ESOP Valuation - Part 5

A Closer Look at the Valuation Report

Other articles in this series on ESOP valuation have touched on who hires the ESOP appraiser and which documents are needed by the ESOP appraiser to perform a valuation.  In this article, we will discuss the general contents of a valuation report in the context of an annual administrative ESOP update valuation.  This report is required by ERISA law as well as by the Department of Labor, one of the two regulatory agencies overseeing ESOPs (the other agency being the Internal Revenue Service).

Typically, a valuation report begins with an Executive Summary, which includes a description of the assignment, a summary description of the subject company, the key regulatory requirements underpinning the analysis and disclosures included in the body of the report, the scope of work, and, finally, the conclusion of value.

The second section of the report lays out the understanding of the subject company including the company's background and history, products/services offered, company facilities and location(s), equipment, customers/clients, markets served, marketing approach, competition and competitive forces, suppliers/vendors, employees, management team, capitalization and ownership, and, depending on which valuation methodology is used, management's expectations.  An understanding of the nature of the business and the history of the enterprise from its inception is necessary in determining the fair market value of an ownership interest in a closely held business.

The third section covers the economic and industry forces at play as of the valuation date.  An understanding of the economic environment in which a business operates and the condition and outlook of the specific industry is necessary in order to identify and understand the economic variables that affect its operations.  An understanding of the economic outlook is fundamental to developing reasonable expectations about a business's future prospects.

The fourth section contains the financial analysis of the subject company, including the financial adjustments made to the company's financial statements and a comparison of the company's financial ratios to the industry ratios.  A business's reported financial condition and earnings should be adjusted to reflect the true economic reality of the business operation.  An understanding of the historical and expected financial condition and earnings capacity of the business is an important factor in determining the value of a business.

The fifth section presents the valuation implications of the factors presented earlier in the report, factors such as the company's earnings, operating and financial risk, national and local economic factors, the industry in which the company competes and operates, and the comparisons drawn between the company and its peers in terms of growth, profitability, leverage, liquidity, and asset management.  This section attempts to synthesize all of the analysis shared in prior sections of the report and draws certain conclusions as to the valuation implications of the factors listed above.

The sixth section presents the various valuation methodologies considered for the valuation and ultimately which method(s) were relied on (and why) in the final conclusion of value.

The next few sections are dedicated to an in-depth presentation of each of the valuation methods employed in the valuation.  A section is devoted to each method.  The most commonly used valuation methods are the:

-    Capitalization of earnings method
-    Discounted future earnings method
-    Comparable transactions method
-    Guideline public companies method
-    Adjusted net assets method

The section following the presentation of the methods is reserved for a discussion of the discount(s) and premium(s), if any, that were applied to the preliminary values and adjusts the results from the methods for differences in the level of control and marketability so that they are appropriate given the ownership interest being valued. This section also discusses a very important element of any successfully managed ESOP, the repurchase liability obligation (RO), a future obligation of the sponsoring company that quantifies the company's expected future cash outlays to departing ESOP participants.  The section concludes by opining as to whether or not the RO will have a material effect on the relative size of the discount for lack of marketability.

The final brief section (before exhibits) presents the conclusion of value, typically presented as the fair market value per share of the company's common or preferred stock.  If the company has any non-operating assets or liabilities, they are added or subtracted from the equity value of the operating assets.  In addition, the current value per share is compared to previous years' values and the main reason(s) for the change in the current year's value vis-a-vis the previous year is discussed.

Subsequent sections consist of exhibits including a statement of limiting conditions and assumptions, the appraiser's certification, the appraiser(s)' qualifications, sources of information (a bibliography), the company's financial statements, a summary of significant forecast assumptions (when forecasted information is presented in the report), the cost of equity capital components underlying the income approach, definitions of financial ratios, and a glossary of business valuation terms.

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