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Valuing
Companies That Have Experienced Large Holding Gains
The Residential Real Estate Industry’s Far-Reaching
Impact
By
Jeffrey W. Lippitt, Nicholas J. Mastracchio Jr., and Eric Lewis
FEBRUARY 2008 - The
housing industry experienced dramatic increases in real estate prices
and frantic activity levels, but is now faced with declining activity
and declining prices. The current environment presents unique challenges
in the valuation of residential housing construction companies,
and it requires adjustments to typical methodology. While
the market was soaring, many speculative buyers purchased residences
in which they never intended to live and assumed they could sell
those homes at a profit once the residences were near completion.
The aftermath of the slowdown is an industry plagued by an extraordinary
number of contract cancellations and competition from a large
inventory of homes for sale, including resales of homes in ongoing
developments. The five biggest U.S. homebuilders—D.R. Horton
Inc., Pulte Homes Inc., Lennar Corp., Centex Corp., and Toll Brothers
Inc.—reported that plummeting land prices cost them a combined
$1.47 billion in the fourth quarter of 2006 (Ottawa Citizen,
Feb. 9, 2007).
Developing
a home community can take five years, and if there is a series
of communities in a master plan, completing that may take 10 years.
The companies are required to evaluate the possibility of impairment
on their land holdings. Nevertheless, the impairment test still
leaves the potential for distortions in the valuation of these
companies. In addition, smaller developers may not have complied
with GAAP and may not have written down their land values.
Impact
on the Income Approach to Valuation
For many
companies in the homebuilding industry, particularly those holding
significant amounts of real estate, the purchase of their land
holdings during different portions of the business cycle can make
assumptions about earnings very difficult. For example, holdings
that were purchased prior to the boom in real property prices
and that are now being sold can create the appearance of a very
high earnings base. That creates the illusion of a very high company
value under the earnings-capitalization model if adjustments are
not made.
The earnings-capitalization
model estimates the value of a company by “capitalizing”
the company’s base earnings. Base earnings are generally
calculated by taking an average of adjusted accounting earnings.
In this application, historical earnings are of interest only
to the extent that they are representative of expected future
earnings. Adjusted accounting earnings or normalized earnings
are used to predict the future benefits that will accrue to the
owners of the company. If historical earnings do not approximate
future earnings, then an adjustment is necessary to arrive at
a satisfactory estimate of future earnings.
A discounted
cash flow method might also be used. Typically, projections are
made for a few years, then a terminal value is calculated. However,
the distortions resulting from the purchase of land at different
times in the business cycle and the timing of future increases
in land values can lead to similar problems in forecasting and
in distinguishing holding gains. With proper adjustments, using
these two methods can give the valuator a corroboration of the
estimated value.
Comparing
the recent past to the expected future of the residential construction
industry suggests that significant adjustments are necessary.
Separate adjustments are necessary for each of the following:
- Removal
from the earnings base of the effect of realized holding gains
due to the dramatic increase in the value of real estate in
the past few years.
- Recognition
of deferred tax liabilities for unrealized holding gains on
assets held where their fair market value is in excess of their
tax basis.
- Building
in the potential of future price declines and consequent holding
losses until there is a market bottom.
Removal
of Realized Holding Gains or Losses
To the extent
that a company holds inventory during a period of significant
change in the value of that inventory, the reported earnings of
the entity are likely to include both operating earnings and realized
holding gains or losses. The realized holding gains and losses
result from the sale of inventory with a replacement cost above
or below its book value. The sale will contribute “operating
income” to the extent that the selling price is above the
replacement cost of the item, and a “holding gain or loss”
to the extent that the replacement cost is above or below the
historical cost of the item. After a period of sharply rising
prices, where price increases are not expected to persist, the
earnings-capitalization model will produce errors in the estimated
value of a firm unless appropriate adjustments are made for unrealized
holding gains included in earnings.
The appropriate
adjustment depends on the nature of the expectations for future
holding gains. If future holding gains are expected to be different
from past holding gains, then past holding gains must be replaced
by expected future holding gains. If no reasonable expectation
of future holding gains can be established, then past holding
gains should be eliminated and the value of the company should
be estimated by capitalizing the operating earnings without any
holding gains. The actual circumstances of the individual company
when it purchased the land will determine the adjustment. The
uncertainty of the future of the market may well lead the valuation
expert to increase the capitalization rate to reflect the uncertainty
with respect to future holding gains.
Holding
Gains
The influence
of holding gains can be illustrated with a simple example. Consider
a company that operates in the home-building industry and holds
significant amounts of land as inventory. Assume that Company
1 was created with an investment of $150,000 from the owners.
The company purchased three parcels of land for $50,000 each.
During the year, before any sales took place, the replacement
cost of each parcel increased from $50,000 to $100,000. Subsequent
to the price increase, the company sold two subdivided parcels
for $150,000 each and held one parcel in its ending inventory
of land.
The earnings
of the company would reflect $120,000 in income after taxes (assuming
a 40% tax rate) resulting from the sales of $300,000 and a cost
of sales of $100,000. The balance sheet would reflect $270,000
in assets and $270,000 in equity. If a reasonable capitalization
rate in this industry was 15%, these results would yield an estimated
value of $800,000, implying goodwill of $530,000. The validity
of this estimate depends on the income of $120,000 expected to
continue into the future.
Sales $300,000
Cost of sales $100,000
Income before taxes $200,000
Income taxes $
80,000
Net income $120,000
Cash $220,000
Land $
50,000
Equity $270,000
If reasonable
expectations are that the price of land will remain stable in
the future, and that sales of two parcels per year for a total
of $150,000 can be expected to continue, it is necessary to isolate
the realized holding gain included in income and remove it from
the earnings base:
Replacement
cost of parcels sold $200,000
Cost of sales $100,000
Realized holding gain
(net of taxes) $
60,000
Net income
$120,000
Realized holding gain
(net of taxes) $
60,000
Operating income $
60,000
Capitalizing
the operating income of $60,000 yields an estimated value of $400,000,
implying goodwill of only $130,000. The unrealized gain remaining
in the third parcel still in inventory would be added to the value
after subtracting the tax effect of the holding gain.
As a reasonableness
test, consider a company that enters the same industry on the
same scale, but after the increase in the price of the land. The
owners must invest $300,000 into Company 2 in order to purchase
three parcels of land for $100,000 each. Assume that before the
end of the year they sell two units for $150,000 each and hold
one unit in inventory at the end of the year:
Sales $300,000
Cost of sales $200,000
Income before taxes $100,000
Income taxes $
40,000
Net income $
60,000
Cash $260,000
Land $100,000
Equity $360,000
Because Company
2 entered the industry after the price increase, its earnings
do not include a holding gain component; its net income is all
operating income. Capitalizing its income at 15% yields an estimated
value of $400,000 and implies goodwill of only $40,000.
Deferred
Tax Liability
The observation
of equal capitalized earnings values for the two companies discussed
above is reasonable in the sense that their prospects for future
economic income are the same. There is, however, reason to believe
that the first company is worth less than the second, because
reported accounting income and taxable income for the two companies
will be different. Because Company 1 has a parcel of land that
has a book value and tax basis below its fair market value, Company
1 has a “built-in” tax obligation that Company 2 does
not. Given the same future pretax economic earnings, but higher
expected future tax payments, Company 1 is less valuable than
Company 2 by the amount of this deferred tax liability:
Fair value
of ending land $100,000
Cost of ending land $50,000
Unrealized holding gain $50,000
Tax rate 40%
Deferred tax liability $20,000
Although
Company 1 will experience higher accounting income because its
ending inventory of land is understated in value, it will have
the same expected economic income as Company 2, but a higher tax
obligation, and consequently a lower value. A reasonable estimate
of value for Company 2 would be the $400,000 capitalized value
of operating income less the $20,000 deferred tax liability, or
$380,000. It should be noted, however, that the investment in
Company 1 is only $150,000, compared to an investment of $300,000
in Company 2.
The
Effect of a Deflating Real Estate Bubble
With an extended
period of increasing prices, or any period of dramatic price increases,
it is possible, if not probable, that replacement costs of land
that has been developed will exceed its original costs. As noted
earlier, in the residential real estate industry, developers often
purchase large tracts of land and hold them for considerable periods
before selling them in smaller parcels as they are developed.
This can lead to the realization of large holding gains even during
periods of declining land values. In the current real estate market,
some of the anticipated decline in land values may still lie ahead,
so builders may be experiencing holding gains with the expectation
that future holding gains will be smaller, or that future holding
losses will be incurred.
Holding
Losses
The influence
of holding losses on the value estimate can also be illustrated
with a simple example. Consider another company that operates
in the homebuilding industry and holds significant land as inventory.
Assume that
Company 3 was created with an initial investment of $150,000 from
the owners. It then purchased two parcels of land for $50,000
each. During the year, before any sales took place, the replacement
cost of each parcel decreased from $50,000 to $30,000. Subsequent
to the price decrease, the company sold two subdivided parcels
for $90,000 each and purchased one additional parcel for $30,000,
which remained in its ending inventory of land.
Company 3’s
earnings would reflect $48,000 in income after taxes, assuming
a 40% tax rate, resulting from the sales of $180,000 and a cost
of sales of $100,000. The balance sheet would reflect $210,000
in assets and $210,000 in equity. If a reasonable capitalization
rate in this industry was 15%, these results would yield an estimated
value of $320,000, implying goodwill of $90,000. The validity
of this estimate depends on the income of $48,000 expected to
continue into the future:
Sales
$ 180,000
Cost of sales $
100,000
Income before taxes $ 80,000
Income taxes $
32,000
Net income $
48,000
Cash $
200,000
Land $
30,000
Equity $
230,000
If reasonable
expectations are that the price of land will remain stable in
the future, and that sales of two parcels per year at $90,000
each can be expected to continue, it is necessary to isolate the
realized holding loss included in income and remove it from the
earnings base:
Replacement
cost of parcels sold $ 60,000
Cost of sales $100,000
Realized holding loss
(net of taxes) $
24,000
Net income
$
48,000
Realized holding loss
(net of taxes)
$ 24,000
Operating income $
72,000
Capitalizing
the operating income of $72,000 yields an estimated value of $480,000,
implying goodwill of $250,000. A failure to properly adjust reported
earnings for the holding losses would result in an estimate that
undervalues the company by the $160,000 difference in the valuation
results shown above.
Valuation
Professionals Must Pay Attention to the Details
Business
valuation models that are based on measures of income or cash
flows depend on how the valuation professional adjusts historical
earnings in order to reflect expectations about future benefits
that will accrue to the owners. In any industry where assets for
sale are held for extended periods of time, the prospect exists
of significant holding gains or losses on those assets at the
time of sale. These gains and losses depend on underlying cycles
in the markets for these assets; they are not part of the value
added by the business that develops them for future sale. The
residential building industry is perhaps an extreme example of
this type of business. Companies purchase land that may be held
for many years before their development and sale are completed.
The impact on valuation, however, applies to any industry with
similar attributes.
Valuation
experts must recognize these holding gains and losses as components
of value that are separate from the normal and expected earnings
stream of the business, and they should adjust expected earnings
to reflect this recognition. Careful attention to this detail
of the valuation process will yield results that more closely
reflect future economic expectations for the business.
Jeffrey
W. Lippitt, PhD, is an associate professor of accounting
at Ithaca College, Ithaca, N.Y.
Nicholas J. Mastracchio Jr., PhD, CPA, is a member
of the accounting faculty at the University of South Florida, Tampa,
Fla., and a member of The CPA Journal Editorial Board.
Eric Lewis, PhD, is an associate professor at
Ithaca College, Ithaca, N.Y. |
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