The Illusion of Value: Everything is Changing

Consider Michael Jackson, the Empire State Building, and Myriad of Value Drivers (Part II of II)

In this concluding article, the second of a two-part series, the authors conclude presenting additional illustrations that underscore their primary thesis: that in many businesses, value is illusory and there are a host of factors that are unanticipated and cannot be modeled.

In this concluding article, the second of a two-part series, the authors conclude presenting additional illustrations that underscore their primary thesis: that in many businesses, value is illusory and there are a host of factors that are unanticipated and cannot be modeled.

Jacqueline Kennedy Onassis

Last year, the trust set up for the Jackie Onassis estate was dissolved. The original estate was worth far less than was widely estimated at the time of her death. The estate had hope to fund a charitable lead trust, but after expenses and taxes, there was not enough for a residuary to create the trust at that time. The former First Lady’s executors valued her estate at approximately $44 million, though the unbelievable prices that some of her property brought at an auction prompted an Internal Revenue Service (IRS) audit to determine whether the estate’s true value was much higher. The principal issue was whether the auctioned items were part of the estate (estate tax) or part of the children’s property (capital gain).

The auction was an incredible event. There was a lottery just to get into the auction. She was considered to be a secular saint. Small pictures as well as large scale portraits of Jackie sold at the event. As the auction proceeded, prices escalated out of control. Any estimates became meaningless. A necklace set of faux pearls costing less than $100 sold for over $100,000. President Kennedy’s golf clubs originally valued between $300 and $500 sold for over $800,000. These items became an extraordinary collection because she was considered an extraordinary person. This is a clear example of illusion of value.

Michael Jackson

Estate tax cases with the IRS are usually about the valuation of something. Whether it is land, a vacation home, a business, or a piece of art, valuation disputes can be difficult, especially when dealing with intangible assets. For estate tax purposes, the net value is subject to tax. The debts were key variables for Michael Jackson’s estate because Mr. Jackson reportedly had many high-value assets but many large debts as well. Beyond this fundamental rule about debts, specific assets must be valued. Jackson owned a music catalog, real estate, and art. The big piece of the real estate was the Neverland Ranch. Although the decree may presume that every piece of real estate is unique, it is usually possible to hash out the value of real estate based on comparable parcels, possible development use, or legal restrictions. Neverland Ranch may be in an especially unique category, however, because it is so intimately tied up with Mr. Jackson’s image.

At the time of his death, Michael Jackson’s reputation had suffered from allegations of child abuse, drug use, and erratic behavior. In valuing Jackson’s estate for estate tax purposes, appraisers valued Jackson’s name and likeness at only $2,105, citing his tarnished reputation. Because of this, Jackson’s estate is embroiled in a legal dispute with the IRS over the value of Jackson’s name and representation. The tax case between the Jackson estate and the IRS is mostly about the value of the singer’s image, likeness, and intellectual properties. The value of these rights accrues to the estate, but valuation swings for assets of that variety can be huge. Not surprisingly, the IRS took issue with this low value, arguing that Jackson’s name and likeness should be valued at $434 million. It is hard to reconcile polarizing values. As in many valuations, timing is the key component. In any event, this is an example of the illusion of value.

Empire State Building

Much value is illusory, but some is not…or is it? For instance, what is an office building worth? Well, it would depend on where it is located, whether it is fully rented or vacant and the amount of the rents, quality of the tenants, length of leases, whether the building is well maintained or has perpetual repairs, its age, zoning, and a myriad other factor.

We remember one time when Donald Trump was part of a group that purchased the Empire State Building for about $40 million and he was bragging about that. Well, at that same moment, the people that had a 90+ year lease on that building were spending $65 million just to replace the windows! The property owners, it seems, were not able to derive any economic benefits of ownership (except possibly the four percent annual return on their investment) while the people with the lease received all the income and other benefits flowing from managing the property.

Myriad Value Drivers

So, what is something’s value? The correct answer is “it depends.”

Some years ago one of the authors asked that same question while reading the front page of The Wall Street Journal. Articles were about home prices starting to heat up, Samsung questioning its game plan, Tom Brady being suspended, the U.S. Air-Traffic system needing rebuilding, Edamame and goat cheese concessions at movie theatres, the differences in over-the-counter pain relievers, the death toll rising due to a faulty switch in some cars, Shell becoming able to drill for oil in the Arctic Ocean, ranchers expanding cattle herds, Morgan Stanley selling its oil-trading business, American Idol being cancelled, the share of Americans that are religiously unaffiliated rose to 22.8% (not about 23% or just over 22%, but 22.8%), and a Picasso selling for $179.4 million.

Each of these affects value. Now, we know that houses of worship are not usually bought and sold, but affiliation affects cash flow which can determine whether a particular church remains open. The thing that got us started on this subject is the Picasso. Ed remembers the big news in 1961 when the Metropolitan Museum of Art purchased Rembrandt’s Aristotle Contemplating the Bust of Homer for $2.3 million. This was big news even making the front page of The New York Times. For months (possibly years) afterwards, there were long lines of people wanting a glimpse at that painting (which most of them probably never heard of before that purchase) signaling the painting’s “extraordinary value.” On some level, the “value” of the Met was likely increased because that purchase had to have led to increased attendance and gift shop revenues, contributions, and memberships.

A Bull

Another day, the front page of The Wall Street Journal reported on the death of a bull. This was no ordinary bull. During its lifetime, 500,000 offspring resulted from that single bull’s semen, resulting in tens of millions of dollars revenue for its owners. The breeder sold the bull 23 years earlier for $4,000. However, he said he had no regrets since the notoriety resulted in substantial revenue from his other bulls and fame for his dairy.

Made in the USA

There could be newfound value in the “Made in the USA” label. Those that stuck to manufacturing in America have added value not only from latent patriotism, but from a more competitive landscape here even with the strengthening dollar. Wages and benefits are stable while low wage countries are seeing unpredictable increases and political interference, low cost domestic energy, availability and use of state-of-the-art technology, tariffs, lower shipping costs and more efficient shipping methods and design, a reemerging supply chain and infrastructure, and more consistent quality control.

Hillary Clinton’s Staff

Hillary Clinton knew value perception when she added John Podesta to her “exploratory” staff for her 2016 campaign. This raised her ability to get contributions and created a barrier for whoever her competition might be. However, that bump up in value perception dissipated as the campaign progressed. Timing can be a factor in valuations, so could the product and message.

LA Clippers

Steve Ballmer’s purchase of the Los Angeles Clippers for two billion dollars changed the methodology for valuing a professional basketball team. Prior to Ballmer stepping up, the largest estimate of value for that team was under one billion dollars. What happened to cause the jump in value?

Steve Ballmer had just retired from Microsoft and was its largest individual stockholder having been there almost from its beginning and had a reputed net worth of $20 billion. His personal wealth before he purchased the Clippers was primarily in index funds and Microsoft stock. He looked at the Clippers as an investment that had a cash flow equal to or greater than what he was getting in dividends, so he did not see any drop in his income because of the acquisition. Dividends are always an important consideration in investing. Assuming the Clippers needed to satisfy him with a 2.5% cash flow, he was able to value the team at a much higher amount than a typical business investor who might look for an above market return on investment needing to earn as much as 15% to 25% depending upon risk. The way Ballmer determined the value makes him more of a strategic investor than a traditional investor eschewing rather than following a traditional “fair market value” based valuation.

Ballmer also believed the risk to owning the LA team was lower than owning stocks and that over time, e.g. thirty years, the team would appreciate at least as much as the market but probably greater. Therefore, he made a nontraditional investment with just 10% of his portfolio with no loss of cash flow, a potential for greater long-term wealth creation, a diversification of his assets into an area that he feels will have increasing investor demand for the limited supply of teams, and an opportunity to have fun. He also pointed out that the business has competent in-place management so there will not be an inordinate demand on his time.

Microsoft’s Value

At the same time Steve Ballmer acquired the LA Clippers, he was interviewed and asked about the poor, i.e. terrible, performance of Microsoft’s stock during his tenure as CEO. His response gave a glimpse on how to evaluate a company.

Ballmer’s comments about the drop-in market cap of Microsoft under his reign as CEO was that he took over at a time when the valuations were not logical, were not based on earnings, and were spurious and nonsensical. He claimed that the market cap when he left was solid and based on earnings and a reasonable dividend yield and P/E ratio. He also pointed out that Microsoft’s earnings tripled under his tenure to approximately $22 billion. Something he was extremely proud of.

Ballmer was hesitant to criticize any specific company with high stock valuations but did point out that he felt the only way to properly value a company was based on earnings and future earnings potential. Temporary infatuation with a company that sends their stock prices sky high cannot have those values maintained without eventual sustainable earnings. Thus the illusion of value until there is a recognized normalization of sustainable cash flow.

Warren Buffett

While companies have many dynamic factors that need to be considered, there also are new ways to finance company acquisitions. One such person developing these novel methods is Warren Buffett. What he does is invest a small portion for the common equity and a much larger amount for preferred equity. The preferred stock pays a higher than usual dividend and can be redeemed at a fixed point in time or converted to common stock. He did this with Coca-Cola, Bank of America, General Electric, Goldman Sachs, Heinz, and too many others to mention. With the preferred he is guaranteed a dividend (which is federally taxed to Berkshire Hathaway at favorable tax rates), gives up a little of the upside but can reap the benefits of substantial growth in the value of the common stock while receiving regular cash flow in the form of dividends. His “newest” method is now corporate debt with above market interest rates. He is adaptable and seems to know what works.

Another factor in valuing Warren Buffett’s reputation for astuteness is when it is announced that he has acquired shares in a company, such as he recently did with Amazon.com. This news, by itself, adds value. This is similar to when Oprah Winfrey bought into Weight Watchers and became its spokesperson. There are initial jumps, but in the long run, the values are determined by sustainable cash flow—but who knows when that will cause the normalized of the values. 

Everything is Changing

Valuations are based on hypothetical circumstances being born and growing in expected ways. Certainly, until just before the birth of personal computers around 1980 expectations were consistent and results from applying what ifs resulted in reasonable valuations within ranges not too unexpected. Jumping forward to today, the changes have become uncertain, exponential, and geometric. Witness the market values of Facebook, Netflix, Amazon, and Lyft. 

Expectations are becoming more ambitious and companies are performing in newly and quickly evolving ways. Let’s use Apple as a window into a model of what to expect. They sell products and have brick and mortar stores. Yet, while they are considered a manufacturer, they really do not make anything—they outsource their production Their strength in getting their products to customers is with coordinating their global supply chains with systems and rigid procedures, quality controls, tight time scheduling, and focused management and oversight. And they are built on a brand that is seen on every laptop in use, and by the sleek shape of its iPhone, which has a built-in camera and GPS that pretty much wiped out those businesses as well as supplanting land line phones and many other products not mentioned here. That is the new model.

New Business Models

What is not measured and counted is the intellectual capital the new model companies have. This includes software, patents, copyrights, brands, other knowledge, customer capital, supplier relationships, and human capital, i.e. the people that work for the company. Bill Gates once said that if a certain 30 people left Microsoft, there would be no company. Maybe that number today is 100. Either way, a very small number of employees appear to create substantial value of today’s new model companies.

Some dramatic illustrations of industry disruption caused by this new model is the travel agency industry where user friendly hotel and airline booking sites caused 18,000 travel agencies to close; selling eyeglasses, men’s grooming products, books, gift items, electronics, and myriad other products caused many traditional retailers to close or hastily adapt to on-line selling. Skype services that brought in two billion-dollar revenues in 2013 to Microsoft wiped out $37 billion of revenues of traditional telecom firms. The market value of Uber is more than eight times the market value of every NYC taxi medallion which has been eroded by the Uber model. Buying habits likewise have changed along with the selling models. On-line selling and Internet based services are no longer the trail blazers—it is the current model, with many other changes indicated and anticipated. 5G is expected to create major disruptions to present models.

Businesses are dynamic with constant changes, and their existence and rationale are subject to many factors. And appraisers have to determine how much each company is worth. Valuing a business or undertaking takes more than a sharp pencil and a neat spreadsheet. It takes awareness, imagination, and a visualization of cash flow creation and perception of possibilities emanating from the ownership. At the end of the day, sellers need buyers who think what they are buying is undervalued. And that is what determines something’s value. Without an actual seller, the value an appraiser comes up with is somewhat illusory. 

Conclusion

Mostly everything everyone does affects value. In some situations, it does not matter…but, typically it does. Good traders are alert to opportunities with unnoticed or unappreciated trends indicating stealth value. For them, it is a way to wealth and the value they see does not “just depend.” Oh, and value can go both ways. Besides going up, it also can decline; and sometimes loss of customer base, parishioners, viewers, market share, or damage to a reputation is terminal. In those cases, it does not just depend!

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Edward Mendlowitz, CPA, PFS, ABV, CFF, is partner with WithumSmith+Brown, PC, in East Brunswick, New Jersey. He has over 40 years of public accounting experience, is a licensed Certified Public Accountant in the states of New Jersey and New York and is one of Accounting Today’s 100 Most Influential People. The author of 27 books, Mr. Mendlowitz has written hundreds of articles for business and professional journals and newsletters and presented over 300 CPE programs. He writes a twice a week blog at www.partners-network.com. 

Mr. Mendlowitz can be contacted at (732) 743-4582 or by e-mail to emendlowitz@withum.com.

Louis Young, CVA, with WithumSmith+Brown, PC, in East Brunswick, New Jersey. He has been engaged to perform valuations primarily of closely held companies and family limited partnerships. These valuations have been performed for estate and gift tax purposes as well as purchasing and selling businesses. Mr. Young has extensive experience in finance, with emphasis on the automotive industry. He has performed corporate financial planning, automotive factory financial statement analysis, and departmental internal control analysis, been involved with mergers and consolidations, and cash flow planning.

Mr. Young can be contacted at (732) 379-5218 or by e-mail to lyoung@withum.com