Academic journal article Journal of Accountancy

Valuations for Financial Reporting in Today's Market: Experts Reconcile Approaches with Emerging Risk Factors

Academic journal article Journal of Accountancy

Valuations for Financial Reporting in Today's Market: Experts Reconcile Approaches with Emerging Risk Factors

Article excerpt

[ILLUSTRATION OMITTED]

The current economic environment has presented unprecedented circumstances for members of the business valuation profession. Those who perform valuations for financial reporting are grappling with issues surrounding impairment, market capitalization versus fair value determinations, reasonable rates of return, and active versus distressed and inactive markets, to name a few.

The JofA hosted a virtual round-table discussion with valuation professionals from the financial reporting sector to gauge how they are handling such issues in today's climate and what their outlook is for the near future.

JofA: Have you ever faced a similar environment, and if so, what kind of lessons did you learn from it?

Carolyn Worth: A lot of economists are making comparisons to the Japanese banking crisis of 1990. I see similarities with a lack of understanding by the investor on the risks that the banks were taking in a very difficult credit environment. Now a lot of companies are relying more heavily on the income approach and ignoring the market approach, because they're seeing dislocation between the two methodologies. If you ignore the market approach, then you're ignoring other investors' understanding of what they think the future economic benefits of the cash flow will be from these companies. The best thing to do is try to reconcile the two.

Bernard Pump: There's an interesting parallel to the tech boom when we couldn't explain the market pricing of companies. Through valuation techniques, you couldn't get as high as the market with some of these tech stocks. The situation is similar today where in many industries, especially financial services, you can't force the valuations low enough to replicate the market pricing of some of these companies.

Dave Dufendach: Another difference between that environment and today is we didn't have FAS 157 (FASB Statement no. 157, Fair Value Measurements) back then with its laser-focus on market observations, so that adds a new element to the current situation.

Pump: It's a wonderful thing that we have companies embracing income approaches under the FASB guidance because you can see the potential for that downward spiral if you are relying exclusively on the market approaches. Many of my clients are private-equity firms that have always used a market multiple in pricing their securities under FAS 157. Now they're looking to the income approach, and I find it somewhat amusing that they've fully embraced the income approach as opposed to the market approach.

COMPARABILITY CHALLENGES

When pricing multiples drop significantly, challenges arise on how to perform services in light of not having a normal, usual market to turn to for comparability. The market is valuing companies at an all-time low, resulting in market approach valuations that are lower than the income approach valuations. The market approach uses pricing multiples of similar public companies as a benchmark to value the subject company, while the income approach tends to rely on a discounted cash flow methodology. Generally, when the market is "properly" priced, these two methods should result in a similar estimate of value for the subject company, assuming all factors are held equal.

However, m today's environment, valuation analysts are seeing a wide spread between these two estimates of value that cannot be easily reconciled. As one panelist suggests, the intrinsic value of the subject company is greater than the indication under the market value, causing problems for the valuation analyst, particularly with respect to impairment testing under FASB Statement no. 142, Goodwill and Other Intangible Assets, since intrinsic value is not fair value.

JofA: Are you able to reconcile values or is it impossible to get back to reconciliation between the market method and an income approach?

Pump: We're performing FAS 142 impairment tests. …

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