The following article was written by Arlene Ashcraft and Donny Springer of Columbia Financial Advisors, and was published in the September 2014 edition of the ESOP Report (monthly newsletter of the ESOP Association).
Appraisal Report Review: Integrating Industry Outlook and Forecasted Performance
An annual ESOP appraisal report stands as a testament to the due diligence undertaken to assist the Trustee in its determination of the fair market value of securities owned by the ESOP. Sections of the report may seem to stand in isolation of one another, but should as a whole lend support to the fair market value determined and provide persuasive evidence for the concluded value. Though each company and its operations are unique, all companies still operate within certain economic and industry constraints. As a reviewer of an ESOP appraisal report, a key area of focus should be the industry outlook with respect to the company’s projected performance. A company’s future earnings provide a return for investors; thus projected performance is a key driver of share price. Therefore, a careful review of the industry outlook, in conjunction with review of the Company’s long-term projections is essential to a critical review of the ESOP appraisal report.
The following are questions that can be helpful in analyzing a company’s projections in conjunction with the industry’s outlook:
• Start at the top line --- revenue growth. What is the magnitude of revenue growth anticipated for the industry? What is the projected trend (strong short-term growth, slow steady growth, decline then strong recovery in later years)? Looking at long-term trends, is the industry mature or in a state of decline? Are there country or regional differences in growth outlook? Are there certain niche areas that are projected to grow faster or slower, or exhibit different trends than the overall industry? Are there certain client groups that are forecasted to have different growth rates or growth trends? Few if any companies in an industry will have revenues that exactly mirror the performance of the overall industry. Each company strives to find its niche and thus has variations on the overall theme exhibited by the industry. Nonetheless, a company still operates within the confines of its industry and adequate explanation of differences should be addressed. General industry trends should still be evident.
• Now consider input costs and gross margins. What factors in the industry dictate the costs of raw materials or inputs? Are these costs rising, falling or volatile? If volatile, is there a general trend (decreasing, flat, or increasing) over the long-term? Are gross margins declining as the industry matures? How do the company’s historical gross margins compare to the industry and gross margins in the forecast?
• Employee and administrative costs. To what extent can companies in the industry leverage employees? Are employees high- or low-skilled? Is technology changing, potentially mitigating some dependence on high cost employees or replacing lower skilled workers? Is it becoming more or less expensive to find quality employees (i.e., how competitive is the marketplace)? What are the major general and administrative costs in the industry and what is the trend in these costs?
• Evaluate other industry factors. What are the legal and regulatory risks that impact the industry? Do these risks impact the company in the same way as the overall industry? Is the company able to differentiate and maintain competitive advantage? Are there any potential substitute products or technologies that could impact the industry? Does significant customer or supplier concentration exist among industry participants?
This exercise may reveal that a company’s projections are not in alignment with industry expectations. If this is the case, it is imperative that these differences are adequately explained in the report and understood. For example, a company may expect double digit annual revenue growth in a declining industry if it has a competitive advantage that allows it to gain significant market share. Alternatively, a company operating in a high growth industry may expect very little growth if it has an inability to expand facilities to meet incremental demand. Further, there may be legal and regulatory issues within an industry that are costly to some participants and beneficial to others. Though differences may be explainable, over the long-run, competition tends to make both under-performing and over-performing companies revert to the mean, or in this case the industry average.
A well written industry outlook should effectively identify and summarize those external factors that impact cash flow expectations for participants in the industry. While it is easy to view the industry outlook in isolation from other report sections, it is often appropriate for the industry outlook to be discussed and referenced in the company description, financial statement analysis, and appraisal methodology and conclusion sections of the report. From the appraisal report in its entirety, a reader should be able to understand the major underlying drivers of the company’s forecast, the reasons for differences in expected performance from that of the average company in the industry, and the potential risks inherent to the company’s forecasted cash flows.
Reviewed by The ESOP Association’s Advisory Committee on Valuation Chair, Jeffrey S. Tarbell, ASA, CFA, Houlihan Lokey, San Francisco, California.