Rotkowski - Income Approach Issues - IPT NW Tax Seminar

August 4, 2016~Hillsboro, Oregon
Income Approach Issues
in Valuations Prepared for Property Tax Purposes
Aaron Rotkowski, CFA, ASA, CBA
Willamette Management Associates
IPT Northwest Regional Property Tax Seminar

Disclaimers
• Opinions are my own, and do not necessarily
represent the opinions of my firm
• All specific examples were selected because the
companies are publicly traded and have abundant
data available
• For some topics, I have purposely endeavored to
use examples from companies or court cases that
are not represented at this conference
2

Topics Covered
1. Value of intangible assets within the income approach
2. Estimating a supportable long‐term growth rate
3. Assessing the reasonableness of market data in the
income approach
4. Assessing the reasonableness of normalized
depreciation expense and capital expenditures
5. Internal consistency of assumptions
3

Hypothetical Company – ABC Construction
Machinery Manufacturing (ABC)
• Manufactures bulldozers
• Began operating in 1952
• One manufacturing facility
• Contract with supplier to purchase raw materials at
below‐market prices
• Proprietary manufacturing process that results in cost
of goods sold (COGS) that are lower than the industry
average COGS
• Taxing jurisdiction doesn’t tax intangible assets
4

Income Statement
5
$000
Revenue 100,000
Cost of Goods Sold (70,000)
Gross Profit 30,000
Operating Expenses (20,000)
Operating Income 10,000
Other Income/Expense 8,000
EBIT 18,000
Interest (5,000)
EBT 13,000
Income Taxes 25%
Net Income 10,000

ABC Cost of Capital and Growth
• Weighted Average Cost of Capital (WACC) of 12%
• ABC management expects NCF growth of 4%*
– Inflationary growth of approximately 2%
– Expected real growth of approximately 2%
* Nominal growth = (1 + inflation) * (1 + real growth) ‐ 1
6

Direct Capitalization Method ‐ ABC
Net Operating Cash Flow $10 million
Direct Capitalization Rate ÷ 8%
Income Approach Value Conclusion: $125 million
This value represents the value of the ABC total unit of
operating assets—i.e., it represents the value of the ABC
tangible assets and intangible assets.
Simplifying assumptions: (1) normalized depreciation and
capital expenditures offset each other and (2) no working
capital requirements are projected.
7

Topic 1: Intangible Assets within the Income
Approach
8

Intangible Assets within the Income Approach
• The concluded value from the income approach often
includes value attributable to the taxpayer’s intangible
assets.
• Intangible assets contribute income (by increasing revenue
or decreasing expenses)
• When the $10 million of ABC business enterprise value (BEV)
income is capitalized, income from intangible assets is also
capitalized
• If (1) intangible assets are not properly accounted for in the
unit valuation analysis and (2) only tangible assets are
subject to ad valorem property taxation, then the concluded
value of taxable assets may be overstated
9

August 4, 2016~Hillsboro, Oregon 10
According to Guide to Intangible Asset Valuation, for an
economic phenomenon to qualify as an intangible asset, it
should be (1) intangible and (2) it should be an asset.
To be intangible, the economic phenomenon should derive its
value from the bundle of legal rights associated with the asset,
and not from the its physical characteristics.
To be an asset, the economic phenomenon should be subject
to private ownership.
Defining Intangible Assets

Tangible and Intangible Assets in the
Taxpayer Capital Structure
• Intangible Asset Handbook: “50% to 90% or more of a
company’s value and capital structure may be represented
by intangible assets”
• If market‐to‐book ratio > 1, a portion of the value of the
company may be derived from intangible assets
11
Company / Index Market‐to‐
Book Ratio
Implied Tangible
Asset Value (percent
of total value)
Implied Intangible
Asset Value (percent of
total value)
S&P 500 2.81 35.6% 64.4%
Apple Inc. 4.04 24.8% 75.2%
Caterpillar Inc. 2.85 35.1% 64.9%
MPLX LP 1.19 84.0% 16.0%

Representative Intangible Assets
• Trademarks and trade names
• Customer relationships (contractual and
noncontractual)
• Licenses and permits
• Trade secrets and patents
• Databases
• Trained and assembled workforce
• Computer software
• Contractual relationships
• Goodwill
12

Income from Intangible Assets in ABC Income
Statement
13
$000
Revenue 100,000
Cost of Goods Sold (70,000)
Gross Profit 30,000
Operating Expenses (20,000)
Operating Income 10,000
Other Income/Expense 8,000
EBIT 18,000
Interest (5,000)
EBT 13,000
Income Taxes 25%
Net Income 10,000
$1,200 cost savings associated with
trade secrets
$800 cost savings associated with
supplier contract
Includes the contributory value from
licenses and permits and trained and
assembled workforce

Intangible Asset Extraction Issues
Industrial and commercial property owners (and their
advisors) should:
• determine if the concluded unit value includes the value of
intangible assets
• identify the intangible assets included in the property value
• value the intangible assets
• extract the value of the intangible assets from the concluded
unit value
Or use summation valuation
14

• Direct subtraction method: the concluded
value of the taxpayer intangible assets is
subtracted from the concluded taxpayer unit
value. The result is the value of the tangible
assets only.
• Transfer price (income allocation) method:
assumes an economic rent is charged to the
taxpayer intangible assets; and that “capital
charge” is subtracted from the total taxpayer
income
Intangible Asset Extraction Procedures
19

ABC– Intangible Assets in the Income Approach
Intangible Asset IA Valuation Method Indicated
Value
Trade Secrets (proprietary
manufacturing process)
Income approach – Direct
capitalization method
$17 million
Favorable Contract with
Supplier
Income approach – Yield
capitalization method
$7 million
Trained and Assembled
Workforce
Cost approach – RCNLD* method $4 million
Licenses and Permits Cost approach – RCNLD method $2 million
16
The value of the ABC intangible asset was estimated at $30 million, or
24 percent of the total ABC unit value.
*RCNLD = Replacement Cost New Less Depreciation

Direct Subtraction Method Example
ABC Unit Value $125 million
‐ ABC Total IA Value ‐ $30 million
= Value of ABC Tangible Assets $95 million

Transfer Price Method Example
Cash Flow from Favorable Contract & Trade Secret $2,000
= Value of ABC Trained and Assembled Workforce and License/Permits $6,000
× Fair Rate of Return on ABC TAWF & Licenses/Permits 12%
= Annual “Capital Charge” (Cash Flow) for TAWF & Licenses/Permits $720
Concluded ABC Total Cash Flow $10,000
‐ Cash Flow from Favorable Contract & Trade Secret ($2,000)
‐ Fair Rate of Return on ABC TAWF & Licenses/Permits ($720)
= Cash Flow from ABC Tangible Assets Only $7,280
÷ Tangible Asset Direct Capitalization Rate 8%
= Concluded Value of ABC Tangible Assets $91,000

Topic 2 ‐ Estimating a Supportable Long‐Term
Growth Rate
19

Value Sensitivity in Direct Capitalization
Method
The concluded value is very sensitive to the selected LTG rate
20
Terminal Cash Flow ($millions) 10.0 10.0 10.0 10.0 10.0
÷ Direct Capitalization Rate 6% 7% 8% 9% 10%
= Terminal Value 167 143 125 111 100
Difference from 8% 33% 14% 0% ‐11% ‐20%
Cap. Rate Assumption
Terminal Value Based on
Alternative Direct Cap Rates

Terminal Value in Yield Capitalization
21
Discrete Period Cash Flow ($millions):
Period 1 2 3 4 5
Cash Flow 10.0 10.5 11.0 11.5 12.0
Present Value Factor ‐ 12.0% WACC 0.8929 0.7972 0.7118 0.6355 0.5674
PV of Cash Flow 8.9 8.4 7.8 7.3 6.8
Terminal Value:
Terminal Period Cash Flow 12.5
÷ Direct Capitalization Rate 8%
= Terminal Value 156.3
× Present Value Factor 0.5674
= Present Value of Terminal Value 88.7
PV of Discrete Period CF 39.2
PV of Terminal Value 88.7
Concluded Unit Value, Rounded 127.9
  (30% of total)
  (70% of total)
  Assumptions:
  WACC = 12.0%
  Growth Rate = 4.0%

What Is (Isn’t) Growing
• Growth relates to the measure of BEV income that is subject
to the direct cap or yield cap analysis (i.e., the BEV income
that is capitalized)
• Growth does not necessarily relate to revenue, historical
growth, or near‐term projected growth
• Net income, cash flow, or some other measure?
• Growth of tangible assets vs. intangible assets
• One common assumption is that the net cash flow is equal
to net operating income (NOI), which assumes that
depreciation expense is equal to capital expenditures (Topic
4).
22

PV of Cash Flow in Years 1 through 20
23

Specific Source of Growth
• Economy Growth
• Industry Growth
• Company‐Specific Factors
– Increasing Prices
– New Products
– Acquisitions & Joint Ventures
24

Growth from Economic Factors
• Ibbotson SBBI Valuation Yearbook: “An example of an indefinitely
sustainable growth rate is the expected long‐run growth rate of
the economy.”
• “Generally, once an industry has matured, a company will grow at
a steady rate that is roughly equal to the rate of nominal GDP
growth.” Global GT v. Golden Telecom
• “The rate of inflation is the floor for a terminal value estimate for
a solidly profitable company that does not have an identifiable
risk of insolvency.” Global GT v. Golden Telecom
• “There also is considerable precedent in Delaware for adopting a
terminal growth rate that is a premium, such as 100 basis points,
over inflation.” Nathan Owen v. Energy Services, Inc.
25

Historical Economic Growth
Min: ‐2.0%
Average: 6.5%
Max: 15.7%
2015: 3.5%

Projected Economic Growth
27
• Projected compound annual
growth rates, next 10 years,
according to the June 2016
Livingston Survey:
– Inflation: 2.2%
– Real GDP growth: 2.3%
– Nominal GDP growth: 4.6%
– Nominal GDP growth calculation:
((1.022)×(1.023))−1
Projected Nominal GDP Growth
Date
Real
Inflation
Nominal
GDPGDP
16‐Jun 2.2 2.3 4.6
15‐Jun 2.5 2.2 4.8
14‐Jun 2.5 2.4 4.9
13‐Jun 2.6 2.5 5.2
12‐Jun 2.7 2.4 5.2
11‐Jun 2.7 2.4 5.2
10‐Jun 2.9 2.5 5.5
09‐Jun 2.7 2.4 5.2
08‐Jun 2.8 2.5 5.4
07‐Jun 3.0 2.4 5.5
06‐Jun 3.2 2.4 5.7
05‐Jun 3.3 2.5 5.9

Growth from Industry Factors
• An industry analysis is also important in the selection of a
LTG rate
• Understand which economic factors affect the company
outlook, and find projections for those factors
• Industry‐specific trade organizations and other market
research firms publish data regarding industry growth rates
• Consider both real and nominal economic growth and if the
subject company is expected to grow faster, slower, or
similar to the growth of the U.S. economy
28

Global GT v. Golden Telecom
• The court considered:
– Russia projected inflation
– Russia projected real GDP growth
– Historical U.S. growth of telecom industry relative to U.S. economy
– Stage of telecom industry in Russia
• The Point: The court considered growth in the overall
economy and projected industry growth
29

Company Growth Exceeding the Growth of the
U.S. Economy
• NYU Finance Professor Aswath Damodaran writes:
“Since no firm can grow forever at a rate greater than economy in which it
operates, the constant growth rate cannot be greater than the overall growth
rate of the economy.”
• In Merion Capital v. 3M Cogent, the court said:
But, a terminal growth rate should not be greater than the nominal growth
rate for the United States economy, because “[i]f a company is assumed to
grow at a higher rate indefinitely, its cash flow would eventually exceed
America's [gross national product].”
30

Fast Growth Example
31
• Even after 100 years of growth (8.0%) that exceeds the U.S.
economy (6.5%), a company with a value of $125 million is still
insignificant relative to the U.S. Gross Domestic Product
• U.S. GNP will equal $10.1 quadrillion after 100 years of 6.5%
annual growth (6.5% = CAGR of GDP between 1948 and 2015)
Value Growth Value after X Number of Years
($millions) Rate 5 25 50 100
ABC Company 125.0 8% 184 856 5,863 274,970
ABC Company 125.0 20% 311 11,925 1,137,555 10,352,246,815
U.S. GNP 17,947,000 6.5% 24,629,385 87,357,541 425,215,354 10,074,558,266

Company‐Specific Factors
• Understand the story
– ABC is operating facility at maximum production
– ABC only offers one product line
• It may not be appropriate to use the same LTG rate for all
companies in an industry
• Growth can come from
– existing assets, both tangible & intangible
– new products or services
– acquisitions & JVs
– capital expenditures
– new intangible asset development
32

Growth of Tangible Assets vs. Intangible Assets
• Tangible property depreciates
• If the goal of an assignment is to value the tangible
property in place on the assessment date and positive
growth is forecast, this may suggest the presence of
intangible assets
33

Topic 3 ‐ Assessing the Reasonableness of
Market Data
34

The Use of Market Data in the Income
Approach
• Discount rate:
– Equity risk premium
– Industry risk premium
– Small stock risk premium
– Beta
– Capital structure
• Working capital requirements
• Normalizing adjustments
• Control and marketability premiums/discounts
35

Potential Errors Related to the use of Market
Data in the Income Approach
• There are a variety of potential errors from the use of market
data (and, specifically, guideline publicly traded companies, or
GPTCs) in an income approach analysis.
• These errors are related to differences between the subject
taxpayer and GPTCs in terms of:
1. expected growth
2. marketability
3. control over the underlying equity/assets
4. intangible assets
5. Risk of the subject property
36

The Acorn or the Oak Tree
37
Day 0
After 200 to 300 years

Exit Multiples in Income Approach
• Use of exit pricing multiples results in a market approach (or
at best a hybrid income/market approach)
• Analysts cannot avoid estimating growth by using exit
pricing multiples in the terminal value
• A capitalization rate is an inverse of a pricing multiple
– i.e., a 20x P/E multiple = 5% direct capitalization rate
• Pricing multiples are based on the same factors that are
considered in the direct cap rate, including risk & growth
• These same issues affect the pricing multiple selection in the
market approach
38

P/E Multiples Example
Variable
Caterpillar
Inc.
Cummins
Inc
Deere &
Co
Komatsu
Ltd
Oshkosh
Corp
Trailing P/E Multiple 11.6x 9.8x 13.2x 12.3x 13.5x
Implied Direct Cap Rate for NI 8.7% 10.2% 7.6% 8.1% 7.4%
Company Cost of Equity per Bloomberg 11.2% 9.5% 8.7% 10.1% 11.3%
Implied LTG Rate 2.5% ‐0.7% 1.1% 2.0% 3.9%
39
• Many state cap rate studies calculate direct capitalization
rates as the inverse of P/E pricing multiples
• Those P/E pricing multiples include assumptions about risk
and growth

Security Analysts’ Growth Rates
• Projections include growth from (1) intangible
assets and (2) assets not in existence as of the
valuation date
– The market values the oak tree, but our task is
usually to value the acorn
• For these companies, real growth may come
from forecast decrease in input costs, increased
manufacturing capabilities, construction of new
facilities, and other similar factors
40

Academic Study of
Analysts’ Growth Rates
• Results of a study of 2,900 publicly traded companies:1
– Analysts are actively selecting company‐specific growth rates
– Actual median real growth rate (3.5%) corresponds closely to real GDP
growth (3.4%)
– The past is a poor predictor of the future
– Analysts are overly optimistic
– Informative only over short time horizons
– Stock valuations do not accurately correspond to future growth
– Absence of predictability
1 = “The Level and Persistence of Growth Rates,” by Lous K.C. Chan, Jason Karceski, and Josef Lakonishok, Journal of
Finance, Vol. LVIII, No. 2, April 2003.
41

Control
• The owner of operating assets will have operational
control of these assets, while the owner of stock in a
publicly traded company will not have control of the
company operations
• Remedies:
– Increase valuation pricing multiple
– Decrease the direct capitalization rate
– Increase the implied security price of the operating
assets
42

Marketability
• Operating assets are less marketable than comparable publicly
traded securities
• Consider the process of selling ABC’s bulldozer manufacturing
equipment vs. the process of selling a share of stock in
Caterpillar, Inc.
• Investors will accept a discount for lack of marketability to
compensate for:
– The longer time involved in selling illiquid investments
– The higher cost involved in selling illiquid investments
• Remedies:
– Decrease valuation pricing multiple
– Increase the direct capitalization rate
– Decrease the implied security price of the operating assets
43

Risk and Return
• Taxpayer assets have different risk and return characteristics
than publicly traded securities
• Some of these reasons were just discussed:
– Expected growth
– Control
– Marketability
• Other factors include:
– Size
– Geographic diversification
– Product diversification
– Reliance on key customers/suppliers
– Others
44

Topic 4 ‐ Assessing the Reasonableness of the
Normalized Depreciation and Capital Expenditures
45

Application by Analysts
• When asked whether depreciation expense should equal
capital expenditures in growth model, in 2012:
– 44 percent said yes
– 29 percent said no
– 27 percent said it should depend on company growth and
inflation.
• When asked how they typically treat capital expenditures
and deprecation expense when estimating cash flow, in
2013:
– 68 percent said they made them equal or close to equal
– 4 percent estimated capital expenditures < depreciation
– 28 percent estimated capital expenditures > depreciation
46

Growth Rate and Capital Expenditures
• If a company consistently had equal capital
expenditures and depreciation expense, net fixed assets
would remain unchanged.
– If earnings increase & net fixed assets remain
constant, ROA would continuously increase
• Projected capital expenditures should reflect the
expected LTG
47

• Direct capitalization method assuming depreciation = capex
• Is this a nonsensical table?
48
Terminal Value in Direct Capitalization Method,
Revised
= Terminal Value 167 143 125 111 100
Difference from 8% 33% 14% 0% ‐11% ‐20%
Cap. Rate Assumption
Terminal Value Based on
Alternative Direct Cap Rates

Consideration of Reinvestment
• Method #1: Capital expenditures = depreciation expense
– Accepted by many courts & widely used in practice
– Over long enough time horizon, depreciation expense and
capital expenditures will be equal
• Method #2: Capital expenditures > depreciation expense
– May be appropriate if the selected LTG rate > inflation
– Plowback ratio: Reinvested CF required to achieve growth
– Theory: If real growth exists, the plowback ratio > 0%
– Theory: If the plowback ratio > 0%, then capex > depr.
49

Calculating Capital Expenditures and
Depreciation Expense
• Capital Expenditures = Initial Capex × (1 + LTG)^Life
• Depr. Expense = FV(LTG, Life, (Capex ÷ Life))×(1 + (LTG ÷ 2))
• Where:
– FV = future value
– Initial Capex = normalized capital expenditures
– Life = depreciable life of the property, plant, and equipment
– LTG = long‐term growth rate of cash flow
• The ratio of normalized depreciation expense and capital
expenditures is based on the results of these two formulas
• Source: James R. Hitchner, Shannon P. Pratt, and Jay E. Fishman, A
Consensus View, Q&A Guide to Financial Valuation (New Jersey:
Valuation Products and Services, 2016), 18‐23.
50

ABC Capital Expenditures and Depr. Expense
• Inputs:
– Initial cap ex: $4.0 million
– Life of assets: 10 years
– LTG: 4.0%
• Calculated capital expenditures: $5.9 million
• Depreciation expense: $4.9 million
• Depreciation expense is equal to 82.7% of capital expenditures in
perpetuity in order to sustain growth of 4.0%.
51
Net Income 10.0
‐ Capital Expenditures (4.0)
+ Depreciation Expense 3.3
= Net Operating Cash Flow 9.3

Revised Terminal Value Example
52
Terminal Values
Terminal Values Considering Reinvestment
= Terminal Value 167 143 125 111 100
Unadjusted Terminal Cash Flow 10.0 10.0 10.0 10.0 10.0
Estimated LTG Rate 6% 5% 4% 3% 2%
Adjusted Terminal Cash Flow 9.0 9.2 9.3 9.5 9.6
÷ Direct Capitalization Rate 6.0% 7.0% 8.0% 9.0% 10.0%
= Terminal Value 150.5 130.9 116.4 105.1 96.3
Difference in Terminal Values ‐9.7% ‐8.3% ‐6.9% ‐5.4% ‐3.7%

Other Factors Impacting Depreciation and
Capital Expenditures
• Capital expenditures and depreciation expense will be
closer to each other when:
– Inflation is lower
– Assets have shorter depreciable lives
• The selected depreciation method related to the
acquired assets impacts the difference between
depreciation expense and capital expenditures.
53

Topic 5‐ Internal Consistency in the Income
Approach
54

Internal Consistency in the Income Approach
• Exclude intangible assets from the unit value if such assets
aren’t subject to ad valorem property taxation
• The selected LTG rate should match the income that is
capitalized
• The capitalized income should reflect the selected LTG rate
• The use of unadjusted market data typically results in unit
value that include intangible assets (including assets not in
place on the assessment date)
• The use of unadjusted market data reflects marketable,
noncontrolling securities, which is not the valuation subject
55

Key Points
1. Value of intangible assets within the income approach
2. Estimating a supportable long‐term growth rate
3. Assessing the reasonableness of market data
4. Assessing the reasonableness of the normalized
depreciation and capital expenditures
5. Internal consistency of assumptions
56

Questions and
Discussion
57
Aaron Rotkowski, CFA, ASA, CBA
Willamette Management Associates
Vice President and Leader of Property Tax Valuation Services Practice
(503) 243‐7522
amrotkowski@willamette.com

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