Question 18.ss.5: You want to estimate the value of a local advertising firm. ...
You want to estimate the value of a local advertising firm. The earnings of the firm are expected to be $2 million next year. Based on expected earnings next year, the average price-to-earnings ratio of similar firms in the same industry is 48. Therefore, you estimate the value of the firm you are valuing to be $96 million.
Further investigation shows that a large portion of the firm’s business is obtained through connections that John Smith, a senior partner of the firm, has with various advertising executives at customer firms. Mr. Smith only recently started working with his junior partners to establish similar relationships with these customers.
Mr. Smith is approaching 65 years of age and might announce his retirement at the next board meeting. If he does retire, revenues will drop significantly and earnings are estimated to shrink by 30 percent. You estimate that the probability that Mr. Smith will retire this year is 50 percent. If he does not retire this year, you expect that Mr. Smith will have sufficient time to work with his junior partners so his departure will not affect earnings when he departs. How does this information affect your estimate of the value of the firm?
Mr. Smith is a key person in this firm. An adjustment should be made to the valuation to account for his potential departure this year.
Taking the possibility that Mr. Smith will retire into account, the expected earnings next year will be:
Therefore, the adjusted value for the fi rm is: $1.7 million × 48 = $81.6 million. We can see that this implies a 15 percent key person discount from the original estimate of $96 million [($81.6 million − $96.0 million)/$96.0 million = −0.15, or −15 percent].