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Why Has The Value Changed this Year?
By
Barry R. Goodman, ASA, CFA, CPA, ABV, CBA
ADVANCED VALUATION ANALYTICS
BUSINESS VALUATION CONSULTANTS
INTRODUCTION
Among their duties, the trustees of the Employees’ Stock Ownership Plan (“ESOP”) are
charged with the fiduciary duty of monitoring any changes in the value of the stock held
by the ESOP. It is the purpose of this article to discuss the reasons why the value might
change, as well as to explore how this change in value might be communicated to the
trustees and to the participants of the ESOP.
The causes of a change in the value of the ESOP stock can be internal or external. Internal changes would include changes that are specific to the sponsor/employer of the
ESOP, such as changes in the nature of the business of the sponsor, changes in key personnel, changes in earnings, and changes in the financial position of the sponsor (such as
increased levels of debt). External factors include changes in interest rates, changes in
equity returns, changes in the economy affecting the sponsor’s operations and changes to
the specific industry environment in which the sponsor operates.
INTERNAL FACTORS
Change in Business If the sponsor closes locations, makes acquisitions, or simply
changes the type of business that it does, this must be considered in the valuation process.
The reasons for these business modifications, along with their expected outcomes in
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terms of changes to cash flow or financial position, are also considered. Changes in the
line of business can mean a corresponding change in the way in which the market approach to valuation is applied.
Change in Personnel The departure of one or more key employees can have a significant
impact on the expected cash flow of the business. Even if the most recent year’s earnings
are significantly higher and the financial position (balance sheet) is stronger, the loss of
one or more key personnel can foreshadow substantially lower profits in the future. A
good appraiser will consider this, and may very possibly determine that the value has declined despite the higher earnings. For example, in the case of one corporation that our
practice recently valued, the company lost its top marketing person and one of its manufacturing managers. These two individuals took approximately 60 percent of that company’s revenue with them, obviously a substantial factor in the valuation.
Change in Profits/Cash Flow The definition of value is the present value of the expected future cash flow. In one way or another, a vast majority of businesses will be valued using some cash flow or income as a major factor. Regardless of the valuation methods used, a substantial increase in a company’s cash flow capacity will normally result in
a substantial increase in the value of that company’s stock. Similarly, a substantial decline in the cash flow capacity will normally result in a decline in value. Cash flow capacity is sometimes referred to as anticipated benefits. An important point to be made is
that the anticipated benefits figure is a “forward-looking” concept. That is, historic cash
flow figures are relevant in the estimation of anticipated benefits only to the extent that
they give some insight as to the cash flow that the company is likely to generate in the
future. For example, if the current year’s cash flow has increased by 25% from the previous year’s cash flow, this would normally point to a higher value. If, however, next
year’s earnings are expected to decline by 33%, then this 25% increase might be nullified
in terms of its effect on the anticipated benefits figure.
Change in Financial Position The value of the company could be significantly affected
by a change in the balance sheet. The most obvious change would be the assumption of
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substantial ESOP debt at the time that the ESOP purchased company stock. Normally,
the value that is used as an adequate consideration figure, which is used to determine
whether the ESOP is overpaying for the company stock, does not directly consider the
manner in which the ESOP will finance its purchase. For that reason, the ESOP debt will
not be directly considered at the time the transaction is completed. 1 In the first update
appraisal, however, this debt will be considered in the valuation process. For example, if
the ESOP purchased all of the stock of a company that was valued at $10 million, and
used a $10 million loan to finance that purchase, there is little question that the first update appraisal would result in a substantially lower value.
EXTERNAL FACTORS
External factors can be defined as those factors over which the management of the company being valued has little or no control. Changes in these factors can significantly affect the value of a company from year to year.
The Economy in General The general condition of the international and national economies, as well as the economy of the region in which a company operates, typically produces a significant impact on business that can change value. For example, a weak economy can result in lower sales, supply shortages, problems in servicing and securing debt
and other problems. On the other hand, aside from higher profits, a strong economy can
mean shortages of labor and higher prices to pay for supplies and goods manufactured.
Indeed, a very strong economy can be a negative factor and a weak economy can be a
positive factor for some companies. Pawn shops, for example, typically thrive during
weak economic conditions.
Interest Rates Aside from affecting the condition of the economy in general, higher interest rates directly impact the value of equity securities in theory. Equities must compete with fixed-income investments, such as bonds and certificates of deposit, for investors. As interest rates rise, companies must offer higher returns to investors in order to
1See Report on Valuation Considerations for Leveraged ESOPs, (Washington, D.C.: The ESOP Association, 1998), p. 15.
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compensate them for the additional risks that equities involve. For example, if historic
equity returns have been 13%, but interest rates have risen to the point where U.S. Treasury notes are yielding close to 13%, investors would generally see little attraction in equities. For that reason, those who are selling equities, such as other investors and companies making equity offerings to the public, would have to offer returns higher than 13% in
order to attract investors. Thus, when interest rates increase, capitalization rates and discount rates also increase. Higher capitalization rates and discount rates mean generally
lower equity values.
The Stock Market Trends To what extent should a significant decline in the general equity market translate into lower prices for the stocks of closely held companies? The answer to this question involves some very subjective decisions on the part of the appraiser.
For example, if the decline in the general level of the stock market has resulted in substantially lower prices for the stocks of companies in the same industry as the company
being valued, as well as in a weaker merger/acquisition market, then some decline in the
value of the stock of the closely held company may be called for. A 10 percent decline in
the Dow Jones Industrials, however, should not automatically translate into a 10 percent
decline in the value of the stock of a closely held company in a niche business.
The Industry/Competition The condition and structure of the industry environment in
which a company operates can have a significant impact on the operations of that company. Substantially lower commodity prices, intensifying competition, industry consolidation and other similar factors can have quite a significant effect on the operations of an
enterprise within the industry. Industry consolidation, for example, can mean significantly increasing competition from those larger companies that are able to secure goods and
supplies at lower prices. On the other hand, consolidation can also mean a much stronger
merger/acquisition market if a particular company fits the profile of a potential consolidation acquisition target.
A deterioration in industry conditions can cause an appraiser to pay less attention to
strong historic earnings and more attention to possibly lower earnings that the company
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being appraised may experience in the future due to the worsening industry situation.
Again, some averaging of historic earnings and/or cash flow should not automatically be
used to indicate earnings or cash flow capacity for a company being appraised.
SUMMARY AND CONCLUSIONS
The appraiser and the trustees must be prepared to communicate to the participants why
the value of the ESOP’s stock has increased or decreased from the previous year. Clearly, the appraiser must fully inform the trustees, taking great care to explain the factors
influencing the appraisal; it is the trustees who should then inform the participants. Appropriate exhibits and illustrations can frequently be of great benefit in this explanatory
process.
In summation, there can be many different factors that cause the value of the ESOP stock
to increase or decrease from one year to the next. It is part of the appraiser’s task to prepare a report that properly communicates the reasons for these changes to the trustees,
and it is part of the task of the trustees of the ESOP to communicate the reasons for the
change in value to the participants of the ESOP. Unfortunately, the reasons for changes
in the value of the ESOP stock cannot be simplified. A 10 percent increase in earnings,
for example, does not automatically translate into a 10 percent increase in the value of the
ESOP’s stock. Clearly understood explanations and appropriate communication among
the participants in the process are vital if the appraiser’s task is to be successfully completed.
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