Hitchner Webinar: How to Attack and Defend Databases Used by Valuation Analysts

How (Use of) the Unknown Will Kill You

On November 17, 2021, Jim Hitchner presented “How to Attack and Defend the Databases Used by Valuation Analysts”. The presentation raised the following questions: Have you ever been cross-examined by an attorney who is more familiar than you with databases referenced in the valuation report? When was the last time, if ever, that you reviewed and studied the methodology and data of databases you are relying on in your analyses and reports? This webinar underscored that the professional standards requires analysts to know the strengths and weaknesses of transactional databases, those relied upon to develop the cost of equity and DLOM and the economic and industry data if these are included in the report. While there are professional reasons for understanding these databases, it is also important to protect the integrity of the analyst’s opinions.

On November 17, 2021, Jim Hitchner presented “How to Attack and Defend the Databases Used by Valuation Analysts”. The presentation raised the following questions: Have you ever been cross-examined by an attorney who is more familiar than you with databases referenced in the valuation report? When was the last time, if ever, that you reviewed and studied the methodology and data of databases you are relying on in your analyses and reports? This is important since blindly using these databases, without fully understanding the terms of use (and limitations), can result in you being impeached and further, it can damage the expert’s credibility, especially if the expert cannot answer questions about the uses and limitations. This webinar underscored that the professional standards require analysts to know the strengths and weaknesses of transactional databases, those relied upon to develop the cost of equity and DLOM and the economic and industry data if these are included in the report. While there are professional reasons for understanding these databases, it is also important to protect the integrity of the analyst’s opinions.

Business Valuation Standards Why it is Incumbent to Understand the Databases Used!

The business valuation standards of AICPA, NACVA/IBA, and ASA require the accredited professionals to understand the databases used forming opinions of value. SSVS No. 1, Paragraph 37 and 38 is cited as one such standard. Paragraph 38 provides that “[i]n applying the methods in paragraph 36 (which includes the Guideline Company Transaction Method) or other methods to determine pricing multiples or metrics, the valuation analyst should consider: a) qualitative and quantitative comparisons, b) arm’s length transactions and prices, and c) the dates and, consequently, the relevance of the market data.” Significantly, the SSVS requires “the valuation analyst [to] set forth in the report the rationale and support for the valuation methods used.” These rules require the analyst to understand the data.

Likewise, NACVA/IBA’s General and Ethical Standards require that its analysts act with integrity and objectivity by not knowingly misrepresenting facts and that they not act in a manner that is misleading. This same standard requires due professional—including completing sufficient research and obtaining adequate documentation—and sufficient relevant data, which in turn requires the member to obtain sufficient relevant data to afford a reasonable basis for conclusions, recommendation, or positions. While IBA and NACVA’s Development Standards does address the reliability of data—“members may rely upon information provided by any source without corroboration if disclosed in the report”—and include scope limitations, which affects the level of reliance on the information, the later should not be considered a right to blindly use data from a database that sells the information.

As with the other two organizations, ASA likewise has a standard. This is found in BVS-V Market Approach to Business Valuation (A) and (B) and SBVS-2, Guideline Transaction Methods. BVS-V (B)(1) and (2) provides that “factors to be considered in judging whether a reasonable basis for comparison exists include: 1) A sufficient similarity of qualitative and quantitative investment characteristics, 2) The amount and verifiability of data known about the similar investment characteristics, and 3) Whether or not the price of the similar investment was observed in an arm’s length transaction, or in a forced distressed sale.”

ASA’s SBVS-2, Guideline Transaction Method, similarly includes a requirement to obtain and analyze relevant financial and operating data of the companies involved in guideline transactions, as available. In short, this and other requirements in this SBVS requires the users to not average or use the data simply because a subscription exists. There may be reasons when this approach is considered to resist using the available.

USPAP Standards Rule 9-1, General Development Requirements, similarly requires appraisers to “be aware of, understand, and correctly employ those recognized approaches, methods, and procedures that are necessary to produce a credible appraisal.” The Commentary explains that “diligence is required to identify and analyze the factors, conditions, data, and other information that would have a significant effect on the credibility of the assignment results.”

Hitchner contends that the above rules require due diligence and that blind use of databases is likely to produce an erroneous conclusion and in a litigation scenario, could lead to the court deeming the expert’s report inadmissible. The latter event would only be the beginning of a string of unfortunate events.

Guideline Company Transactions Method: Deal Stats, BIZCOMPS, ValuSource

Hitchner commented that where the market approach is used, he has often observed that the databases are being applied incorrectly. For instance, data derived from DealStats, BIZCOMPS, and ValuSource/NACVA/IBA cannot be grouped; if used, use independently. Second, when one or more of these databases are used, the analyst must understand the data source and their respective limitations and such are used, and that determine whether the data makes sense.

When using the market approach and any of the above databases, the analyst must be cognizant that there may be potential or actual mistakes in the data and or the application of the data to the subject company being valued. Before using any “comparable” data, consider the following:

• Is a stretch being made in business activity similarity?
• Does the transactional data correspond to the same economic or industry cycle? (If data that does not correspond to the same economic or industry cycle within the database and that of the subject company, there may be disconnect and misuse of the data.)
• Avoid averaging widely dispersed multiples.
• Be careful because some transactional data may include a strategic premium and the use and extent of the premium may not be known; so, ask questions, dig into the data before using it or remove that transaction, if known, from the indication of value.
• Obtain more than one year of financial information from the subject company and beware if transactions with limited financial disclosures.
• Avoid using multiples based upon old financial information, e.g., revenue, DE, and EBITDA.
• Not knowing or guessing at what assets and liabilities were transferred.
• Not knowing the future outlook for the acquired companies, including profits.
• Not knowing the estimated growth rates of the acquired companies.
• Not knowing any risk factors particular to the acquired companies.
• Not knowing the normalized earnings of the acquired company.
• Not knowing the depth of management.
• Not knowing the specific markets served.

To effectively use the market approach, it is incumbent to conduct a fair amount of due diligence not only about the transactions, but also about the subject company.

Certainly, DealStats has numerous transactions of private companies buying private companies. Those analysts using or considering using this database are exhorted to read “Data are Restated”, “EBITDA” and “SDE”. With regard to the data submitted by intermediaries to BVR, Hitchner observes that intermediaries may recast the data, but it is not clear how this is being done. In a majority of cases, the P&L is not recasted. Hence, there is potentially an issue using the restated and recasted P&L. As for the EBITDA value, Hitchner also observes that if the contributor/intermediary recasted the EBITDA value, that value will be given a preference and displayed in the EBITDA field instead of the restated EBITDA. The provided EBITDA value will also be used in other calculations that use EBITDA, such as MVIC/EBITDA and EBITDA Margin.

As for “SDE”, if the business has more than one working owner, generally, the highest-paid partner’s compensation is added back and the lesser paid partner’s compensation is normalized. Typically, brokers who sell businesses try to indicate the highest earnings available to one working owner.

Again, the analysts needs to understand how the database collects and publishes data and recognize that there may be a mismatch of values (e.g., some MVIS/EBITDA using restated and others using recasted values), and questions surrounding how the statement was recasted. Similar comments apply to BIZCOMPS and ValuSource. Those using or subscribed to DealStats that want to use the market approach should consider using the public buyers of private sellers and any buyers of public sellers when using the market approach.

As for BIZCOMPS, Hitchner recommends that those subscribing to that database read the User’s Guide, note that fair market value is cash or cash equivalent, and that BIZCOMPS includes the following cautionary note:

The information presented in this survey has been obtained with the greatest care from sources believed to be reliable, but it is not guaranteed. The author expressly disclaims any liability, including incidental or consequential damages, arising from any errors or omissions in this study.

BIZCOMPS can still be used, and in this presentation, Hitchner includes the best ways to use this database.

As for ValuSource, which acquired the IBA database, again, Hitchner reiterates that there are uses but also limitations using this database. The latter being said, Hitchner notes that he could not find a tutorial or disclaimer on the ValuSource website; IBA previously cautioned its users to use a multiple of SDCF; IBA previously recommended that there should be at least five transactions in the applicable SIC as the basis for a rough estimate of the mean of the total market. And acknowledged the sample size recommendation was arbitrary. There were other issues with use of the IBA database and those included, among others, the following:

• Owner’s compensation expense—“This category is not available for all transactions and is of only marginal utility given the quality of small business financial statements.”
• Annual Earnings before owner’s compensation expense, interest expense, and income tax expense—“This data category is not available for all transactions and is only marginal utility given the quality of small business financial statements.”
• “Small to medium sized closely held businesses are less likely to sell for a price approximating fair market value than are large closely held businesses.”
• “They [Businesses] are bought and sold based upon imperfect information, risk perceptions and tolerances of different individuals, compulsions and behavioral characteristics of different individuals, synergetic possibilities, etc.”

Last, while IBA stated that “to be an equally desirable substitute for the closely held businesses, the guideline business must be both similar and relevant”, the IBA database lacked data to quantify these factors.

Cost of Capital Databases

Here too, there are cautionary notes. Hitchner discusses BVR’s Cost of Capital Professional, Duff and Phelps Cost of Capital Navigator, Damodaran’s Supply Side ERP, and Pepperdine Surveys. Here, the issues that continue to be debated are whether to add a size premium; Prof. Crain criticizes its use, while D&F sells a Risk Premium Report Size Studies.

Damodaran argues that the size premium debate is incorrect. Hitchner quotes Damodaran as saying:

• The small cap premium is firmly entrenched in practice, with analysts generally adding on 3% to 5% to the conventional cost of equity for small companies, with the definition of small shifting from analyst to analyst.
• Even if you believe that small cap companies are more exposed to market risk than large cap ones, this is a sloppy and lazy way of dealing with that risk, since risk ultimately has to come from something fundamental (and size is not a fundamental factor).

Pepperdine Surveys critiques the traditional ERP development by business valuation practitioners stating that:

• One of the biggest business valuation mistakes is confusing historical equity returns with expected or required equity returns.
• The bottom line is that the traditional backward-looking models do not provide anything close to a reasonable estimate for the required rate of return on equity capital for most investments, with possible exception of a highly diversified portfolio of public companies that will be held for at least a generation.
• CAPM and BUM as typically applied are not the product of reliable procedures, they cannot be applied in a way that creates a reliable result, and, indeed, if done blindly and without the application of judgment, the results obtained from use of these methods will almost always be wrong, because in isolation, they are incapable of reflecting the thought process of actual buyers and sellers in the market.

Pepperdine espouses the implied ERP but cautions it too has an “optimism bias” that skews the implied ERP and that the lack of coverage by analyst for all but the biggest firms makes the implied ERP hard to extrapolate to private entities and certainly is irrelevant for a minority interest in a private entity.

Again, this is a critical area for business valuation analysts to understand, be able to debate, and justify in the reports.

DLOMS Database

Hitchner further discussed the Stout Restricted Stock Study, Stout Three-Step Method, Valuation Advisors Lack of Marketability Discount Study, Pre-IPO Data, Restricted Stock, and Pre-IPO Benchmark Studies. Here too, business valuation analysts engaged to value nonmarketable minority interests need to understand the various methods and critiques to properly discuss these in their reports and in court.

Economic Reports

In this section of the webinar, Hitchner discussed BVR’s The Economic Outlook Update, KeyValueData National Economic Report, Mercer Capital’s The National Economic Review and TagniFi Quarterly Economic Update. Here too, analysts need to understand the relevance of data and determine whether to use, if at all.

BVR Report requires a specific footnote providing attribution to BVR if the report is used in part or in whole in the body of a valuation report. Yet, BVR in its fine print states:

Part/All [choose one] of the contents of the economic outlook section of this valuation re quoted from the Economic Outlook Update 1Q2021 published by Business Valuation Resources ©2021 reprinted with permission. The editors and Business Valuation Resources, LLC, while considering the contents to be accurate as of the date of publication of the EOU, take no responsibility for the information contained therein. Relation of this information to this valuation engagement is the sole responsibility of the author of this valuation report.

Usually, the analyst in a litigation engagement will also use a disclaimer that he or she assumes the information is accurate as well. From a litigation perspective, this means that no one is taking responsibility for the accuracy of the data. As Hitchner observes, “this is not good.”

This criticism is not unique to BVR; KeyValueData similarly states:

Neither KeyValueData nor the editors take any responsibility nor offer any warrants for the accuracy of the data or any consequences that may result from use of this data or any other contents of this Report for personal or professional purposes.

Mercer similarly disclaims liability stating:

Mercer Capital is not responsible for any specific application of the data or discussion contained in the review, and subscribers affirmatively assume responsibility for any material prepared using this information.

TagniFi is described as a “free and good valuable product, but one that is not fully cited and contains, on occasion, ‘internal inconsistencies with data’”.

Despite the liability disclaimers of the first three sources, each has its pros and cons. Each presents useful information. Hitchner goes into far more detail on the pros and cons.

The presentation also included the perils of an expert using an economic report from an entity that disclaims its accuracy and outside use. The case of Miller v. Sun Capital Partners, Inc. C.A. No. 13-1996, in which an IBISWorld Industry Report was used by an expert to highlight the risks of an expert relying on outside economic reports in a report they prepare.

Conclusion

The webinar covered a broad swath of issues and important issues involving the reliance and use of databases. There is a degree of comfort subscribing to databases, but not knowing how to use them or their limits may destroy an analyst’s credibility and unintentionally harm the client.

---

Roberto H. Castro, JD, MBA, MST, CVA, is Managing Member of the Law Office of Roberto H Castro, PLLC and Legal Compliance counsel for Equilus Capital Partners, LLC, a closely held Real Estate Limited Partnership Fund. He is also Technical Editor of QuickRead and a member of NACVA’s CUV team.

Mr. Castro can be contacted at (509) 679-3668 or by e-mail to rcastro@rcastrolaw.com.