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Determining fair value for business combinations and impairments · PwC's accounting podcast

• 0:00
  SPEAKER_00: Thought Leadership from PWC's National Office.
• 0:06
  SPEAKER_03: Welcome to PWC's Accounting Podcast.
• 0:10
  SPEAKER_03: I'm Heather Horn.
• 0:11
  SPEAKER_03: Valuation is a key aspect of many accounting areas, which means all of us need to have some understanding of the key judgments, even if we're not valuation specialists.
• 0:22
  SPEAKER_03: In today's episode, we focus on key points of understanding related to goodwill impairments, long-lived asset impairments, and business combinations, areas where there's a lot of similarities in determining valuations, but also some very important differences.
• 0:38
  SPEAKER_04: And what can really make this challenging is that the executive management team often has a strong belief in the vision of the company.
• 0:44
  SPEAKER_04: Like that's what you would expect, right?
• 0:45
  SPEAKER_04: These are the CEOs, the CFOs, they've got to believe in the vision and drive the company's strategy.
• 0:50
  SPEAKER_04: But when their view seems to differ from market participants, they need to balance that under GAAP, right?
• 0:55
  SPEAKER_04: It's difficult to really substantiate, well, the market's just wrong, or they don't really understand the company because the fair value principle is based on the market participant assumptions.
• 1:05
  SPEAKER_04: So you have to consider that, right?
• 1:07
  SPEAKER_04: We've got highly sophisticated investors in the market that do invest significant amounts of money.
• 1:17
  SPEAKER_03: That was Beth Paul, Deputy Chief Accountant in PWC's national office, who leads our acquisitions, divestures, and consolidations team.
• 1:26
  SPEAKER_03: Beth is joined by Adam Smith, a managing director who focuses on valuations of businesses, business interests, intangible assets, and derivatives.
• 1:34
  SPEAKER_03: They both have great insight into this topic.
• 1:37
  SPEAKER_03: So let's tune in to the conversation.
• 1:40
  SPEAKER_03: Beth, Adam, so nice to have you both on today to talk about valuation considerations.
• 1:45
  SPEAKER_03: And I think this is such a great topic because we have so many podcasts and just accounting conversations where terms like fair value come up.
• 1:53
  SPEAKER_03: And like, for example, Beth, I think the idea for this podcast came up because you and I were talking about impairments, but then we don't actually get into, we talk about the accounting, but we don't actually talk about valuation.
• 2:03
  SPEAKER_03: So we thought for today we would actually jump into that and focus on a few specific areas within financial reporting.
• 2:10
  SPEAKER_03: So goodwill impairments, long life asset impairments, and then business combinations.
• 2:14
  SPEAKER_03: So all perfect topics for Beth and then Adam.
• 2:17
  SPEAKER_03: Nice to have you here from a valuation point of view.
• 2:19
  SPEAKER_03: Um, but Beth, maybe I'll start with you first, just why these particular topics.
• 2:24
  SPEAKER_04: Yeah, certainly.
• 2:25
  SPEAKER_04: I mean, given current economic trends, we're seeing more companies need to consider fair value in connection with either impairment analysis or if they're considering disposals, so assets held for sale.
• 2:35
  SPEAKER_04: And as we start to see a glimmer in the MA market, we also are seeing companies consider acquisitions and therefore it will need to think about fair value in connection with business acquisitions.
• 2:46
  SPEAKER_03: All right, definitely agree.
• 2:47
  SPEAKER_03: I think though, before we even get into it, this almost may seem self-evident, but I think it would be helpful to actually talk about what we mean when we say fair value.
• 2:55
  SPEAKER_03: So obviously we have the fair value accounting standard, ASCE 20, and that's very far reaching and covers a lot of financial, you know, areas of the financial statements and transactions.
• 3:06
  SPEAKER_03: But I think it would be good to level set what's the definition of fair value and what are we really focused on when we're talking about fair value and valuation for financial reporting.
• 3:18
  SPEAKER_04: Right.
• 3:18
  SPEAKER_04: So GAAP defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.
• 3:28
  SPEAKER_04: So it's really an exit price concept under the prevailing market conditions as of your valuation date, based on methods, inputs, and assumptions that would be expected to be used by market participants, right?
• 3:39
  SPEAKER_04: So in determining a fair value estimate for financial reporting purposes, the key points really are that companies should consider market participant evidence because GAAP requires the valuation to utilize a market participant lens.
• 3:53
  SPEAKER_04: And for the estimate, really to maximize the use of what we'll call like observable transaction prices, which the standard refers to as level one inputs.
• 4:02
  SPEAKER_04: For companies, though, that are gonna use a discounted cash flow to determine fair value, they have to consider or should consider the need to reconcile to any observable indications of value when possible.
• 4:13
  SPEAKER_04: And what can really make this challenging is that the executive management team often has a strong belief in the vision of the company.
• 4:20
  SPEAKER_04: Like that's what you would expect, right?
• 4:21
  SPEAKER_04: These are the CEOs, the CFOs, they've got to believe in the vision and drive the company's strategy.
• 4:25
  SPEAKER_04: But when their view seems to differ from market participants, they need to balance that under GAAP, right?
• 4:31
  SPEAKER_04: It's difficult to really substantiate, well, the market's just wrong, or they don't really understand the company because the fair value principle is based on the market participant assumptions.
• 4:41
  SPEAKER_04: So you have to consider that, right?
• 4:43
  SPEAKER_04: We've got highly sophisticated investors in the market that do invest significant amounts of money.
• 4:48
  SPEAKER_04: They often have a legal fiduciary duty to like their own stakeholders, right?
• 4:52
  SPEAKER_04: So they they understand the market.
• 4:54
  SPEAKER_04: And so, you know, occasionally we can see some short-term deviations in prices, right?
• 4:59
  SPEAKER_04: Like you could have, you know, a management team, maybe they know about a potential deal or a new customer, or maybe on the other side they know they're gonna settle a lawsuit.
• 5:08
  SPEAKER_04: So you could have this short-term phenomenon of a disconnect, but generally, right, management has an obligation to let their shareholders know of material transactions through an AK or otherwise.
• 5:18
  SPEAKER_04: And so the market's gonna get that information and it's sort of a short-term disinformation.
• 5:23
  SPEAKER_04: And, you know, if management's right with their you know, um projections of growth and revenue, then that's gonna show up in the numbers, and then the stakeholders and the markets are gonna react accordingly.
• 5:33
  SPEAKER_04: So, you know, it's really hard like to say.
• 5:35
  SPEAKER_04: So if you're in a situation and management saying or thinking, well, the numbers are just wrong, I think you've got to really pause and think about that.
• 5:42
  SPEAKER_01: Aaron Powell I was just gonna say, I think it fundamentally comes down to a just a different perspective, not necessarily of either being wrong, but just thinking about value in different ways.
• 5:52
  SPEAKER_01: Management often thinks about value in terms of once I've made a plan, this is what I'm gonna do with it, this is what the business is worth because I'm going to achieve X, Y, and Z.
• 6:01
  SPEAKER_01: Well, the market often looks at it more as, okay, make some progress on that first.
• 6:06
  SPEAKER_01: You know, the plan isn't what creates the value.
• 6:09
  SPEAKER_01: We want to see you actually start achieving that before we give you the credit for that.
• 6:13
  SPEAKER_01: So it's not that either of them are wrong.
• 6:15
  SPEAKER_01: It's more that they're just looking at value a little bit differently.
• 6:19
  SPEAKER_01: And obviously, for fair value, it is the market participant view that really matters the most.
• 6:24
  SPEAKER_01: And I've had this conversation with many management teams of saying, I believe you.
• 6:28
  SPEAKER_01: It's not that I'm saying you're wrong.
• 6:30
  SPEAKER_01: It's that I think we need to say, when does that value actually accrue in terms of fair value of this business?
• 6:37
  SPEAKER_03: Yeah, and I do think, and I'm curious from both of your perspectives, that when this valuation guidance came in, which is at least 15 or more years ago when it was, you know, first issued as 157 and then it was codified, this idea of like being so focused on market participant was something relatively new that wasn't the case.
• 6:58
  SPEAKER_03: Maybe it was for observable markets, but not otherwise.
• 7:00
  SPEAKER_03: So I do think even just this concept of like caring more about what someone else thinks than what your own management team thinks, it's a hard thing for companies to get over.
• 7:09
  SPEAKER_03: And obviously, what you guys were saying is companies still struggle with that because they're saying, I know more, basically.
• 7:15
  SPEAKER_04: Right.
• 7:16
  SPEAKER_04: Absolutely.
• 7:16
  SPEAKER_04: And sometimes they do, right?
• 7:17
  SPEAKER_04: But I think sometimes it's what Adam said.
• 7:19
  SPEAKER_04: They know what they expect to happen, and the other side wants to see those, you know, growth rates actually occur and then and then put it into the valuations.
• 7:27
  SPEAKER_03: Yeah.
• 7:28
  SPEAKER_03: So I do think that's important and we'll probably come back to that in terms of the market participant.
• 7:32
  SPEAKER_03: But maybe we can start getting into some of the accounting and then the intersection with these sort of fair value concepts.
• 7:39
  SPEAKER_03: So, Beth, perhaps starting then with goodwill, because since that's the recurring one, you have to make valuation estimates.
• 7:45
  SPEAKER_03: And, you know, I think there's a few different places that come into play.
• 7:49
  SPEAKER_03: So, from your perspective, as you work with companies as they're going through this process, what are some of the more important valuation considerations or some of the areas where you would focus more?
• 7:59
  SPEAKER_04: Yeah, the goodwill impairment test, right?
• 8:01
  SPEAKER_04: It requires companies to compare the fair value of the reporting unit to the carrying value.
• 8:05
  SPEAKER_04: And if the fair value is below the carrying value, recorded impairment loss to the extent of goodwill, right?
• 8:11
  SPEAKER_04: And so when determining the fair value, because GAAP requires those observable inputs I talked about, if you've got a public company, their market cap is an observable input of the value of the overall company.
• 8:22
  SPEAKER_04: And so we have to think about that.
• 8:24
  SPEAKER_04: However, a lot of companies have multiple reporting units, so they might need to use an alternative method to come up with a fair value of sort of each reporting unit, and that might be a discounted cash flow.
• 8:33
  SPEAKER_04: And when they use the discounted cash flow, a best practice then is to take sort of those individual pieces, add them up, and reconcile them to the market cap.
• 8:41
  SPEAKER_04: When you do that reconciliation, the sum of the individual fair values can be greater than the overall market cap.
• 8:48
  SPEAKER_04: And this is referred to as a implied control premium.
• 8:51
  SPEAKER_04: We get questions about management's use and how do they sort of justify an implied control of a premium that maybe seems higher than others, or just you know, just sort of overall, how do we justify it?
• 9:04
  SPEAKER_04: And I think that the fact that a reporting unit estimate is different, you need to sort of calibrate it or reconcile it to that market cap.
• 9:14
  SPEAKER_04: That doesn't mean they have to be the same, but we have to understand what's causing that difference.
• 9:20
  SPEAKER_04: And that is this control premium.
• 9:23
  SPEAKER_04: So, like what's causing the underlying control premium?
• 9:26
  SPEAKER_04: Is it because you're buying an assembled company, not an individual stock?
• 9:31
  SPEAKER_04: So there's value in the fact that the business is already together.
• 9:34
  SPEAKER_04: Is it because you have to entice somebody to sell their business?
• 9:38
  SPEAKER_04: Is it because you as the buyer believe you can achieve sort of a better cost model, you can have better synergies, or maybe you have a lower cost of debt?
• 9:46
  SPEAKER_04: Those are things you want to think about that would sort of reconcile or help folks understand that difference.
• 9:52
  SPEAKER_04: I think one thing to think about is that you know, it might not be intuitive that the better run your company is, the better it is being managed compared to peers, then the smaller your control premium would be.
• 10:03
  SPEAKER_04: That's because there's less potential incremental benefit that one could expect to generate in an acquisition.
• 10:08
  SPEAKER_04: The buyer isn't going to be able to achieve those benefits, those savings, the enhanced costs if you're already running it pretty effectively.
• 10:14
  SPEAKER_03: Beth, before you go on, and I think I know the answer, but would we ever see a case where you do the individual components and it actually adds up to less than the market value?
• 10:25
  SPEAKER_03: And then how do you think about that?
• 10:26
  SPEAKER_01: Aaron Powell So it does happen.
• 10:28
  SPEAKER_01: Um it's it can be for a number of reasons, one of which is just management might be being conservative in their cash flows and wanting to put something together that reflects perhaps a worst case scenario or something that might be a little bit lower than what the market might expect.
• 10:47
  SPEAKER_01: When that happens, well, there's kind of two instances where if the company's still passing the impairment test and they're using best case scenario or worst case scenario.
• 10:56
  SPEAKER_03: Yeah, it doesn't matter.
• 10:57
  SPEAKER_01: Not a problem.
• 10:57
  SPEAKER_03: Yeah.
• 10:58
  SPEAKER_01: If they're using worst case scenario, though, and there's a failure, it's important to say, you know, fair value is not worst-case scenario.
• 11:05
  SPEAKER_01: Fair value is the market participant view.
• 11:08
  SPEAKER_01: And so if you're taking an impairment, you can't be going with this worst case, what's the lowest we could be?
• 11:15
  SPEAKER_01: That starts to look unreasonable.
• 11:17
  SPEAKER_01: And again, as Beth said, you know, it depends how far off from the market cap you are.
• 11:22
  SPEAKER_01: So if you add them up and you're at 98%, we're we're okay.
• 11:27
  SPEAKER_01: Yeah, you're you're pretty close to the market cap.
• 11:29
  SPEAKER_01: If you're at 70% of the market cap, we're gonna look at that very um intently and try to figure out what's going on because that starts to seem unreasonable.
• 11:39
  SPEAKER_03: Yeah, I think that's helpful perspective.
• 11:41
  SPEAKER_03: And I guess this also comes back to something, Beth, I think we've talked about before, is just how much headroom do you have between these valuations and your underlying value you're comparing it to.
• 11:51
  SPEAKER_03: If there's lots of headroom, then some of this precision, I mean, precision is always important, but maybe you don't have to delve as deeply versus if it's closer to the point Adam you made is triggering an impairment.
• 12:03
  SPEAKER_03: You know, sometimes an unnecessary impairment is no better than missing an impairment.
• 12:08
  SPEAKER_04: So you're so right, you might have to sharpen the pencil the less sort of headroom you have, because the more important these estimates could be.
• 12:15
  SPEAKER_03: Yeah.
• 12:16
  SPEAKER_03: So then, Beth, I think um I jumped in before you were able to finish, but anything else then from sort of a control premium point of view that you'd point out before we move on.
• 12:27
  SPEAKER_04: Maybe one minor point is, you know, sometimes companies say, well, in the market, I'm seeing, you know, everyone's got, you know, whatever, 20% premium, whatever the number is.
• 12:35
  SPEAKER_04: And I think you got to remember that there's sort of an upward bias because the reason those companies were targets in the first place is because there was cost savings to be achieved or someone thinks they can run it better or, you know, exploit it differently.
• 12:47
  SPEAKER_04: And so I think you just gotta be careful when you think about that.
• 12:50
  SPEAKER_03: And Adam, anything else from your point of view that you would focus on?
• 12:54
  SPEAKER_01: Yeah, I mean, I I would just we we've kind of touched on it, but I would really stress the point that the more extraordinary your premium is, the more support is going to be needed from an audit perspective.
• 13:06
  SPEAKER_01: Um, you know, people almost make fun of me for bringing up the example of, you know, if I tell you that I have a dog, which I do, you're likely going to believe me.
• 13:15
  SPEAKER_01: And you might want to see a picture just because she's very cute.
• 13:18
  SPEAKER_01: But there's not going to be a lot of pushback.
• 13:21
  SPEAKER_01: But if I told you I have a unicorn, you're likely going to want a lot of evidence of this unicorn, right?
• 13:27
  SPEAKER_01: You're going to want to meet the unicorn and perhaps have an expert inspect the unicorn before you really believe me, right?
• 13:33
  SPEAKER_02: Yeah, or perhaps question your, you know, um overall reliability.
• 13:38
  SPEAKER_02: But yes, agree.
• 13:39
  SPEAKER_02: That's a very good example.
• 13:42
  SPEAKER_01: And so I mean, I think there's no lines in the sand when it comes to control premiums.
• 13:47
  SPEAKER_01: But you know, again, if you have a$100 million market cap company and your valuation comes in at 105 or 110, it's likely going to be fairly easy to get comfortable.
• 13:58
  SPEAKER_01: That yes, maybe some market participant buyer would be able to eliminate a small amount of costs that might be duplicative with their own, or perhaps there's some synergies in revenue, or they can sell the target's company products to their own customers, or something that could lead to a minor premium to the market cap.
• 14:18
  SPEAKER_01: But we sometimes see companies with an implied premium of 50% or 100% or very large premiums.
• 14:26
  SPEAKER_01: Those are not necessarily unreasonable, but we're going to require a lot of evidence for why is that reasonable in this particular case?
• 14:35
  SPEAKER_01: And as Beth mentioned, saying, oh, this other company was acquired at that kind of a premium isn't enough.
• 14:41
  SPEAKER_01: We need to know why this company is warranting that kind of premium.
• 14:47
  SPEAKER_01: And when you get into these really large ones of 100% or more, one of the questions we ask is, well, if it's worth this much, where are these buyers?
• 14:56
  SPEAKER_01: Who's making offers?
• 14:58
  SPEAKER_01: If someone can come in and buy a company and create that much value, where are they?
• 15:03
  SPEAKER_01: Right.
• 15:04
  SPEAKER_01: And so, you know, it's a difficult question.
• 15:07
  SPEAKER_01: As I said, there's no lines in the sand, but there's certainly ranges of where we need some extra support, I think.
• 15:15
  SPEAKER_03: And I guess, Adam, I know one of the places where questions can come up is a case where maybe a company's had a lot of acquisitions or they're built up from a lot of acquisitions.
• 15:25
  SPEAKER_03: So then there's all of that cost that's built up into the company's value.
• 15:30
  SPEAKER_03: How does that interact then, particularly if maybe the market hasn't moved where they were hoping when they made those acquisitions?
• 15:37
  SPEAKER_01: Yeah, it's a really good question.
• 15:39
  SPEAKER_01: I mean, with companies that have grown through acquisitions, they just paid for control of all of these acquisitions.
• 15:48
  SPEAKER_01: They paid for that level of benefit that they think they can do better.
• 15:53
  SPEAKER_01: And particularly where the those acquisitions have been recent, the question needs to be asked: well, if there was someone willing to pay 30% more than you did, where why didn't they buy it in the first place?
• 16:06
  SPEAKER_01: Like how how did you get it for such a you know bargain price if there's someone out there, another market, who can do even better than you?
• 16:13
  SPEAKER_01: And so, you know, sometimes we'll see companies that, you know, a$10 billion company that was just formed through the merger of two$5 billion companies.
• 16:23
  SPEAKER_01: So half of their business was just acquired for control.
• 16:27
  SPEAKER_01: Certainly there can be some control premium, perhaps related to the other half, but that would certainly mute the acceptable level of control premium, I think.
• 16:37
  SPEAKER_03: Yeah.
• 16:37
  SPEAKER_03: And I I think then the related question is if I'm I have a company, it's publicly traded, so I can see that valuation, and I'm trying to argue that's this huge control premium.
• 16:48
  SPEAKER_03: Wouldn't that already be built into my market value, or how does that interaction work?
• 16:53
  SPEAKER_01: Aaron Powell And it's a great question.
• 16:55
  SPEAKER_01: The difficulty, I think, is theoretically a control premium should only reflect a control premium that some other owner could achieve, but that current management can't.
• 17:06
  SPEAKER_01: And that's often a question that we ask is uh yeah, particularly when it's when the control premium is supported, for example, with cost reductions.
• 17:15
  SPEAKER_01: Well, why can't you reduce these costs?
• 17:18
  SPEAKER_01: Why wouldn't that be built into the market price of the company that you can do this yourself?
• 17:22
  SPEAKER_03: Or why aren't you doing this that way?
• 17:24
  SPEAKER_03: Why aren't you?
• 17:25
  SPEAKER_01: Exactly.
• 17:26
  SPEAKER_01: And so we we often have that conversation because uh, you know, it does need to reflect a value that market participants can achieve, but that the current ownership structure cannot.
• 17:38
  SPEAKER_03: All right, that's helpful.
• 17:39
  SPEAKER_03: And then Beth, I know often when you're having these conversations with clients, they often want to do their own reading or sort of understand for themselves some of the background and theory on this.
• 17:49
  SPEAKER_03: And so when you get those questions, where what are some of the resources or where do you kind of point them to go look for more information?
• 17:57
  SPEAKER_04: Yeah, I I think the appraisal foundation's market participant um acquisition premium guide includes some best practices on the things we've talked about here, right?
• 18:05
  SPEAKER_04: They they don't call it a control premium, they call it a market participant acquisition premium.
• 18:09
  SPEAKER_04: That's a mouthful.
• 18:10
  SPEAKER_04: But they they go through, you know, thinking about the amount, thinking about, you know, how do you support the control premium, and they discuss the need to consider and apply normalized premiums on a total invested capital or total entity basis as opposed to an equity basis.
• 18:27
  SPEAKER_04: So I think those are good places to look.
• 18:28
  SPEAKER_01: Aaron Powell Yeah, I think that's a really important point about some of the studies or articles that have been written about control premiums were based on an equity premium.
• 18:38
  SPEAKER_01: And sometimes that can be thrown off by companies being acquired that perhaps have only a sliver of equity, but mostly debt, and that premium can be magnified on the equity basis.
• 18:50
  SPEAKER_01: And so to try to normalize that premium, best practice right now in the valuation profession is to look at those control premiums more on a total invested capital basis to try to eliminate some of that noise that can come out of different capital structures.
• 19:06
  SPEAKER_03: So then, with then some of that background from your perspective, Adam, as you're working with teams and clients, what are some of the issues that you see that are resulting in some of these implied control premiums that you think are are too high, really, in the context of a you know the market-based fair value requirements?
• 19:26
  SPEAKER_01: Sure.
• 19:27
  SPEAKER_01: I think two of the most common um sets of uh facts that often lead to large control premiums are one is how corporate costs are being allocated.
• 19:39
  SPEAKER_01: And two is um just a mismatch between the projections being used in the perspective financial information or PFI and the discount rate being applied to that PFI.
• 19:51
  SPEAKER_01: Um to start off with the corporate cost point, um many businesses are made up of a number of reporting units, and then there's kind of a corporate reporting unit essentially that handles a lot of various things, you know, accounting and legal, and the CFO and the CEO and HR potentially, but there's a lot of corporate costs that are sitting at a level that's not in the reporting units themselves.
• 20:16
  SPEAKER_01: And what we'll often see is a discussion around what corporate costs should be essentially pushed down to the reporting unit level versus which ones should be kept at that corporate reporting unit essentially.
• 20:31
  SPEAKER_01: And sometimes the decision is made by management that none of those costs should be pushed down, that they're all not really related to the reporting units themselves.
• 20:42
  SPEAKER_01: And that's not necessarily a wrong perspective, but it is sometimes an aggressive perspective.
• 20:47
  SPEAKER_01: Like when a market participant buyer comes in and purchases one of your reporting units, it's true.
• 20:53
  SPEAKER_01: They might already have a CEO and a CFO and HR and legal and accounting.
• 20:59
  SPEAKER_01: But at the same time, as businesses grow, um you know, your CEO of a$10 billion company generally makes more than the CEO of a$1 billion company, right?
• 21:09
  SPEAKER_01: You only need one, but you you have to pay them more as you get larger, right?
• 21:13
  SPEAKER_01: And so it might be a bit aggressive to say that a a market participant buyer is not going to assume any corporate costs associated with this acquisition.
• 21:22
  SPEAKER_01: So it's something that should be looked at, I think.
• 21:25
  SPEAKER_04: Aaron Powell So Adam, you just spoke about allocation of costs, but I also get questions related to the allocation of assets and liabilities among the multiple reporting units and how to ensure that the estimate of fair value of the reporting unit is done on call it a consistent, you know, apples to apples basis with the caring value of the assets and liabilities.
• 21:42
  SPEAKER_04: And so I think it's important to just think okay, if the asset's going to be employed in the operations of the reporting unit, then it should be part of the carrying value.
• 21:51
  SPEAKER_04: And if the liability relates to the operations of the reporting unit, it should be in the carrying value.
• 21:55
  SPEAKER_04: And then you want to make sure the fair value is considering those assets.
• 22:00
  SPEAKER_04: Those liabilities.
• 22:00
  SPEAKER_04: Really, it's just making sure you've got a consistent methodology between the essence and liabilities that are assigned from a carrying value perspective to what you're looking at from a fair value perspective.
• 22:10
  SPEAKER_04: And an entity should base its determination on a reporting at its fair value on assumptions that the market participant would use.
• 22:16
  SPEAKER_04: So these assumptions include the likely structure of the sale.
• 22:20
  SPEAKER_04: That's when you want to think about okay, if if I'm going to sell something, would I sell the asset?
• 22:26
  SPEAKER_04: Is that if I have a shared asset, would it go with the sale?
• 22:29
  SPEAKER_04: Is that what I likely expect?
• 22:30
  SPEAKER_04: Or is that going to sort of stay behind with corporate as you think about, you know, because when I say like, oh, well, the asset, it's easy to say if it goes to the reporting unit.
• 22:37
  SPEAKER_04: Sometimes it's not quite so easy.
• 22:38
  SPEAKER_04: And so you have to think about, well, what would a market participant do?
• 22:41
  SPEAKER_04: Would they want this asset or not?
• 22:43
  SPEAKER_04: And then kind of follow that through from a fair value perspective.
• 22:46
  SPEAKER_03: And I think Beth, I probably should have asked this question before, and it's for both of you.
• 22:50
  SPEAKER_03: You know, we keep saying, okay, what does the market participant think?
• 22:53
  SPEAKER_03: And I I know we talked earlier that part of the struggle is management has their own views, et cetera.
• 22:58
  SPEAKER_03: But I think the other part of the struggle is you don't like have full visibility into what market participants do think.
• 23:04
  SPEAKER_03: And it really triggered it for me, Beth, thinking about individual assets or how assets are going to be structured.
• 23:10
  SPEAKER_03: And so how do you go about thinking of putting yourself in the shoes of the market participant?
• 23:17
  unknown: Yeah.
• 23:17
  SPEAKER_04: I think that's kind of what you're doing.
• 23:19
  SPEAKER_04: You put your shoes in there.
• 23:20
  SPEAKER_04: And so like I think the example that I use with people is like a trade name.
• 23:23
  SPEAKER_04: You know, if if you've got a trade name, you have to think about is it likely if I sold this component of the business, would I sell the trade name?
• 23:32
  SPEAKER_04: Would somebody buy this business without being able to brand the products with the trade name?
• 23:36
  SPEAKER_04: If the answer to that's no and I'm gonna sell it with the business, then I know how to think about that when I think about the reporting unit.
• 23:41
  SPEAKER_04: Or maybe I'm saying, well, I'm not gonna sell it, but I am gonna grant some sort of rate and I have to think about like a royalty.
• 23:46
  SPEAKER_04: So maybe it's not revenue all up front, but some sort of royalty income over time, you want to think about that.
• 23:51
  SPEAKER_04: But then if you say, no, no, I've got like sort of my trade name, but the individual line that I'm gonna sell product, like somebody's gonna rebrand that, or maybe it has, you know, a different name, not sort of the overall name.
• 24:02
  SPEAKER_04: And so the trade name's not going.
• 24:03
  SPEAKER_04: So I wouldn't then allocate or give that that asset to that reporting unit when thinking about carrying value and fair value.
• 24:09
  SPEAKER_04: So you're trying to think like what would somebody want to buy from their perspective.
• 24:12
  SPEAKER_03: Yeah.
• 24:13
  SPEAKER_03: Anything else, Adam, from your point of view of thinking of putting yourself in the shoes of the market participant?
• 24:18
  SPEAKER_01: I mean, I I think there's in GAP a concept of you know, you don't have to turn over every rock to determine what the market participant view is.
• 24:28
  SPEAKER_01: But there's a certain ability to look at what the company's doing, their market capitalization, and kind of drawing everything together to see if you have a good market participant view.
• 24:38
  SPEAKER_01: Um I think whenever we do evaluation, we're looking at comparable companies ideally in the same industry doing similar things and comparing growth rates and profit margins and um asset levels and how they've structured deals, all those things that are publicly available are things that should be being considered.
• 24:59
  SPEAKER_01: But you don't have to be calling up every CEO of a company and saying, or every investor in those companies.
• 25:06
  SPEAKER_01: It's not an exhaustive process.
• 25:08
  SPEAKER_01: It's more of a common sense, I think, view.
• 25:11
  SPEAKER_03: Okay, that's super helpful.
• 25:12
  SPEAKER_03: So then if we think about, you know, we've been kind of talking about this idea of reconciling the market capitalization and these market indications with then the also the allocation of costs, benefits, assets, liabilities.
• 25:25
  SPEAKER_03: Adam, any other sort of key concepts that you would focus on in doing these valuation estimates?
• 25:32
  SPEAKER_01: Yeah.
• 25:32
  SPEAKER_01: So as I mentioned, the other area that I think sometimes leads to large control premiums is every set of prospective financial information or PFI has to be discounted at an appropriate discount rate for that PFI.
• 25:48
  SPEAKER_01: We usually develop a discount rate using what we call a capital asset pricing model or CAPM.
• 25:53
  SPEAKER_01: That conceptually is a great model.
• 25:55
  SPEAKER_01: Nobody's come up with a better model for developing a discount rate, really.
• 26:00
  SPEAKER_01: But conceptually, it's more about market risk and diversifiable risk, and you don't get compensated for risk that you can diversify away by investing in a portfolio of assets.
• 26:11
  SPEAKER_01: But when we're talking about a reporting unit or an overall business, there is risk that people expect to be compensated for.
• 26:20
  SPEAKER_01: You can see this in really early stage companies like private equity-level companies, they have very high projections, you know, that with a lot of growth in them.
• 26:29
  SPEAKER_01: And investors in those companies expect to be compensated for that.
• 26:32
  SPEAKER_01: And they require often rates of return of 20%, 30%, or more.
• 26:37
  SPEAKER_01: And so investors do expect to be compensated for that risk.
• 26:41
  SPEAKER_01: So when we have a set of projections, particularly in an impairment analysis, when we have a set of projections that display tremendous growth and either revenue or margin or both, we often have to look at those and say, what is the risk here?
• 26:58
  SPEAKER_01: Um, what would market participants really expect to achieve in this set of projections?
• 27:04
  SPEAKER_01: What kind of uh return would they demand?
• 27:07
  SPEAKER_01: And in an impairment analysis, the the risk is if you don't tack on what we call a company-specific risk premium to potentially, I don't want to use the term aggressive, but um high growth projections.
• 27:23
  SPEAKER_01: Um, if we don't do that, we're gonna get a very high value that might not reconcile very well to the market capitalization of the company if it's even public.
• 27:31
  SPEAKER_01: But you know, for private companies, we don't even have that market cap reconciliation.
• 27:35
  SPEAKER_01: But if it if we don't put on this company-specific risk premium, we're going to get a much higher value that's going to indicate, obviously, no impairment when perhaps there could be one because there's additional risk in those cash flows that investors or market participants would expect to be compensated for.
• 27:52
  SPEAKER_03: So then how do you think about this discount rate or any specifics that you would highlight?
• 27:58
  SPEAKER_01: Yeah, it's a it's a very complex area to determine number one, whether there should be this company-specific risk premium.
• 28:06
  SPEAKER_01: And number two, how much of a company-specific risk premium should you include?
• 28:11
  SPEAKER_01: You know, in years past, perhaps people often just relied on appraiser judgment.
• 28:16
  SPEAKER_01: I looked at the forecast.
• 28:18
  SPEAKER_01: This is clearly a high growth rate.
• 28:21
  SPEAKER_01: And I think that as a valuation professional with much experience, I think that there should be a 5% company-specific risk premium.
• 28:28
  SPEAKER_01: In today's world, in accounting and auditing, that doesn't fly.
• 28:33
  SPEAKER_03: It'd be nice, but no.
• 28:35
  SPEAKER_01: So the valuation profession has had to evolve.
• 28:38
  SPEAKER_01: And the primary two methods that we see out there are what we what I like to call at least the calibration method and the discount rate adjustment technique.
• 28:48
  SPEAKER_01: The calibration method assumes you have some actual independent um estimate of value out there.
• 28:55
  SPEAKER_01: So if you have a public company that is publicly traded, you know at least what the total of the reporting units are worth from a valuation perspective.
• 29:04
  SPEAKER_01: And we can use the calibration method to say, yeah, if we take the forecasts of management and we, you know, apply a discount rate from the Cap M with no company-specific risk premium, and it yields a 200% control premium, we might say, well, that indicates there should probably be a company-specific risk premium in this discount rate.
• 29:27
  SPEAKER_01: And you can use that relationship between the implied market cap or the market cap and the implied premium to that market cap to select a company-specific risk premium that causes that relationship to get into a more reasonable range.
• 29:42
  SPEAKER_01: Um, this also is used a lot in um business combinations.
• 29:46
  SPEAKER_01: When there was a recent acquisition of a reporting unit, for example, we can look at what was the implied rate of return from that transaction and calculate what was the actual company-specific risk premium from the transaction.
• 30:01
  SPEAKER_01: And then as we move forward, adjustments need to be made, though.
• 30:04
  SPEAKER_01: So an example is if you bought a company and there was a 10% company-specific risk premium implied in your internal rate of return, but most of that was because of tremendously high growth in the first three years of the projections.
• 30:21
  SPEAKER_01: Well, if you're now two years down the road and you've actually achieved or exceeded those really high growth rates, it's absolutely appropriate to bring that calibrated company-specific risk premium down a bit, or perhaps eliminate it if you're through that period of growth and now have reached more of a steady state.
• 30:39
  SPEAKER_01: So it's important when you're using the calibration method based on kind of past transactions to really think about what's happened since then.
• 30:46
  SPEAKER_01: The other method I mentioned is the discount rate adjustment technique.
• 30:49
  SPEAKER_01: And this one is more common when we don't have those really good market evidence of value or a recent transaction.
• 30:58
  SPEAKER_01: What's involved in that is looking at the prospective financial information and really identifying what is it about this prospective financial information that is perhaps optimistic or just different than the typical companies in that industry.
• 31:14
  SPEAKER_01: And often it comes down to it's usually either revenue growth or margin expansion.
• 31:20
  SPEAKER_01: And so if we look at a company that has expected margin expansion from 10% margin to 35% margin, for example, that's a lot of growth.
• 31:31
  SPEAKER_03: Yes.
• 31:32
  SPEAKER_01: And market participant investors are likely going to look at that and say, I it's not that I don't believe you, but I'm I think there's risk in achieving that 35% margin when you're only at 10% today.
• 31:44
  SPEAKER_01: And what they're likely going to look at is, well, what are other market participants in this industry achieving in their margin?
• 31:51
  SPEAKER_01: And let's say that the average of the market participants is 25% or something like that.
• 31:57
  SPEAKER_01: They might apply a adjustment to the discount rate essentially that reflects a little less risky assumption of what that margin is going to achieve.
• 32:07
  SPEAKER_01: Um, same thing with the revenue growth rate.
• 32:09
  SPEAKER_01: You know, it's again not that necessarily they disagree with those projections, but there's risk when you have really high revenue growth expected.
• 32:18
  SPEAKER_01: Maybe you'll achieve it, maybe you won't.
• 32:21
  SPEAKER_01: A lot of times companies will say we're projecting 40% growth next year, and oh, they only hit 35.
• 32:27
  SPEAKER_01: Yeah, like it's still great growth, but maybe it's there's risk in hitting that 40 that you initially expected.
• 32:33
  SPEAKER_01: And so in the discount rate adjustment technique method, what we're doing is kind of adjusting the projections down to what we think might be a more typical market participant view, you know, bringing that revenue growth rate from 40 down to 30, or bringing that expected margin from that 35 to the industry average of 25, something like that that we think we can apply a discount rate without a company-specific risk premium to, and use that value of the company to estimate the what additional premium do we have to add to the discount rate for those original projections to yield the same value.
• 33:14
  SPEAKER_03: All right.
• 33:15
  SPEAKER_03: Definitely a lot to think about there.
• 33:17
  SPEAKER_03: So then, Adam, let me ask you one follow-up question before we move to some of our other areas of valuation.
• 33:23
  SPEAKER_03: And that would be, you know, we've been really talking about an income approach, but I know you can also take a market approach.
• 33:29
  SPEAKER_03: So any specific considerations that you would highlight there?
• 33:33
  SPEAKER_01: Yeah, that's a good question.
• 33:34
  SPEAKER_01: Um, you know, the income approach is certainly very frequently used in these impairment analyses, but the market approach is often used as well and can absolutely result in similar levels of value with potentially very high control premiums.
• 33:49
  SPEAKER_01: And a few ways that that sometimes comes about.
• 33:52
  SPEAKER_01: You know, the the selected multiples for the reporting units, similar to the way the DCF or discounted cash flow should result in a reasonably reconcilable value for the company compared to its market or its total value or market capitalization, the multiples in the market approach should reconcile well with the multiple of the company if it's publicly traded.
• 34:15
  SPEAKER_01: So if the company overall has a 10 times eBit DA multiple, for example, and we look at the three reporting units that make up that company, and the appraisers selected 16 to 20 times multiple on all three of them, we're going to say that doesn't seem right, right?
• 34:34
  SPEAKER_01: And it can also be similar things to what we were talking about in terms of allocation of corporate expenses.
• 34:40
  SPEAKER_01: If we're looking at the projected financial information for the reporting unit to which we're going to apply the multiple, if that's a number that excludes all corporate expenses or excludes some shared assets, we might end up with a very high value for the company because it's already built in, for example, some market participant synergies of the ability to eliminate those costs.
• 35:05
  SPEAKER_01: And then a third way that that can happen is often in the market approach, because people are using guideline public companies, and those stock prices are inherently a non-controlling basis.
• 35:18
  SPEAKER_01: It's one share trading.
• 35:20
  SPEAKER_01: Often appraisers will explicitly apply a control premium in that analysis.
• 35:26
  SPEAKER_01: As we've been talking about, we like to see support for that magnitude of the control premium, but it's often included as an explicit premium.
• 35:36
  SPEAKER_01: And so we run the risk sometimes of including some level of control premium in the projected financial information we're applying the multiple to, such as by eliminating corporate costs, which is an aspect of a control premium.
• 35:51
  SPEAKER_01: And then potentially additionally adding on a control premium again.
• 35:55
  SPEAKER_01: So kind of double stacking the control premium is a risk.
• 35:58
  SPEAKER_03: All right.
• 35:59
  SPEAKER_03: Very helpful and a lot to think about.
• 36:02
  SPEAKER_03: I know goodwill impairment testing has sort of its own set of issues because you're thinking about an entire reporting unit.
• 36:10
  SPEAKER_03: You're thinking more of a business.
• 36:11
  SPEAKER_03: But Beth, you and I recently have been talking about long-lived asset impairment.
• 36:16
  SPEAKER_03: And we did a few episodes that went through and talked about those models.
• 36:20
  SPEAKER_03: But I think I'd like to focus now on valuation considerations for those.
• 36:24
  SPEAKER_03: But maybe before we talk about valuation, we should just remind people of the models and then we can refer them to those other episodes for more detail.
• 36:31
  SPEAKER_04: Sure.
• 36:31
  SPEAKER_04: So the models are different, right?
• 36:34
  SPEAKER_04: The model for long-lived assets is a two-part test.
• 36:37
  SPEAKER_04: So you have a recoverability test where you look at undiscounted cash flows compared to the carrying value.
• 36:43
  SPEAKER_04: And if the undiscounted cash flows are greater, you don't actually move on to the impairment analysis.
• 36:48
  SPEAKER_04: Um that is different than the one-step goodwill test.
• 36:51
  SPEAKER_04: The other thing that's important to know is the order of testing.
• 36:54
  SPEAKER_04: So in terms of the order of impairment testing, the long life democrats are tested first before goodwill.
• 36:59
  SPEAKER_04: So if you think you have a goodwill trigger, you probably got to pause and say, well, then do I have an impairment trigger for my long-lived democrats and think about that test and do that first if needed.
• 37:08
  SPEAKER_03: All right, that's helpful.
• 37:09
  SPEAKER_03: And I think very important.
• 37:10
  SPEAKER_03: I know we've talked about that, but you are not going to get to the right answers if you do these things out of order.
• 37:14
  SPEAKER_03: So definitely important to do that.
• 37:16
  SPEAKER_03: So if we're thinking about the fair value of a reporting unit or step one of the ask group impairment test, you would need a terminal value for the reporting unit and a residual value for step one.
• 37:28
  SPEAKER_03: Are there any other differences, Adam, that you would focus in on when you're thinking about inputs and assumptions other than the fact like what you're valuing is actually you're you're looking at sort of different units of things?
• 37:39
  SPEAKER_01: Yeah.
• 37:40
  SPEAKER_01: I mean, I'll start off assuming the reporting unit and the asset group are both businesses.
• 37:46
  SPEAKER_01: The main difference between a residual value and a fair value and a terminal value of the reporting unit is oftentimes the time at which we hit that point.
• 37:59
  SPEAKER_01: So in a long-lived asset impairment test, explicitly in ASC360, that residual value happens at the end of the life of the primary asset, right?
• 38:11
  SPEAKER_01: There's a very distinct time period for that test.
• 38:14
  SPEAKER_01: In contrast, for a goodwill impairment or reporting unit value, that terminal value isn't set at a particular time.
• 38:23
  SPEAKER_01: You don't have to go out an explicit number of years.
• 38:25
  SPEAKER_01: And so oftentimes what we do is that is calculated whenever the business hits a stable level of growth and profit margin, a steady state kind of a business.
• 38:37
  SPEAKER_01: And so there's going to be differences.
• 38:39
  SPEAKER_01: If that steady state, for example, isn't going to expect it to happen until 10 years, but the uh long-lived asset impairment test only going out five years, there's going to be just an explicit difference between the stage of the company at that five-year point versus the 10-year point.
• 38:56
  SPEAKER_01: And that could be evidenced just in terms of the discount rate being applied, as well as revenue growth rates and profit margins and things of that nature.
• 39:08
  SPEAKER_01: So you're going to get differences mainly related to that timing difference.
• 39:12
  SPEAKER_03: All right.
• 39:13
  SPEAKER_03: So then I think one of the challenges here, we talked about the challenge of putting yourself market participants, all the fact there's assumptions and otherwise, but a big part of this is the fact that we're looking at projective financial information.
• 39:25
  SPEAKER_03: And that's something that for companies can be challenged, something auditors spend a lot of time on.
• 39:30
  SPEAKER_03: We know that PCOB has also been focused on it because the fact no one has a crystal ball, right?
• 39:35
  SPEAKER_03: So inherently you're dealing with different types of issues depending on the type of company, stage, industry, and the whole environment.
• 39:43
  SPEAKER_03: But I think another challenge that can come in here is the fact that in many cases, a company could be considering different courses of action that then could also impact its cash flow forecast.
• 39:55
  SPEAKER_03: And that can lead to more uncertainty.
• 39:57
  SPEAKER_03: So, Beth, I know the model lets us deal with this, but how do you think about that?
• 40:01
  SPEAKER_04: Yeah, I mean, the accounting standards do, right?
• 40:03
  SPEAKER_04: They allow for the possibility to take into account multiple probability-weighted cash flow scenarios when developing your forecasts, right?
• 40:11
  SPEAKER_04: So most frequently we see companies use their best estimate or the most likely cash flow they anticipate, but a probability-weighted approach with multiple scenarios may be preferable in certain fact patterns, the one you mentioned, right?
• 40:23
  SPEAKER_04: Where they're thinking about alternative courses of actions to recover the carrying amount of the long-lived asset, or if the range in estimate of amounts for possible future cash flows is associated with a particularly likely course of action is, you know, kind of significant.
• 40:38
  SPEAKER_04: One common example we see of multiple probability-weighted scenarios being modeled is when there's lack of clarity for when an asset group or assets within the group are going to be disposed of.
• 40:47
  SPEAKER_04: For example, there may be different projected cash flow streams depending on when and if management disposes of a large asset within an asset group or disposes of the asset group itself.
• 40:57
  SPEAKER_04: So management might say, like, hey, I got an 80% probability I'm going to just kind of keep this asset, run it long term, but I got a 20% probability I'm considering things like selling in two years.
• 41:06
  SPEAKER_04: Those assumptions could drive significantly different probability-weighted cash flows.
• 41:11
  SPEAKER_04: And so you might want to think about that as opposed to a best estimate because you're not really sure yet what method or strategy you're going to follow.
• 41:18
  SPEAKER_04: You need to be mindful though that assumptions utilize don't create a different disconnect between the test you're doing, right?
• 41:23
  SPEAKER_04: And I know we talked about this on our last podcast.
• 41:25
  SPEAKER_04: You know, if you're in the held and use model, then you should probably be not saying, well, there's a probability I'm going to sell this like at 90%, because that might suggest we're actually in the wrong model and we should be in a held for sale model.
• 41:35
  SPEAKER_04: So you just want to make sure all the kind of assumptions hang together with the overall strategy.
• 41:40
  SPEAKER_03: I think that's helpful.
• 41:41
  SPEAKER_03: I think one thing that really struck me there though, Beth, when you're walking through that is you made it sound so easy.
• 41:45
  SPEAKER_03: 80% chance of this, 20% chance of that, which is easy if it's theoretical.
• 41:50
  SPEAKER_03: But I think this sometimes can be one of the hardest parts is figuring out what really is the probability of these different strategies, because often management really doesn't know.
• 41:59
  SPEAKER_03: And so what are some of the things people take into account when they're trying to probability weight different scenarios?
• 42:06
  SPEAKER_01: Yeah.
• 42:06
  SPEAKER_01: I mean, as we've been talking about, um, you know, using market participant or objective data is the ideal, not always possible.
• 42:15
  SPEAKER_01: But one example of an area where we do see that objective data being used is and and multiple scenarios being used is in the pharmaceuticals and life sciences area.
• 42:25
  SPEAKER_01: So when a company has a new drug in development and they're going through FDA approval process, for example, they're in phase two clinical trials, there's data out there that gets very granular in terms of very specific types of drugs or for certain what indications of what percentage of these drugs end up getting approved.
• 42:48
  SPEAKER_01: If they're in phase two, what's the potential probability of reaching phase three and then getting approved after phase three?
• 42:55
  SPEAKER_01: And so that's an example of an area where there's pretty good objective data to say, you know, we have two scenarios, one where this drug gets approved and one where it doesn't.
• 43:03
  SPEAKER_01: And here's the probabilities that we have actual decent evidence for.
• 43:07
  SPEAKER_01: That's obviously the ideal when we have really great evidence.
• 43:11
  SPEAKER_01: More often, though, it's more of a discussion with management around what do we think is going to happen, what's the most likely course of action.
• 43:19
  SPEAKER_01: And in times where they really don't have a very good view into that, sometimes equal weighting of various scenarios just makes the most sense.
• 43:29
  SPEAKER_01: An example is, you know, when COVID happened in early 2020, you know, it was really coming into play in March, right?
• 43:38
  SPEAKER_01: And a lot of companies had March 31st um financials to file.
• 43:42
  SPEAKER_01: And so what a lot of companies were doing, particularly in retail, which was largely shut down as of March 31st, is they were thinking about we don't know how long this shutdown is going to last.
• 43:53
  SPEAKER_01: And so they ran multiple scenarios.
• 43:56
  SPEAKER_01: And then they said, you know, we don't know which of these is really the most likely.
• 44:00
  SPEAKER_01: Likely, so let's just equally weight them.
• 44:02
  SPEAKER_01: Now, in reality, I think the shutdowns ended up going much longer than most people had expected.
• 44:08
  SPEAKER_01: But from an accounting perspective, as of March 31st, that was the best data we had.
• 44:13
  SPEAKER_01: And what's more important is that they're at least thinking about it, and we have contemporaneous documentation of what was going on on that date.
• 44:22
  SPEAKER_01: We're never going to be perfect.
• 44:23
  SPEAKER_01: We're never going to have absolute insight into exactly what's going to happen in those scenarios.
• 44:28
  SPEAKER_01: But it is important to be thinking about them in situations like COVID.
• 44:33
  SPEAKER_03: So then let's turn to the last area of evaluation of business combinations, which probably deserves its own podcast, but we can at least hit a few highlights.
• 44:40
  SPEAKER_03: And Beth, you and I talked last year about some of the comment letters on business combinations from the SEC.
• 44:47
  SPEAKER_03: And specifically, you know, this obviously has been a top area of focus.
• 44:51
  SPEAKER_03: It was the fourth most uh common area of comment by the SEC.
• 44:54
  SPEAKER_03: And one of the factors that you talked about was the fact that related to valuations.
• 44:59
  SPEAKER_03: So can you just remind listeners of some of those key points?
• 45:03
  SPEAKER_04: Yeah, certainly, right.
• 45:03
  SPEAKER_04: So because in a business combination, one of the big pieces is doing that purchase price allocation.
• 45:08
  SPEAKER_04: And you have various assets and liabilities that need to be valued at fair value.
• 45:11
  SPEAKER_04: Those can be intangibles, tangible assets, you know, you can have contingent consideration, you can have liabilities, which we haven't even talked about, but things like debt.
• 45:18
  SPEAKER_04: And so, you know, each of these will have their own valuation inputs and assumptions, many of which are interrelated and can have offsetting sort of valuation impacts.
• 45:27
  SPEAKER_04: From an internal controls perspective, what it's important for management to think about is how are they appropriately identifying the assumptions that most significantly impact the fair value, and then ensure they've sufficiently documented controls that support the most significant inputs and assumptions.
• 45:43
  SPEAKER_04: You know, if you have assumptions that rely on data, whether that's entity generated or market data, how do you ensure you have controls around the completeness and accuracy of the data?
• 45:52
  SPEAKER_04: And to assist with all this, you know, you it's often necessary to work with valuation specialists or other individuals to really help identify the most sensitive assumptions, which will be dictated really by the nature of the assets or liabilities that we're valuing.
• 46:04
  SPEAKER_04: And then you'll ensure once you've kind of identified those most significant, do you have the right support and then the appropriate documentation?
• 46:11
  SPEAKER_04: And you know, to pick up on what Adam said before, that contemporaneous documentation is so important because when people come in, even if it's comment letters from SEC, you know, six months, a year later, it's good to have what were the facts at the time?
• 46:23
  SPEAKER_04: Like hindsight might give you a different answer.
• 46:26
  SPEAKER_04: Right.
• 46:26
  SPEAKER_04: Yeah.
• 46:27
  SPEAKER_04: You've got to kind of do what you do and know at the time of the analysis.
• 46:30
  SPEAKER_03: Adam, from your point of view, then what are some of the significant things that people should be focused on there?
• 46:35
  SPEAKER_01: Yeah.
• 46:36
  SPEAKER_01: And in the context of a business combination, it really the significant assumptions are really determined by what asset you're valuing and what method you're using.
• 46:46
  SPEAKER_01: So for example, customer relationships are often valued under what we call a multi-period excess earnings method.
• 46:52
  SPEAKER_01: Some of the key inputs into that are what's the assumed attrition rate of the customers going forward?
• 46:59
  SPEAKER_01: Um, there's been a lot of focus from the PCOB on that in the past, um, but really having good data historically to look at what attrition has been like in your customer base is important.
• 47:11
  SPEAKER_01: There's also an assumption, you know, most people would agree that your existing customers are generally more profitable than the future ones you still haven't even gotten yet, right?
• 47:21
  SPEAKER_01: You have to spend money to get those new customers.
• 47:24
  SPEAKER_01: And so there's usually an adjustment to the sales and marketing expense associated with existing customers versus future.
• 47:32
  SPEAKER_01: Um, when we're talking about technology, again, also often valued under the multi-period excess earnings method, uh, but sometimes valued under relief from royalty as well.
• 47:42
  SPEAKER_01: But under both situations, one of the key assumptions that has gotten a lot of focus from regulators is that technology migration curve.
• 47:50
  SPEAKER_01: Similar to attrition, it's you know, how long is the technology that you purchased on the date of this business combination really going to be used?
• 48:00
  SPEAKER_01: Because over time, technology evolves and you spend RD to replace that over time, right?
• 48:05
  SPEAKER_01: And so that migration curve is a really important assumption that gets a lot of input.
• 48:12
  SPEAKER_01: Same thing with the when we're valuing a trade name or technology under a relief from royalty method, that royalty itself is really critical and having support from that from you know similar royalty agreements in the past you know from other companies that have been disclosed publicly, perhaps in their public filings.
• 48:31
  SPEAKER_01: We can use those to kind of sanity check the royalty rate that we're using in the analysis.
• 48:37
  SPEAKER_01: There's other areas that we've seen comments, Sean, from the PCOB or the SEC, like in the oil and gas industry, the unproved reserves.
• 48:46
  SPEAKER_01: There's often an adjustment factor for um, you know, what the probability essentially of those unproved reserves actually creating future production volume.
• 48:55
  SPEAKER_01: Then in loan portfolios, um, you know, thinking about how you've assumed the credit ratings are going to be developed.
• 49:02
  SPEAKER_01: So you know, you really have to look at each individual asset being acquired to determine what the significant inputs and assumptions are.
• 49:11
  SPEAKER_01: And as we've been saying, regardless of what it is, having data to support it is really ideal.
• 49:18
  SPEAKER_03: All right, I know there's tons more detail we can get into.
• 49:20
  SPEAKER_03: So, like I said, I feel like this is a whole other podcast itself.
• 49:24
  SPEAKER_03: So I may need to have the two of you back.
• 49:26
  SPEAKER_03: But maybe if we just take a big step back and say, okay, across the board, I think there's some general themes we've been talking about today.
• 49:33
  SPEAKER_03: But perhaps, Beth, starting with you, if you're thinking, you know, if you're a company dealing with valuation in any of these contexts, or there's other contexts as well, what advice would you give as you're working with teams and clients?
• 49:47
  SPEAKER_04: Yeah, I mean, I think I would start.
• 49:48
  SPEAKER_04: We do have a fair value guide, so that's always a good place to start.
• 49:51
  SPEAKER_04: We've also talked about this a little bit in our business combination guide and our PP ⁇ guide.
• 49:55
  SPEAKER_04: We mentioned the appraisal guide here on the podcast.
• 49:58
  SPEAKER_04: And then you could always phone a friend like Adam or you know, your other valuation specialists.
• 50:02
  SPEAKER_01: Yeah, I mean, I I think that's obviously as a valuation specialist, I'm going to emphasize that point that, you know, people in accounting at at various companies, they see valuation occasionally, right?
• 50:15
  SPEAKER_01: A valuation specialist sees it every day.
• 50:17
  SPEAKER_01: They live and breathe it.
• 50:18
  SPEAKER_01: So, you know, it's always going to be beneficial to get the perspective of someone that does valuation all the time when you're someone that only touches on valuation once a year or a couple times a year.
• 50:29
  SPEAKER_03: Yeah, and I guess maybe I'll add my own perspective on this because I agree completely with what you both said.
• 50:34
  SPEAKER_03: And then I think also from the point of view of someone in the company, making sure it's not just the accountants, right?
• 50:40
  SPEAKER_03: Like you need to make sure the strategy people are involved, the other people who are going to be making some of these decisions in the future because the accountants don't have all the information in the background.
• 50:49
  SPEAKER_03: So even if you have the best valuation specialist, you also need that best underlying information.
• 50:55
  SPEAKER_03: So it definitely takes a team to do all of this.
• 50:58
  SPEAKER_03: But Beth, Adam, this was a great topic, so much to think about, and really appreciate your time today.
• 51:04
  SPEAKER_03: Thanks so much for joining me.
• 51:05
  SPEAKER_01: Thanks for having me.
• 51:07
  SPEAKER_03: That's our show for today.
• 51:09
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• 51:15
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• 51:20
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• 51:29
  SPEAKER_03: From Thought Leadership at PWC, I'm Heather Horn.
• 51:34
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• 51:53
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• 52:02
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