1. society
2. work
3. unemployment

 ValuationofSampleMetal
Company,Inc.
January1,2012
Jay R. Hill, CPA, P.C. Jay R. Hill, CPA∙ABV
JayR.Hill,CPA,P.C.
Cell (816) 674‐3141 A Professional Corporation P.O. Box 29090 Parkville, Missouri 64152 www.jrhillcpa.com Email [email protected] Mr. Sample Attorney Representative of Sample Metal Company, Inc. I have been engaged to establish a reasonable estimate of the fair market value of a minority interest in the common stock of the Sample Metal Company, Inc. (herein referred to as either “Sample” or “the Company”), a Illinois Subchapter S corporation, as of January 1, 2012. The purpose of this valuation is solely for gift and estate tax purposes. It is my understanding that you and other representatives of the Company agree to restrict the use of this report for the stated purposes and that no distribution of this report to outside parties to obtain credit or for any other purpose will occur. I conduct this valuation engagement and present this detailed report in conformity with the “Statement of Standards for Valuation Services No. 1” (SSVS) of the American Institute of Certified Public Accountants.1 My analysis and report are also performed with reference to the Uniform Standards of Professional Appraisal Practice (“USPAP”) promulgated by the Appraisal Foundation and with IRS business valuation development and reporting guidelines including Revenue Ruling 59‐60 (C.B. 1959‐1, 237), as modified and amplified, which provides guidelines for the valuation of closely‐held corporate stock for federal income, estate and gift tax purposes. Revenue Ruling 59‐60, while used in tax valuations, is also used in many nontax valuations. The standard of value for this valuation is fair market value. A common definition reference is Revenue Ruling 59‐60, which defines fair market value as “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” In performing this valuation, I rely on the accuracy and reliability of historical financial statements along with other financial data and oral representations of representatives of the Company. I did not audit or review such financial statements or other data, and I do not express an opinion or any other form of assurance on them. Based on my valuation study of Sample, as described in the body of this report, it is my opinion that the fair market value of a minority interest in the common stock of Sample Metal Company, Inc. as of January 1, 2012 is $1,027 per share 1
SSVS defines a valuation engagement as “an engagement to estimate value in which a valuation analyst determines an estimate of the value of a subject interest by performing appropriate procedures, as outlined in the AICPA Statement on Standards for Valuation Services, and is free to apply the valuation approaches and methods he or she deems appropriate in the circumstances. The valuation analyst expresses the results of the valuation engagement as a conclusion of value, which may be either a single amount or a range.” I base my conclusion on the documents and information in Exhibit A and my opinion is subject to the assumptions and limiting conditions listed in the last section of this report. No one should rely on this engagement to disclose errors, irregularities, or illegal acts, including fraud or defalcations, that may exist in the financial information and/or operations of the subject entity. March 11, 2012 Kansas City, Missouri TableofContents
CERTIFICATIONSTATEMENT .............................................................................................. 2 INTRODUCTION .................................................................................................................... 3 METHODOLOGY AND GUIDELINES ............................................................................................. 3 STANDARD AND PREMISE OF VALUE .......................................................................................... 4 PROCEDURES AND DOCUMENTATION ....................................................................................... 4 OVERVIEW ............................................................................................................................. 5 NATURE AND HISTORY OF THE COMPANY ................................................................................. 5 PRODUCTS ................................................................................................................................... 5 CUSTOMERS ................................................................................................................................ 5 MANAGEMENT AND EMPLOYEES ............................................................................................... 5 FACILITIES .................................................................................................................................... 5 STOCK OWNERSHIP AND TRANSFERS OF STOCK ........................................................................ 6 FINANCIAL OVERVIEW ................................................................................................................ 6 ECONOMICANDINDUSTRYOUTLOOK ............................................................................... 7 GENERAL ECONOMIC CONDITIONS ............................................................................................ 7 REGIONAL ECONOMIC OVERVIEW ........................................................................................... 10 INDUSTRY OVERVIEW AND OUTLOOK ...................................................................................... 11 IMPACT ON COMPANY ............................................................................................................. 15 FINANCIALSTATEMENTANALYSIS .................................................................................. 16 FINANCIAL POSITION OF COMPANY AND TRENDS ................................................................... 16 OPERATING RESULTS AND TRENDS .......................................................................................... 19 COMMON SIZE AND RATIO ANALYSIS ...................................................................................... 22 VALUATIONANALYSISANDCONCLUSIONOFVALUE ..................................................... 25 VALUATION ANALYSIS ............................................................................................................... 25 VALUATION METHODS CONSIDERED BUT NOT UTILIZED ........................................................ 26 CAPITALIZATION OF CASH FLOW METHOD .............................................................................. 26 PUBLIC GUIDELINE COMPANY METHOD .................................................................................. 35 DEVELOPMENT OF VALUE FACTORS – GUIDELINE COMPANIES .............................................. 35 RECONCILATION OF VALUE ESTIMATES – PUBLIC GUIDELINE COMPANY METHOD ................ 44 RECONCILIATION OF ALL VALUE ESTIMATES ............................................................................ 44 ADJUSTMENT FOR LACK OF MARKETABILITY ........................................................................... 44 FMV VALUE STUDY – RESTRICTED STOCKS ............................................................................... 46 VALUATION SUMMARY AND CONCLUSION OF VALUE ............................................................. 53 ASSUMPTIONSANDLIMITINGCONDITIONS .................................................................... 54 DOCUMENTSANALYZEDANDUTILIZED .......................................................................... 57 QUALIFICATIONSOFVALUATOR ...................................................................................... 58 INDEPENDENCEOFVALUATOR......................................................................................... 58 © Jay R. Hill, CPA, P.C. 1 CERTIFICATIONSTATEMENT
I certify that, to the best of my knowledge and belief:  The statements of fact contained in this detailed appraisal report are true and correct.  The reported analyses, opinions and calculated value are limited only by the reported assumptions and limiting conditions, and are my personal, impartial, independent, unbiased, objective professional analyses, opinions and conclusions.  Jay R. Hill or Jay R. Hill, CPA, P.C. have no present or prospective/contemplated financial or other interest in the business or property that is the subject of this report, and I have no personal financial or other interest or bias with respect to the property or the parties involved.  My engagement in this assignment was not contingent upon developing or reporting predetermined results.  My compensation for completing this assignment is fee‐based and is not contingent upon the development or reporting of a predetermined value or direction in value that favors the cause of the client, the outcome of the valuation, the amount of the value opinion, the attainment of a stipulated result, or the occurrence of a subsequent event directly related to the intended use of this appraisal.  The economic and industry data included in the valuation report have been obtained from various printed or electronic reference sources that the valuation analyst believes to be reliable. The valuation analyst has not performed any corroborating procedures to substantiate that data.  My analyses and calculation were developed in conformity with the American Institute of Certified Public Accountants Statement on Standards for Valuation Services No. 1.  The parties for which the information and use of the valuation report is restricted are identified; the valuation report is not intended to be and should not be used by anyone other than such parties.  The valuation analyst has no obligation to update the report or the opinion of value for information that comes to my attention after the date of the report.  This report and analysis were prepared under the direction of Jay R. Hill. Jay R. Hill is a Certified Public Accountant licensed in the State of Missouri and is accredited in business valuation by the American Institute of Certified Public Accountants. Jay R. Hill, CPA∙ABV © Jay R. Hill, CPA, P.C. 2 INTRODUCTION
The valuator has been engaged to estimate the fair market value of a minority interest in the common stock of Sample Metal Company, Inc., a Illinois Subchapter S corporation, as of January 1, 2012 for gift and estate tax purposes. It is the valuator’s understanding that the results of this study will determine the price of transfers of voting common stock by the Company’s shareholders. METHODOLOGY AND GUIDELINES The valuator has performed a valuation engagement and presents his detailed report in conformity with the “Statement of Standards for Valuation Services No. 1” (SSVS) of the American Institute of Certified Public Accountants. SSVS defines a valuation engagement as “an engagement to estimate value in which a valuation analyst determines an estimate of the value of a subject interest by performing appropriate procedures, as outlined in the AICPA Statement on Standards for Valuation Services, and is free to apply the valuation approaches and methods he or she deems appropriate in the circumstances. The valuation analyst expresses the results of the valuation engagement as a conclusion of value, which may be either a single amount or a range.” SSVS addresses a detailed report as follows: “The detailed report is structured to provide sufficient information to permit intended users to understand the data, reasoning, and analyses underlying the valuation analyst’s conclusion of value.” The valuation of an interest in a closely‐held entity requires the consideration of a number of factors. Revenue Ruling 59‐60 outlines the basic methodology the valuator employed in this valuation. The factors in 59‐60 are essential in estimating the fair market value of a closely‐held entity; however, the valuator did not limit his valuation analysis to these factors. Revenue Ruling 59‐60 – The factors in Revenue Ruling 59‐60 are as follows:  The nature of the business and the history of the enterprise from its inception.  The economic outlook in general and the condition and outlook of the specific industry in particular.  The book value of the stock and the financial condition of the business.  The earnings capacity of the company.  The dividend‐paying capacity of the company.  Whether or not the enterprise has goodwill or other intangible value.  Sales of the stock and the size of the block of stock to be valued.  The market price of stocks of corporations engaged in the same or similar line of business having their stocks actively traded in a free and open market, either on an exchange or over‐the‐counter. © Jay R. Hill, CPA, P.C. 3 STANDARD AND PREMISE OF VALUE The standard of value that is being determined in this study is fair market value. Revenue Ruling 59‐60 defines fair market value as: The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. Fair market value is also defined in a similar way in the International Glossary of Business Valuation Terms as: The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. The premise of value is a going concern. The liquidation premise of value was considered and rejected as not applicable, as the going‐concern value results in a higher value for the interest than the liquidation value, whether orderly or fixed. PROCEDURES AND DOCUMENTATION In reaching his valuation conclusion, the valuator performed certain procedures including the following:  Reviewed and analyzed the Company’s financial information from calendar years ending December 31, 2007 through December 31, 2011.  Reviewed and analyzed other pertinent documents provided by management and the Company’s outside accountant.  Reviewed and analyzed economic, industry and equity market data.  Interviewed management and made a site visit to the Company’s headquarters on February 15, 2012. Descriptions of the documents used in this valuation are in Exhibit A. The qualifications and independence of the valuator are set forth in Exhibit B. The valuation is subject to the assumptions and limiting conditions listed in the last section of this report before the exhibits. © Jay R. Hill, CPA, P.C. 4 OVERVIEW
NATURE AND HISTORY OF THE COMPANY Sample operates a full service scrap metal recycling facility in Rockford, Illinois. The Company purchases, sells and processes scrap metal within a 30 mile radius of Rockford. Primary suppliers of scrap metal and customers of the Company’s processed metal are industrial companies; however, Sample does serve individual customers at its location. The Company was founded in 1977 by John Sample. The present corporation was incorporated on November 1, 1982. PRODUCTS The Company purchases copper, brass, aluminum, iron and several other metals that come from industrial uses or discarded products including autos and appliances. In turn, the Company processes the metals by either shearing the metal down to an aggregate or bailing it into transportable blocks to be used by industrial customers in new products or applications. CUSTOMERS Primary customers for the Company’s processed scrap metal are steel mills, foundries or brokers. The customer base is generally decreasing through consolidation and there is some concentration of business in a few large customers. MANAGEMENT AND EMPLOYEES Sample’s primary management personnel are as follows: Mr. John Sample, President Mr. Jack Sample, Sales Mr. Son Sample, Industrial Products Supply Mr. Robert Smith, Maintenance Sample has 28 full‐time employees and 2 part‐time employees. The Company offers 100% health insurance for employees and family options. Sample also offers a 401k plan with 100% matching for the first 3% contribution and 50% matching on the next 2% contribution. Valuator’s Note: The age of the management personnel is somewhat of a concern as most of the personnel is approaching retirement age. Although the next generation of management is being developed there is no guarantee that this will be a successful transition, which increases the risk of this investment. FACILITIES The Company’s operations are located at 1212 First Street, Rockford, Illinois. The location provides 10 acres of land and 20,250 square feet of office, warehouse and utility building space. © Jay R. Hill, CPA, P.C. 5 The facility is leased from a related party at approximately $5 per building square feet. Management represents that this rate approximates fair rental rates in the area. Therefore, no adjustment will be made to rent expense. STOCK OWNERSHIP AND TRANSFERS OF STOCK An ownership summary of common stock outstanding at January 1, 2012 is as follows: OWNERSHIP SUMMARY Shareholder % Shares John Sample Trust 57.1
400 Jack Sample Trust 42.9
300 100.0
700 Total There have been no transfers of stock over the last five years prior to valuation date. FINANCIAL OVERVIEW A summary of Sample’s historical operating results and financial position through December 31, 2011 (closet data to valuation date) is provided below: December 31,
2007
2008
2009
2010
2011
Income Statement (000's)
Net Sales
Gross Margin
Pre‐tax income
Pre‐tax margin
$ 8,181.7 $ 11,133.4 $ 5,901.7 $ 9,577.3 $ 10,206.6
17.8%
13.6%
13.2%
19.2%
14.1%
657.4 679.1 133.4 1,107.4 718.5
8.0%
6.1%
2.3%
11.6%
7.0%
Balance Sheet (000's)
Total Assets
Total Liabilities
Stockholder's Equity
Interest Bearing Debt
$ 1,614.4
585.0
1,029.5
$ 131.0
$ 1,382.6
324.7
1,057.8
$ 75.3
$ 1,613.5
428.4
1,185.1
$ 146.0
$ 2,076.4
383.9
1,692.5
$ 106.6
$ 1,615.7
867.3
748.5
$ 275.2
The Company’s revenues have increased in the last two year after a poor 2009 as a result of the economic recession. Profits also have recovered with margins returning to pre‐recession levels. Management believes that growth will continue at a moderate pace. The Company’s financial position is very solid with moderate debt leverage. © Jay R. Hill, CPA, P.C. 6 ECONOMICANDINDUSTRYOUTLOOK
Understanding the current state of the national economy and its impact on business entities in the United States is important for the valuation of a privately held entity. The following section discusses general economic indicators, their historical trends and outlook. GENERAL ECONOMIC CONDITIONS2 The U.S. economy experienced its quickest growth rate in the 4th quarter of 2011 since the second quarter of 2010. Unfortunately, most economists do not believe this growth rate is sustainable. To further dampen the news, the Economic Policy Institute (EPI) points out that, if you remove changes in private inventories (a particularly volatile part of the economy), final demand grew at only a 0.8% rate in the 4th quarter of 2011. Domestic demand grew at only 0.9%. The EPI concludes “this [economic] health is poor.” Consumer spending grew this quarter, but was partially financed from consumers’ savings as disposable personal income only grew modestly. This marks the fifth consecutive quarter of decline for the personal savings rate. Decreasing food and energy prices eased the growth of the Consumer Price Index and Producer Price Index and the Federal Open Market Committee believes that inflation will settle, over AFTER DROPPING SHARPLY IN OCTOBER, coming quarters, at levels at or below THE CONSUMER CONFIDENCE INDEX® those consistent with their goal SHOWED STEADY GROWTH IN NOVEMBER inflation rate. AND DECEMBER. REGARDLESS, THE INDEX REMAINS LOW AND MANY ARE UNSURE WHETHER THIS IS A REBOUND FROM EARLIER DECLINES OR A SUSTAINABLE SHIFT IN IMPROVING CONSUMER OPTIMISM. After dropping sharply in October, the Consumer Confidence Index® showed steady growth in November and December. Regardless, the index remains low and many are unsure whether this is a rebound from earlier declines or a sustainable shift in improving consumer optimism. The Institute for Supply Management’s manufacturing sector index and services sector index increased slightly in the 4th quarter of 2011. While the two indexes remain at a level signifying growth, they are barely within the healthy range and indicate that growth is sluggish. 2
The contents of the economic outlook section of this valuation report are quoted from the Economic Outlook Update™ 4Q 2011 published by Business Valuation Resources, LLC, © 2012, 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 Update, 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. The valuator has made wording and format changes to the content to improve readability and understanding by the reader as it pertains to the subject company of this valuation. © Jay R. Hill, CPA, P.C. 7 The consensus forecasts for GDP, personal consumption, business investments, unemployment, along with other key indicators, remain mostly positive and indicate slow growth ahead. GROSS DOMESTIC PRODUCT3 The U.S. Department of Commerce reported that the nation's economy—as indicated by GDP—
increased at an annual rate of 2.8% in the fourth quarter. The fourth‐quarter 2011 rate is an increase from the previous quarter’s rate of 1.8%. Economists noted that a GDP growth rate of 2.8%, if sustained for over a year, would put mild downward pressure on the unemployment rate. Unfortunately, very few estimates believe future growth will continue at the fourth quarter’s rate. The U.S. Department of Commerce found that the increase in real GDP in the fourth quarter reflected positive contributions from private inventory investment, personal consumption expenditures, exports, residential fixed investment, and nonresidential fixed investment. This growth was partly offset by negative contributions from federal government spending and state and local government spending. Imports, which are a subtraction in the calculation of GDP, increased. For all of 2011, the economy grew 1.7% after growing 3.0% in 2010. BUSINESS SPENDING AND INVENTORIES Business spending4 grew at a rate of 1.7% in the fourth quarter of 2011. This was a deceleration from a rate of 15.7% in the previous quarter. Business spending has now grown for eight consecutive quarters. Business spending increased 8.6% in 2011 and 4.4% in 2010. Business spending contributed 0.18 percentage points to the fourth‐quarter GDP. Business spending on structures (nonresidential structures) declined at an annual rate of 7.2% in the fourth quarter. Business expenditures on equipment and software increased at an annual rate of 5.2% in the fourth quarter—the tenth consecutive quarterly increase. Business investments in inventories increased at a faster pace in the fourth quarter than in the previous quarter. Private businesses increased inventories $56.0 billion in the fourth quarter, following increases of $2.0 billion in the third quarter and $39.1 billion in the second. The increased pace of real private inventories added 1.94 percentage points to the fourth‐quarter change in GDP. ENERGY PRICES The Energy Information Administration (EIA) reported that the spot price for a barrel of West Texas Intermediate (WTI) crude oil was $98.83 at the end of the fourth quarter. This is a sizable 3
GDP is the total market value of goods and services produced in the U.S. economy and is generally considered the most comprehensive measure of economic growth. 4
Also known as nonresidential fixed investment. © Jay R. Hill, CPA, P.C. 8 increase from $78.93 per barrel at the end of the third quarter. A year ago, the spot price for a barrel of WTI crude oil was $91.83. The EIA predicts that the WTI crude oil spot price will average approximately $100.25 per barrel in 2012 and $103.75 per barrel in 2013, up from $94.86 in 2011. UNEMPLOYMENT The U.S. Department of Labor reported that the December unemployment rate decreased slightly to 8.5% (or approximately 13.1 million unemployed)—this was the lowest unemployment rate in nearly three years. The good news is that the fall in the unemployment rate was not heavily influenced by the “discouraged‐worker effect,” as was the case in previous months. Private sector employment increased by 212,000 jobs while government jobs declined by 12,000, for 200,000 net new jobs. Goods‐producing industries led the way by adding 48,000 new jobs for the month, while the construction and manufacturing industries reported increases of 17,000 and 23,000 new jobs respectively. Employment in the public sector has decreased 17 of the past 19 months. There were 5.6 million long‐term unemployed (those jobless for 27 weeks or more) which made up 42.5% of unemployed persons at the end of December (down slightly from November). INTEREST RATES The Federal Open Market Committee (FOMC) met twice during the fourth quarter of 2011, issuing two statements on their target for the federal funds rate.5 The FOMC establishes a target rate and expands or contracts the money supply with the aim that the federal funds rate, a market rate, will approximate the target rate. As expected, the FOMC pledged to keep their target for the federal funds rate near zero, at least until mid‐2013. The FOMC stated that the information they have received indicated that the economy was growing at a moderate pace, despite the slowing in global growth. They noted that labor market conditions have improved somewhat, but unemployment remains high. They also acknowledged that, while household spending continues to improve, growth in business spending appears to be tapering off. Further, the housing sector continues to be weak. During the fourth quarter of 2011, the Board of Governors of the Federal Reserve left the discount rate unchanged at 0.75%.6 The board of directors of each Reserve Bank establishes the discount rate every 14 days, subject to the approval of the Board of Governors. The Federal Open Market Committee (FOMC) did not change its target range for the federal funds rate during 2010. The rate is 0% to 0.25%. 5
The federal funds rate is the interest rate at which a commercial bank lends immediately available funds in balances at the Federal Reserve to another commercial bank. 6
The discount rate is the interest rate a commercial bank is charged to borrow funds, typically for a short period, directly from a Federal Reserve Bank. © Jay R. Hill, CPA, P.C. 9 ECONOMIC OUTLOOK Consensus Economics, Inc., publisher of Consensus Forecasts ‐ USA, reports that the consensus of U.S. forecasters believes real GDP will increase at a seasonally adjusted annual rate of 1.8% in the first quarter of 2012. Every month, Consensus Economics surveys a panel of 29 prominent U.S. economic and financial forecasters (the “forecasters”) for their predictions on a range of variables including future growth, inflation, current account and budget balances, and interest rates. The forecasters expect GDP to grow 2.1% for all of 2012, and 2.8% in 2013. In the long term, they report that real GDP will grow by an average annual rate of 2.4% between 2017 and 2021. The forecasters expect industrial production to increase at a rate of 2.4% in the first quarter of 2012. They forecast industrial production will increase 2.8% for all of 2012. Nominal pre‐tax corporate profits are forecasted to increase at a rate of 4.6% in 2012. A summary of certain historical economic data since 2006 and consensus forecasts is shown below: Historical Economic Data 2006‐2011 and Forecasts 2012‐2021
HISTORICAL DATA
2007 2008 2009 2010
2011
2012
Real GDP*
2.7
1.9
‐0.3
‐3.5
3.0
Industrial Production*
2.2
2.7
‐3.7
‐11.2
5.3
Personal Consumption*
2.9
2.3
‐0.6
‐1.9
2.0
Real Disposable Personal Income* 4.0
2.4
2.4
‐2.3
1.8
Nonresidential Fixed Investment*
8.0
6.5
‐0.8
‐17.8
4.4
Nominal Pre‐Tax Corp. Profits*
10.5
‐6.1
‐16.4 ‐0.2
28.9
Total Government Spending*
1.4
1.3
2.6
1.7
0.7
Consumer Prices*
3.2
2.8
3.8
‐0.4
1.6
3 Month Treasury Bill Rate
4.9
4.5
1.4
0.2
0.1
10 Year Treasury Bond Yield
4.8
4.6
3.7
3.3
3.2
Unemployment Rate
4.6
4.6
5.8
9.3
9.6
1.801 1.355 0.906 0.554 0.587
Housing Starts (millions )
1.7
4.1
2.2
0.9
8.6
7.8
‐2.1
3.2
0.1
2.8
9.0
0.607
2.1
2.8
2.0
1.3
7.4
4.6
‐1.0
2.1
0.1
2.7
8.8
0.690
2006
CONSENSUS FORECASTS**
2013 2014 2015 2016 2017‐2021
2.8
3.3
2.5
2.3
6.0
4.9
NA
2.1
0.9
3.6
NA
NA
3.1
3.6
2.7
2.9
6.1
5.1
NA
2.3
2.1
4.2
NA
NA
3.1
3.2
2.7
2.7
5.7
5.3
NA
2.3
3.2
4.6
NA
NA
2.8
3.0
2.6
2.7
4.9
4.9
NA
2.2
3.6
4.9
NA
NA
2.4
2.6
2.3
2.4
4.0
4.2
NA
2.2
3.6
5.0
NA
NA
Source of historical data: U.S. Department of Commerce, U.S. Department of Labor, U.S. Census Bureau and The Federal Reserve Board.
Source of forecasts: Consensus Forecasts ‐ USA, December 2011.
Notes: * Numbers are based on percent change from preceding period. Consumer Prices are the percent change between annual averages.
Historic Unemployment Rate, 3 Month Treasury Rate and 10 Year Treasury Yield are the annual averages.
**Forecast numbers are based on percent change from preceding period (excludes Unemployment Rate, Housing Starts, 3 Month Treasury Rate and 10 Year Treasury Yield). Consumer Price Index information is the percent change between annual averages. The 2012 through 2016 forecasts for the 3 Month Treasury Rate and 10 Year Treasury Yield are for the end of each period. Forecasts for 2017‐2021 signify the average for that period. REGIONAL ECONOMIC OVERVIEW7 The rate of growth of economic activity in the Seventh District picked up in late November and December. Contacts were generally optimistic about the economic outlook for 2012, but many also expressed concern about potential weakness in demand from abroad, particularly from China and Europe. Consumer spending increased, while business spending was steady. Manufacturing production increased. Construction was again subdued, although conditions in 7
Federal Reserve Bank’s Beige Book – Chicago 7th District, Data as of January 11, 2012 and includes Rockford, Illinois. © Jay R. Hill, CPA, P.C. 10 real estate markets improved slightly. Overall, credit conditions were little changed from the last reporting period. Wholesale price increases slowed, but there was some further pass‐
through to the retail level. Corn, soybean, and cattle prices increased, while milk and hog prices decreased. INDUSTRY OVERVIEW AND OUTLOOK8 Recyclable material wholesalers in the U.S. include about 6,200 companies with combined annual revenue of about $77 billion. Major scrap metal wholesalers include Schnitzer Steel, The David J Joseph Company, OmniSource, and America Chung Nam. The industry is fragmented: the top 50 companies account for about 45 percent of revenue. The global recycling industry generates about $200 billion in revenue, according to the Bureau of International Recycling (BIR). Turkey is the largest scrap import market; the U.S. is the largest scrap exporter. Major recyclable material wholesalers outside the U.S. include Sims Metal Management and OneSteel Recycling (headquartered in Australia); TSR Recycling and ELG Haniel (Germany); and European Metal Recycling (UK). The industry includes companies engaged in wholesale distribution of automotive scrap, industrial scrap, and other recyclable materials, along with auto wreckers primarily engaged in dismantling motor vehicles for the purpose of wholesaling scrap. COMPETITIVE LANDSCAPE Demand from the steel, auto, and construction industries drives the scrap metal wholesaling industry. The profitability of individual companies depends on cultivating relationships with suppliers and buyers. Most companies are small and compete by specializing in one type of material in their local market. Large companies have economies of scale in purchasing equipment and transportation. The industry is capital‐intensive: average annual revenue per employee is about $700,000. The U.S. is the world's largest net scrap exporter. Major export markets for U.S. waste and scrap include Turkey, China, South Korea, Taiwan, Canada, and India. Exports account for about 35 percent of U.S. production, according to the Institute of Scrap Recycling Industries (ISRI). 8
Contents of industry analysis are quoted from First Research’s Industry Profile – Recycling Materials Wholesalers. The valuator has made wording and format changes to the content to improve readability and understanding by the reader as it pertains to the subject company of this valuation. © Jay R. Hill, CPA, P.C. 11 PRODUCTS, OPERATIONS AND TECHNOLOGY Major sources of revenue are ferrous metal scrap (iron and steel), which accounts for about 45 percent of sales, and nonferrous metal scrap (mainly aluminum, copper, copper alloys, lead, and zinc), which accounts for about 35 percent. Other sources of revenue include recyclable paper, plastics, and textiles. The industry processes about 130 million tons of material annually, including 75 million tons of ferrous metals; 50 million tons of paper; 10 million tons of nonferrous metals; 3.5 million tons of electronics; 1 million tons of plastics (PET and HDPE bottles); and 90 million tires. Almost all old cars are recycled, along with 90 percent of appliances, 70 percent of newspaper, and 30 percent of glass containers, according to the ISRI. Scrap metal is classified as "industrial" or "obsolete." Industrial scrap is left over from industrial manufacturing operations like cutting, casting, stamping, and boring; the auto industry is the largest single source. Obsolete scrap is metal recovered from old or used consumer and industrial products, mainly cars, cans, and appliances, but also machinery, railroad cars and rails, construction girders, wire, pipes, and ships. To be suitable for reuse, scrap metal must be cut to convenient sizes, sorted according to metal or grade, and often formed into bales, pellets, or briquettes that end‐users can put directly into their operations. The smaller and denser the scrap, the more valuable it is, because end‐users can use it more efficiently. Many scrap metal wholesalers operate near their customers, because the low value‐to‐weight ratio of most scrap discourages long‐distance transportation. Scrap metal is collected at junkyards, recycling centers, or directly at industrial sites. Scrap metal processors often have long‐standing relationships with industrial producers of scrap, and have drop‐boxes on their sites for efficient collection. Because the quality of new steel made from scrap depends on the quality of the scrap, an extensive metal scrap grading system exists, with more than 80 grades of unprocessed ferrous scrap, including sheet iron; "white goods" (appliances); "unclean motor block"; and "whole prepared car bodies." Metals processors use crane‐mounted "alligator" or scissor shears and stationary guillotine shears to cut large pieces of scrap, such as girders, into smaller pieces. Cars, appliances, and other light scrap are processed by shredders that break the scrap into fist‐sized pieces in less than a minute. Shredding operations use magnets to separate ferrous metals and nonferrous metals from residual "shredder fluff," which is put into landfills. Many nonferrous metals have a higher value than ferrous iron or steel, and are therefore sorted and separated using more labor‐intensive methods. Light‐gauge metals may be processed in balers, large hydraulic presses that compress the metal into uniform blocks. Nonferrous metals are often melted or pressed into ingots or "pigs" for the end‐user. © Jay R. Hill, CPA, P.C. 12 Nonmetal materials like paper, glass, plastics, and rubber undergo less processing than metals before being shipped. Rubber tires are processed by removing steel belts mechanically, then shredding the tire into chips varying from three inches to the size of a grain of sand. SALES AND MARKETING End‐users of scrap metals are metal manufacturers. Traditional steel makers add scrap to other raw materials when making new steel. For operators of steel mini‐mills that use electric arc furnace (EAF) technology, scrap is the main raw material. Mini‐mill production has rapidly increased in the US during the past 20 years, and now accounts for about half of domestic steel production. Paper companies process scrap paper back into pulp, largely for use in making cardboard containers; glass makers mix recycled glass (cullet) with raw materials to make new glass bottles; and plastics manufacturers can add scrap directly to their operations. Recycled rubber is used by paving manufacturers to make asphalt, and by rubber flooring manufacturers to make rubberized mats. The industry's fragmented nature means that sales are typically handled by dealers and brokers, and increasingly on the Internet. Large scrap processors cultivate established relationships with big customers, but long‐term contracts are rare. Prices for scrap metal can change rapidly, because they depend on demand for newly made products and on import and export prices. Prices for some materials like paper can be negative, meaning that sellers essentially must pay buyers to take the product, often the case for mixed office paper. Prices for processed scrap metal and other scrap products are usually negotiated directly with large customers because of grade variations and because transportation costs are a significant part of the delivered price. The spread between prices for unprocessed and processed scrap is often large, as processors try to protect themselves against sudden price changes. FINANCE AND REGULATION Cash flow is uneven because demand and prices fluctuate greatly. When demand dips, wholesalers can be left holding uncommitted inventory. Although the industry is fragmented, the increasing use of power processing equipment has led to some consolidation, because larger companies can more easily afford the capital investment. The cost of scrap transportation, usually by rail cars or trailer trucks, has increased over the last decade due to consolidation in the rail industry. Many recyclers subcontract trucking services. During the past two decades, federal, state, and local governments have passed a number of laws and regulations that more tightly regulate pollution levels, other environmental concerns, and workplace safety. Steel mills have also adopted more stringent quality‐control policies that have forced scrap dealers to spend more to meet necessary quality levels. Scrap metal © Jay R. Hill, CPA, P.C. 13 collectors and processors may have pollution problems that stem from fluids in cars, or, in the case of lead and mercury, from the material itself. Transferring and processing scrap metal is inherently dangerous and subject to strict OSHA regulations TRENDS AND CHALLENGES High Dependence on End‐Use Industries – Demand for scrap steel comes mainly from the U.S. steel industry, which in turn depends heavily on the auto, machinery, and construction industries. The shift of more auto production to foreign plants will negatively affect scrap metal demand long‐term. Greater use of electric arc furnaces, which require less energy to operate than blast furnaces, makes steel production less costly, which in turn can increase demand. Scrap Metal Prices Fluctuate – Scrap prices can change quickly, making revenues unpredictable both monthly and yearly. The industry is vulnerable to fluctuations in both foreign and domestic markets. Excess world supply of steel and scrap has caused market disruptions in the U.S. In recent years, overcapacity in China has led to excessive imports into the U.S., putting downward pressure on domestic prices. Foreign Demand Inflates Prices – Trade barriers inflate the cost of U.S. scrap metal, which then raises domestic manufacturing costs. Many countries, such as China, India, and Russia, enact quota restrictions and put additional taxes on scrap exports. As a result, exports from the U.S., which does not restrict trade, increase. The higher demand for U.S. scrap abroad reduces available domestic scrap and causes prices to rise. Higher scrap prices cannot always be passed on to consumers, which can erode processor margins. Pollution Cleanup Costs – Although some scrap dealers may be exempt in the Superfund law, a program aimed at cleaning up abandoned hazardous waste sites, from current cleanup requirements, many large sites will eventually have to be cleaned up. Currently, most states don't have laws exempting scrap dealers from the Superfund law. Tight Scrap Copper Refining Capacity – Although the U.S. is one of the leading consumers of copper in the world, it has relatively few copper smelters. In recent years the number of secondary copper smelters in the U.S. has declined. The environmental difficulties of copper smelting have deterred investment in new facilities. Consolidation – Some scrap companies have made acquisitions in a bid to become large enough to produce a steady supply of raw material to large producers. Supply contracts with large customers can bring higher prices over longer periods than can the volatile spot market. A diversified customer base can also help to insulate the company during a difficult economy. © Jay R. Hill, CPA, P.C. 14 Scrap Steel Prices Continue to Grow – Scrap steel prices in the U.S. continue to climb as do exports of the metal. After dipping in 2009, U.S. prices and exports were near all‐time high levels in 2011. In the first half of 2011, total export volume increased about 25 percent over the same time period in 2010, according to Scrap Price Bulletin. Demand from China, Taiwan, South Korea, and Turkey has boosted U.S. exports. More‐Efficient Collection Systems – Scrap metal processors need a constant flow of low‐cost raw material, making improvements in sourcing and collecting scrap important. Some processors have partnered with used auto parts dealers to regularly collect stripped auto bodies. The Internet also provides collectors and processors with better information about raw material availability. INDUSTRY OUTLOOK A graphical display of the output of U.S. scrap from 2012 through 2015 is shown below: Output of U.S. Scrap From 2012 ‐ 2015
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
2012
2013
2014
2015
First Research forecasts are based on INFORUM forecasts that are licensed from the Interindustry Economic Research Fund, Inc. (IERF) in College Park, MD. INFORUM's "interindustry‐macro" approach to modeling the economy captures the links between industries and the aggregate economy. The First Research Industry Growth Rating reflects the expected industry growth relative to other industries, based on INFORUM's forecasted average annual growth for the combined years of 2010 and 2011. INFORUM forecasts were prepared by the Interindustry Economic Research Fund, Inc. Data Published: March 2012 IMPACT ON COMPANY Sample is impacted by many of the general factors discussed above. The growth outlook for the Company is similar to the industry although it may be greater in the 2012 and 2013. © Jay R. Hill, CPA, P.C. 15 FINANCIALSTATEMENTANALYSIS
FINANCIAL POSITION OF COMPANY AND TRENDS Historical trends normally are the best indicators of future trends. An analysis of these trends over a period of time can provide additional information on a company’s financial stability and performance. The following is an analysis of the subject company’s financial statements. A graphical display of the pertinent balance sheet items and a growth rate analysis for the last five calendar years ending December 31 are below: Total Assets
Accounts Receivable
2,500
Thousands
Thousands
2,000
1,500
1,000
500
‐
2007
2008
2009
Liabilities
2010
2011
800
700
600
500
400
300
200
100
‐
2007
600
400
Thousands
Thousands
500
300
200
100
‐
2008
2009
2010
2011
2010
2011
Working Capital
Inventory
2007
2008
Equity
2009
2010
1,800
1,600
1,400
1,200
1,000
800
600
400
200
‐
2007
2011
2008
2009
Growth rate analysis
Working capital
Stockholders' equity
Total assets
4‐Year*
0.7%
‐7.7%
0.0%
2008
‐0.8%
2.8%
‐14.4%
* Annual compound growth
2009
20.3%
12.0%
16.7%
2010
23.1%
42.8%
28.7%
2011
‐30.1%
‐55.8%
‐22.2%
GENERAL TREND The Company’s financial position is strong and overall growth is moderate as operating results have recovered from the 2008 recession. Cash, accounts receivable and inventory are the Company’s primary assets. Debt leverage is moderate and relatively stable. © Jay R. Hill, CPA, P.C. 16 A more detailed analysis of the Company’s financial position is presented below: Historical Balance Sheets ‐ Sample Metal Company, Inc.
2008
170,708
236,291
322,950
55,798
443,371
1,229,118
December 31,
2009
303,444
496,087
502,512
71,909
108,863
1,482,815
Assets
Cash
Accounts receivable
Inventory
Prepaid expenses
Other current assets
Current assets
2007
541,806
528,402
324,444
45,927
2,145
1,442,724
2010
270,814
727,503
517,589
66,134
200,076
1,782,116
2011
348,236
562,920
489,737
112,492
‐
1,513,385
Net fixed assets
171,725 153,434 130,675 294,291 102,353
Total assets
1,614,449 1,382,552 1,613,490 2,076,407 1,615,738
Liabilities and Equity
Accounts payable
Accrued expenses
2007
2008
2009
2010
2011
193,906 70,385 74,843 69,325 113,316
133,444 52,122 76,768 74,699 255,411
Current liabilities
327,350 122,507 151,611 144,024 368,727
Long term debt Due to shareholder
Total liabilities
130,992 75,325 145,984 106,590 275,164
126,649 126,889 130,816 133,302 223,370
584,991 324,721 428,411 383,916 867,261
Stockholders' equity
Total liabilities and equity
1,029,458 1,057,831 1,185,079 1,692,491 748,477
1,614,449 1,382,552 1,613,490 2,076,407 1,615,738
Working capital
1,115,374 1,106,611 1,331,204 1,638,092 1,144,658
Interest‐bearing debt
130,992 75,325 145,984 106,590 275,164 Total Assets – Sample’s current financial position is solid. The Company’s primary assets are cash, accounts receivable and inventory. Accounts receivable generally increase or decrease with sales. Inventory has remained relatively level the last three years as sales have flatten the last two years. The Company’s interest‐bearing debt increased in 2011, but management expects to maintain the current debt leverage for the foreseeable future. Total assets have not grown since 2007. Accounts Receivable – Accounts receivable was $562,920 as of December 31, 2011. This was a decrease from the previous year end despite slightly higher sales. This was a result of a concerted effort to lower receivables. Inventory – Inventory was about $489,737 as of December 31, 2011. Inventory has remained relatively flat while revenues have increased. Inventory turnover has improved from 12 to 17 times since 2009. © Jay R. Hill, CPA, P.C. 17 Working Capital – The Company’s working capital has been more than sufficient to maintain operating cash flow. Stockholders’ Equity – Stockholders’ equity was $748,477 as of December 31, 2011, an approximate 56% decrease from the prior year end as a result of shareholder distributions. Stockholders’ equity has decreased an annual compound rate of ‐7.7% since 2007 as the Company makes regular S corporation distributions to the stockholders. Overall, the risk level is low in connection with Sample’s financial position. © Jay R. Hill, CPA, P.C. 18 OPERATING RESULTS AND TRENDS ADJUSTMENTS TO HISTORICAL EARNINGS In evaluating the Company’s earnings capacity, the following adjustments were made to the last five years of historical operating results: 1. Income taxes – In order to present the Company’s earnings on a basis that is comparable to the public guideline companies and general market equity data that is utilized to value Sample, estimated corporate income taxes are applied to the adjusted pre‐tax income at an estimated effective combined federal and state tax rate. A summary of the adjustments to the historical income statements is shown below: 2007
2008
2009
2010
2011
267,000 276,000 40,000 462,000 293,000
40.6%
40.6%
30.0%
41.7%
40.8%
Year
Taxes
Effective rate
Graphical displays of pertinent income statement categories and a growth rate analysis for the Company from 2007 through 2011 are shown below. EBITDA
25.0%
10,000
20.0%
8,000
1,400
1,200
1,000
Thousands
Thousands
Revenue
12,000
15.0%
6,000
10.0%
4,000
2,000
5.0%
‐
0.0%
600
400
200
‐
2007 2008 2009 2010 2011
Revenue
800
2007
2008
2009
2010
2011
Gross Profit %
Adjusted Net Income
8.0%
700
Thousands
600
6.0%
500
400
4.0%
300
200
2.0%
100
0.0%
‐
2007
2008
2009
Adjusted Net Income
2010
2011
Net Profit Margin
© Jay R. Hill, CPA, P.C. 19 Growth Rate Analysis
Revenue
Operating income
Net income
* Compound annual growth
4‐Year*
5.7%
1.7%
2.2%
2008
36.1%
6.0%
3.3%
2009
‐47.0%
‐65.6%
‐76.8%
2010
62.3%
325.2%
590.9%
2011
6.6%
‐30.9%
‐34.1%
GENERAL TREND The Company’s operating results have been mixed over the last five years. Revenue growth has recovered significantly after the downturn in 2009 related to the economic recession. Profit margins have fluctuated as a result of the recession, but have recovered to pre‐recession levels. A more detailed analysis of the Company’s operating results is presented below: Historical Income Statements ‐ Sample Metal Company, Inc.
Category
Revenue
Cost of goods sold
Gross profit
Operating expenses
Operating income
Other income (expenses)
Income before taxes
Income taxes
Net income
2007
8,181,706
6,726,718
1,454,988
621,682
833,306
(175,952)
657,354
For the Years Ending December 31, 2008
2009
2010
11,133,433 5,901,739 9,577,251
9,620,449 5,119,800 7,741,487
1,512,984 781,939 1,835,764
629,973 478,592 545,918
883,011 303,347 1,289,846
(203,898) (169,934) (182,434)
679,113 133,413 1,107,412
2011
10,206,587
8,764,749
1,441,838
550,686
891,152
(172,666)
718,486
657,354
679,113
718,486
Depreciation expense
Interest expense
326,223 447,904 233,827 394,316 738,417
49,879 72,989 22,382 44,995 44,175 133,413
1,107,412
Revenue – Sample’s revenues have increased the last two years since dropping significantly in calendar year 2009 as a result of the economic recession. Since 2007, revenue has grown at an annual compound rate of 5.7%. Management expects revenue growth to continue in the foreseeable future but at a slightly slower rate. Gross profits – Gross profits have fluctuated with revenues over the last five years. In calendar year 2010, gross profits increased significantly above pre‐recession levels. In calendar 2011 gross profits dipped back to pre‐recession levels. EBITDA and Adjusted net income – Earnings before Interest Expense, Income Taxes, Depreciation and Amortization expense (EBITDA) have also fluctuated over the last five years along with revenues. However, the last two years, profits have returned and exceeded pre‐
recession levels. © Jay R. Hill, CPA, P.C. 20 Overall, the relatively solid profit performance results in a low risk assessment of this investment. However, the apparent exposure to poor economic conditions does raise the risk level to investors. Detailed historical income statements are shown at the end of this section. S Corporation Distributions – Sample normally distributes from 50% to 95% of its yearly earnings to the shareholders. Assuming the average shareholder’s tax liability is about 43%, the additional 10% to 55% of earnings the shareholders retain is not subject to the 20% combined federal and state dividend tax that C Corporation shareholders have to pay for a similar cash dividend. This tax avoidance increases the value of a minority interest shareholder’s investment. However, at any time the majority shareholder could decide to reduce or eliminate distributions. Furthermore, the S election can be revoked by either a violation of the S election rules or by the Board of Directors decision to convert back to a C Corporation. Thus, the distribution benefits are not guaranteed. However, the valuator quantifies this benefit in the valuation calculations in the next section. In addition, the Company’s consistent distribution of cash to the shareholders also has an impact on the marketability of the Company’s stock. See the “Valuation Analysis and Conclusion” section below. © Jay R. Hill, CPA, P.C. 21 COMMON SIZE AND RATIO ANALYSIS A common size and ratio analysis of a company can lend further insight to the financial health of the company and identify trends. A common size analysis of Sample’s balance sheets and income statements from 2007 through 2011 with a comparison to industry benchmarks9 are shown below. BALANCE SHEETS Assets
Cash
Accounts receivable
Inventory
Prepaid expenses
Other current assets
Current assets
Net fixed assets
2007
33.6%
32.7%
20.1%
2.8%
0.1%
89.4%
2008
12.3%
17.1%
23.4%
4.0%
32.1%
88.9%
Common Size
2009
2010
18.8%
13.0%
30.7%
35.0%
31.1%
24.9%
4.5%
3.2%
6.7%
9.6%
91.9%
85.8%
2011
21.6%
34.8%
30.3%
7.0%
0.0%
93.7%
Straight Weighted
Average
Average
19.9%
18.3%
30.1%
31.6%
26.0%
27.4%
4.3%
4.8%
9.7%
8.2%
89.9%
90.3%
NAICS
42393
8.8%
22.3%
28.5%
5.8%
65.4%
10.6%
11.1%
8.1%
14.2%
6.3%
10.1%
9.7%
20.5%
Total assets
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
Liabilities and Equity
Accounts payable
Accrued expenses
2007
12.0%
8.3%
2008
5.1%
3.8%
2009
4.6%
4.8%
2010
3.3%
3.6%
2011
7.0%
15.8%
6.4%
7.2%
5.6%
8.2%
16.1%
17.7%
Current liabilities
20.3%
8.9%
9.4%
6.9%
22.8%
13.7%
13.9%
33.8%
Long term debt Due to shareholder
Total liabilities
8.1%
7.8%
36.2%
5.4%
9.2%
23.5%
9.0%
8.1%
26.6%
5.1%
6.4%
18.5%
17.0%
13.8%
53.7%
9.0%
9.1%
31.7%
10.1%
9.7%
33.7%
21.2%
55.0%
63.8%
100.0%
76.5%
100.0%
73.4%
100.0%
81.5%
100.0%
46.3%
100.0%
68.3%
100.0%
66.3%
100.0%
45.0%
100.0%
Stockholders' equity
Total liabilities and equity
0
Sample’s current assets account for more of its total assets compared to the industry as a whole. This is likely because Sample’s fixed assets are slightly older and more depreciated. However, this has had minimal effect on the Company’s operations. ADJUSTED INCOME STATEMENTS Revenue
Cost of goods sold
Gross profit
Operating expenses
Operating income
Other income (expenses)
Income before income taxes
Income taxes
Adjusted net income
2007
100.0%
82.2%
17.8%
7.6%
10.2%
‐2.2%
8.0%
3.3%
4.8%
Common Size
2008
2009
2010
100.0%
100.0%
100.0%
86.4%
86.8%
80.8%
13.6%
13.2%
19.2%
5.7%
8.1%
5.7%
7.9%
5.1%
13.5%
‐1.8%
‐2.9%
‐1.9%
6.1%
2.3%
11.6%
2.5%
0.7%
4.8%
3.6%
1.6%
6.7%
2011
100.0%
85.9%
14.1%
5.4%
8.7%
‐1.7%
7.0%
2.9%
4.2%
9
Source: First Research’s Industry Profile – Recycling Materials Wholesalers © Jay R. Hill, CPA, P.C. 22 Straight Weighted
Average
Average
100.0%
100.0%
85.0%
84.5%
15.0%
15.5%
6.2%
6.2%
8.8%
9.3%
‐2.1%
‐2.0%
6.7%
7.2%
2.7%
2.9%
4.0%
4.3%
NAICS
42393
100.0%
77.4%
22.6%
20.0%
2.6%
‐0.5%
2.1%
0.8%
1.3%
Sample’s profitability is higher than the industry as a whole. Operating expenses appears to be the key to the Company’s ability to earn a higher profit margin than its peers. RATIO ANALYSIS A ratio analysis of Sample with a comparison with public guideline companies described in the “Valuation Analysis and Conclusion” section is presented below: SCHN
Liquidity Ratios
Current Ratio
Quick Ratio
Inventory to NWC
Activity Ratios
A/R Turnover
Collection period (days)
Inventory Turnover
Days of Inventory
Operating Cycle (days)
NWC Turnover
Total Asset Turnover
Fixed Asset Turnover
Acct Payable Turnover
A/P Turnover (days)
Leverage Ratios
Debt‐to‐Equity
Debt‐to‐Assets
Times Interest Earned
LT Debt to NWC
CLH
Public Guideline Companies
DAR
RSG
ECOL
WCN
Group
Average
Sample
2.80 2.34 1.73 0.67 1.31 0.88 1.62 4.10 1.37 2.19 1.33 0.67 1.31 0.88 1.29 2.47 0.80 0.11 0.55 ‐ ‐ ‐ 0.24 0.43 19.43 18.79 10.19 35.83 54.62 9.59 2.14 6.81 26.38 13.83 4.78 76.41 27.38 13.33 89.74 4.15 1.08 2.54 8.76 41.67 19.61 9.90 4.89 9.17 18.61 36.86 74.65 39.82 26.29 ‐ ‐ ‐ 13.88 ‐ ‐ ‐ 13.88 ‐ ‐ ‐ 29.18 (7.95) 11.28 (41.34)
1.28 0.42 0.74 0.48 4.53 1.21 1.51 1.08 19.42 4.16 20.83 9.51 18.79 87.79 17.52 38.38 11.30 44.19 10.64 10.51 26.37 0.82 1.02 2.95 14.84 36.33 15.82 23.07 17.40 20.97 44.05 7.34 5.53 51.46 95.98 3.80 0.37 0.21 21.82 0.96 0.60 0.26 5.60 1.04 0.30 0.20 7.33 3.03 0.57 0.26 10.75 (5.82)
0.37 0.17 49.74 0.24 0.90 0.35 3.06 (10.90)
0.41 0.84 0.20 0.35 19.58 7.13 4.62 (33.66)
Sample compares favorably to the guideline group in terms of liquidity and activity ratios. The Company’s debt leverage is similar to the group and the Company’s cash flows comfortably cover its debt obligations. A comparison of profitability is presented below: SCHN
Profitability Ratios
Gross Margin
Operating Margin
Pre‐Tax Margin
Profit Margin
Pre‐Tax ROE
After Tax ROE
Pre‐Tax ROA
After Tax ROA
© Jay R. Hill, CPA, P.C. 11.19%
5.38%
5.08%
3.42%
16.04%
10.82%
9.74%
6.71%
Public Guideline Companies
CLH
DAR
RSG
ECOL
30.45%
10.97%
9.31%
6.41%
20.50%
14.12%
10.78%
8.03%
29.47%
17.50%
15.15%
9.43%
29.59%
18.41%
21.84%
14.58%
23 40.62%
18.95%
11.07%
7.19%
11.80%
7.67%
4.64%
3.01%
34.77%
20.89%
19.24%
11.86%
29.76%
18.34%
15.50%
9.86%
WCN
43.03%
21.06%
18.14%
10.98%
19.58%
11.85%
9.54%
6.30%
Group
Average
31.59%
15.79%
13.00%
8.22%
21.21%
13.53%
12.01%
8.08%
Sample
14.13%
8.73%
7.04%
4.17%
95.99%
56.85%
44.47%
26.33%
Sample’s profitability ratios indicate that Company’s is performing below the guideline group but with a better return on equity and assets. However, the better return on equity and assets is likely because of the fact the Company is an S corporation and is distributing profits on a regular basis. Overall, the ratio analysis indicates that the financial performance risk associated with Sample is higher than the guideline companies (this excludes difference in size and management depth). © Jay R. Hill, CPA, P.C. 24 VALUATIONANALYSISANDCONCLUSIONOFVALUE
VALUATION ANALYSIS There are three traditional approaches to calculate the fair market value of a closely‐held business. These approaches are the market, income and cost approaches. Below is a brief description of these approaches.  Market Approach – This approach considers the prices from actual transactions of comparable investments, often with adjustments made to the derived price factors to reflect comparability differences with the subject investment.  Income Approach – This approach involves the estimation of the prospective economic benefits of ownership whereby the anticipated income stream from the subject investment is stated in current dollars by discounting the income stream by an appropriate rate of return.  Cost Approach – This approach considers the investment necessary to reproduce or replace the subject investment adjusted for estimated depreciation and /or deterioration. Normally, if the subject entity is an operating entity that sells a product or service, then the most important factor to an investor is the subject entity’s earnings history and future earnings stream. Conversely, if the subject entity is a holding entity that is holding assets for investment purposes, then an investor’s interest is in the fair market value of the subject entity’s underlying assets. Sample is an operating company that sells products. Therefore, several earnings methods under the income and market approach are used to value the Company. A summary of the approaches and related methods used to estimate the fair market value of Sample are as follows:  INCOME APPROACH o Capitalization of Cash Flow  MARKET APPROACH o Public Guideline Company Method  Price/earnings method  TIC/EBIT method  TIC/EBITDA method Below is a further description of these methods and the resulting value estimates derived from the use of these methods. © Jay R. Hill, CPA, P.C. 25 VALUATION METHODS CONSIDERED BUT NOT UTILIZED DISCOUNTED CASH FLOW OR EARNINGS METHODS These methods estimate the value using future estimates of earnings and discounting them to present day dollars. Reasons for not using these methods: Management does not expect significant changes in operating results or growth expectations. The selected methods rely on historical results which adequately represent the expected future operating results of the Company. CAPITALIZATION OF CASH FLOW METHOD Frequently, a company’s historical operations provide a good indication of the future earnings or growth rate of the business. Therefore, an appropriate method to determine the value of Sample is projecting next year’s cash flow of the Company based on historical results and capitalizing this cash flow to determine the minority‐marketable value of the subject company. COST OF EQUITY (COE) Both the Capital Asset Pricing Model (CAPM) and Build‐Up Method, is used to derive a cost of equity or rate of return for Sample. CAPM is one of the primary aspects of the modern capital market theory. The Build‐Up method is modeled after CAPM, but does not specifically include beta, which is discussed below. Both methods attempt to quantify the return an investor requires to invest in securities that bear the risk of failure to pay a return on such investment, or even a complete loss as opposed to the “guaranteed” or “risk‐free” return on a U.S. treasury security. The additional return that an investor requires above the risk‐free return is known as a “premium”. The pure CAPM model formula determines the required return by summing the risk‐free rate and the additional return required by investors in the market as a whole (known as systematic risk) adjusted for volatility (beta10) of the price of the particular security as follows: Required Return = rf + ß(rm ‐ rf) Where: rf = risk‐free rate of return ß = Beta or volatility of the security rm = equity market return NOTE: (rm ‐ rf) is referred to as the equity market risk premium which is discussed in more detail below. The difference between the CAPM model and the Build‐Up Method is that the Build‐Up method normally assumes that Beta is 1, which assumes the subject security is no more or less volatile than the market as a whole. However, Morningstar11 has developed an industry 10
Beta is a statistical measure of systematic risk of a stock; the sensitivity of a stock’s price relative to movements of a specific market benchmark or index. 11
Morningstar’s Ibbotson Stocks, Bonds, Bills and Inflation Valuation Yearbook, Table 3‐5 © Jay R. Hill, CPA, P.C. 26 discount/premium which attempts to account for specific risk differences by industry, which can be included in the build‐up method. In addition, both the CAPM and Build‐Up Model may include a specific company risk factor to account for idiosyncratic risk that may be present in a subject stock compared to the market as a whole. Therefore, the CAPM model used is as follows: Required Return = rf + ß(rm ‐ rf) +/‐ Alpha Where: rf = risk‐free rate of return ß = Beta or volatility of the security rm = equity market return Alpha = specific company risk factors, if applicable The Build‐Up model used is a follows: Required Return = rf + 1(rm ‐ rf) +/‐ rind +/‐ Alpha Where: rf = risk‐free rate of return rm = equity market return rind = industry premium or discount (Per Morningstar data) Alpha = specific company risk factors In developing an equity rate for Sample, the risk‐free rate is based on 20‐Year treasury rates. For the expected risk premium of a typical equity investor, a long‐run average historical risk premium is often used. The source of the risk premia used in estimating the cost of equity capital (“required rate of return on equity capital”, “cost of equity”, or “COE”) for Sample is the 2011 Duff & Phelps Risk Premium Report12 (data through December 2010). In this study Duff & Phelps (D&P) has developed a risk premium analysis to determine the equity market risk premium (rm ‐ rf). The D&P study gives average historical risk premiums for the period 1963 through 2010. All financial service companies are excluded from the study. D&P’s measure of returns is based on dividend income plus capital appreciation and represents returns after corporate taxes (but before owner level taxes). 12
Originally published by Roger J. Grabowski and David King, “New Evidence on Size Effects and Equity Returns, “Business Valuation Review (September 1996, revised March 2000), and now published annually as the Duff & Phelps Risk Premium Report. © Jay R. Hill, CPA, P.C. 27 D&P stratifies historical equity market premiums of publicly‐traded equity securities by size of companies in order to incorporate any differences in returns observed in the market as a result of the size of a certain company. The study uses eight (8) criteria of “size” to stratify the data. The D&P Risk Premium Calculator is used to calculate the total COE for Sample (i.e. includes risk‐free rate, risk premium and specific risk where applicable). The D&P calculator derives the return based on two methods, 1) “Guideline Company Method” which derives the return through direct comparison to companies in a specific size category and 2) Regression Analysis which derives a return based on the resulting relationship from each size category. The regression calculation is normally a better indicator as it adjusts for subject companies that may fall outside the size categories. The Duff & Phelps Risk Premium Report includes a “Size Study” and a “Risk Study”: Size Study: Analyzes the relationship between equity returns and company size, using up to eight measures of company size (i.e. “size measures”). Three separate COE calculations are derived in this study called Buildup 1, Buildup 2 and CAPM. Risk Study: Analyzes the relationship between equity returns and accounting‐based fundamental risk measures and gives indication of whether the subject company is either less risky or more risky than the comparable companies in the study. This study can be used to assist the valuator in determining a specific company risk factor or adjust the indicated rates from the size study. The key inputs used to calculate the COE for Sample are as follows: © Jay R. Hill, CPA, P.C. 28 Summary of Inputs – Size Study and Risk Studies
GENERAL INPUTS: Values as of the January 1, 2012 valuation date.
Subject Company:
Risk‐Free Rate:1
Equity Risk Premium:2
Beta:3
Industry Risk Premium:4
Sample Metal Co.
2.57%
6.0%
1.20
1.0%
SIZE STUDY INPUTS: Values for the most recent year relative to the January 1, 2012 valuation date.
Estimated Market Value of Common Equity (in $millions)
Book Value of Equity
(in $millions)
5‐Year Average Net Income
(in $millions)
Market Value of Invested Capital $2.00
$0.75
$0.42
$2.28
Total Assets
(in $millions)
5‐Year Average EBITDA
(in $millions)
Net Sales
(in $millions)
Number of Employees
$1.62
$0.92
$10.21
30
RISK STUDY INPUTS: Values for the 5 most recent years relative to the January 1, 2012 valuation date.
2011
2010
2009
2008
2007
Net Sales
(in $millions)
$10.21
$9.58
$5.90
$11.13
$8.18
Operating Income
(in $millions)
$0.89
$1.29
$0.30
$0.88
$1.45
Book Value
(in $millions)
$0.75
$1.69
$1.19
$1.06
$1.03
Net Income Before Extraordinary Items
(in $millions) $0.45
$0.69
$0.10
$0.43
$0.80
1
Long‐term (20‐year) U.S. Treasury Bond Yield (constant maturity).
Duff & Phelps 2011 Risk Premium Report
3
Medium of Beta for Public Guideline Companies selected for Sample was .90, however, Sample operates
solely in the more volatile recycle sector as indicated by the 2.06 Beta of the one public guideline company (SCHN)
that operates specifically in the recycling sector. Note: It was not necessary to re‐lever the Beta as Sample's
capital structure is comparable to the Public Company group.
2
4
Morningstar's Ibbotson SBBI 2011 Valuation Yearbook, Table 3‐5 Industry Premia Estimates, SIC
Code 4953 Refuse Systems: ‐2.22, however, includes all waste management companies while
Sample operates in the more volatile recycling sector. Therefore, adjust discount to plus 1.
The resulting risk premiums and adjustments using the data in the D & P study are displayed below: PREMIA Equity Risk Premium (ERP) Long‐horizon expected return of large stocks over risk free securities. © Jay R. Hill, CPA, P.C. 6.0% Median Premium Over Risk Free Rate (RPm+s) Buildup 1 The long‐horizon expected return of stocks over risk free securities in terms of the combined effect of market risk and size risk. 29 17.3% Median Premium Over CAPM (RPs) CAPM and Buildup 2 The return on small company stocks in excess of that predicted by CAPM (also known as "beta‐adjusted size premium"). 9.9% 1.6% Adjusted Industry Risk Premium (IRPadj) An IRP adjusted for the difference between the historical ERP used as an input to compute the IRP, and the forward‐looking ERP chosen as of the valuation date. Source: Morningstar SBBI 0.9% ADJUSTMENTS ERP Adjustment An adjustment made to reconcile a historically‐derived ERP with a forward‐
looking ERP as of the valuation date. The calculation of cost of equity capital for Sample with the key inputs plugged into each of the models is shown below: COST OF EQUITY CAPITAL (COE), ALL MODELS . Size Study Buildup 1 COEBuildup 1 21.5% Buildup 2 COEBuildup 2 19.3% = rf + RPm+s + ERP Adjustment = 2.6% + 17.3% + = rf + ERP + RPs + IRPadj = 2.6% + 6.0% + 9.9% + 0.9% 1.6% Capital asset pricing model (CAPM) = rf + (β x ERP) COECAPM 19.6% = 2.6% + (1.2 x 6.0%) + RPs + 9.9% These methods resulted in a range of cost of equity capital estimates for Sample of 19.3% to 21.5% using the Size Study. The average for the Size Study is 20.1%. The Risk Study compares three fundamental accounting measures – operating margin, coefficient of variation13 (COV) of operating margin and COV of return on equity – of the subject company with the companies in the study and indicates whether the subject company is less or more risky based on the strength or volatility of these measures. Sample had a higher average operating margin than the companies in the study which indicates that Sample is less risky than those companies. 13
Coefficient of variation expresses the standard deviation (i.e. difference or variation from the mean or mean) as a percentage of the mean or average. © Jay R. Hill, CPA, P.C. 30 However, Sample’s COV of the operating margin of 47.3% and COV of return of equity of 56.8% were higher than the COVs of the companies in the study of 41.8% and 54.2%, respectively. The net result is that Sample is deemed risker than the comparable companies in the study. The additional risk is deemed to be at least 3%. Therefore, the COE selected for Sample is 23%. Conversion to Capitalization Rate – Because only one year of projected cash flow is being used for this method, future growth has to be incorporated into the COE by reducing it by a long‐
term expected growth rate in earnings for Sample. This adjusted COE is called a capitalization rate. In general, most companies cannot sustain long‐term earnings growth greater than the long‐term risk‐free rate as the resulting implied market share, revenues and profits reach levels that cannot be reasonably obtained considering competition, capital resources, etc. The current risk‐free rate is about 2.57%. Sample last four year growth rate has been about 2.2%. Therefore, it is assumed that the Company will grow at its current rate or 2%. Therefore, the capitalization rate applicable to Sample is as follows: Selected Cost of Equity 23.0% Less: Long‐term expected growth rate ( 2.0% ) Capitalization Rate for Subject Company 21.0% CASH FLOW PROJECTION Next, it is necessary to develop an appropriate return stream to apply the above capitalization rate. A 5‐year weighted average of the Company’s profit and expense margins will be applied to projected 2012 revenue that is 3% greater than 2011. Although Sample’s revenue has grown at a 5.7% annual compound rate since 2007, the industry forecast is for only 1% growth in 2012. Therefore, it is assumed that revenue growth will slow in 2012 for Sample as well. Estimated income taxes were calculated on the resulting pre‐tax income using applicable federal and state rates. A detailed income statement projection for calendar year 2012 for Sample is shown on the next page. © Jay R. Hill, CPA, P.C. 31 Sample Metal Company, Inc.
Income Statement Projections ‐ Base Scenario
in thousands
Category
Revenue
Cost of good sold
Projected
2012
10,513.0
8,887.0
%
2012
100.0%
84.5%
Gross profit
1,626.0
15.5%
Operating expenses
Operating income
Other income (expenses)
Income before income taxes
Income taxes
652.0
974.0
(214.0)
760.0
311.0
6.2%
9.3%
‐2.0%
7.2%
3.0%
Net income
449.0
4.3%
Depreciation Expense
300.0
2.9%
13.0
0.1%
Interest Expense
Growth Rate Assumptions
Year
Revenue
2012
3.00%
Net cash flow for valuation purposes is determined by adding back non‐cash items, subtract capital expenditures and add or subtract the decrease or increase in debt and working capital. For capital expenditures, it is assumed that they equal the depreciation expense amount. Debt structure is assumed to be stable, therefore, it is assumed that increases and decreases in cash flow from borrowings and payments are equal and no adjustment is necessary. The working capital requirement is based on historical changes experienced by Sample. The requirement is 10% of the change in revenue from one year to the next. DCF CALCULATION The traditional discounted cash flow model is adjusted to quantify the additional value of the pass‐through nature of Sample’s tax structure as described below. ADDITIONAL VALUE OF PASS‐THROUGH ENTITY As discussed above, it is possible that the pass‐through structure of Sample can add value to a minority interest shareholder in the form of additional cash flows. However, the market data from which the discount rate is developed is applicable to C Corporation cash flows. Therefore, the DCF calculation is broken into two separate parts as follows: © Jay R. Hill, CPA, P.C. 32 Value of Retained Cash Flow – C Corporation Equivalent: The value of the entity as a C Corporation equivalent is calculated through the assumed retained cash flow after cash distributions to shareholders (see discussion below). These cash flows are capitalized using the capitalization rate developed above. Value of Distribution Benefits: Although an S Corporation avoids corporate level taxes, S Corporation shareholders pay individual income tax on the pre‐tax earnings of the S Corporation. The income tax rate in this instance is assumed to be 42%.14 However, an S Corporation can distribute additional or “excess” cash to its shareholders tax‐free. Therefore, it is common that total S distributions exceed the tax burden. These excess distributions are valued separately. Recent distributions have been approximately 85% to 95% of earnings. A 90% distribution rate is assumed in the calculation. However, to reflect the risk that the majority shareholder could suspend these distributions at any time and force the shareholders to satisfy their tax burden using other sources of income, the discount rate is increased by 1%. In addition to the value of the excess distributions, the benefit to the shareholders of avoiding the dividend tax on the excess distributions is also calculated. Whereas C Corporation shareholders pay income taxes at a 20% combined federal and state tax rate on C Corporation dividends, S Corporation distributions are not subject to this dividend tax. See Dividend Tax Avoidance in the calculations below for the details. Offsetting the benefits above is the fact that the personal tax rate is greater than the corporate tax rate by about 1%, i.e. 42%15 rate versus a 41% corporate rate. The difference is included in the calculation. See the Tax Differential in the calculation below for details. The DCF calculation is shown on the next page. 14
The actual estimated rate is 43% but this rate is reduced by 1% to reflect the fact that shareholders in the S Corporation increase their basis in their stock by the amounts retained in the corporation. 15
As discussed above, the actual estimated rate is 43% but this rate is reduced by 1% to reflect the fact that shareholders in the S Corporation increase their basis in their stock by the amounts retained in the corporation. © Jay R. Hill, CPA, P.C. 33 Net Cash Flow Projection and Value Calculation
2012
(in thousands, rounded)
Normalized pre‐tax income
Cash flow adjustments
Noncash items
Capital expenditures
Change in working capital
Net cash flow
760.0
42%
S Corp tax distribution paid
S Corp "excess dist" paid
Retained cash flow
Capitalization rate
Indicated value of retained cash flow
300.0
(300.0)
(21.4)
738.6
(319.2)
(335.5)
83.9
21%
399.5
Cash Flow Projection ‐ Net Distribution Benefits
S Corp "excess dist" paid
S Corp dividend tax avoidance ‐ Note 1
Tax differential liability ‐ Note 2
Net distribution benefits
Capitalization rate
Indicated value of net distribution benefits
335.5
68.7
(8.2)
396.0
22.0%
1,800.2
2,199.7
Indicated value of equity on a minority‐marketable basis
NOTE 1 ‐ Dividend Tax Avoidance Benefit
Total S corp distributions
C Corp entity‐related taxes
Distributions avoiding dividend tax
Estimated combined capital gains tax
Dividend tax avoidance benefit
41.0%
654.7
(311.0)
343.7
20%
68.7
NOTE 2: Tax Differential
S Corp tax distribution paid
C Corp entity‐related taxes
Tax differential
42.0%
41.0%
319.2
311.0
(8.2)
ESTIMATE OF S CORPORATION PREMIUM In order to apply the implied S Corporation premium in this method to the Public Company Guideline Method below, the above DCF calculations is recalculated as if Sample was a C Corporation and then calculates the difference in value in the form of a premium. The calculation of Sample on a C corporation equivalent is below: © Jay R. Hill, CPA, P.C. 34 Sample Metal Company ‐ C Corporation Equivalent
Capitalization of Cash Flow
Net Cash Flow Projection and Value Calculation
2012
449.0
(in thousands, rounded)
Normalized net income
Cash flow adjustments
Noncash items
Capital expenditures
Change in working capital
Net cash flow
Capitalization factor
Estimate of minority‐marketable value
300.0
(300.0)
(21.5)
427.6
21.0%
2,036.0
The implied premium is about 8% ($2,199.7 ÷ $2,036.0 = 1.08 or 108%). This premium will be applied to the public company guideline method. PUBLIC GUIDELINE COMPANY METHOD The public guideline company method entails determining a single period estimate of future earnings and applying market value factors for each method from appropriate guideline publicly‐held companies’ transaction data. Since the transaction data represents freely traded minority interests, the use of this method derives a freely traded no controlling or minority value for the subject company. It is the valuator’s opinion that net income, earnings before interest expense and income taxes (EBIT) and earnings before interest expense, income taxes, depreciation and amortization (EBITDA) are the most appropriate earnings bases to value the subject company. A five‐year weighted average of fiscal year 2007 through 2011 operating results are used as a basis for each earnings method as follows: Sample – Five‐Year Weighted Average Adjusted Earnings Bases Net income $ 412.0 EBIT 706.5 EBITDA 964.9 (in thousands, rounded) DEVELOPMENT OF VALUE FACTORS – GUIDELINE COMPANIES Sample operates in a niche industry that has few public companies that compete specifically in their industry. However, there are public companies that have divisions that operate in the niche or serve a similar customer base and are similar in both their operational and financial structure. The valuator searched for public companies that are categorized under waste management and basic materials as listed by Yahoo Finance. About twenty‐five companies were initially identified. Several companies were foreign and others were not considered compatible as their products diversification was too great or the trading volume of their stock © Jay R. Hill, CPA, P.C. 35 too low. Descriptions of the public guideline companies selected in the development of valuation factors for Sample are as follows:16 SCHNITZER STELL INDUSTRIES, INC. (SCHN) – Schnitzer Steel Industries, Inc. engages in recycling ferrous and nonferrous scrap metals, and used and salvaged vehicles; and manufacturing finished steel products. The company operates through three segments: Metals Recycling Business (MRB), Auto Parts Business (APB), and Steel Manufacturing Business (SMB). The MRB segment involves in the purchase, collection, processing, recycling, sale, and broking of ferrous scrap metals. It processes mixed and large pieces of scrap metal into smaller pieces by sorting, shearing, shredding, and torching. This segment’s products include ferrous products, including ferrous scrap metal, a feedstock used in the production of finished steel products; and nonferrous scrap metals, including aluminum, copper, stainless steel, nickel, brass, titanium, lead, high temperature alloys, and joint products, such as zobra (mixed nonferrous material) and zurik (stainless steel). The MRB segment sells its products to steel mills and smelters. The APB segment purchases used and salvaged vehicles and sells serviceable used auto parts from these vehicles through its 45 self‐
service auto parts stores, which are located across the United States and western Canada. It also sells other vehicles, including auto bodies; cores, such as engines, transmissions, alternators, and catalytic converters; and nonferrous materials to metal recyclers. The SMB segment engages in the purchase of recycled metal, and processing of the recycled metal and other raw materials into finished steel products. Its product portfolio comprises semi‐finished goods and finished goods consisting of rebar, coiled rebar, wire rod, merchant bar, and other specialty products. This segment serves steel service centers, construction industry subcontractors, steel fabricators, wire drawers, and farm and wood product suppliers. The company exports its products worldwide. Schnitzer Steel Industries, Inc. was founded in 1946 and is based in Portland, Oregon. CLEAN HARBORS (CLH) – Clean Harbors, Inc., through its subsidiaries, provides environmental, energy, and industrial services. Its Technical Services segment offers hazardous material management services, including the packaging, collection, transportation, treatment, and disposal of hazardous and non‐hazardous waste; and CleanPack services comprising the collection, identification, categorization, specialized packaging, transportation, and disposal of laboratory chemicals and household hazardous wastes. The company’s Field Services segment offers various environmental cleanup services on customer sites or other locations on a scheduled or emergency response basis, including tank cleaning, decontamination, remediation, spill cleanup; used oil and oil products recycling; polychlorinated biphenyls management and disposal; and filtration and water treatment services. Its Industrial Services segment offers industrial and specialty services, such as high‐pressure and chemical cleaning, catalyst handling, decoking, material processing, and industrial lodging services to refineries, chemical plants, pulp and paper mills, and other industrial facilities. The company’s Oil and Gas Field Services segment provides fluid handling, fluid hauling, downhole servicing, surface rentals, exploration, mapping, and directional boring services to the energy sector serving oil and gas exploration, production, and power generation. Clean Harbors, Inc. has approximately 200 locations, including approximately 50 waste management facilities in 37 U.S. states, 7 16
Description source: Yahoo Finance, finance.yahoo.com © Jay R. Hill, CPA, P.C. 36 Canadian provinces, Mexico, and Puerto Rico. The company also has operations in Bulgaria, China, Singapore, Sweden, Thailand, and the United Kingdom. It serves Fortune 500 companies and private entities, as well as federal, state, provincial, and governmental agencies. The company was founded in 1980 and is headquartered in Norwell, Massachusetts. DARLING INTERNANTIONAL, INC. (DAR) – Darling International Inc. provides rendering, cooking oil, and bakery waste recycling and recovery solutions to the food industry. The company operates in two segments, Rendering and Bakery. The Rendering segment processes poultry, animal by‐products, and used cooking oil into fats, such as bleachable fancy tallow, poultry grease, and yellow grease; protein, such as meat and bone meal, and poultry meal; and hides. This segment also provides grease trap services; schedules services, such as fat and bone, and used cooking oil collection, as well as trap cleaning services for contracted customers. The Bakery segment collects bakery products from commercial bakeries that produce cookies, crackers, cereal, bread, dough, potato chips, pretzels, sweet goods, and biscuits, as well as processes these raw materials into bakery by‐products, including Cookie Meal, an animal feed ingredient primarily used in poultry rations. Darling International Inc. sells its products to producers of animal feed, pet food, fertilizer, bio‐fuels, and other consumer and industrial ingredients, including oleo‐chemicals, soaps and leather goods through commodities brokers, company agents, and directly to customers worldwide. The company was formerly known as Darling‐Delaware Company, Inc. and changed its name to Darling International Inc. in December 1993. Darling International Inc. was founded in 1882 and is headquartered in Irving, Texas. REPUBLIC SERVICES, INC. (RSG) – Republic Services, Inc. provides non‐hazardous solid waste collection, transfer, and disposal services for commercial, industrial, municipal, and residential customers in the United States and Puerto Rico. Its residential collection operations comprise the curbside collection of refuse from small containers into collection vehicles for transport to transfer stations or directly to landfills; and commercial and industrial collection operations include supplying waste containers, renting compactors to large waste generators, and collecting and transporting containers or compacted waste to landfills or transfer station for disposal. The company is also involved in materials recovery and other recycling operations that sort recyclable paper, aluminum, glass, and other materials. As of December 31, 2011, it owned and operated 334 collection companies, 194 transfer stations, 191 active solid waste landfills, and 74 recycling facilities in 39 states and Puerto Rico. The company also operates 69 landfill gas and renewable energy projects. Republic Services, Inc. was founded in 1996 and is based in Phoenix, Arizona. U.S. ECOLOGY, INC. (ECOL) – US Ecology, Inc., through its subsidiaries, provides waste treatment, disposal, recycling, and transportation services to commercial and government entities in the United States. The company offers treatment and disposal services for radioactive, hazardous, polychlorinated biphenyl, and non‐hazardous industrial wastes. Its customers include oil refineries, chemical production facilities, manufacturers, electric utilities, steel mills, biotechnology companies, military installations, waste brokers/aggregators, and © Jay R. Hill, CPA, P.C. 37 medical and academic institutions. The company was formerly known as American Ecology Corporation and changed its name to US Ecology, Inc. in February 2010. US Ecology, Inc. was founded in 1952 and is headquartered in Boise, Idaho. WASTE CONNECTIONS, INC. (WCN) – Waste Connections, Inc., an integrated solid waste services company, provides solid waste collection, transfer, disposal, and recycling services. Its solid waste services include residential, commercial, and industrial collection services; landfill disposal services; recycling services for various recyclable materials, including cardboard, office paper, plastic containers, glass bottles, and ferrous and aluminum metals of residential, commercial, industrial, and municipal customers. The company also owns and operates transfer stations that receive, compact, and load solid waste to be transported to landfills via truck, rail, or barge. In addition, it treats and disposes non‐hazardous waste generated in the exploration and production of oil and natural gas. Further, the company offers intermodal services, including repositioning, storage, maintenance, and repair of cargo containers for international shipping companies for the rail haul movement of cargo and solid waste containers in the Pacific Northwest through a network of intermodal facilities. Additionally, it provides container and chassis sales and leasing services to its customers. As of March 31, 2012, the company owned or operated a network of 148 solid waste collection operations, 59 transfer stations, 39 recycling operations, 46 landfills, 7 intermodal facilities, and 1 exploration and production waste treatment and disposal facility. It also served approximately two million residential, commercial, and industrial customers from a network of operations in 30 states in the United States. The company was founded in 1997 and is based in The Woodlands, Texas. Below is a summary of pertinent financial data for the guideline companies including the five‐
year weighted average price/earnings, EBIT and EBITDA value factors. The EBIT and EBITDA factors are on a “debt‐free” basis or before the consideration of debt service (principal and interest) to ensure that this method does not result in over or under valuation of the subject company as a result of differences in debt leverage. The numerator in the guideline value multiples are the market value of total invested capital (TIC), which consists of the fair market value of a company’s equity plus the fair market value of the interest‐bearing debt (in this instance, the market value of debt for all the public guideline companies is equal to book value). The denominator consists of the five‐year weighted average EBIT or EBITDA base. Subsequently, to derive an equity value applicable to Sample, the subject company’s interest‐
bearing debt, if any, is subtracted from the TIC value. © Jay R. Hill, CPA, P.C. 38 Summary of Financial and Value Factor Information for Public Guideline Companies
SCHN
CLH
DAR
RSG
ECOL
WCN
AVG
MED
Revenue
3,459.2
Market capitalization
1,235.3
Total invested capital
1,639.3
5‐year earnings growth est.
11.5%
Net book value
1,094.7
Total assets
1,890.2
5‐Year avg. net income
57.0
5‐Year avg. EBITDA
154.1
Employees
193
BETA
2.06
1,984.1
2,921.9
3,460.8
13.8%
901.0
2,085.8
96.7
265.5
8,320
0.46
1,797.2
1,720.4
2,000.4
3.0%
920.4
1,417.0
85.2
198.2
3,320
1.60
8,192.9
10,179.6
17,101.4
6.4%
7,681.3
19,551.5
530.2
2,245.5
30,000
0.67
154.9
305.5
346.1
7.6%
100.2
202.6
15.0
36.2
387
1.11
1,505.4
2,447.3
3,626.0
7.3%
1,394.9
3,328.0
136.7
417.7
5,909
0.34
2,849.0
3,135.0
4,695.7
8.26%
2,015.4
4,745.8
153.5
552.9
8,021.5
1.04
1,890.7
2,083.9
2,730.6
7.45%
1,007.5
1,988.0
90.9
231.8
4,614.5
0.89
5‐Year Weighted Average
Price/earnings
TIC/EBIT
TIC/EBITDA
31.04
20.63
13.59
19.79
12.83
9.97
22.15
14.42
8.86
18.59
12.37
8.90
18.37
13.72
8.97
20.44
14.11
9.64
19.19
13.28
8.94
12.70
10.69
7.56
NA – Not Available It is the valuator’s opinion that the public guideline group’s median value factors are reasonable benchmarks to derive appropriate value factors for Sample. There is one of the companies that have factors which are considerably higher than the remaining companies that skew the average factors. The median factors for the group need to be adjusted to reflect the fundamental differences (herein referred to as the “Fundamental Adjustment”) between Sample and the public guideline group in terms of both risk and growth expectations. RISK DIFFERENCE There is more risk in the subject company’s stock due to the size difference between Sample and the guideline companies in terms of revenue, capital resources, geographic sales area and workforce. In order to quantify these risk differences, Sample’s cost of equity developed in the Capitalization of Cash Flow (CCF) method discussed above of 23% is compared to the estimated average cost of equity for the guideline group. The guideline group equity rate is estimated using the same Duff & Phelps data sources used to derive Sample’s cost of equity as follows: © Jay R. Hill, CPA, P.C. 39 Summary of Inputs – Size Study and Risk Studies
GENERAL INPUTS: Values as of the January 1, 2012 valuation date.
Subject Company:
Risk‐Free Rate:1
Equity Risk Premium:2
Beta:3
Industry Risk Premium:4
Sample Metal Co. ‐ Guideline
2.57%
6.0%
1.00
‐1.0%
SIZE STUDY INPUTS: Values for the most recent year relative to the January 1, 2012 valuation date.
1
Estimated Market Value of Common Equity (in $millions)
Book Value of Equity
(in $millions)
5‐Year Average Net Income
(in $millions)
Market Value of Invested Capital $2,083.90
$1,007.50
$90.90
$2,730.60
Total Assets
(in $millions)
5‐Year Average EBITDA
(in $millions)
Net Sales
(in $millions)
Number of Employees
$1,988.00
$231.80
$1,890.70
4,615
Long‐term (20‐year) U.S. Treasury Bond Yield (constant maturity).
2
Duff & Phelps 2011 Risk Premium Report
Average Beta for Public Guideline Companies used to reflect higher Beta for only primary recycle public
company ‐ SCHN
3
4
Morningstar's Ibbotson SBBI 2011 Valuation Yearbook, Table 3‐5 Industry Premia Estimates, SIC
Code 4953 Refuse Systems: ‐2.22, increased to ‐1.0 to reflect higher volatility of primary recycle company
The resulting risk premiums and adjustments using the above data in the D & P study are displayed below (Note: the Risk Study is not needed for the guideline companies and not included): PREMIA Equity Risk Premium (ERP) Long‐horizon expected return of large stocks over risk free securities. Median Premium Over CAPM (RPs) CAPM and Buildup 2 The return on small company stocks in excess of that predicted by CAPM (also known as "beta‐adjusted size premium"). 6.0% 4.4% Median Premium Over Risk Free Rate (RPm+s) Buildup 1 The long‐horizon expected return of stocks over risk free securities in terms of the combined effect of market risk and size risk. © Jay R. Hill, CPA, P.C. 9.4% 40 ADJUSTMENTS ERP Adjustment An adjustment made to reconcile a historically‐derived ERP with a forward‐
looking ERP as of the valuation date. 1.6% Adjusted Industry Risk Premium (IRPadj) An IRP adjusted for the difference between the historical ERP used as an input to compute the IRP, and the forward‐looking ERP chosen as of the valuation date. Source: Morningstar SBBI ‐0.9% The calculation of cost of equity capital for Guideline Companies with the key inputs plugged into each of the models is shown below: COST OF EQUITY CAPITAL (COE), ALL MODELS . Size Study Buildup 1 COEBuildup 1 13.6% Buildup 2 COEBuildup 2 12.1% = rf + RPm+s + ERP Adjustment = 2.6% + 9.5% + = rf + ERP + RPs + IRPadj = 2.6% + 6.0% + 4.4% + ‐0.9% 1.6% Capital asset pricing model (CAPM). COECAPM = rf + (β x ERP) 13.0% = 2.6% + (1.0 x 6.0%) + RPs + 4.4% The applied methods resulted in a range of cost of equity capital estimates for the Guideline Companies of 12.1% to 13.6% with an average of 13%. For purposes of comparison to Sample, a cost of equity of 13% is selected. GROWTH DIFFERENCE Next, the median 5‐year growth expectation for the public guideline group is compared to Sample’s growth expectations. The guideline companies’ median earnings growth outlook is 7.45% per year, rounded to 7%, for the next five‐years. Sample’s earnings growth expectations are about 2% per year as discussed in the CCF method. The determination of the Fundamental Adjustment is below: © Jay R. Hill, CPA, P.C. 41 Fundamental Adjustment Calculation
Public Guideline Company 5‐Year Weighted Median Price/Earnings
Guideline Company Capitalization Rate (1/(Price/Earnings))
Cost of Equity for Subject Company (Per CCF Method)
Less: Cost of Equity for Guideline Companies
Risk Premium Differential
Guideline Company Average Expected Growth Rate Next Five Years
Less: Subject Company Expected Earnings Growth Rate Next Five Years
Growth Rate Differential
Capitalization Rate Applicable to Subject Company
Price/Earnings Multiple Applicable to Subject Company ‐ Rounded
Implied Fundamental Adjustment of Guideline Median Multiple
19.19
5.2%
23.00%
‐13.00%
10.0%
7.0%
‐2.0%
5.0%
20.2%
4.9
74.5% The resulting price/earnings factor for Sample is 4.9. The implied Fundamental Adjustment of 74.5% is applied to the two invested capital method’s equity value indication, i.e. after subtracting Sample’s interest‐bearing debt. The valuation calculations for the public guideline company method using the selected earnings bases are below. © Jay R. Hill, CPA, P.C. 42 Price/Earnings Method
Year
2007
2008
2009
2010
2011
Adjusted net income
390.0
403.0
93.0
645.0
425.0
Weight
1
2 3 4 5
Weighted
390.0
806.0
279.0
2,580.0
2,125.0
Total
6,180.0
Divided by total weight
15
Weighted average adjusted net income
412.0
Price/earnings value factor (including Fundament Adjustment)
4.9
Indicated equity value equivalent to public guideline companies
2,019.0
TIC/EBIT Method
Year
2007
2008
2009
2010
2011
EBIT
670.0
686.0
141.0
1,117.0
733.0
Weight
1
2 3 4 5
Weighted
670.0
1,372.0
423.0
4,468.0
3,665.0
Total
10,598.0
Divided by total weight
15.0
Weighted average adjusted EBIT
706.5
Value factor
13.28
Capitalized EBIT
9,379.0
Less interest bearing debt
(275.2)
Indicated equity value before fundamental adjustment
9,104.0
Fundamental adjustment
74.5%
(6,779.0)
Indicated equity value equivalent to public guideline companies
2,325.0
(in thousands, rounded)
TIC/EBITDA Method
Year
2007
2008
2009
2010
2011
EBITDA
818.0
927.0
349.0
1,286.0
1,122.0
Weight
1
2 3 4 5
Weighted
818.0
1,854.0
1,047.0
5,144.0
5,610.0
Total
14,473.0
Divided by total weight
15.0
Weighted average adjusted EBITDA
964.9
Value factor
8.94
Capitalized EBITDA
8,621.0
Less interest bearing debt
(275.2)
Indicated equity value before fundamental adjustment
8,346.0
Fundamental adjustment
74.5%
(6,215.0)
Indicated equity value equivalent to public guideline companies
2,131.0
(in thousands, rounded)
© Jay R. Hill, CPA, P.C. 43 RECONCILATION OF VALUE ESTIMATES – PUBLIC GUIDELINE COMPANY METHOD In estimating a single point value for the Public Guideline Company Method, equal weight is accorded to all three methods as they fall within a relatively tight range. Below is the valuator’s reconciliation of the indicated values: Reconcilation of Value Estimates ‐ Public Guideline Company Method
Price/earnings method
2,019.0 x 34.0% =
TIC/EBIT method
2,325.0 x 33.0% =
TIC/EBITDA method
2,131.0 x 33.0% =
Indication of value per public guideline company method
100.0%
686.0
767.0
703.0
2,156.0
The S Corporation premium is applied to the indicated value to arrive at an S Corporation equivalent value of $2,328.5 ($2,156.0 x 108%). RECONCILIATION OF ALL VALUE ESTIMATES In summary, the indicated values for Sample on a minority‐marketable basis are as follows: INDICATED MINORITY‐MARKETABLE VALUE OF SUBJECT COMPANY
Capitalization of Cash Flow
Public Guideline Method
2,199.7
2,328.5
In estimating a single point of value equal weight is given both methods as they fall within a relatively tight range. Therefore, the estimated value of Sample on a minority‐marketable basis as of January 1, 2012 is $2,265,000 ADJUSTMENT FOR LACK OF MARKETABILITY Sample shares are not trading on a public market. Accordingly, the valuation of such an interest is normally subject to a discount for marketability. Below is a schedule of factors that influence the size of the marketability discount and how they specifically affect a minority interest in the subject company: Summary Of Factors That Affect The Marketability Discount Affect on Minority Interest Shareholder in Sample Metal Co. The company’s distribution policy and the size of The Company is an S corporation that has made the distributions, if any. distributions to cover the shareholders’ tax obligations and distribute profits. It is likely that these types of distributions will continue. These distributions are more attractive than regular dividends that would be paid if the Company was a © Jay R. Hill, CPA, P.C. 44 C corporation. Overall, this factor decreases the discount. The history of profitable versus unprofitable operations (nature and history of the business), the attractiveness of the company’s industry and its position in the industry and the company’s quality of earnings (financial statement analysis). The Company has had a mixed earnings history, but has remained profitable despite the severe recession. The recycle industry can be volatile and competitive. However, the subject company appears to be in solid position. Prospects for the future appear good. These factors decrease the marketability discount. The company’s management. Solid but older management team. Ability to successfully transition to new generation will be important and is uncertain at this time. This factor increases the discount. Amount of control in transferred shares or size Major shareholder with significant influence on of the interest being valued. Company policy and management. Overall, the lack of control increases the discount. Restrictions on transferability of interest. Shareholders will likely be restricted in the transfer of stock through right of first refusal or some other agreement. Increase in discount. The anticipated holding period for stock. Anticipated holding period is unknown, however likely holding period is probably at least 10 years. This factor increases the marketability discount The company’s redemption policy No specific redemption policy in place. This factor increases the marketability discount. Likelihood of going public and the costs Sample is a small closely‐held company and public associated with making a public offering. offering does not appear to be likely in the future. This increases the discount. The most important factor is the expected distributions to the shareholders. This factor is important to attracting investors for a minority interest in the subject company. However, most of the other factors decrease the marketability of the stock. In order to determine a discount specific to the subject company, an analysis of empirical evidence is performed to set benchmarks in which to apply the above analysis along with other subject company characteristics that impact the discount. There are two primary sources of empirical evidence of marketability discounts applicable to closely‐held securities. © Jay R. Hill, CPA, P.C. 45  Studies of transactions comparing the prices before companies made public offerings with the prices after public offerings.  Studies of transactions comparing the prices of restricted "letter" stock of publicly‐
traded companies with the prices of the related freely traded shares. The restricted stock studies determine the discount at which restricted publicly traded stocks (subject to Rule 144) traded from their freely‐traded counterparts. The restriction period for these stocks is between one and two years; therefore, the discount for an equivalent privately‐
held stock would be greater because the privately‐held stock does not become a freely traded public stock after two years. Pre‐IPO studies focus on true closely‐held stocks that have no market prior to the IPO. These studies measure the difference in price between private transactions of the subject stock five to six months prior to the IPO and the public offering price. Both studies have flaws as factors other than illiquidity may impact the transaction prices; however, they both offer excellent empirical evidence of lack of marketability. FMV VALUE STUDY – RESTRICTED STOCKS In this instance, restricted stock transactions are used to determine the marketability discount. Specifically, the valuator uses the FMV Opinions, Inc.’s (FMV) Restricted Stock Study and its companion tool – FMV Discount for Lack of Marketability (DLOM) Calculator. The methodology developed by FMV is a comparative analysis in which characteristics of the subject company are compared to characteristics of the companies involved in the restricted stock transactions. This method is very similar to the way the public guideline company data was used above in which a group of similar public guideline transactions are used as a benchmark to determine an appropriate value factor for a private subject company. Similar to those methods, a regression analysis in this instance is not necessary to determine an appropriate discount and relying on such an analysis without consideration of other factors could lead to a false conclusion. An analysis of the transactions in the FMV database clearly indicated that there are relationships between certain financial characteristics of the business and the discount associated with the restricted stock. FMV analyzes the data by quintiles17 as it found that this offered sufficient data points and optimal observations for comparison purposes.18 Below is a summary of selected financial characteristics and resulting discounts from the database. 17
One of the four numbers (values) that divide a range of data into five equal parts, each being 1/5th (20 percent) of the range. 18
Deciles (one of ten numbers (values) that divide a range of data into ten equal parts) offered to few data points within the deciles and quartiles (defined above) offered sufficient data points, but too wide of dispersion within the quartiles for comparison purposes. © Jay R. Hill, CPA, P.C. 46 1980 – 2008 (All Transactions, 597 Count*)
Quintile
1
2
3
4
5
Quintile Discount 1.60%
10.50%
16.70%
27.30%
43.70%
Market Value ($) 166,358 162,682 110,814 68,824 44,309
Total Assets ($) 66,025 65,752 39,844 18,245 9,434
Book Value ($) 37,988 30,916 22,669 8,443 4,978
Revenues ($) 23,335 29,136 28,811 14,118 7,764
Percentage Block Size 7.90%
9.90%
10.10%
9.40%
12.40%
MTB Ratio 3.5 3.9 3.7 5.8 6.0
Volatility 68.3%
67.5%
71.8%
80.2%
104.2%
Price per share
$ 12.49 $ 11.07 $ 12.02 $ 8.15 $ 8.17
* All company financial characteristics throughout this presentation have been
inflation‐adjusted
Notes: $ amounts in thousands MTB Ratio – Market‐To‐Book Ratio In summary, the main conclusions of the FMV Study are that the magnitude of the DLOM is: Negatively correlated (i.e. the larger the characteristic the smaller the discount) with: 1. the issuing firm’s market value of equity; 2. the issuing firm’s revenues; 3. the issuing firm’s total assets; 4. the issuing firm’s book value of shareholders’ equity; and 5. the issuing firm’s net profit margin. Positively correlated (i.e. the larger the characteristic the larger the discount) with: 1. the issuing firm’s MTB ratio; 2. the issuing firm’s stock price volatility; 3. the block size of the placement, described as a percent of the total ownership; and 4. the level of market volatility prevailing as of the transaction date, as measured by VIX. Further analysis of the FMV data by FMV suggests that the most important determinants of the DLOM are (1) the issuing firm’s financial and market risk; (2) the level of stock market volatility prevailing around the transaction date; and (3) the degree of liquidity of the securities. Accordingly, FMV’s determination of the appropriate DLOM for minority interests in private companies involves a three‐step analysis: 1. Restricted Stock Equivalent Discount (“RSED”). The discount applicable to the shares (or other equity interest) in a private company, as if they were typical restricted shares in a public company. The determination of the RSED is based on a comparative analysis of the subject company and the FMV Study companies issuing small blocks of restricted stock (less than 30% shares placed) by the following size, balance sheet, profitability and volatility characteristics: a. Size characteristics © Jay R. Hill, CPA, P.C. 47 i. Market value ii. Revenues iii. Total assets b. Balance sheet characteristics i. Shareholders’ equity ii. Market‐to‐book ratio c. Profitability characteristics i. Net profit margin d. Market risk characteristics i. Volatility of stock price – this is difficult to assess for private companies and sometime can be measured using public guideline companies’ Beta or industry group betas. In this instance, the valuator elected not to use the Beta from the public guideline companies cited above. 2. Market Volatility Adjustment. The adjustment to the RSED required in the event that equity markets demonstrate unusually high volatility around a given valuation date. The adjustment factor is derived from a comparison of FMV Study transactions occurring during months with normal trailing 6‐month average Chicago Board Option Exchange Volatility Index (VIX) values versus those occurring during months with very high trailing 6‐month average VIX values. The result of applying the Market Volatility Adjustment to the RSED is the Adjusted Restricted Stock Equivalent Discount, referred to hereinafter as the “ARSED.” 3. Private Equity Discount (“PED”). The discount required for private equity, which reflects the fact that interests in private companies are significantly less liquid than all but the most illiquid issues (i.e., the largest blocks) of restricted stock in public companies. The adjustment to go from the ARSED to the PED is based on the adjustment factors derived from the comparison of discounts associated with small‐block versus large‐block transactions in the FMV Study. FMV uses the discounts associated with large‐block transactions as a proxy for the lack of liquidity usually present for a private interest. The following inputs and the results of the FMV DLOM Calculator to determine the RSED and ARSED are shown below: © Jay R. Hill, CPA, P.C. 48 FMV Discount for Lack of Marketability Analysis and Conclusion
Company Name
Valuation Date
Inflation Adjusted
Sample Metal Company
1/1/2012
Yes
Transactions adjusted for inflation for use in present day
Company Financials (latest twelve months, $ thousands, except volatility)
Market Value of Equity
$2,265
Market to Book Ratio
Revenues
$10,207
Net Income
Total Assets
$1,616
Net Profit Margin
Shareholders' Equity
$748
Volatility
3.0
$425
4.2%
NA
Restricted Stock Equivalent Discount Analysis1
(1) Financial Characteristics Comparison
Subject
Company
Value
FMV StudyTM
Quintile
Discount
Indication
Selected
Weight
FMV
Suggested
Weight
2,265
10,207
1,616
5th Quintile
3rd Quintile
5th Quintile
23.7%
18.5%
27.3%
2
1
3
2
1
3
Balance Sheet Risk Characteristics
Shareholders' Equity ($000s)
Market‐To‐Book Ratio
748
3.0
5th Quintile
3rd Quintile
20.9%
14.2%
2
1
2
1
Profitability Characteristics
Net Profit Margin
4.2%
1st Quintile
13.9%
1
1
Market Risk Characteristics
Volatility
NA
NA
NA
0
0
5 7 37.5%
6 0 NA
Size Characteristics
Market Value ($000s)
Revenues ($000s)
Total Assets ($000s)
Indicated Restricted Stock Equivalent Discount
(2) Best Comparables Analysis
Weights Selected
for Financial
Characteristics
Comparison Analysis
Market Value
2
Revenues 1
Total Assets 3
Shareholders' Equity
2
Market‐To‐Book Ratio
1
Net Profit Margin
1
Volatility
0
21.8%
Variables Selected
For Best
FMV
Comparables Suggested
Analysis
Variables
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
No
No
Number of Variables to Match:
Number of Matches
Transaction Count
Median Discount
1 494 15.8%
2 221 23.1%
6
3 85 26.7%
Indicated Restricted Stock Equivalent Discount Range
4 31 38.8%
16% ‐ 39%
1
Excludes transactions with "% Shares Placed" > 30%. Sample includes 682 transactions between July 1, 1980 and December 31, 2011.
© Jay R. Hill, CPA, P.C. 7 0 NA
49 Restricted Stock Equivalent Discount Conclusion
Restricted Stock Equivalent Discount
Financial Characteristics Comparison
Best Comparables Analysis
21.8%
16% ‐ 39%
Selected Restricted Stock Equivalent Discount
22.0%
Market Volatility Adjustment Analysis
Selected Restricted Stock Equivalent Discount
22.0%
Multiplicative
Adjustment
VIX Range1
Low
High
Factor
0.00
23.20
26.00
32.90
40.00
50.00
23.20
26.00
32.90
40.00
50.00
60.00
1.00
1.16
1.23
1.37
1.54
1.75
Indicated
VIX Value
Valuation Date
Trailing 1‐Month Average
Trailing 6‐Month Average
1
23.40
25.17
30.16
Mult. Adj.
Factor
1.16
1.16
1.23
Selected Market Volatility Adjustment Factor2
1.16
Adjusted Restricted Stock Equivalent Discount
25.5%
The fourth, fifth, and sixth levels (32.9‐40, 40‐50, 50‐60) are implied levels extrapolated from the first three levels, given the unusually high
levels of volatility in 2008‐2009.
2
Used valuation date volatility for Sample as recycle industry is volatile
The adjusted restricted stock equivalent discount for Sample is 25.5% (i.e. the estimated discount that Sample’s stock would sell on the market if it was a publicly‐traded restricted stock). PRIVATE EQUITY DISCOUNT (PED) Sample‘s stock is closely‐held so, as described above, a range of marketability or private equity discounts for Sample is determined by using the differences between discounts observed in transactions involving smaller blocks of stock (less than 30% of total) and large blocks of stock (30% or greater). FMV study of restricted stock transactions has shown that all else being © Jay R. Hill, CPA, P.C. 50 equal, large blocks of unregistered stock (expressed as a percent of total shares outstanding) are more illiquid than small blocks. This results from (i) Rule 144’s19 volume limits after the initial required holding period and prior to the ultimate holding period, and (ii) the difficulty in disposing of a large block of stock in a short time period through public sales due to general market supply and demand conditions. Rule 144’s volume limits allow for the resale, in any three‐month period, of the greater of 1% percent of the company’s total outstanding shares or the average weekly trading volume for the four weeks before each sale of the subject stock. Therefore, under the dribble out provisions, a block of 20% or more would take up to five years to resell after the initial holding period assuming that it was sold to just one buyer and that the holder of the block was deemed an affiliate under Rule 144. Thus, this block of stock would be subject to Rule 144 volume limits indefinitely. Furthermore, it would also assume that the trading volume of the stock was so low that 1% percent of total shares outstanding was the most that the buyer could sell in any three‐month period. As one can expect, the discount is correlated with the size of the block of stock sold in the private placement, as shown in the chart below: Block Size and Discounts
45.0%
40.0%
35.0%
Discount
30.0%
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
0 ‐ 10%
10 ‐ 20%
20 ‐30%
30 ‐40%
> 40%
Block Size (% of Outstanding)
The data shows that the discount increases due to a greater degree of illiquidity (i.e., larger block size), and the magnitude of this relationship is most significant among block sizes greater than 30%. Specifically, increasing block size from less than 30% (median discount of 16.5%) to greater than 30% (median discount of 38.5%) results in an increase to the median discount of 19
In January 1972, the SEC adopted Rule 144 under the Act as an objective safe harbor for the resale of restricted securities. The result was an improvement in the liquidity of restricted stock as the rules surrounding resale became significantly more predictable. Rule 144 regulates public sales of restricted securities, including both unregistered securities and control securities. © Jay R. Hill, CPA, P.C. 51 22 percentage points (38.5% ‐ 16.5% = 22.0%), or 2.33 times (38.5% / 16.5% = 2.33, called a multiplicative adjustment factor). Therefore, it is reasonable to state that the largest blocks of restricted stock, which may require many years to liquidate through public sales, are so illiquid that they resemble private equity. Another way to view these results is to state that the Rule 144’s dribble‐out provisions, in addition to general supply‐demand conditions for the securities, make it so difficult to sell such blocks in public trading that the more attractive solution, in most cases, would be to sell the stock in the private market. Therefore, using this difference between small and large blocks, a private equity discount is developed for Sample. In order to ensure the reasonability of the PED indications, in addition to calculating multiplicative adjustment factors, FMV calculates inverse multiplicative adjustment factors (i.e, a multiplicative adjustment factor based on one minus the discount indication). The inverse of the discount represents the percent of the publicly traded value that the transaction price represents, rather than the discount to the publicly traded value. For example, an $8.00 per share purchase price where the publicly traded value is $10.00 per share represents either a 20% discount or 80% of the publicly traded value. In this case, 80% is the inverse of the 20% discount. If the actual discount for a large‐block transaction is 40% (60% inverse discount), and the RSED for the same transaction is 20% (80% inverse), the inverse multiplicative factor is calculated as 60% / 80%, or 0.75. The range of discounts using both a multiplicative and inverse multiplicative factors is below: Private Equity Discount Analysis
Median Adjustment Factors
% Shares
Inverse
Placed Multiplicative Multiplicative
30 ‐ 40%
40 ‐ 50%
Private Equity Discount Range
Multiplicative
Inverse Multiplicative
1.56
1.82
0.85
0.76
Low
39.8%
36.7%
High
46.4%
43.4%
FMV indicates that when the adjusted restricted stock equivalent discount is above 25%, the inverse multiplicative factor discounts are the most appropriate. However, the RSED is very close to the break line, therefore, the entire range of discounts is considered. Therefore, the indicated private equity discount range for Sample is 37% to 46%. When determining a specific discount for Sample, most of the qualitative factors discussed above would indicate a discount © Jay R. Hill, CPA, P.C. 52 near the middle end of the range or 42%. However, the overriding factor is the anticipated distributions to the shareholders. It is the valuator’s opinion that this opportunity and available cash flow eliminates most of the additional “large” block discount that FMV uses to measure the private equity discount. A 10% reduction is deemed appropriate. A summary of the selected marketability discount is shown below. Summary and Conclusion
Restricted Stock Equivalent Discount
Financial Characteristics Comparison
Best Comparables Analysis
Selected Restricted Stock Equivalent Discount
Times: Selected Market Volatility Adjustment Factor
Adjusted Restricted Stock Equivalent Discount
Selected Private Equity Discount Before Consideration of Distribution Policy
Less Reduction For Regular Distributions to Shareholders
Discount for Lack of Marketability Conclusion
21.8%
16% ‐ 39%
22.0%
1.16
25.5%
42.0%
‐10.0%
32.0%
VALUATION SUMMARY AND CONCLUSION OF VALUE A summary of the valuation conclusion is shown below: Valuation Conclusion
Estimate of fair market value as if freely traded
Shares outstanding
Estimate of fair market value per share as if freely traded
Less discount for marketability
Estimate of fair market value per share on a minority‐nonmarketable basis
2,265,000
1,500
$ 1,510
(483)
$ 1,027
In the valuator’s opinion, the methods and procedures followed recognize the relevant facts and circumstances significantly affecting the value of Sample Metal Company, Inc. common stock as of January 1, 2012. © Jay R. Hill, CPA, P.C. 53 ASSUMPTIONSANDLIMITINGCONDITIONS
Possession of this report or any copy thereof does not imply the right of use or publication. Neither may the report or copy be used for any purpose by anyone but the client without the previous written consent of Jay R. Hill, CPA, P.C., and then only with proper qualifications. 1. The conclusion of value arrived at herein is valid only for the stated purpose as of the date of the valuation. The report must be considered in its entirety and the separation of any part from the whole will have the effect of invalidating the entire report. No change of any item in this appraisal report shall be made by anyone other than Jay R. Hill, CPA, P.C., and I shall have no responsibility for any such unauthorized change. 2. Financial statements and other related information provided by Sample or its representatives, in the course of this engagement, have been accepted without any verification as fully and correctly reflecting the enterprise’s business conditions and operating results for the respective periods, except as specifically noted herein. Jay R. Hill, CPA, P.C. has not audited, reviewed, or compiled the financial information provided to us and, accordingly, I express no audit opinion or any other form of assurance on this information. 3. Public information and industry and statistical information have been obtained from sources I believe to be reliable. However, I make no representation as to the accuracy or completeness of such information and have performed no procedures to corroborate the information. 4. I have conducted interviews with the current management of Sample concerning the past, present, and prospective operating results of the company. However, I do not provide assurance on the achievability of the results forecasted by Sample because events and circumstances frequently do not occur as expected; differences between actual and expected results may be material; and achievement of the forecasted results is dependent on actions, plans, and assumptions of management. 5. The conclusion of value arrived at herein is based on the assumption that the current level of management expertise and effectiveness would continue to be maintained and that the character and integrity of the enterprise through any sale, reorganization, exchange, or diminution of the owners’ participation would not be materially or significantly changed. 6. This report and the conclusion of value arrived at herein are for the exclusive use of my client for the sole and specific purposes as noted herein. They may not be used for any other purpose or by any other party for any purpose. Furthermore the report and conclusion of value are not intended by the author and should not be construed by the reader to be investment advice in any manner whatsoever. The conclusion of value represents the considered opinion of Jay R. Hill, CPA, P.C., based on information furnished to them by Sample and other sources. © Jay R. Hill, CPA, P.C. 54 7. Neither all nor any part of the contents of this report (especially the conclusion of value, the identity of any valuation specialist(s), or the firm with which such valuation specialists are connected or any reference to any of their professional designations) should be disseminated to the public through advertising media, public relations, news media, sales media, mail, direct transmittal, or any other means of communication, including but not limited to the Securities and Exchange Commission or other governmental agency or regulatory body, without the prior written consent and approval of Jay R. Hill, CPA, P.C. 8. Future services regarding the subject matter of this report, including, but not limited to testimony or attendance in court, shall not be required of Jay R. Hill, CPA, P.C. or Jay R. Hill unless previous arrangements have been made in writing. 9. Jay R. Hill, CPA, P.C. is not an environmental consultant or auditor, and it takes no responsibility for any actual or potential environmental liabilities. Any person entitled to rely on this report, wishing to know whether such liabilities exist, or the scope and their effect on the value of the property, is encouraged to obtain a professional environmental assessment. Jay R. Hill, CPA, P.C. does not conduct or provide environmental assessments and has not performed one for the subject property. 10. Jay R. Hill, CPA, P.C. has not determined independently whether Sample is subject to any present or future liability relating to environmental matters (including, but not limited to CERCLA/Superfund liability) or the scope of any such liabilities. Jay R. Hill, CPA, P.C.’s valuation takes no such liabilities into account, except as they have been reported to Jay R. Hill, CPA, P.C. by Sample or by an environmental consultant working for Sample, and then only to the extent that the liability was reported to us in an actual or estimated dollar amount. Such matters, if any, are noted in the report. To the extent such information has been reported to us, Jay R. Hill, CPA, P.C. has relied on it without verification and offers no warranty or representation as to its accuracy or completeness. 11. Jay R. Hill, CPA, P.C. has not made a specific compliance survey or analysis of the subject property to determine whether it is subject to, or in compliance with, the American Disabilities Act of 1990, and this valuation does not consider the effect, if any, of noncompliance. 12. Unless otherwise stated, no effort has been made to determine the possible effect, if any, on the subject business due to future Federal, state, or local legislation, including any environmental or ecological matters or interpretations thereof. 13. If prospective financial information approved by management has been used in my work, I have not examined or compiled the prospective financial information and therefore, do not express an audit opinion or any other form of assurance on the prospective financial information or the related assumptions. Events and circumstances frequently do not occur © Jay R. Hill, CPA, P.C. 55 as expected, and there will usually be differences between prospective financial information and actual results, and those differences may be material. 14. Except as noted, I have relied on the representations of the owners, management, and other third parties concerning the value and useful condition of all equipment, real estate, investments used in the business, and any other assets or liabilities, except as specifically stated to the contrary in this report. I have not attempted to confirm whether or not all assets of the business are free and clear of liens and encumbrances or that the entity has good title to all assets. © Jay R. Hill, CPA, P.C. 56 Exhibit A DOCUMENTSANALYZEDANDUTILIZED
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Compiled financial statements for fiscal years ending December 31, 2007 through 2011 www.samplemetal.com Ownership summary Management compensation summary from 2007 ‐ 2011 Fixed asset listing Other pertinent information per interview with John Sample. Market and industry data:  As cited in report © Jay R. Hill, CPA, P.C. 57 Exhibit B QUALIFICATIONSOFVALUATOR
This valuation report is prepared by Jay R. Hill, CPA, P.C., a Certified Public Accounting firm which conducts valuation studies of closely‐held corporations for income, gift and estate tax planning, buy/sell agreements, mergers/acquisitions/divestitures, expert witness testimony, Employee Stock Ownership Plans and other related purposes. Jay R. Hill, CPA, ABV Jay R. Hill, CPA, ABV is a certified public accountant and accredited in business valuation. He has over 24 years of business valuation and related services experience and is President of Jay R. Hill, CPA, P.C. He earned a Bachelor of Arts degree in Political Science in 1984 and a Bachelor of Science degree in Business Administration in 1985 from the University of Kansas. He completed additional undergraduate courses in accounting from the University of Missouri‐
Kansas City and Rockhurst University. In addition, he is a candidate member of the American Society of Appraisers. INDEPENDENCEOFVALUATOR
Neither Jay R. Hill, CPA, P.C., nor the individuals involved with this valuation have a present, prospective or contemplated interest in the business discussed in this report. Further, the compensation and employment for this valuation were not contingent upon the conclusions stated. © Jay R. Hill, CPA, P.C. 58