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Share Valuation
Nice One Delia!
As one of the expert witnesses involved, MICK RUSE reviews the share valuation case Marks v Sherred (SpC 418).
Share Valuation
Nice One Delia!
As one of the expert witnesses involved, MICK RUSE reviews the share valuation case Marks v Sherred (SpC 418).
WHEN DELIA SMITH in her How to Cook series explained and demonstrated skills such as boiling an egg correctly, some people questioned if this served any real purpose. However, for many years prior to How to Cook Delia had attracted a noticeable following amongst men who did not normally venture far into kitchens, so I am sure these viewers at least found it useful.
Fiscal share valuation is not (so far anyway) graced by Delia and there have been few recent UK cases in which the basics have been considered. Marks v Sherred SpC 418 establishes nothing that is new, but it is illustrative (especially perhaps to the non-expert) of some fundamental principles. Perhaps Delia has started something.
Background
It was necessary for CGT to ascertain the market value at 31 March 1982 of a 66% holding in Ross Marks Limited (RML). This private company was formed in 1972 by the taxpayer, Ross Marks, since when it had traded with some success in consumer electronic products of which, by 1982, personal headphones were the primary lines.
It was directed that prior to the hearing of the taxpayer's appeal the experts were to meet and issue a joint statement of the matters upon which they were agreed and the matters upon which they were unable to agree.
Inter alia, the joint statement identified:
A mutual understanding of the nature of the business.
A mutual rejection of six valuation methods (namely discounted cash flow, net tangible assets, liquidation proceeds, dividend yield, cost and multiple of gross profit).
Agreement that capitalising the company's earnings was the applicable valuation method. This involves estimating the sustainable earnings and an appropriate multiplier.
That one expert considered the multiple of revenue implied by the earnings derived value provided a useful cross check to its reasonableness, whereas the other expert believed multiples of revenue to be very nearly irrelevant.
Agreement that the market value of the 66% holding should be calculated as a 66% proportion of the market value of the company in its entirety. The fiscal convention of discounting sub-75% control holdings by typically 10% to 15% from their pro rata 100% company values (to reflect the inability to pass a special resolution) was considered inapplicable to the circumstances of RML.
A very material disagreement as to the level of earnings to be adopted.
A relatively modest disagreement as to the multiplier.
Due to the joint statement, the hearing was efficient and quick. If only all litigation could proceed similarly!
Earnings
The Special Commissioner had to decide what represented the sustainable earnings capacity of the company.
Three main questions arose:
To what extent would a prospective purchaser have been influenced by RML's performance post 31 March 1981, i.e. a period in respect of which there were neither audited nor management accounts in existence at 31 March 1982?
The Special Commissioner decided it was correct to have regard to what happened in the year to 31 March 1982. Albeit a prospective purchaser would not have had the audited figures for the year to 31 March 1982, nevertheless they represented the best guide to what, upon making proper enquiries, he would have discovered from an analysis of all the raw financial data to which he would have been entitled.
In my view this is entirely sensible, first, in the light of the size of holding being valued and, secondly, in that RML supplied the retail sector and the majority of its orders were satisfied and billed before Christmas.
RML sourced its products in the Far East with the bulk of purchases being transacted in US dollars. During the early 1980s, sterling had fallen quite sharply against the US dollar. In the year to 31 March 1982, this adverse movement resulted in a deterioration in pre-tax profit from £160,074 (a margin of 10.7%) in the previous year to £54,311 (a margin of 2.9%). How would this have affected the estimation of sustainable earnings?
The Special Commissioner rejected the proposition that average historical exchange rates over a preceding three year period (indicating $2.13 to £1 as opposed to $1.82 to £1 at 31 March 1982) could be used to estimate sustainable earnings. RML could not protect itself against currency movements which had already occurred and had to buy products at the prevailing exchange rate, not at an historical rate.
In my view this reflects no more than commercial reality.
What adjustments should be made to the reported profits?
The Special Commissioner decided it was fair to adjust profits to take account both of the high historical levels of directors' emoluments and the high historical costs of entertaining. Moreover, as the business was a sound one which had suffered one year's set-back following a history of growth, a prospective purchaser would uplift what he anticipated to be the results for the year to 31 March 1982 to take account also of the future potential of the business, including the effect of the decision to establish a UK manufacturing base for some products which would in the medium term partially protect RML from currency movements.
In addition the Special Commissioner took into account the fact that the taxpayer's aim of a flotation on the Unlisted Securities Market was achieved in 1987 and that RML did indeed begin manufacturing at a time — not ascertained precisely — after 31 March 1982.
The sustainable earnings were concluded to be £115,000 pre-tax, whereas the experts' estimates were £100,000 and £190,000 respectively.
In my view the Special Commissioner's approach here for fiscal purposes accords with well-established professional valuation truths of a general nature, such as stated for example by J C Bonbright:
'Value, under any plausible theory of capitalised earning power, is necessarily forward looking. It is an expression of the advantages that the owner of the property may expect to secure from the ownership in the future. The past earnings are therefore beside the point, except as a possible index of future earnings.'
Multiplier
The Special Commissioner concluded the appropriate multiplier, which was expressed as a post-tax price/earnings ratio (PER), to be 10 whereas the experts adopted 10 and 11 respectively.
At 31 March 1982 the Electricals group of the FT Actuaries Share Indices displayed a PER of 17.6 and the PER of the most directly comparable company, Amstrad Consumer Electronics plc, was 11.6. Bank base lending rates stood at 13%. The PER of 17.6 covered a broad range of businesses and was treated by the Special Commissioner with great caution. As regards Amstrad's PER, it was felt an investor in RML (particularly one willing to take some chance on the future) and buying less readily marketable shares would expect to fix his price by reference to a smaller multiplier.
In my view, given that these quoted companies were so much bigger than RML, it would have been difficult to conclude a PER of more than 10, even allowing for the fact that quoted statistics normally derive from sales involving holdings of shares substantially below 1%.
The determined value
As it is not possible in 2004 to calculate what would have been the actual rate of corporation tax on RML's profits as adjusted for valuation purposes, the Special Commissioner took the average rate for the three years to 31 March 1982 and the sustainable earnings of £115,000 thereby reduce to £95,910 post-tax. A multiplier of 10 gives the entire company a market value of £959,100 of which 66% is £633,006.
This value exceeded the net tangible assets comfortably. The implied multiple of revenue was not considered.
The experts' market valuations at 31 March 1982 of the 66% holding were £561,000 and £1,050,000 respectively.
How important is Marks v Sherred?
Although not ground breaking the case disposes of these quite commonly met misconceptions:
that the valuation of a trading company proceeds simply from averaging the historical profits; or alternatively
that the valuation proceeds simply from adopting a 'snapshot' of the earnings achieved in the most recent completed financial year or as anticipated for the current financial year;
that it can never be justifiable to take into account the subsequent fruition of matters that were only in contemplation at the valuation date.
The case confirms that share valuation is essentially judgmental rather than mechanical in nature.
As one would expect, the technical interpretation of hypothetical sales and the characteristics of the hypothetical parties to such a sale, etc. are ratified, but this is not why the case report deserves attention. It is because the primary valuation issues are straightforward, the Special Commissioner's decisions reflect sound commercial practice and his reasoning is explained clearly and succinctly.
It is not possible in a short article to include a detailed description of the company or to narrate all the questions which were considered, but no important feature of the case has been ignored.
Mick Ruse is in practice at 140 Tabernacle Street, London EC2A 4SD; tel. 020 7300 7345.
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Specialists in Senior Appointments. Contact us at www.integralsearch.co.uk
