data about it.
- Using the cost of replacement model, the difference between the sums paid to the partner (regardless of the label given to the payments or category assigned by the partnership) and the cost of his replacement by a non-partner is either added back to pre-tax profit if the partner’s compensation has been over-stated, or deducted from the pre-tax profit if his compensation has been under-stated.
- If the employee/partner of a partnership is paid a smaller amount in comparison to a non-partner employee, then the reported profits of the business will be overstated. Making the adjustment for reasonable replacement compensation results in the identification and recognition of the actual profits of the partnership – basically resulting in a lower value for the business, all else being equal. On the other hand, if the owners are paid above-market levels of compensation, then the adjustment for market compensation results in a higher value for the business, all else being equal.
How much to adjust the earnings base to reflect discrepancies between compensation paid and value of service performed depends on the purpose of the valuation. In this case, the reasonable compensation adjustment was needed in order to distinguish between the two components of earnings received by the partner: return on labor (compensation for services) and return on capital (return for being a partner in the firm).
Discount Rate for the Discounted Cash Flow Method
A basic principle of the income approach in business valuation is that the discount rate must match the economic income being discounted. The choice of the discount rate is driven by the definition of economic income used in the numerator. The discount rate used in the analysis must be appropriate for the definition of the economic income in the numerator and for the class of capital (or other type of investment) to which it applies. We cannot overemphasize how important it is that the discount rate developed must be matched conceptually and empirically to the definition of economic income being discounted. Also, the discount rate must reflect the degree of risk of the investment.
Beyond the technical issues in the valuation, we learned two other lessons from this case:
- In high-stakes divorce valuations, it is important that the parties have experts of equal caliber. So if the other party hires a nationally-known expert, you would best serve your client by also hiring a nationally-known expert.
- Try to hire the best expert at the beginning of the case, because it may not be possible to hire additional experts later in the process. In this case, the client was “stuck” with the experts originally hired and could not bring in additional experts at trial or at the appeals.
Shannon P. Pratt, CFA, ARM, ABAR, FASA, MCBA, CM&AA, is the founder and Alina V. Niculita, CFA, ASA, MBA, is the president of Shannon Pratt Valuations, Inc., a national business valuation firm located in Portland, OR. Dr. Pratt has more than ten books in print on various business valuation topics, including valuations for marital dissolution purposes, and he has testified in court on hundreds of occasions. Ms. Niculita manages valuation engagements at Shannon Pratt Valuations, and has contributed to several business valuation books. www.shannonpratt.com