Using the DMDM to Rebut an Unreasonable Estimate of Value

The owners of Flora's Flowers, a retail flower shop, are in the process of divorce. The managing spouse, who will keep the business after the divorce, has retained an appraiser. This appraiser estimated the fair market value of the stockholder's equity from information which appeared in an article in INC. magazine.

In the most recent year, Flora's Flowers had earnings of $41,700 on a sales volume of $400,000. Following the procedure described in the INC. article, the appraiser multiplied Flora's Flowers' annual earnings of $41,700 by the 5.5 average P/E ratio of florist industry stocks on the New York Stock Exchange on the valuation date. This resulted in a preliminary estimate of fair market value of $41,700 x 5.5 = $229,350. The appraiser then added a 35 percent "control premium," and arrived at a final value of $309,623, which was rounded to $300,000.

The final value estimate of $300,000 was 7.2 times earnings.

Before agreeing to a financial settlement based on the $300,000 figure, the non-managing spouse has asked for a review of the appraiser's estimate and an independent opinion concerning this estimate.

You have obtained transaction data on sales of retail florist shops from the IBA Transaction Data Base. The database lists a total of 180 transactions, with annual earnings information available for 131 of these transactions.

Analysis Using P/E Ratios:

You have calculated the average sale price to annual earnings ratio for the 131 retail florist sales in the IBA Transaction Data Base for which annual earnings are known. This average P/E ratio is 3.09.

The average price to annual earnings ratio of 3.09 for the transactions in the IBA Transaction Database is significantly lower than the price to annual earnings ratio of 7.2 used by the other appraiser.

Next, you arrange the price to annual earnings ratios in the IBA Transaction Data Base in ascending order. This shows that there are only 13 of the 131 ratios which are higher than 7.2. Thus, Flora's Flowers would need to be among the 10 percent most desirable retail florists to justify the estimated value of $300,000.

Analysis using P/G ratios:

Comparing coefficients of correlation of price vs. earnings and price vs. revenue, you determine that small retail florist shops tend to sell for a multiple of revenue.

At a price of $300,000, the P/G ratio for Flora's Flowers would be $300,000/$400,000 = 0.75.

Arranging the price to annual gross ratios in the IBA Transaction Data Base in ascending order, you determine that there are only 17 of the 180 ratios which are higher than 0.75.

Here again, Flora's Flowers would need to be among the ten percent most desirable retail florists to be worth as much as $300,000.

You have analyzed Flora's Flowers' financial statements, have made comparisons with the industry. and have investigated the competitive situation. You find little or no evidence that Flora's Flowers is among the most desirable retail florists in the community.

The conclusion is that the $300,000 amount appears too high.