Let us all be grateful we were not given the unenviable task of assessing the fair market value of Housatonic Water Works (HWW). Appraisers must color within the lines dictated by the Uniform Standards of Appraisal Practice, yet so much about HWW falls outside well-established lines. The Uniform Standards are designed to lead to objective results rather than subjective opinion—we would put little faith in any appraisal based on “curb appeal.” The downside is that the Uniform Standards so tie an appraiser’s hands that an appraisal, through no fault of the appraiser, may lead, as here, to absurd results. And by that I mean, HWW is many things to many people, but no one is paying HWW’s purported fair market of $2.3 million suggested by the Uniform Standards.
Great Barrington reasonably requested a fair market valuation of HWW. But let us not confuse the valuation report it received last week with reality. For at least the following reasons, the right appraisal methods produced the wrong results:
- Income Approach: The most common method to value a business is the income approach, which asks how much one would pay for the stream of expected future cash flows. Relying entirely on math, it is generally considered the most objective means to value a business—determine the free cash flow based on projections as to future performance of the firm, calculate a discount rate, and apply an anticipated growth rate and you obtain a value based on what a willing buyer would consider fair market value. Plainly, if any one of those inputs is misstated, then the result could be wildly skewed. Garbage in, garbage out.
While an appraiser typically has a lot of discretion in choosing the discount rate and growth rate, management is primarily in charge with providing projections. In a closely held business, it is not uncommon, and not nefarious, for the managers to exercise their business judgment to purposefully have the business reflect a certain income stream. Having an established income stream enables the business to borrow more freely. If a business is family owned, as here, the family might prefer to build up equity in the business (taxed at capital gains rates years later upon sale) rather than pay family members market rate salaries (taxed currently at income tax rates). If a family decides not to replace aging machinery, the firm’s income stream does not reflect deferred capital costs. So it goes that a business can look good on paper and still be an equipment breakdown or two away from bankruptcy.
Only HWW’s managers will know if the business is managed to show positive cash flow. One can surmise, however, that if a willing buyer of HWW had to employ professional managers, the cost of such managers would exceed the salaries of current HWW personnel, hitting cash flow. One can also surmise that if a willing buyer had to replace aging equipment or purchase systems to, you know, provide clean water, the income stream would be affected. So the math on an income stream can be both right and get an appraisal value entirely wrong.
Regarding HWW, we know, and any willing buyer would know, that in 2021 AECOM recommended capital upgrades totaling approximately $31 million to take place over 20 years (which amount would be presumably higher today due to inflation). While it is true that utilities are usually able to look to their ratepayers to cover capital improvements, no one believes that HWW’s 849 customers can, should, or would pay in excess of $100,000 each (with interest) for capital upgrades, suggesting upgrade costs would fall, at least in part, on HWW. One can easily surmise that the entirety of HWW’s income, and then some, would be wiped up if compelled to make the upgrades suggested in the AECOM Report.
The income approach is not dissimilar to the factors a bond purchaser considers in determining an interest rate sufficient to justify known risk factors when lending to a business or government. We understand that a bond purchaser insists on higher interest payments from Venezuela than from the United States (assuming no defaults, of course), because the coupon payments from the United States are considered risk free. If a business is facing significant headwinds, think Bed Bath & Beyond, its borrowing costs can be very high. Where, as here, a potential buyer perceives risk in expected cash flows, the income approach provides dubious values.
One could quibble with the appraiser’s aggressive long term growth rate at 3.4 percent. According to industry statistics, the utilities industry in the US has grown 0.7 percent per year on average between 2018 and 2023. Between 2017 and 2021, HWW has gone from 848 to 849 customers, for a growth rate of 0.001 percent. Anecdotally, HWW customers are considering well water as an alternative to brown water, so HWW may consider its prior four years’ growth rate to be its days of wine and roses. If the growth rate is set at the industry average, 0.7 percent, the income approach suggests a value of $1,364,829; and if it the growth rate is set at HWW’s recent experience, 0.001 percent, the income approach suggests a value of $1,257,079.
HWW’s appraiser suggests a hypothetical buyer might pay $2.1 million for the expected future cash flows reflected in HWW’s current financials, although the figure might be closer to $1.3 million depending on assumptions. Setting the precise amount aside, that hypothetical buyer will always remain hypothetical. An actual buyer would be well aware that HWW would require market rate employees forced to consider the AECOM Report proposing investing future cash flows in capital improvements in order to turn HWW’s brown water to clear. Without being able to adjust for these factors, it is fair to say the income appraisal analysis here is of little, um, utility.
- Market Approach: The market approach is a useful guide when valuing businesses—if 10 Subway sandwich shops in your area are similarly trafficked and sold for $1 million, the market approach is likely to suggest a similar value. When your 3-bedroom home is appraised by looking at recent 3-bedroom homes sales, that is the market approach.
Valuing like 3-bedroom houses is fairly straightforward, assuming there are sufficient houses in the area for comparison. But a market approach valuation of a water utility (1) with few customers (2) where the customers will not drink or bathe in the utility’s water (3) where the utility faces enormous capital costs—well, I think it is fair to say HWW is in a class all by itself. HWW is incomparable.
The appraisal report identified 10 potentially relevant transactions for the market approach, acknowledging that none were sufficiently comparable. Certain of the utilities had substantially more customers, certain were also wastewater facilities, certain were … well, the fact is, it is unlikely any of the recently sold private water utilities provide consistently brown water and require $31 million in capital upgrades over the next 20 years. Can we all agree, for better or worse, there really is nothing comparable to HWW? The market approach suggests a $2.47 million value, but using this approach to value HWW would be like valuing a 3-bedroom home based on recent comps without noting the home is sitting on a fault line next to Love Canal.
- Asset Approach: The asset approach considers the value of the entire system—the equipment, the land, rights, and inventory of an entity dating back to at least 1897. Everything, soup to nuts, values HWW’s assets at $3 million. But that does not suggest there is any willing buyer writing a $3 million check for HWW’s assets.
To be sure, HWW has assets. It has ready access to a water supply from Long Pond Reservoir. It has a water treatment plant. It has a million-gallon storage tank. It owns fire hydrants. It has nearly 20 miles of pipes. It has valuable permits. Some of its physical assets are merely decades old, some presumably far older.
The asset approach works best when there is a ready market for the entity’s assets. It would be far easier to value Hertz through an asset approach, considering the value of its automobiles and airport leases then, say, a private utility with fixed immovable assets. No one is digging twenty miles of pipes out of the ground for salvage value. HWW’s treatment plan cannot go up on eBay.
Without question, HWW’s assets have a value, but that value pales in comparison to AECOM’s assessment of the needed upgrades to the system. The Blue Book value of a car is readily ascertainable; on the other hand, the asset value of a car on blocks without an engine, far less so. You can come to your own opinion, but it appears that in AECOM’s opinion, HWW is the car in need of serious repair.
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In conclusion, HWW’s appraiser was handcuffed by Uniform Standards that lack real world practicality here. No one is writing a $2.3 million check for HWW. The fact is, the valuation report and a token will get you on the subway. Hypothetically, someone may be willing to pay $2.3 million for HWW. In reality, no one would consider swapping that token for HWW.
The valuation report is helpful in at least this regard—it is a starting place to consider what HWW could be worth if it achieved its sole purpose, delivering clean water to Housatonic customers. If I owned HWW, after reading the valuation report, I would turn the keys over to the Town and call it a day. The owners must know the value of HWW is in its future promise, not its current state.
