Abstract: Valuation of S Corp. vs. C Corp. has received focus as a result of three recent court rulings in Gross, Adams, and Heck. According to these court rulings S Corp. income should not be tax-affected for valuation purposes. This is in contrast to the common practice by the valuation community of tax-affecting S Corp. income.
If one were to use traditional income approach for valuation, not tax-affecting S Corp. income would cause S Corp. to be valued higher than an otherwise identical C Corp. The value difference could be significant. As an example, an S Corp. could be valued 1.66 times more than an identical C Corp. if both had the same operating income, no debt and the C Corp. tax rate was 40%.
However, such valuation difference between an S Corp. and an otherwise identical C Corp. is not found in the market. Also, the valuation practitioners value both corporate structures essentially the same. They arrive at equal value for an S Corp. and a C Corp. by tax-affecting S Corp. income, and using traditional income approaches for valuation (tax-affecting means reducing S Corp. income by the tax liability incurred by the S shareholder). If they were to implement the above court rulings of no tax-affecting, and continue using traditional income approach for valuation they will wind up valuing S Corp. significantly higher than an otherwise identical C Corp.
So, the question arises, is the court decision correct? If the answer is yes, then may be the market is wrong in assigning equal values to both the corporate structures. However, market being wrong is unlikely. This leads one to the easy route of challenging the court decision. However, there is another explanation: the valuation process is flawed.
Abstract: The capitalization formula is the foundation of the Income Approach to business valuation. The weighted average cost of capital (WACC) used in the formula is a measure of the combined cost of capital of all the investors. A fundamental assumption in this formula is that the cash flow will be distributed, in each period, to all the investors in proportion to their holdings. Proportional distribution of cash flow may occur in some situations, however, it generally does not happen in leveraged acquisitions. In leveraged acquisitions debt holders have priority. They get paid interest and principal before dividends are paid to the equity holder. As a result, the equity holder’s cash flow is pushed back in the future. There appears to be no discussion in the valuation field on how equity holder’s return is impacted due to preferential distribution to the debt holder. Analysis here shows that the actual return to the equity holder is significantly lower than the one used in calculating WACC due to priority of payments to debt holder. In other words, capitalization formula with WACC overvalues a business from the equity holder’s perspective.
Abstract: Terminal Value (aka Horizon Value) is the value of a firm when the firm is expected to grow at a constant rate forever. The method to calculate value a constant-growth firm is sometimes called Capitalization. Currently, and for decades, the primary method, if not the only method, to calculate Terminal Value is a formula commonly known as the Gordon Growth Model (GGM). In addition to the constant growth assumption, Gordon Growth Model assumes “constant capital structure” which results into “Constant WACC” (Weighted Average Cost of Capital) as a discount rate. This paper will show following: 1) The “constant WACC” assumption of the Gordon Growth Model implies that the capital markets will accept “Dividend First” financing terms. However, the capital markets function with “Debt First” financing terms. When a firm operates with “Debt First” financing terms, but the value is based on “Dividend First” financing terms, the equity IRR is less than expected. This means GGM overvalues a firm. And, such over valuation is material, 10 to 50% and sometimes even more. 2) Introduce Advance Growth Model (AGM) to value a constant-growth firm assuming capital markets acceptable “Debt First” financing terms. AGM formula is a generalized formula for Terminal Value; AGM value is equal to GGM value if GGM assumptions are plugged into the AGM formula.