Valuing Pass-Through Entities Using the Guideline Public Company Method

January 1, 2015 | Download PDF

Pass-through entities (PTEs) comprise approximately 78% of all business entities, yet their valuation is one of the most discussed, controversial and least understood areas of business appraisal practice. Much attention has been focused on valuing PTEs, yet there remains a lack of clarity and consensus. In this article, Barr critiques the manner in which business appraisers have historically applied the Guideline Public Company Method when valuing PTEs and offers a new perspective on how to apply this method.

"Valuing Pass-Through Entities Using the Guideline Public Company Method", By Eric Barr, originally appeared in the January-February, 2015 issue of The Value ExaminerThe Value Examiner is published by NACVA.

This article originally appeared under the firm of Fischer, Barr & Wissinger LLC (FBW), now part of Marks Paneth LLP.

Valuing Pass-Through Entities Using the Guideline Public Company Method

Guideline Public Company Method and PTE Value to the Holder

Guideline Public Company Method and PTE Investment Value

Guideline Public Company Method and PTE Fair Market Value

Summary

Valuing Pass-Through Entities Using the Guideline Public Company Method

The market approach is one of three generally accepted approaches to value.  Under the market approach, indications of value can be obtained by analyzing transactions of ownership interests of companies in the same or similar lines of business.  Like the income approach, it is referenced in IRS Revenue Ruling 59-60, as well as in other valuation standards, such as those of the Appraisal Standards Board and the AICPA.  The Guideline Public Company Method is a method that is often used to apply the Market Approach.  However, special issues arise when applying the Guideline Public Company Method to the valuation of pass-through entities (“PTE”).

Guideline Public Company Method and PTE Value to the Holder

Assuming a value to the holder assumption, when the valuation analyst applies a valuation multiple to a PTE based on the guideline public company method (“GPCM”), it is assumed that the PTE’s owner(s) will receive the same risk adjusted after-tax returns as the public company’s owners.  Under a value to the holder assumption, a price-to-revenues multiple assumes that the combination of cost of goods sold, operating expenses, and income taxes for the public company will approximate that of the PTE.  A price-to-gross-profit multiple assumes that the combination of operating expenses and income taxes for the public company will approximate that of the PTE.  A price-to-pretax-income multiple assumes that the income taxes to a holder of the guideline public company’s stock will approximate that of the PTE.  Clearly, as one moves down the income statement, under value to the holder, there are fewer expense items that could deviate as a percent of revenues.  This would, at least theoretically, make the price-to-net-income multiple more reliable than the price-to-revenues multiple.  But how reliable is even the price-to-pretax-income multiple?

Many of the tax-affecting issues that have been identified under the income approach also apply when valuing a PTE under the guideline public company method.  This is because PTEs do not pay entity-level federal corporation income taxes, whereas guideline public companies from which pricing metrics are derived are subject to federal corporation income taxes at the entity level.  Accordingly, the PTE conundrum needs to be considered when applying the guideline public company method in connection with value to the holder.

Let’s consider the impact of income taxes on after-tax returns to an owner of a C corporation versus the owner of a PTE, assuming value to the holder.  Table 1 presents the normalized income statement of a potentially comparable guideline public company and the after-tax returns to an investor in that company. 

Assuming an equity valuation of $500 million for the guideline public company, pricing multiples are calculated based on six company-level metrics, and one metric is developed based on the holder’s after-tax returns.  This example also assumes an effective combined federal and state corporation income tax rate of 40% and an effective combined federal and state investor dividend tax rate of 20%.

For this analysis, it is also assumed that the subject PTE has valuation multiples equal to 70% of the guideline public company’s valuation multiples based on an analysis of risk and other factors (but not financial/common-sized expense factors).  Accordingly, the price-to-revenues multiple should be 1.00 multiplied by 70% equals .70, etc., for the subject PTE.  The inputs for the subject PTE assume (1) revenues of $5 million and (2) a normalized common-sized income statement that exactly matches the guideline public company, from the “cost of goods sold” line all the way through to the “pretax income” line (30.8% of revenues). The results are shown in Table 2.

Five of the six company-level multiples indicate a PTE value to the holder of $3.5 million, and one company-level multiple indicates a PTE value to the holder of $5.8 million.  The PTE valuation based on investor net income after taxes is $4.375 million. 

This example yields vastly different results, but which amount is correct?  Should the majority rule? Five of the six company-level multiples indicate that $3.5 million is the PTE value to the holder.  This clustering ordinarily would be a compelling factor in determining PTE value to the holder.  On the other hand, the price-to-net-income multiple indicates a value of $5.8 million, and this is the amount of after–corporation taxes but before individual income taxes typically considered in connection with the income approach.  This metric takes into consideration any differences between the subject PTE’s costs of operations and the guideline public company’s cost of operations and, it can be argued, is more appropriate when applying a value to the holder standard of value. 

The problem with each of these six company-level multiples is that not one takes into consideration the holder’s tax savings benefit of the subject company’s PTE status.  Since our definition of value is based on the after-tax risk-adjusted present value of future cash flows to the holder, the PTE tax savings benefit must be considered.  The final value derived in the above example, $4.375 million, is the only one that accomplishes this; it follows then that $4.375 million is the appropriate conclusion of value.

What happens when we modify several of the operating expense amounts of the PTE subject company in the above example?  Assuming increases of 5% in common-sized “cost of goods sold” and “selling, general and administrative expenses,” the indicated values of each multiple now are vastly different, as you can see in Table 3.

By simply modifying two of the common-sized expenses, the five previously identical valuation amounts of $3.5 million now range from a low of $2.363 million to a high of $3.939 million. 

It is not unusual for the subject PTE (or any privately-held company) to have a different cost structure than the guideline public companies from which valuation metrics and multiples are derived.  Consequently, a valuation analyst may frequently find that applying guideline public company multiples based on different income statement line items yields very different results.  In this example, as in the previous one, the value derived from investor net income after all taxes ($2.955 million, in this case) would arguably indicate a more appropriate PTE value.    Revenue, gross profit, EBITDA, EBIT, pretax, and net income valuation multiples can be reverse engineered assuming a final valuation amount of $2.955 million.

It is worth noting that when more than one guideline public company is considered with respect to the development of applicable valuation metrics, the process by which one selects metrics may change, but the same analysis presented above with respect to the final conclusion of value is necessary.

Guideline Public Company Method and PTE Investment Value

Value to the holder considers normalized results of operations of the subject interest in the hands of its current owner; investment value considers normalized results of operation of the subject interest in the hands of the buyer.  The buyer may have significant influence with or without control.  Accordingly, application of the guideline public company method involves consideration of the subject PTE’s historical and projected revenues, expenses, and income taxes, inclusive of synergies, in the hands of the owner.  If the buyer has the ability to increase the after-tax cash flows of the subject PTE, that fact must be taken into consideration in applying the guideline public company method and the investment value assumption.

Under value to the holder in the previous series of examples, it was assumed that the subject company multiples were 70% of the guideline public company’s multiples.  Given the potential for synergies with the buyer and the possibility that the buyer has a substantially lower risk profile than the guideline public company, it is possible that the 30% discount will be less, perhaps even 0%.  Facts and circumstances will dictate whether the valuation analyst applies multiples that are greater than, equal to, or less than the guideline public companies when applying the guideline public company method.    

Another factor to consider is whether the buyer will be able to enjoy the tax savings and other benefits of the subject company’s status as a PTE.  If so, then such benefits must be incorporated into the valuation analysis.

Assume the same facts as in the previous example under value to the holder except that (1) revenues increase by 10% from $5 million to $5.5 million; (2) the buyer has cost savings synergies that reduce “selling, general and administrative expenses” from 25% of revenues to 20%; (3) the buyer can take advantage of the subject company’s PTE status; and (4) the guideline public company multiples are reduced by 10% (not 30%).

 

As shown in Table 4, by modifying three inputs—revenues (increased by 10%); selling, general and administrative expenses (decreased from 25% to 20% of revenues), and the discount applied to the metric multiples (30% discount reduced to 10%)—a substantially different range of values is derived (i.e., $4.281 million to $7.135 million).  Under a value to the buyer assumption, the value is $5.351 million (which contrasts with $2.955 million under the value to the holder assumption).  This analysis illustrates the sensitivity of changing even a few inputs when applying the guideline public company method.

If the same facts as in the previous example are assumed except that the buyer will not be able to enjoy the benefits of PTE status and will have an effective C corporation federal and state income tax of 40% (same as the guideline public company), then the investment value of the ownership interest decreases from $5.351 million to $4.281million, as shown in Table 10.5.

Guideline Public Company Method and PTE Fair Market Value

Many valuation analysts apply guideline public company multiples to the normalized historical results of operations of the PTE subject company when deriving fair market value (“FMV”).  This application of the guideline public company method assumes that the hypothetical buyer will be unable to utilize the benefit of the subject company’s PTE status and that prior transactions involving the guideline public company are relevant with respect to the pricing of the subject PTE. Are these valid assumptions, and are they consistent with the definition of fair market value?

The FMV standard of value requires consideration of value to the holder/seller (floor value) as well as value to the buyer (ceiling value).  Relying on transaction prices of a guideline public company is consistent with this concept. 

However, the other assumptions employed by implementing the guideline public company method in this manner require further analysis.  When applying the guideline public company method, the transactions from which pricing metrics are derived involve non-controlling minority interests without the ability to impact the normalized results of operations of the public company.  When the guideline public company method is applied to a minority interest in a PTE, the buyer may also have limited ability to change the normalized results of operations of the investee.  If so, it is logical and appropriate to utilize historical, normalized PTE results of operations under the guideline public company method when applying the FMV standard of value to value a non-controlling minority interest. 

Let’s next consider the appropriateness of using the normalized PTE historical results of operations when valuing a controlling interest under the FMV standard of value.  If the subject interest in the PTE enjoys the prerogatives of control and the buyer’s after-tax economic return on investment is different than that of the seller, it may be inappropriate to utilize the seller’s normalized PTE results of operations for valuation purposes under the guideline transactions method.  The resulting indication of value would be based, at least in part, on the seller’s returns, which may be different than the buyer’s returns, or some other mutually agreeable amount.  Some might argue that the buyer will not (or should not) pay for synergistic benefits that result from a transaction.  Again, facts and circumstances will dictate whether that is true.

The valuation analyst should also investigate the likely population of buyers and determine if there are two groups of hypothetical buyers: one that can take advantage of the pass-through status of the subject ownership interest and one that cannot.  If there are buyers that would enjoy the tax and other benefits of the subject PTE, they may have a financial incentive to pay more for the PTE ownership interest than for a C corporation.  Under the FMV standard of value, the holder/seller is fully informed and is under no compulsion to sell; accordingly, the hypothetical buyer may be able to enjoy the continued benefits of PTE status and pay more than the valuation multiple of the guideline public company.

Summary


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