Valuing a Closely Held Manufacturer

Editor:

Albert B. Ellentuck, Esq.
Of Counsel
King and Nordlinger, L.L.P.
Arlington, VA

Editor's note: This case study has been adapted from PPC Tax Planning Guide--Closely Held Corporations, 14th Edition, by Albert L. Grasso, Joan Wilson Gray, R. Barry Johnson, Lewis A. Siegel, Richard L. Burris, James A. Keller, Linda Ketter-Craig and Gregory B. McKeen, published by Practitioners Publishing Company, Fort Worth, Tex., 2001 ((800) 323-8241; www.ppcnet.com).

Facts: FabrikCo Inc. is a Texas corporation engaged in the custom metal and plastic fabrication business. The company has been in existence for 25 years and is owned by three sisters, Karen, Ingrid and Helen. Karen and Ingrid manage the business, while Helen is an inactive investor. • Throughout its history, the company has been moderately successful, with sales and profits growing by about 8% annually. However, FabrikCo is now poised for a period of higher sales and profitability due to anticipated new business in the former Eastern Bloc countries. Over the next five years, the company expects to increase sales and profits by about 25% annually, before returning to a more normal growth rate of about 10%. • As of the most recent year-end, FabrikCo's net asset value is $45 million; its liquidation value is $30 million; its after-tax GAAP income is $3 million; and its normalized income is $3.5 million. FabrikCo has no significant identifiable intangible assets and is not highly leveraged (corporate debt is about $10 million). • There are two small publicly traded corporations comparable to FabrikCo in terms of products and past financial performance. They have traded at an average price/earnings (PE) ratio of 13 over the past 12 months. Unlike FabrikCo, however, they have not identified any new markets, and expect sales and earnings to increase only by 7–10% annually in the foreseeable future. • The two sisters who are active in the business both want to cash out and invest the proceeds in a new venture that will produce virtual reality vacation experiences for sale and distribution via the Internet. (The third sister is also amenable to selling out.) They contact their tax adviser to advise them on determining a suitable sale price for the business. Issue: How should FabrikCo be valued for sale to an outside party?

Analysis

Although an earnings-based valuation method would appear to be appropriate, a practitioner can still use the net asset value of $45 million as a check for the absolute lowest value derived from the earnings-based methods. Because comparable company data is available, one of the valuation methods should be a value-multiples method. In this situation, basing a value on the average PE ratios of the two comparable publicly traded companies makes sense. However, because their growth prospects are less favorable than those of FabrikCo, it would be appropriate for a practitioner to use a somewhat higher PE ratio, or to use the PE ratios of the comparable companies as an absolute floor for FabrikCo's value.

In addition, because of the projected five-year period of exceptional growth (25% annually), followed by a return to a more normal growth rate (10% annually after six years), it is clearly acceptable to use a discounted future-returns method to value FabrikCo.

The projected levels of normalized after-tax GAAP income for future years will closely approximate the business's after-tax cashflow. Therefore, the second valuation method can be the discounted net-cashflow method (using normalized GAAP income as a proxy for net cashflow).

Using the average PE ratios of the comparable companies and the projected 2002 normalized after-tax GAAP income, FabrikCo's value would be $56.875 million (13 x $4.375 million).

However, a higher PE ratio may be appropriate for FabrikCo because of its superior growth prospects. If a PE range of 15–18 is considered reasonable, FabrikCo's value could be from $65.625 million (15 x $4.375 million) to $78.75 million (18 x $4.375 million).

The appropriate discount rate must be determined. Assume that 15% is selected. The net cashflows for the next five years (2002–2006) are discounted to present value. The terminal value is calculated by taking the year 2007 net cashflow amount, capitalized at a 10% rate, and then discounted to net present value using the 15% discount rate. The discounted cashflow (DCF) for each year can be found in Exhibit 1.

Thus, there are five estimated values for FabrikCo:

Conclusion

The net asset value is useful only as a check for the lowest value estimated using an appropriate earnings-based method. Accordingly, a professional appraiser (to be hired by the sisters) may very well not consider the $45 million value.

Although the appraiser will make the final determination, the $56.875 million value based on comparable-company PE ratios might serve as an absolute floor value for FabrikCo, because the company has growth prospects superior to the comparable businesses. The best estimate of the reasonable value range for FabrikCo is from $65.625 million (based on a PE ratio of 15) to $78.75 million (based on a PE ratio of 18). The best single estimate of value appears to be the $73.424 million amount based on DCFs.