AITF Issues Futile Wish List

My partner Alex Hodgkin just returned from the quarterly meeting of The Appraisal Issues Task Force in Chicago. In case you haven’t heard (I hadn’t either), the AITF issued a paper in February 2006 that listed their Top 25 issues they have with FASB’s position on Fair Value for Financial Reporting. Apparently, they couldn’t keep the list to ten.

The purpose of the paper is “to demonstrate that one of the industry’s most pressing needs… is to address common application problems that currently lead to diversity in valuations that limit the comparability and consistency of financial statements.”

As you can see from the attached document, there are some significant yet unresolved issues that we all have to contend with when navigating the waters of Fair Value for Financial Reporting.

One issue that might be interesting to readers without plunging into erudite financial theory is Issue 2, which begins on page 4 of the attached document. The question is this:

Should a control premium be applied to the present value of free cash flows in a DCF enterprise valuation?

In fact, you may have an opinion on this issue yourself. Below are three competing views outlined in the AITF document, all of which are supportable.

View A: the financial projections of a given company include 100% of the expected operating cash flows of the company; further, they reflect assumptions consistent with management’s policies and decision-making. The DCF is based upon a discount rate that reflects elements of non-diversified risk and the concept of optimal capital structure with only a controlling investor can influence. Therefore, the incremental value of control is already included in the present value result because it is baked into the projections and the DCF.

View B: For a given class of shares, the resulting equity value is available to all shareholders pari passu, including non-controlling interest owners. Further, observed control premiums in qcquisition transaction sreflect additional synergies available to marketplace participants that are not included in management’s projections. Discount rates based on WACC are influenced by the volatility of trading prices of non-controlling shares. Therefore, the incremental value of control is not included in the present value result, and must be applied to the present value of free cash flows in a DCF when valuing a controlling interest.

View C: The willingness of a third party to pay a premium for control of a business depends on a number of factors, including the buyer’s ability to achieve operational improvements, Therefore, neither a control premium nor a discount may be appropriate unless there is an expectation of an increase in cash flows or a reduction of risk associated with control.

The issue that the AITF apparently wants to point out is that neither the SEC nor the FASB have weighed in on this and many other topics. There is no authoritatively favored approach. In other words, we as practitioners do not intend to develop groundbreaking finance theory. Rather, we would like to adhere to a well-formed standard based on authoritative guidance from the FASB and/or SEC. What guidance we have now is piecemeal, and often contradictory.