BUSINESS VALUATION an integrated theory. 9781119583110, 111958311X

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Roger J. Grabowski, FASA, Managing Director, Duff & Phelps “Mercer and Harms’ Business Valuation – An Integrated Theory, 3rd edition provides valuation professionals, attorneys, other users of valuations, and students of valuation a resource for better understanding how the pieces of the valuation puzzle fit together. The book is written in an easy to follow style. This book is worthy of being added to your valuation library.” James R. Hitchner, CPA/ABV/CFF, ASA, Managing Director, Financial Valuation Advisors “It has been 13 years since the second edition of this book came out. It was certainly worth the wait. All the core chapters have been updated with easy-to-understand explanations of valuation concepts. Mercer and Harms have also added new chapters on the Income Approach (Cash Flows), the Income Approach (Discount Rate), the Market Approach (Guideline Public Companies), the Market Approach (Guideline Transactions), and Restricted Stock Discounts and Pre-IPO studies. This well written book presents a thoughtful approach to business valuation. The bottom line is that this is a valuable resource that tackles controversial topics head on.”

Business Valuation

Business Valuation An Integrated Theory Third Edition

Z. CHRISTOPHER MERCER TRAVIS W. HARMS

Copyright © 2021 by Z. Christopher Mercer and Travis W. Harms. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright .com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at www.wiley.com/go/ permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993, or fax (317) 572-4002. Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com. Library of Congress Cataloging-in-Publication Data: Names: Mercer, Z. Christopher, author. | Harms, Travis W., author. | John Wiley & Sons, Ltd., publisher. Title: Business valuation : an integrated theory / Z. Christopher Mercer, Travis W. Harms. Description: Third edition. | Hoboken, New Jersey : John Wiley & Sons, Inc., [2021] | Includes index. Identifiers: LCCN 2020025969 (print) | LCCN 2020025970 (ebook) | ISBN 9781119583097 (cloth) | ISBN 9781119583110 (adobe pdf) | ISBN 9781119583103 (epub) | ISBN 9781119583134 (obook) Subjects: LCSH: Business enterprises—Valuation. | Corporations—Valuation. Classification: LCC HG4028.V3 M47 2021 (print) | LCC HG4028.V3 (ebook) | DDC 658.15/5—dc23 LC record available at https://lccn.loc.gov/2020025969 LC ebook record available at https://lccn.loc.gov/2020025970 Cover Design: Wiley Cover Images: © pedrosek/Shutterstock, ranjith ravindran/Shutterstock Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1

Contents

Introduction What’s New in the Third Edition? Who Should Read This Book?

xiii xiv xvii

PART ONE

Conceptual Overview of the Integrated Theory CHAPTER 1 The World of Value

3

Introduction Common Questions The World of Value The Organizing Principles Summary

3 3 4 5 16

CHAPTER 2 The Integrated Theory (Equity Basis)

19

Introduction Common Questions The Fundamental Valuation Model The Conceptual Levels of Value Symbolic Notation for the Integrated Theory The Marketable Minority Interest Level of Value Introduction to the Control Levels of Value

19 20 21 23 27 29 35

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Strategic Control Level of Value Firmwide Levels versus the Shareholder Level of Value The Nonmarketable Minority Level of Value The Integrated Theory of Business Valuation on an Equity Basis Summary

CHAPTER 3 The Integrated Theory (Enterprise Basis) Introduction Comparing the Levels of Value: Equity and Enterprise Bases Final Comparisons of the Equity and Enterprise Bases Summary

51 58 60 67 67

71 71 73 77 79

PART TWO

Valuing Enterprise Cash Flows CHAPTER 4 Income Approach (Cash Flows) Introduction Reconciling Single-Period Capitalization and Discounted Cash Flow Methods Defining Enterprise Cash Flows Defining Equity Cash Flows Reinvestment Rates and Interim Growth Rates Terminal Growth Rates Expected Cash Flows and the Integrated Theory Marketable Minority Interest Level: Public Company Equivalent Financial Control Level: Private Equity Cash Flows

83 83 84 90 95 99 104 108 115 124

Contents

Strategic Control Level: Strategic Acquirer Cash Flows Assessing the Reasonableness of Projected Enterprise Cash Flows Conclusion

CHAPTER 5 Income Approach (Discount Rate) Introduction Return Basics: Realized versus Required Returns Components of the Weighted Average Cost of Capital Market Participants and the WACC The Levels of Value and the WACC Assessing Overall Reasonableness

CHAPTER 6 Market Approach (Guideline Public Companies) Introduction Relationship of the Income and Market Approaches What Do Observed Public Company Valuation Multiples Mean? Adjusting Valuation Multiples for Differences in Risk and Growth Guideline Public Company Multiples and the Enterprise Levels of Value Assessing Overall Reasonableness

CHAPTER 7 Market Approach (Guideline Transactions) Introduction Attributes of Guideline Transaction Data

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128 136 139

141 141 142 148 165 169 175

177 177 178 180 199 214 219

221 221 222

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Drawing Valuation Inferences from Guideline Transaction Data Minority Interest Discounts Inferred from Observed Control Premiums Guideline Transaction Multiples and the Levels of Value Assessing Overall Reasonableness Appendix 7-A: A Historical Perspective on the Control Premium and Minority Interest Discount

225 240 242 244 247

PART THREE

Valuing Shareholder Cash Flows CHAPTER 8 Restricted Stock Discounts and Pre-IPO Studies Introduction An Overview of Restricted Stock Discounts Review of the FMV/Stout Restricted Stock Database Pre-IPO Discounts Conclusion

CHAPTER 9 Introduction to the QMDM (Quantitative Marketability Discount Model) Introduction Potential Valuation Approaches at the Shareholder Level A Shareholder Level Discounted Cash Flow Model in Outline Economic Factors Giving Rise to the Marketability Discount Conclusion Appendix 9-A: Liquidity and Marketability

271 271 275 306 317 325

327 327 328 331 338 346 349

Contents

CHAPTER 10 The QMDM Assumptions in Detail Introduction Assumption 1: Expected Holding Period for the Investment (HP) Assumption 2A: Expected Dividend Yield (D %) Assumption 2B: Expected Growth of Dividends (GD ) Assumption 2C: Timing of Dividend Receipt Assumption 3A: The Expected Growth Rate in Value (GV ) Assumption 3B: Adjustments to the Terminal Value Assumption 4: Required Holding Period Return (Rhp ) Conclusion

CHAPTER 11 Applying the QMDM Introduction Comprehensive Example of the QMDM in Use Condensed QMDM Examples The Uniform Standards of Professional Appraisal Practice and the QMDM

CHAPTER 12 Applying the Integrated Theory to Tax Pass-Through Entities Introduction The Nature of the S Corporation Benefit The Firmwide Level Value of S Corporations Other Observations Regarding Relative Value at the Firmwide Levels The Shareholder Level Value of S Corporations

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359 359 360 368 377 378 379 385 385 399

401 401 401 414 427

435 435 437 440 443 446

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S Corporations and the Tax Cuts and Jobs Act of 2017 Conclusion

458 467

About the Authors

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Index

477

Introduction

hat do we mean by an integrated theory of business valuation? We use the term integrated theory to refer to our rather dogged insistence that the key to answering thorny valuation questions is devoting one’s attention to cash flow, risk, and growth. Simply put, we propose that any valuation question (or problem, or controversy, depending on your perspective) is ultimately answerable by analyzing expected cash flows, risk, or growth expectations. In this book, we provide readers with both the conceptual basis for – and practical application of – the Integrated Theory, which we can summarize as follows:

W

The value of any business or business ownership interest is a function of the expected cash flows attributable to the business or business ownership interest, the expected growth in those cash flows over the relevant holding period, and the risks associated with achieving those expected cash flows.

The Integrated Theory provides a conceptual framework for disciplined analysis of valuation questions. Too often, valuation analysts are tempted to view individual components of a valuation assignment on a piecemeal basis. Adhering to the Integrated Theory helps valuation analysts develop base valuation conclusions, discounts, and premiums that are rooted in a shared perspective of the subject company and the subject ownership interest. The most transparent application of the Integrated Theory is in developing the conceptual underpinnings of the so-called levels of value.

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Why are controlling interests in businesses generally assumed to be worth more than minority interests in those same businesses? In the chapters that follow, we propose – somewhat counterintuitively – that they are not, unless the owner of the controlling interest expects more cash flow, bears less risk, or experiences faster growth than the owner of a corresponding minority interest. Why are nonmarketable minority interests often worth less than otherwise comparable, but marketable, minority interests? Spoiler alert: nonmarketable minority investors often expect lower cash flows, bear more risk, or experience slower growth than the owner of a corresponding marketable minority interest.

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As we will demonstrate throughout this text, the Integrated Theory, as manifest in the conceptual levels of value, provides a robust template for addressing other potential areas of valuation controversy.

WHAT’S NEW IN THE THIRD EDITION? In the decade or so since the second edition of this book, valuation analysts have increasingly recognized the importance of evaluating private operating businesses from the perspective of the enterprise (equity plus net debt) rather than restricting the focus of analysis to the net equity of the business. The Integrated Theory is readily extended to the enterprise value perspective, and we demonstrate that extension in this third edition. Further, recognizing the need for more practical guidance regarding the application of the Integrated Theory to the valuation of enterprise value, we have added new chapters on estimating enterprise cash flows and developing enterprise discount rates. This third edition also includes new chapters relating to the market and income approaches, using the Integrated Theory to expose the common conceptual underpinnings of the two approaches. Finally, we have added a new chapter dedicated to dissecting the oft-cited

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but less often understood restricted stock and pre-IPO studies using the Integrated Theory as our scalpel. The twelve chapters in this edition are organized into three sections.

Part One: Conceptual Overview of the Integrated Theory ■

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Chapter 1, “The World of Value.” We begin the book by laying out some fundamental principles that undergird the Integrated Theory. The principles of expectations, growth, risk and reward, present value, alternative investments, and rationality lay the necessary conceptual and theoretical foundation for the Integrated Theory. Chapter 2, “The Integrated Theory (Equity Basis).” In Chapter 2, we describe the Integrated Theory on an equity basis, giving particular attention to the conceptual scaffolding the Integrated Theory provides to discussions of the levels of value and the associated valuation discounts and premiums. Chapter 3, “The Integrated Theory (Enterprise Basis).” New to the third edition, Chapter 3 extends the conceptual basis for the Integrated Theory described in Chapter 2 to the enterprise value perspective.

Part Two: Valuing Enterprise Cash Flow Each of the chapters in Part Two is new to the third edition. ■

Chapter 4, “Income Approach (Cash Flows).” Our exposition of the Integrated Theory in Part One relies on the conventions of the single-period capitalization method. In Chapter 4, we demonstrate how valuation analysts can apply the Integrated Theory in forecasting cash flows, whether using a single-period capitalization or multi-period discounted cash flow method. We also explore the relationship between reinvestment and growth, and the role of normalizing adjustments to derive cash flows applicable to the valuation of interests on a marketable minority interest basis. Finally, we discuss potential control adjustments

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to cash flows and provide a roadmap for assessing the overall reasonableness of cash flow projections. Chapter 5, “Income Approach (Discount Rate).” We suspect that more is written about discount rates each year than any other valuation topic. In Chapter 5, we cast a somewhat skeptical eye over the discount rate terrain, concluding that valuation professionals devote far too much time and attention to competing techniques for sifting through the mountains of available historical return data, and too little time and attention on developing reasonable – although admittedly less precise – discount rates for valuation subjects. In addition, we consider the relationship between the discount rate and the level of value. Chapter 6, “Market Approach (Guideline Public Companies).” Although we develop the Integrated Theory using the language of the income approach, it is equally applicable to the market approach. In Chapter 6 we reveal the conceptual components of common valuation multiples and demonstrate how to use the Integrated Theory to make supportable adjustments to observed public company valuation multiples for application to private businesses. Chapter 7, “Market Approach (Guideline Transactions).” In Chapter 7, we turn our attention to the unique challenges that arise when analyzing guideline transactions to develop firmwide indications of value. This chapter is followed by an appendix providing a historical perspective on the control premium and minority interest discount, using the Integrated Theory to trace the evolution of these key concepts in practice.

Part Three: Valuing Shareholder Cash Flows ■

Chapter 8, “Restricted Stock Discounts and Pre-IPO Studies.” In this new chapter, we analyze restricted stock discounts and pre-IPO studies through the lens of the Integrated Theory. While restricted stock discounts provide meaningful benchmarks for marketability discounts applicable to private companies only by chance, we demonstrate how the restricted stock data confirms the existence of both an implied holding period and a holding period premium applicable to illiquid

Introduction

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xvii

interests in restricted stock transactions and, by implication, for private companies. We also conclude that observed pre-IPO discounts actually capture two distinct phenomena: the marketability discount applicable prior to the IPO and the “pickup” in value associated with the IPO itself. Chapter 9, “Introduction to the QMDM (Quantitative Marketability Discount Model).” The Quantitative Marketability Discount Model is a shareholder-level discounted cash flow model. In Chapter 9, we describe the QMDM, showing that the marketability discount is ultimately attributable to differences in expectations for cash flow, risk, and growth for minority shareholders in private companies. Chapter 10, “The QMDM Assumptions in Detail.” In Chapter 10, we present a more detailed review of the QMDM inputs: the expected holding period, dividend yield, growth in value, and required holding period return. Chapter 11, “Applying the QMDM.” The QMDM is adaptable to the attributes of specific illiquid minority interests. In this chapter, we apply the QMDM to a variety of fact patterns, illustrating how to use the QMDM to identify the relevant cash flow, risk, and growth characteristics of the subject interest for a valuation. Chapter 12, “Applying the Integrated Theory to Tax PassThrough Entities.” We close by using the disciplined framework of the Integrated Theory for the valuation of shareholder interests in S corporations and other tax pass-through entities.

WHO SHOULD READ THIS BOOK? A variety of business valuation, legal, and accounting professionals and students should read Business Valuation: An Integrated Theory, third edition.

Valuation Analysts (Business Appraisers) The Integrated Theory provides the foundation for a deeper understanding of business valuation concepts. These insights will

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INTRODUCTION

be helpful for beginning and experienced appraisers alike. In this book, we will use the term “valuation analyst” to be synonymous with the standard definition of a business appraiser. In addition, the Integrated Theory raises (and answers) a number of questions about “standard” valuation practices employed by many appraisers, including the application of control premiums, minority interest discounts, and marketability discounts.

Auditors and Financial Statement Users Considering Fair Value Measurements The prominent role of fair value measurements in generally accepted accounting principles means that auditors need to be fluent in fundamental valuation principles. While the Integrated Theory does not address specific fair value measurement applications, it does provide assistance to CPAs and valuation analysts as they both attempt to translate interpretations of the concept from the FASB, the SEC, or elsewhere into reliable valuation techniques. Familiarity with basic valuation principles and techniques is also beneficial for financial analysts and others who regularly review financial statements. To be an informed reader of financial statements, it is critical that one be able to evaluate not just the “what” but also the “why” of fair value measurements. The Integrated Theory provides a unique introduction to these issues.

Users of Business Appraisal Reports The Integrated Theory will also be helpful for users of appraisal reports, including accountants, financial planners, and attorneys. The basic concepts of the Integrated Theory are not difficult, and the limited use of symbolic math is fairly easy to follow. For many years we have advised clients, “If you don’t understand it, then don’t stand for it.” The Integrated Theory, particularly when consulted on a specific-topic basis when questions arise, can help readers develop a better understanding of business valuation reports.

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Corporate Finance and Valuation Students Finally, we believe that the Integrated Theory is an ideal teaching tool for students in accounting, finance, and economics. Valuation courses are increasingly common in business and economics programs at both the graduate and undergraduate levels. The Integrated Theory provides a concise, thorough, and logically consistent framework for introducing students to valuation theory and practice. The length and breadth of the book make it ideal for fitting into college or graduate school semesters.

Where the Third Edition Fits into the Valuation Literature Many of the current valuation texts survey many valuation topics and issues and yet fail to address the theoretical underpinnings of most of those topics and issues. They are “large” books (8 1/2 by 11 inches), with many hundreds or a thousand or more pages of text. Business Valuation: An Integrated Theory, third edition, is a “small” book containing less than 500 pages of text. Yet this small book will enable valuation analysts, accountants, and students to grasp the essential elements of valuation and apply them to any of the myriad valuation topics and issues raised in the “large” valuation books. Our goal is to provide the theoretical underpinnings to enable valuation analysts, accountants, and students to integrate the many seemingly disparate valuation concepts through a consistent analysis of expectations for cash flows, risk, and growth related to businesses or to interests in them. Despite its small size, we believe Business Valuation: An Integrated Theory, third edition, is a “large” valuation text. We hope you agree.

PART

One

Conceptual Overview of the Integrated Theory n this opening section, we describe the conceptual basis for the Integrated Theory. Before turning to practical application of the Integrated Theory in Parts Two and Three, we first provide the foundation of the Integrated Theory, which is rooted in the expected cash flows, risk, and growth attributes of businesses and business ownership interests.

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Chapter 1 sets the stage for our conceptual discussion by means of an overview of the organizing principles of the so-called world of value. These organizing principles provide a consistent framework for interpreting the actions of market participants in the real world. In Chapter 2, we transpose the organizing principles into a conceptual key through analysis of the fundamental valuation model. Using the fundamental valuation model as our conceptual scaffolding, we build out the Integrated Theory,

1 Business Valuation, First Edition. Z. Christopher Mercer and Travis W. Harms. © 2021 Z. Christopher Mercer and Travis W. Harms. Published 2021 by John Wiley & Sons, Inc.

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demonstrating the relationships among the various levels of value in terms of differences in expected cash flows, risk, and growth from the perspective of the equity owners of a business. The market for private businesses is typically denominated in terms of enterprise, rather than equity, value. In other words, buyers and sellers of private businesses generally measure the aggregate value of the equity and net debt, rather than focusing on the equity value. In Chapter 3, we present the Integrated Theory on an enterprise value basis.

CHAPTER

1

The World of Value

INTRODUCTION We have identified several underlying financial, economic, logical, and psychological principles that provide a solid basis for looking at what we can call the “World of Value.” We refer to these as the organizing principles of business valuation, because the integration of the principles provides a logical and consistent framework within which to examine business valuation questions and issues. These principles also provide the qualitative framework within which to discuss the Integrated Theory of Business Valuation.

COMMON QUESTIONS The discussion of the world of value in this chapter will help readers answer the following questions: 1. What are organizing principles that can help valuation analysts and market participants form reasonable valuation conclusions? 2. What is the relevance of market behavior for valuation conclusions? 3. Is a forecast necessary to derive a valuation conclusion?

3 Business Valuation, First Edition. Z. Christopher Mercer and Travis W. Harms. © 2021 Z. Christopher Mercer and Travis W. Harms. Published 2021 by John Wiley & Sons, Inc.

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4. What determines the level of return expected by investors? 5. What is the significance of present value concepts in valuation analysis?

THE WORLD OF VALUE The world of value consists of all the various markets in which valuation and investment decisions are made by real investors, whether individuals, companies, institutions, or governments. This world includes (but is certainly not limited to) the public stock and bond markets, the private placement markets for debt and equity securities, and the private equity markets. The world of value is the real world. If valuation analysts develop a solid understanding of the world of value, they are more likely to be able to develop reasonable valuation conclusions under the standards of value appropriate for specific valuation assignments, including fair market value, fair value, investment value, and others. So we begin with a general discussion of the world of value. The goal of the world of value is to understand value. For purposes of this book, we are talking about the value of businesses, business ownership interests, securities, and intangible assets. These organizing principles provide the foundation for the Integrated Theory. The world of value begins with cash flow. The underlying foundation for business value lies in expectations for future cash flow in the context of several organizing principles, including: Principle of Expectations. Value is expectational (not historical) in nature. Principle of Growth. Value today is influenced by expectations for future growth. Principle of Risk and Reward. Value is impacted by the relationship between risk and reward. Present Value Principle. Business value is based on the present value of expected future cash flows, discounted to the

The World of Value

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present at a rate reflecting the risks of receiving those cash flows. Principle of Alternative Investments. Businesses and business investments are valued in relationship to reasonable alternative and competing investments. Principle of Rationality. The world of value is one of inherent rationality, sanity, and consistency. The world of value is fascinating. The organizing principles lay the groundwork for the Integrated Theory and provide a basis for addressing nearly every business valuation issue. They describe the underlying behavior of public and private securities markets, which collectively form the (direct or indirect) reference point for valuing most businesses and business interests. The principles also provide a framework for testing the reasonableness of valuation positions advanced by valuation analysts. We have used these principles actively for many years, both as an organizing tool for valuation thinking and as a review tool for work performed by Mercer Capital and other firms.

THE ORGANIZING PRINCIPLES Others have surely discussed the meaning and implications of the organizing principles. We make no claim of originality here, other than in using them as a means of describing and discussing the world of value. In the following sections, we will discuss each of the organizing principles. At the conclusion of the chapter we will see that, while each principle stands on its own, it is by integrating them that we can better understand the world of value and business valuation.

1. The Principle of Expectations The first organizing principle of the world of value is that value is based on expectations for the future. We refer to this as the Principle of Expectations. Valuation analysts routinely examine a company’s historical performance and develop estimates of earning power based on that

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history. The earnings that are capitalized may be a simple average of recent years’ earnings, or a weighted average of those earnings. In the alternative, a valuation analyst might capitalize the current year’s earnings or annualize a partial year of earnings. A specific forecast of expected earnings for next year might be made. The purpose of all historical analysis, however, is to develop reasonable expectations for the future of a business. History is the window through which valuation analysts look at the future. We should never forget, however, that visibility is not the same through all windows. Some windows have been cleaned recently and provide a good picture; others are shaded, tinted, or dirty. And the view through some windows is just blocked. Valuation analysts must make reasonable judgments about the expected future performance of subject companies. And those judgments can often be tested or evaluated in light of a company’s recent history. While it may appear to be obvious, the Principle of Expectations is one of the most difficult for beginning (and even experienced) valuation analysts to embrace in practice. The efficient market hypothesis suggests that market information that is known about a company (which forms the basis for future expectations regarding its performance) is reflected in its stock price at any point in time. This information is considered, of course, in the context of expectations regarding the company’s industry and economic conditions. In other words, the market evaluates the expected future performance in light of the consensus risk assessment for a security and moves the price of a stock to the level that equates that expected performance with its expected risk. The Principle of Expectations suggests that participants in the world of value must deal with uncertainty. After all, we cannot know the future until it happens, so the future is always uncertain. Sometimes expectations are binary. Either A will occur or B will occur. If A occurs, one level of pricing for a company is suggested. If B occurs, an entirely different level of pricing is indicated. Investors deal with the potential for binary (or multiple) future outcomes using various forms of probability analysis. In appropriate circumstances, valuation analysts may need to use probability analysis, as well.

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Consider the following example: a real-world investor plans to invest in a company that expects to engage in an initial public offering (IPO) within a year or so. The stock is currently illiquid and is burdened by a right of first refusal flowing to the shareholders and the company. If the IPO does occur as expected, there will likely be a substantial boost in the overall value of the company and the subject shares. However, if the IPO does not occur, growth prospects will be significantly lower than if it had (because the expected capital infusion will not occur). And the investor knows that one of the reasons that companies do not go public is because their emerging performance does not meet expectations. If the company does not have the IPO, the investor faces a potentially lengthy holding period before other opportunities for liquidity arise. In this case, the subject shares would be worth much less than if the IPO had occurred. What does the investor do in this world of value we live in? He or she makes an informed judgment about the probabilities of the favorable and unfavorable outcomes. A decision is made at a value above the no-IPO scenario level, but below the IPO scenario. Why? Because investors tend to be risk-averse, and, according to the Principle of Risk and Reward, may charge a high price for uncertainty. The investor in our hypothetical example makes a decision based on his probability-adjusted expected return, writes a check, and moves on. Either A (the IPO) or B (getting stuck) will occur, and the ultimate return on the investment will be determined over time. Unlike the type of investors described above, who will take their licks or count their rewards based on the negotiated price, the business valuation analyst must write a report. In situations like this, the report’s conclusion is almost certain to appear to be wrong at some point in the future with the benefit of hindsight. If the company goes public, the conclusion of value may appear to have been low in relationship to the ultimate IPO price. If the IPO is unsuccessful, the report’s conclusion, which considered favorable aspects related to that potential, will appear to have been too high.

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Business valuation analysts facing similar valuation situations must attempt to mirror the thinking of investors in the world of value and must reach conclusions and document them. We must solve valuation problems with reference to the appropriate organizing principles if our conclusions are to have credibility. A or B will occur, and the valuation report must withstand critical scrutiny regardless of which happens.

ASSESSING PROJECTIONS A sidebar to this brief discussion of the role of expectations in valuation relates to the use of unrealistic expectations. One of the most frequent problems seen in appraisal reports today is the use of projected earnings that bear little or no resemblance to those of the past. These projections often lack any explanation of how the rose-colored glasses through which they view a business reflect realistic expectations for the future of a business. The projection phenomenon just described is so common that it has been given a name: “hockey-stick projections.” In a deposition a number of years ago, Mercer was asked how a bank with currently low earnings could possibly meet the projections found in bank management’s own current capital plan for the next five years. The deposing attorney accused Mercer of unrealistically relying on the capital plan, which was prepared by his client for regulatory review in the normal course of business. How could any bank possibly achieve the results of such a “hockey-stick” set of projections? Mercer referred the attorney to the exhibit in our report that compared the previous five years’ performance with the earnings and returns of the capital plan. There, it was clear that the projected returns (on assets and equity) were within the levels achieved by the bank in the previous few years, and below the current level of the bank’s peer group. Value today is a function of expectations for future performance – and the

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expectations we used were in line with past performance, management’s stated plans, management’s business plan, and the performance of similar banks. Valuation analysts should remember that every goingconcern business appraisal reflects, implicitly or explicitly, a projection of expected future performance. If the expectations imbedded in the valuation are not realistic, the resulting conclusions will be flawed.

2. Principle of Growth We live in a growing world. Change and growth are integral parts of nature, economies, and business. Investors look at the world, the economy, individual businesses, and specific investments with an eye toward growth prospects. There can, of course, be negative aspects to economic, industrial, or business growth. But we live in an economic world where growth is viewed, on balance, as good. The national and world economies have grown unevenly but steadily for hundreds of years. All valuation of businesses is considered in the context of growth of population, productivity, and inflation. Equity securities are purchased for their growth prospects. Other things being equal, a growing business is more valuable than a similar business that is not growing. Why? The growing business will generate greater future cash flows than the one that is not growing. More future cash flows from the perspective of today, other things being equal, means more value today. The Principle of Growth suggests, in nonmathematical terms, that there is an underlying relationship over time between growth and value. That relationship is indirectly reflected in Exhibit 1.1, which tracks the S&P 500 Index over the fifty years ending December 2019. The index has grown at a compound annual rate of 7.3% over the period, largely tracking the growth in underlying corporate earnings, supplemented by generally higher valuation multiples. Valuation analysts addressing valuation questions need to focus on relevant aspects of growth, ranging from the world economy, to

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S&P 500 Index

3,000 2,500 2,000 1,500 1,000 500 Dec-69 Dec-71 Dec-73 Dec-75 Dec-77 Dec-79 Dec-81 Dec-83 Dec-85 Dec-87 Dec-89 Dec-91 Dec-93 Dec-95 Dec-97 Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11 Dec-13 Dec-15 Dec-17 Dec-19

0

EXHIBIT 1.1 S&P 500 Index: December 1969 through December 2019. the national economy, to the regional economy, to a local economy, to a particular industry, to a particular company, or to the facts and circumstances influencing the ownership of a particular business interest. As Exhibit 1.1 illustrates, while the long-term trend in asset values is upward, the rise is punctuated by reversals, or decreases in valuation. After all, when we value companies, we do so at particular points in time. The level and direction of movement of relevant markets will influence valuation decisions at any point in time. The Principle of Growth is often linked, as we will see, to the Principle of Expectation and to the Present Value Principle. But they are not the same principles.

3. The Principle of Risk and Reward In the world of value there are predictable relationships between expected future risks and rewards. The Principle of Risk and Reward can be summed up in the words of an immortal unknown: “No risk, no blue chips!” This principle is integrated with the Present Value Principle via the factor known as the discount rate, or

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Expected Return

required rate of return. It is also embodied, implicitly or explicitly, when we employ the Principle of Alternative Investments. The Principle of Risk and Reward suggests that an investor considering two possible investments, with one clearly riskier than the other, will require a greater expected reward for the riskier investment. If it were not so, there would be no incentive to purchase the riskier investment. Return expectations or requirements are reflected in different discount rates, or required returns. Investments of relatively higher risk require relatively higher returns. We can see the Principle of Risk and Reward at work in Exhibit 1.2, which illustrates the general relationships between required returns (i.e., discount rates) and investments of generally increasing risk. These return expectations influence value through the Present Value Principle, which is discussed next.

Venture Capital Private Equity International Stocks

Small-Cap Public Stocks

Large-Cap Public Stocks Below Investment-Grade Corporate Bonds Investment-Grade Corporate Bonds Long-term Treasury Notes Short-term Treasury Notes

EXHIBIT 1.2 Relationship between Risk and Expected Return.

Risk

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4. The Present Value Principle Stated in its simplest form, the Present Value Principle says that a dollar today is worth more than a dollar tomorrow. Alternatively, a dollar tomorrow is worth less than a dollar today. Present value is really an intuitive concept that even children understand. Ask any child whether it is better to get a toy today or to get the same toy next week. The Present Value Principle addresses four aspects of investments: ■

■

■

■

Equity Investments are expected to grow in value. Recall the Principle of Growth. Investments have cash flow characteristics. Valuation analysts must understand the nature of the cash flows of a business over time, and the fact that the cash flows of the business may differ materially from the cash flows available to its minority shareholders. Investments have duration. They exist over time. Investors forgo consumption today (or make a choice among competing alternatives) in order to gain the benefit of the investment over its duration. Investments have different risk characteristics. Risk is the great leveling force in the world of present value via investors’ required rates of return, or discount rates.

The Present Value Principle enables us to compare investments of differing durations, growth expectations, cash flows, and risks. We use present value calculations to express the value of different investments in terms of dollars today and, therefore, to provide a means to make investment or valuation decisions. Alternatively, we sometimes compare investments based on their expected values at dates in the future. Exhibit 1.3 summarizes the fundamental valuation model. This generalized model reflects a single-period income capitalization valuation method commonly employed by business valuation analysts. Assume that the net cash flow to equity of a

13

The World of Value

Value0 =

Cash Flow1 r−g

= Cash Flow1 × Multiple

EXHIBIT 1.3 The Fundamental Valuation Model.

business (for which earnings is often a suitable proxy) is $1.00 per share. Assume further that the appropriate discount rate (r) is 13% and that expected growth (g) (at a constant rate into the indefinite future) is 3%. The expression (1 / (r – g)) converts to a multiple of 10.0x (1 / (13% − 3%). So capitalized value, today, is $10.00 per share, or $1.00 per share x 10.0. This method yields an identical conclusion of value to a discounted cash flow method under the same assumptions. Both single-period capitalizations of earnings as illustrated above and the application of the discounted cash flow method, both of which are discussed in more detail in Chapter 4, are applications of the Present Value Principle. Both methods convert expected future cash flows into value today via the process of discounting them to the present at the selected discount rate or required return. Normally, we use the fundamental valuation model to solve for the value of a business. However, the Principle of Present Value can also be used to facilitate comparing alternative investments. If we can estimate the future cash flows from a business (or a business strategy or investment), and we know what that business or strategy or investment costs today, we can solve for the implied internal rate of return. If we calculate the implied internal rates of return from similar investments and hold other risk factors constant, the investment with the higher internal rate of return is the preferable investment. Whether a valuation analyst solves the DCF equation for its value conclusions, or a CFO of a company makes comparisons of investments based on their relative expected internal rates of return, both are applying the same principle.

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BUSINESS VALUATION

Business valuation analysts and market participants must be intimately familiar with present value concepts and be able to articulate valuation facts and circumstances in a present value context.

5. The Principle of Alternative Investments We live in an alternative investment world. The Principle of Alternative Investments suggests that investments are made in the context of choices between or among competing alternatives. The Principle of Alternative Investments lies at the heart of business valuation theory and practice. When Revenue Ruling 59–60 directs valuation analysts to make comparisons of a subject enterprise with the securities of similar companies with active public markets, the Principle of Alternative Investments is being invoked. The public securities markets are massive and active and provide liquid investment alternatives to investments in many privately owned businesses. Business valuation analysts need to have a thorough, working knowledge of these markets in order to provide realistic appraisals of private business interests. By combining the organizing principles, we begin to describe the workings of the world of value. For example, by combining the Principle of Risk and Reward and the Principle of Alternative Investments, investors make asset allocation decisions regarding their investments. In the public securities markets, investors ask questions like “Should we buy shares in Amazon or Alphabet? Should we buy large cap or small cap stocks? Should we buy stocks or bonds or real estate?” The Principle of Alternative Investments suggests that there are many competing alternative investments. The mirror suggestion is that there are many alternative investors evaluating investments in different ways. This realization is causing valuation analysts to focus more frequently on the typical buyers for particular assets. For example, valuation analysts now generally recognize that there are different types of buyers for companies, including financial buyers and strategic or synergistic buyers. Strategic or synergistic buyers can often pay more for companies than financial buyers who may be substantially dependent upon a company’s existing

The World of Value

15

cash flows for returns. Decisions by valuation analysts regarding who constitutes the “typical buyer” for an asset can significantly impact their conclusions of value. The Principle of Alternative Investments also suggests the concept of opportunity costs. When resources are deployed to acquire one asset, they are not available to purchase another. When business assets are lost, destroyed, or diminished in value, valuation analysts and economic experts employ the organizing principles to estimate the magnitude of alleged damages. The Principle of Alternative Investments confirms that business valuation analysts must be familiar with the public securities markets and capable of making objective comparisons between the public and private markets and drawing reasonable valuation inferences.

6. The Principle of Rationality The Principle of Rationality assumes, for the most part, that markets are rational and consistent. When we speak to valuation analysts about the nature of the public securities markets, many are quick to point out many (apparent or real) exceptions to sane, rational, or consistent investment behavior. However, while the exceptions are always interesting, what we are discussing is the underlying rationality of the markets operating as a whole. Many an unthinking investor has been taken to the proverbial cleaners by the investment pitch that “seemed almost too good to be true” and turned out to be. Lying beneath the surface of this comment are implicit comparisons with alternative investments that are sane, rational, or consistent with normal expectations. Other valuation analysts are quick to point out that the markets sometimes behave abnormally or, seemingly, irrationally. We are using the comments of valuation analysts to illustrate that too many of us get caught up in the exceptions and miss the big picture that is played out in the public securities markets. If we can accept the underlying rationality or sanity of the markets, we then have a basis to explain or to try to understand the apparent exceptions.

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BUSINESS VALUATION

The Principle of Rationality should be applied to valuation analysts as well as markets. Revenue Ruling 59–60, in the paragraph prior to the enumeration of the eight factors that are listed in nearly every appraisal report, suggests that valuation analysts employ three additional factors – common sense, informed judgment, and reasonableness. We call the eight factors the “Basic Eight” factors of valuation. We call the less well-known factors from Revenue Ruling 59–60 the “Critical Three” factors of valuation. The Principle of Rationality suggests that valuation analysts need to study the markets they use as valuation reference points (comparables or guidelines). It also suggests that valuation conclusions should be sane, rational, consistent, and reasonable. We employ tests of reasonableness in Mercer Capital valuation reports to compare our conclusions with relevant alternative investments or to explain why we believe our conclusions are reasonable. Other valuation analysts call the same process that of using sanity checks. Readers of appraisal reports should expect such “proof” of the rationality of the conclusions found in those reports as well as at key steps along the way as critical valuation decisions are made.

SUMMARY The organizing principles provide an excellent framework within which to think about the world of value. Business value is determined by investors “out there” who either have or are seeking information about their potential investments. The various bits of information that are gathered are part of a mosaic. When the pieces are put together in an organized fashion, they form the knowledge that is necessary for decision-making about investments and their future performance in the face of uncertainty. From the viewpoint of business valuation analysts and market participants, the organizing principles provide a number of avenues along which to seek and obtain the knowledge necessary to develop and support, and later, to defend valuation conclusions. Valuation analysts and market participants who have a grasp on the organizing principles of business valuation have a leg up in the

The World of Value

17

process of developing reasonable valuation conclusions. Attorneys and other advisors to business owners who use these principles as a framework within which to discuss valuation questions can get to bottom-line issues more rapidly and effectively. The importance of understanding the organizing principles of business valuation and being able to employ them in valuation assignments or investment decision-making should become clearer as this book progresses. The Integrated Theory presented in the next chapter relies heavily on these principles.

CHAPTER

2

The Integrated Theory (Equity Basis)

INTRODUCTION In the first two editions of Business Valuation, we developed the Integrated Theory of Business Valuation on an equity basis. The “value” that was referred to is the value of the equity of business enterprises. In Chapter 3, we will extend the Integrated Theory to the enterprise, or total capital, basis. The “value” in that chapter will pertain to the enterprise value of businesses, or the market value of equity, plus debt, less cash (so on a net debt basis). In this chapter, we introduce the Integrated Theory of Business Valuation. Simply stated, the Integrated Theory allows valuation analysts to account for all the cash flows of a business, whether in the aggregate or the portions attributable to specific ownership interests. We do so by correlating the fundamental valuation model to the familiar levels of value conceptual framework. More specifically, the Integrated Theory uses the fundamental valuation model to define each level of value and explain why the value of a given business differs at the various levels. In addition, the Integrated Theory defines the conceptual adjustments relating the various levels of value to each other (control premiums, minority interest discounts, and marketability discounts) in terms of the

19 Business Valuation, First Edition. Z. Christopher Mercer and Travis W. Harms. © 2021 Z. Christopher Mercer and Travis W. Harms. Published 2021 by John Wiley & Sons, Inc.

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BUSINESS VALUATION

fundamental valuation model. Finally, the Integrated Theory also describes the economic factors that cause the relevant valuation premiums or discounts to be observed in the real world.

COMMON QUESTIONS Not every question posed here is answered (or addressed) in this chapter. However, the framework for addressing these and other valuation-oriented questions is established here in Chapter 2. 1. What is the source of value for an interest in a business? 2. What are the theoretical reasons for the existence of a control premium? 3. In the context of determining fair market value, should control premiums be applied “automatically” in developing controlling interest value indications? 4. What factors give rise to financial control premiums? 5. What factors give rise to strategic control premiums? 6. When applying the DCF method, should valuation analysts apply control premiums when developing controlling interest values? 7. What does the term marketable minority level of value mean in the context of public security values and in terms of the valuation of private businesses? 8. When using guideline public company multiples, should valuation analysts apply control premiums to the resulting indications of value? 9. Are marketability discounts applicable to 100% controlling interests? To 51% controlling interests? 10. What economic factors give rise to the marketability discount? 11. What is the relationship between the standard of fair market value and the strategic control level of value? 12. In valuing nonmarketable interests in private businesses, why do valuation analysts normally begin with appraisals at the marketable minority level of value?

21

The Integrated Theory (Equity Basis)

THE FUNDAMENTAL VALUATION MODEL We use the single-period capitalization model as conceptual shorthand for summarizing the way securities are valued in the public markets.1 This fundamental valuation model is shown in the equation in Exhibit 2.1 as a beginning point for discussing the Integrated Theory. The fundamental valuation model defines the value of a business or ownership interest as the next period’s expected cash flow (CF1 ) divided by an appropriate capitalization rate (the discount rate (r) less the expected growth rate of the specified cash flow (g)). As we show in Chapter 4, this formula is a summary of the discounted cash flow method of valuation when the cash flows to equity are expected to grow at a constant rate (g). The fundamental valuation model provides an ideal basis for developing the Integrated Theory of Business Valuation. In practice, CF1 often represents the estimate of earnings for the next period so we can generalize and refer to the cash flow measure as Earnings. The expression (r − g) is known as a capitalization rate, or a rate used “to convert anticipated economic benefits of a single period into value.”2 When earnings are used as a proxy for CF1 , the model further assumes that all earnings are either distributed in the current period or reinvested to earn the discount rate (r).

Value0 =

Cash Flow1 r−g

= Cash Flow1 × Multiple

EXHIBIT 2.1 The Fundamental Valuation Model.

1 The single-period capitalization valuation model was first described by Myron J. Gordon, and is often referred to as the “Gordon Model.” See The Investment, Financing, and Valuation of the Corporation (Homewood, IL: Richard D. Irwin, 1962). 2 ASA Business Valuation Standards, “Glossary” (American Society of Appraisers, 2009), p. 26.

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BUSINESS VALUATION

The expression (r – g) is the denominator in the fundamental valuation model. Assume r is 15% and g is 5%; (r – g) is therefore 10%, which as the denominator would convert an indication of earnings into value. If earnings are $1.00 per share, the denominator of 10% results in a value of $10.00 per share. The expression (1 /(r − g)) is also a multiple of earnings. In this example, 1 divided by 10% implies a multiple of 10x earnings. Given earnings of $1.00 per share, we obtain the same value indication of $10.00 per share ($1.00 per share x 10). As shown in Exhibit 2.1, the fundamental valuation model may also be expressed in terms of cash flow and a valuation multiple. These factors are so familiar that valuation analysts sometimes forget their source. Earnings in the generalized valuation model must be clearly defined and the multiple must be appropriate for the defined measure of earnings. For purposes of the Integrated Theory, we develop two versions of the fundamental valuation model, one based on equity valuation and the other based on enterprise, or total capital, valuation. Equation 2.2 depicts the equity version. We have used the subscript “Equity” in Exhibit 2.2 to denote clearly that we are using the fundamental valuation model to derive the value of equity. The expected cash flow to equity holders (CFEquity ) is capitalized at the equity discount rate (REquity ) minus the expected growth rate in cash flows to equity holders (GEquity CF ). We will use the equity version of the fundamental valuation model in this chapter. We begin with the equity version of the Integrated Theory because valuation premiums and discounts have traditionally been measured in relationship to equity values. In this chapter,

ValueEquity =

CFEquity REquity − GEquity CF

EXHIBIT 2.2 The Fundamental Valuation Equation: Equity Basis.

23

The Integrated Theory (Equity Basis)

ValueEnterprise =

CFEnterprise REnterprise − GEnterprise CF

EXHIBIT 2.3 The Fundamental Valuation Model: Enterprise Basis.

we introduce the Integrated Theory and develop the financial rationale for the existence of control premiums (whether financial or strategic), minority discounts, and marketability discounts in the context of what valuation analysts call the “levels of value.” Exhibit 2.3 depicts the enterprise, or total capital, version of the fundamental valuation model. The subscript “Enterprise” denotes that we refer to the entire enterprise, and not just the equity. The cash flows of the enterprise include net cash flows to all capital providers, both lenders and shareholders. The relevant cash flow in Exhibit 2.3 is measured with reference to debt-free net income, or net operating profit after taxes (NOPAT). (CFEnterprise ) is capitalized at the discount rate applicable to the enterprise (REnterprise ) less the expected growth rate in enterprise cash flows (GEnterprise CF ). The discount rate REnterprise is the weighted average cost of capital, or WACC, which is discussed in Chapter 5. We discuss the enterprise version of the fundamental valuation model, and situate enterprise value within the levels of value framework in Chapter 3.

THE CONCEPTUAL LEVELS OF VALUE The levels of value chart for business valuation relates the various “levels” of value to one another on a conceptual basis. It was first published in 1990. This chart recognized what the markets and business valuation analysts had understood for some time about “levels” of value of businesses:

24 ■

■

■

BUSINESS VALUATION

Trading prices of public companies, referred to as the marketable minority level of value, provide a base from which to analyze value at the other levels. Public companies that are sold in change of control transactions tend to trade at prices higher than their previously unaffected market prices. Restricted shares of public companies tend to trade at prices lower than the price of otherwise identical shares that are not restricted.

While the levels of value chart was new in 1990, the concepts embodied in the chart were generally accepted by valuation analysts (and courts) prior to that time based on the observations outlined above. The initial levels of value chart showed three conceptual levels, as indicated in Exhibit 2.4.3 The levels of value chart is so important to an understanding of valuation concepts that analysts at Mercer Capital have included versions of it in virtually every valuation report since about 1992. Like most valuation analysts, we initially assumed the existence of the conceptual adjustments referred to as the control premium, the minority interest discount, and the marketability discount as shown in Exhibit 2.4:

3 Z. Christopher Mercer, “Do Public Company (Minority) Transactions Yield Controlling Interest or Minority Interest Pricing Data?” Business Valuation Review Vol. 9, No. 4 (1990). This article was written in response to an insightful article by Eric Nath, published earlier that year. See Eric W. Nath, “Control Premiums and Minority Interest Discounts in Private Companies,” Business Valuation Review, Vol. 9, No. 2 (1990). See also James H. Zukin, Financial Valuation: Business and Business Interests (New York: Maxwell MacMillan, 1990), pp. 2–3. While the concepts of the levels of value had been around for some time prior to 1990, to the best of our knowledge, the levels of value chart was not published until the Mercer article in 1990 and in the Zukin text that same year.

k Controlling Interest Basis

Obtain indirectly by reference to freely tradable values by applying Control Premiums

Control Premium (CP)

Obtain indirectly by reference to control valuation by applying a Minority Interest Discount

Obtain directly by reference to actual change of control transactions or other control methodologies

Minority Interest Discount (MID)

Marketable Minority Interest Basis

Obtain directly by reference to "freely tradable" comparable companies or by "build-up" methodologies that develop capitalization rates by estimating required rates of return in relation to public markets

Marketability Discount / DLOM

Obtain indirectly from Marketable Minority valuation by applying a Marketability Discount

Nonmarketable Minority Interest Basis

EXHIBIT 2.4 Early Levels of Value Chart (1990).

Obtain directly from actual transactions

k

26 ■

■

BUSINESS VALUATION

We relied on market evidence from control premium studies to help ascertain the magnitude of control premiums (and the related, or so we thought, minority interest discounts). We relied on certain benchmark studies, the various Pre-IPO and Restricted Stock Studies, as the basis for estimating marketability discounts.

What we, like most valuation analysts, did not realize in the early 1990s was that Exhibit 2.4 is descriptive only. In other words, the discounts and premiums in the chart provided no guidance regarding the how or the why of observed levels of value, and merely described what business valuation analysts and market participants had observed to that point. By the early 1990s, we had become increasingly uncomfortable with the prevailing methodologies for developing marketability discounts. The Quantitative Marketability Discount Model (QMDM), which is based on our early development of the Integrated Theory, was introduced in speeches beginning in 1994 and in a book in 1997.4 The purpose of this chapter is to move beyond the conceptual description of valuation relationships found in Exhibit 2.4 and to integrate the fundamental valuation model with how the markets value companies. The Integrated Theory introduced in this chapter is designed to: ■

■

4

Provide a conceptual description of each level of value in the context of the fundamental valuation model. Use the components of the fundamental valuation model to define the conceptual adjustments between the levels of value. These adjustments reflect differing perceptions of expected cash

See Z. Christopher Mercer, Quantifying Marketability Discounts (Memphis: Peabody Publishing, LP, 1997).

The Integrated Theory (Equity Basis)

■

27

flows, growth, and risk from the viewpoint of various market participants. We define the control premium, the minority interest discount, and the marketability discount in terms of the components of the fundamental valuation model. Reconcile the resulting integrated valuation model to observed pricing behavior in the market for public securities (the marketable minority level), the market for entire companies (the controlling interest levels of value), and the market for illiquid, minority interests in private enterprises (the nonmarketable minority level of value).

With these objectives in mind, we proceed with the development of the Integrated Theory on an equity basis.

SYMBOLIC NOTATION FOR THE INTEGRATED THEORY First, we will introduce the symbolic notations for the components of the fundamental valuation model (for both the equity and enterprise models) to facilitate discussion and to provide a roadmap to readers. The four conceptual levels of value of the Integrated Theory on an equity basis will be developed in detail: Strategic Control, Financial Control, Marketable Minority, and Nonmarketable Minority. The first three levels are firmwide levels, and are dependent on the equity cash flows of businesses. The fourth level is the shareholder level of value, where value is determined, not by the equity cash flows of entire businesses, but by the portion of equity cash flows that are attributable to holders of illiquid minority ownership positions.

Equity Basis Symbolic notations for the components of the fundamental valuation model on an equity basis are provided in Exhibit 2.5.

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BUSINESS VALUATION

Conceptual Levels

Value

Cash Flow

Growth Rate

Return

Firmwide Levels Strategic Control

VEq(sc)

CFEq(sc)

GCF Eq(sc)

REq(sc)

Financial Control

VEq(fc)

CFEq(fc)

GCF Eq(fc)

REq(fc)

VEq(mm)

CFEq(mm)

GCF Eq(mm)

REq(mm)

VSh

CFSh

Gv

Rhp

Marketable Minority The Shareholder Level Nonmarketable Minority

EXHIBIT 2.5 Symbolic Notation for Integrated Theory: Equity Basis.

Enterprise Basis There is no shareholder level in the Integrated Theory on an enterprise basis. The three firmwide levels correspond to those of the equity basis; however, the cash flows include cash flows to all capital providers, both lenders and equity holders. The symbolic notations for the three conceptual levels of value of the Integrated Theory on an enterprise basis are shown in Exhibit 2.6. With this summary of symbolic notation in hand, we proceed to develop the Integrated Theory on an equity basis in the remainder of this chapter, and on an enterprise basis in Chapter 3.

Conceptual Levels

Value

Cash Flow

Growth Rate

Return

Firmwide Levels Strategic Control

VEnt(sc)

CFEnt(sc)

GCF Ent(sc)

WACCsc

Financial Control

VEnt(fc)

CFEnt(fc)

GCF Ent(fc)

WACCfc

VEnt(mm)

CFEnt(mm)

GCF Ent(mm)

WACCmm

Marketable Minority

EXHIBIT 2.6 Symbolic Notation for Integrated Theory: Enterprise Basis.

29

The Integrated Theory (Equity Basis)

THE MARKETABLE MINORITY INTEREST LEVEL OF VALUE The fundamental valuation model provides a shorthand representation of public share prices at the marketable minority interest level of value. For privately owned enterprises, it indicates the same level of value (referred to as the “as-if-freely-traded” level). In developing the Integrated Theory, we use the fundamental valuation model to analyze how the levels of value relate to each other. To do so, we introduce a symbolic notation to designate which elements of the model relate to each level of value. Exhibit 2.7 introduces the conceptual math of the marketable minority value. The marketable minority level of value is the benchmark to which control premiums are added to derive controlling interest indications of value, and from which marketability discounts are subtracted to reach the nonmarketable minority level of value. The terms of the equation in Exhibit 2.7 are defined as follows: VEq(mm) is the equity value of a company at the marketable minority level of value, whether public or private. This is the benchmark, observable value for public securities. The as-if-freely-traded value for private enterprises is a hypothetical value. By definition, it is not observable for minority interests of private enterprises because there are no active, public markets for their shares. Indications of value at the marketable minority level are developed either by reference to the public securities markets (using the guideline public company method), or through methods under the income approach.5

VEq (mm) =

CFEq(mm) REq(mm) − GCF Eq(mm)

EXHIBIT 2.7 Marketable Minority Level of Value.

5

See Chapter 5 for further discussion of discount rate development.

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BUSINESS VALUATION

CFEq(mm) is the expected cash flow available to equity holders. This level of cash flow reflects net equity cash flow of the business as a whole, after payments of interest, taxes, and payments to other capital providers. This measure of cash flow is “normalized” for unusual or nonrecurring events. It is further normalized to adjust items like owner or key shareholder compensation to market levels for similar services.6 Public companies seek to keep investors focused on their “normalized” earnings. Many public companies, for example, provide guidance regarding pro forma earnings, or earnings after adjusting for unusual or nonrecurring (and sometimes not so nonrecurring) items. REq(mm) is the equity discount rate at the marketable minority level of value. While it is not directly observable, it can be inferred from public pricing or estimated using the Capital Asset Pricing Model or other models. For private companies, REq(mm) is most often estimated using one of several build-up approaches.7 GCF Eq(mm) is the expected growth rate of equity cash flows for the business as a whole. As we will demonstrate in Chapter 4, analysts using the single-period capitalization of earnings method must make an appropriate estimate of expected growth. For purposes of this chapter, however, it is sufficient to know that GCF Eq(mm) is the rate at which cash flow to equity at the marketable minority level is expected to grow over the long-term. 6

See Chapter 4 for further discussion of normalizing adjustments. Z. Christopher Mercer, “The Adjusted Capital Asset Pricing Model for Developing Capitalization Rates: An Extension of Previous ‘Build-Up’ Methodologies Based Upon the Capital Asset Pricing Model,” Business Valuation Review, Vol. 8, No. 4 (1989): pp. 147–156. See the more detailed discussion of discount rates in Chapter 5. 7

The Integrated Theory (Equity Basis)

31

At this point, we can begin to connect the fundamental valuation model to the conceptual levels of value chart. The marketable minority level of value is the conceptual base level of value from which other levels of value are derived. Exhibit 2.8 presents the symbolic notations of conceptual math of the marketable minority level of value on an equity basis. We refer to the marketable minority level of value as a firmwide level of value. We do so because CFEq(mm) is defined as the cash flow to the equity holders of the firm as a whole. As the discussion of the Integrated Theory progresses in this chapter, we will consistently discuss the market value of the equity of businesses. In previous editions of this book, we used the term “enterprise levels of value” to refer to the strategic control, financial control, and marketable minority levels of value. However, the term “enterprise value” is more commonly used by valuation analysts today to describe the market value of the total capital of a business, inclusive of equity and net debt. We extend the Integrated Theory to include the enterprise value of businesses in the next chapter. To avoid unnecessary confusion, we have substituted “firmwide levels of value” for “enterprise levels of value” as we used that term in previous editions. In this chapter, we consistently focus on market values of equity at each level of value where such values are a function of the expected cash flows to equity of the firm as a whole. We will address the concept of levels of value in the context of enterprise values (in its common usage as the value of equity and debt, net of cash) in the next chapter. Nevertheless, this level of value is referred to as the marketable minority level of value. There is no inconsistency, however, as marketability affords minority shareholders with effective access, via the public markets, to the market values of firmwide equity cash flows. The economic impact of the marketability enjoyed by public equity securities is that there is no (or as we will see, very little) minority interest discount reflected in public market pricing. We build the Integrated Theory from the base presented in Exhibit 2.8. The conceptual math is illustrated in the leftmost

Conceptual Math Marketable Minority Value (Equity Basis)

CFEq(mm) REq(mm) – GCF Eq(mm)

Relationships

GCF Eq(mm) = REq(mm) –

Value Implications

CFEq(mm) VEq(mm)

EXHIBIT 2.8 The Benchmark Marketable Minority Level of Value: Equity Basis.

VEq(mm) is the benchmark for the other equity levels of value ("as-if-freely-traded")

The Integrated Theory (Equity Basis)

33

column. We will develop the conceptual math for the other levels of value as the chapter progresses. The middle column is labeled “Relationships.” The expected growth in value, GCF Eq(mm) , is equal to the discount rate, REq(mm) , less the expected dividend yield. We will follow the progression of relationships between expected cash flows, growth, and risk as we develop the other levels of value. The rightmost column in Exhibit 2.8 is labeled “Value Implications.” The conceptual math yields the benchmark marketable minority value, or VEq(mm) . The value implications of the other levels of value will be explored in relationship to VEq(mm) as the discussion progresses. The marketable minority level of value of equity is the conceptual level to which valuation analysts have traditionally applied control premiums to develop controlling interest indications of value. It is also the level from which valuation analysts have subtracted marketability discounts to derive indications of equity value at the nonmarketable minority level of value. As we develop the Integrated Theory, we will see the why of observed premiums and discounts and understand why market participants tend to pay more for control (relative to marketable minority values) and less for illiquid minority investments (again, relative to marketable minority values). Only if we understand the whys can we make reasonable estimates of value at the different levels of value. Refer back to original levels of value chart in Exhibit 2.4. The control premium enables valuation analysts to relate the marketable minority level of equity value with the controlling interest level, and the marketability discount relates the marketable minority and nonmarketable minority levels of value. The minority interest discount also relates the controlling interest and marketable minority levels. We will see that these conceptual adjustments were based on the observed behavior of market participants. The idea of a conceptual base level of value and premiums and discounts is important in business valuation, as evidenced by

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BUSINESS VALUATION

Paragraph II of “BVS-VII Valuation Premiums and Discounts” in the ASA Business Valuation Standards.8 II. The concepts of discounts and premiums A. A discount has no meaning until the conceptual basis underlying the base value to which it is applied is defined. B. A premium has no meaning until the conceptual basis underlying the base value to which it is applied is defined. C. A discount or premium is warranted when characteristics affecting the value of the subject interest differ sufficiently from those inherent in the base value to which the discount or premium is applied. D. A discount or premium quantifies an adjustment to account for differences in characteristics affecting the value of the subject interest relative to the base value to which it is compared. This guidance is clear. Valuation premiums and discounts have no meaning unless the base to which they are to be applied is clearly specified. Why do premiums and discounts exist? The standard above says they are warranted “when the characteristics affecting the value of the subject interest differ sufficiently from those inherent in the base value.” In the context of the Integrated Theory, those characteristics pertain to the relevant expected cash flows of business enterprises, their risks, and their expected growth in relationship to those characteristics found in the base level of value. The marketable minority value of equity is the benchmark level of value for the Integrated Theory. It is the “base value” from which discounts are taken and to which premiums are applied. A review of the valuation literature prior to the late 1990s yields little insight into the theoretical basis for applying the well-known conceptual premiums and discounts. Practically, valuation analysts applied judgmental control premiums because they were frequently 8

ASA Business Valuation Standards, “BVS-VII Valuation Premiums and Discounts,” American Society of Appraisers, November 2009.

The Integrated Theory (Equity Basis)

35

observed when public companies changed control. And judgmental marketability discounts were applied because analysts observed that restricted stocks of public companies traded at prices lower than their freely traded counterparts. Since then, however, valuation analysts have begun to understand and to articulate why control premiums and restricted stock discounts exist, and consequently, to understand the theoretical basis for their existence. The Integrated Theory explains the why behind the generally accepted valuation premiums and discounts.

INTRODUCTION TO THE CONTROL LEVELS OF VALUE There is now broad consensus that there are two conceptual levels of value above the marketable minority level: ■

■

9

Financial Control. The first control level describes what a financial buyer is willing to pay in order to obtain control of a business. Financial buyers acquire companies based on their ability to extract reasonable rates of return, often on a leveraged basis. Strategic Control. The second control level is referred to as the strategic, or synergistic, control level of value. Strategic buyers can pay more for companies than financial buyers because they expect to realize synergies from acquisitions (e.g., through eliminating duplicate expenses or achieving cross-selling benefits) or other strategic benefits that increase their expected future cash flows from acquired businesses.9

Steven D. Garber, “Control vs. Acquisition Premiums: Is There a Difference?” Presentation at the American Society of Appraisers International Appraisal Conference, Maui, HI, June 23, 1998. Z. Christopher Mercer, “A Brief Review of Control Premiums and Minority Interest Discounts,” Journal of Business Valuation (Toronto: Carswell Thomas, 1997), pp. 365–387. Mark Lee, “Premiums and Discounts for the Valuation of Closely Held Companies: The Need for Specific Economic Analysis,” Shannon Pratt’s Business Valuation Update, August 2001.

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Supported by evidence from change-of-control transaction data, we began to conclude that the conceptual levels of value charts should have four, rather than three, levels (see Exhibit 2.9).10 The left side of Exhibit 2.9 presents the traditional, three-level chart, including the conceptual premium and discounts that enable valuation analysts to relate the three levels to each other. The right side of the exhibit presents the expanded, four-level chart. ■

■

The control premium (CP) on the left side of the chart is equal to the sum of any financial control premium (FCP) and any strategic control premium (SCP) on the right side. The “financial control premium” on the right and the “control premium” on the left are the equivalent conceptual premiums. ■ As a result, the minority interest discounts shown on the left and right sides of Exhibit 2.9 are the same conceptual discount. ■ We have called the conceptual premium relating the financial control value to the strategic control value the “strategic control premium.”

The modified levels of value chart on the right captured the differences in observed prices between transactions involving financial buyers and those involving strategic acquirers. However, the newer chart raised questions for which there were no easy answers. For example, the newer chart divided the “control premium” on the traditional chart into two components, the “financial control premium” and the “strategic control premium.” There was no name for the implied conceptual discount that would reduce the strategic

10 We developed this chart, which shows the “traditional” levels of value chart (Exhibit 2.4) and the then new, expanded chart with four levels. Mercer used the chart in articles and speeches during the latter 1990s. The chart received considerable exposure and discussion. For example, it was reproduced as Exhibit 15-2 in Pratt’s Valuing a Business Fourth Edition (New York, McGraw Hill, 2000), pp. 384–387. A similar (in concept) four-level chart was also presented as its Exhibit 15-1.

37

The Integrated Theory (Equity Basis) Traditional

Modified

Control Value

Strategic Control Value Strategic Control Premium (SCP)

Control Premium (CP)

Minority Interest Discount (MID)

Financial Control Value Financial Control Premium (FCP)

Marketable Minority Value Marketability Discount/DLOM

Nonmarketable Minority Value

Minority Interest Discount (MID)

Marketable Minority Value Marketability Discount/DLOM

Nonmarketable Minority Value

EXHIBIT 2.9 Traditional and Modified Levels of Value Charts. control to the financial control value. And this conceptual discount was not the minority interest discount relating the financial control value with the marketable minority level of value. This led business valuation analysts to begin to think about the why of premiums for control, which led to a focus on expected cash flows. Around that time, Mercer recalls hearing Shannon Pratt and others say, “The difference in control value is in the numerator, and not the denominator.” The numerator was, of course, the CF, or expected cash flows, in the fundamental valuation model. The denominator was driven by R, or the discount rate. In other words, the observation was that the discount rate does not change materially between marketable minority and control levels, but the expectation for future cash flows could have a profound impact on value. As we move up from the marketable minority level to the levels of financial control and strategic control on the right side of Exhibit 2.9, we see that it is possible that a controlling shareholder may make adjustments to expected cash flows based on the expected

38

BUSINESS VALUATION

ability to run an enterprise more efficiently (financial control) or differently (strategic control). Such control adjustments could have the effect of increasing value if such adjustments would normally be negotiated between buyers and sellers. In other words, from a conceptual viewpoint, control adjustments are those that, if appropriate, increase firmwide cash flow above that of the normalized marketable minority level. ■

■

■

■

Careful review of the control premium data available to valuation analysts indicates such premiums generally result from transactions motivated by strategic or synergistic considerations. Consequently, the available control premium data more generally reflects the combination of the financial control premium and the strategic control premium (see Exhibit 2.9).11 This observation suggests the following conclusions:12 Use of available control premium studies as a basis for inferring minority interest discounts in a fair market value context is conceptually incorrect. The improper use of such data would tend to overstate the magnitude of minority interest discounts. When applied to financial control values, discounts developed based on observations from control premium studies would not yield marketable minority interest levels of value, but rather something below that level. Furthermore, the resulting value would be of uncertain conceptual pedigree. And finally, the application of a “standard” marketability discount to that lower (and conceptually undefinable) value would tend to understate the value of illiquid interests of private enterprises.

11 FactSet Mergerstat/BVR Control Premium Study. This study is available in print versions and online at https://www.bvresources.com/products/ factset-mergerstat-bvr-control-premium-study. 12 Z. Christopher Mercer, “Understanding and Quantifying Control Premiums: The Value of Control vs. Synergies or Strategic Advantages,” Journal of Business Valuation (Toronto: Carswell Thomas, 1999), pp. 31–54.

39

The Integrated Theory (Equity Basis)

VEq(fc) =

CFEq(fc) REq(fc) − GCF Eq(fc)

EXHIBIT 2.10 Financial Control Level of Value.

The Financial Control Level of Value With this conceptual backdrop, we can examine the controlling interest levels of value. Exhibit 2.10 illustrates the conceptual math of the first control level of value – the financial control value. Consistent with the marketable minority level of value, we define the terms found in Exhibit 2.10 as follows: VEq(fc) is the value of total equity from the viewpoint of financial control buyers. These buyers do not expect to achieve strategic benefits relative to the marketable minority value. Traditionally, valuation analysts developed the financial control level of value in two ways: (1) directly, by comparison with change of control transactions of similar businesses (the guideline transaction method); and (2) indirectly, by application of control premiums to indications of marketable minority value. CFEq(fc) is the expected cash flow to equity from the viewpoint of financial buyers. The first step in developing CFEq(fc) is to derive CFEq(mm) by normalizing the earnings stream.13 We refer to this as normalizing to the equivalent of a well-run public company. The second step involves judging the ability of a control buyer to improve the earnings stream beyond the normalization process. This could involve the ability of a specific buyer to improve the existing operations or to run the target company more efficiently. However, unless there 13

The issue of normalizing earnings is discussed at more length in Chapter 4.

40

BUSINESS VALUATION

are competing financial buyers, a single buyer would likely be unwilling to share the benefit of any expected cash flow improvement with the seller. In the real world, there would be a negotiation to determine the extent of such sharing.14 REq(fc) is the discount rate at the financial control level of value. In the real world, REq(fc) is most often identical to REq(mm) . While market forces will tend to equate REq(fc) and REq(mm) , REq(fc) is distinctly specified to allow for potential differences. Financial control buyers may bid up prices in competition with other financial or strategic buyers, causing them to reduce REq(fc) to below REq(mm) . Certain buyers may consciously lower their return requirements to secure a deal, leading to potential overvaluation. Alternatively, the possibility that REq(fc) exceeds REq(mm) recognizes that the value of total equity to financial control buyers may be less than the freely traded value for minority interests in the public markets. This result could occur, for example, when speculative trading pushes a stock’s price above financial control values. In the context of various control premium studies, this would potentially explain the existence of occasional negative control premiums in acquisitions, or acquisition prices below the before-announcement trading prices of targets. GCF Eq(fc) is the expected growth rate of equity cash flow for the financial control buyer. Expected growth from the perspective of a financial control buyer will either equal or exceed growth expected at the marketable minority level. GCF Eq(fc) can equal GCF Eq(mm) for either of two reasons:

14

Note that the negotiation between buyers and sellers affects the purchase price and not the expected after-acquisition cash flows. This suggests that observed takeover premiums in public company transactions do not necessarily reflect the total expected change in cash flow, but only the portion negotiated and shared with sellers.

The Integrated Theory (Equity Basis)

41

(1) the universe of buyers may not expect such an increment in growth; or (2) a specific buyer who can accelerate growth may not share that expected benefit in a negotiation.15 Nevertheless, we need to allow for the possibility of incremental growth expectations from the perspective of a financial control buyer in order to understand market behavior. Financial control buyers might expect to augment growth by better managing the relationship between the growth of revenue and expenses, more productive use of facilities, better processes, and the like. Note that, unlike strategic benefits or synergies, these internal opportunities for cash flow enhancement do not depend on a specific combination with another business. We now have a conceptual model describing the financial control level of value, consistent with the previously specified conceptual model for the marketable minority level of value. The relationship between the two levels of value is shown in Exhibit 2.11. The conceptual differences in equity value at the benchmark marketable minority and financial control levels of value can be discerned by examining Exhibit 2.11. This analysis illustrates that control premiums (or other conceptual adjustments) are not automatic. Recall the quote from the ASA Business Valuation Standards above regarding premiums and discounts.16 A discount or premium is warranted when characteristics affecting the value of the subject interest differ sufficiently from those inherent in the base value to which the discount or premium is applied.

15

Multiple financial buyers in an auction process may end up competing with each other such that the seller gains all or most of the growth benefit from the second-highest estimate of GCF Eq(fc) . 16 ASA Business Valuation Standards, “BVS-VII Valuation Premiums and Discounts,” American Society of Appraisers, November 2009.

Conceptual Math

Financial Control (Equity Basis)

Marketable Minority Value (Equity Basis)

CFEq(fc) REq(fc) – GCF Eq(fc)

CFEq(mm) REq(mm) – GCF Eq(mm)

Relationships

Value Implications

CFEq(fc) ≥ CFEq(mm) GCF Eq(fc) ≥ GCF Eq(mm)

VEq(fc) ≥ VEq(mm)

REq(fc) ≈ REq(mm)

GCF Eq(mm) = REq(mm) –

CFEq(mm) VEq(mm)

VEq(mm) is the benchmark for the other equity levels of value ("as-if-freely-traded")

EXHIBIT 2.11 Comparison between the Benchmark Marketable Minority and Financial Control Levels of Value: Equity Basis.

The Integrated Theory (Equity Basis)

43

The differences that warrant a premium or discount, if any, between the financial control and marketable minority equity values are the differences highlighted in Exhibit 2.11 between expected cash flows, expected growth, and risk. Based on Exhibit 2.11, the financial control value would exceed the marketable minority value if, all other things being equal, one or more of the following conditions were true: ■

■

■

CFEq(fc) is greater than CFEq(mm) . This would be true if the financial control buyer could be expected to improve the operations of the enterprise, and would share that expected benefit with the seller. GCF Eq(fc) is greater than GCF Eq(mm) . If the financial control buyer expects to augment the future growth of cash flows, and would share that benefit with the seller, then VEq(fc) can exceed VEq(mm) . REq(fc) is less than REq(mm) . Conceptually, REq(fc) could be a bit less or more than REq(mm) . Either condition could be true for a specific buyer; however, it is likely that market forces would force the relevant universe of buyers to expect a return no greater than REq(mm) as the appropriate discount rate. Specifying REq(fc) discretely does provide an explanation for financial control premiums that might be paid for enterprises based on competition between private equity funds. Such funds have the capacity to bid up prices by accepting lower returns on individual deals.

Once again, the point of this analysis is that the financial control premium is not automatic. Sellers have a history of earnings and cash flow (appropriately adjusted) that provides the basis for future cash flow expectations. Buyers have the benefit of that history and may perceive greater future cash flows. Any differential in value is the function of negotiations between buyers and sellers of enterprises. The conceptual analysis of the Integrated Theory provides a vocabulary to describe the economic behavior of rational

44

BUSINESS VALUATION

CPf =

VEq(fc) − VEq(mm) VEq(mm)

EXHIBIT 2.12 The Financial Control Premium.

market participants. The Integrated Theory also provides the conceptual and analytical framework within which valuation analysts can estimate financial control value in appropriate situations. Financial Control Premium Given the specification of financial control value (VEq(fc) ), the control premium relating the price a financial control buyer might pay to the marketable minority value can be specified in terms of differences (from the marketable minority level) in expected cash flow, growth, and/or risk. Exhibit 2.12 defines the financial control premium (CPf ) as the difference in value between the financial control value (VEq(fc) ) and the marketable minority value (VEq(mm) ). Several observations regarding the relationship between equity value at the marketable minority and financial control levels of value follow. Referring to Exhibit 2.11 above, application of financial control premiums should be limited to situations in which the hypothetical willing buyer reasonably expects to: ■

■ ■ ■

Increase cash flows relative to normalized cash flows of the enterprise; and/or Increase expected growth of cash flows of the enterprise; and/or Accept a return less than REq(mm) ; and Be willing to share all or a portion of the expected benefits of these items with seller.

If these conditions exist, from a valuation perspective, it might be preferable to model the expected benefits using the discounted cash flow method and value the business directly at the financial control level. The implied financial control premium to the marketable minority level of value could then be calculated.

The Integrated Theory (Equity Basis)

45

In the absence of any of the preceding conditions, the financial control value will be the same as the freely traded, marketable minority value. For example: ■

■

Values derived by applying guideline public company multiples to normalized earnings of privately owned enterprises will approximate financial control values. This assumes, of course, that the public multiples are properly adjusted for fundamental differences in expectations (primarily for risk and growth) between the guideline public companies and the subject private enterprises. The concept of the fundamental adjustment and its role in the Integrated Theory is discussed in Chapter 6. Values derived using a single-period capitalization method and normalized cash flows would also approximate financial control value.

The financial control premium is clearly a range concept. The financial control premium that might be paid for a particular business will vary with potential buyers based on their unique circumstances and the degree of competitive bidding. However, to the extent such a premium exists, it is likely to be modest. We have come a long way catching up to Eric Nath’s startling suggestion in 1990 that the public market multiples of guideline companies yielded controlling interest values.17 Suffice it to say that many valuation analysts, including Mercer, thought this observation was nothing short of heresy.18 The Integrated Theory reconciles

17

Eric W. Nath, “Control Premiums and Minority Interest Discounts in Private Companies,” Business Valuation Review, Vol. 9, No. 2 (1990): pp. 39–46. 18 Z. Christopher Mercer, “Do Public Company (Minority) Transactions Yield Controlling Interest or Minority Interest Pricing Data?” Business Valuation Review, Vol. 9, No. 4 (1990): pp. 123–126. In this article, Mercer charged to the defense of public multiples providing marketable minority value indications. In retrospect, Mercer did not fully appreciate the subtlety, and full implications, of Nath’s argument at the time.

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BUSINESS VALUATION

Nath’s position of control multiples coming from the public markets if the financial control premium is zero. We have defined VEq(fc) from the viewpoint of financial control buyers. The greater the positive differences between VEq(fc) and VEq(mm) , the greater the likelihood that transactions will occur. Nath’s insight was that, given the relatively low number of acquisitions in any year relative to the total number of public companies, the difference, in most instances, must be zero (or not large enough to warrant the interest of financial buyers). This suggested to Nath that public market pricing could reflect both marketable minority and financial control pricing. The conceptual math of the Integrated Theory confirms Nath’s logic. The prevailing consensus among valuation analysts is that financial and strategic control values are different, and a growing recognition that, to the extent they exist, financial control premiums are likely small. The Minority Interest Discount The conceptual difference between the financial control value and the marketable minority value is the financial control premium (see Exhibit 2.12). If that premium is zero (or quite small), it is also true that the corresponding minority interest (or lack of control) discount is zero or quite small. The definition of the minority interest discount is, “A discount for lack of control applicable to a minority interest.”19 Several observations about the relationships between the marketable minority and financial control levels of value are summarized in the following paragraphs. Minority shareholders of public companies lack control, which is vested with management. Yet we have observed (practically as with Nath, and conceptually with the Integrated Theory) that the marketable minority value and the financial control value may approximate each other for most public companies. Otherwise

19 ASA Business Valuation Standards, “Glossary” (American Society of Appraisers, 2009), p. 30. This lack of control discount is theoretically consistent with eliminating a financial control premium.

The Integrated Theory (Equity Basis)

47

there would be strong financial incentive for the takeover of many more public companies. Absent such a level of activity, it is reasonable to assume that the marketable minority and financial control values for most public companies approximate each other. Further, as noted above, minority shareholders of public companies do have a measure of discretion not available to minority owners of private businesses. They can place sell orders for their shares and receive cash, at the marketable minority/financial control value (i.e., at the market price), in three days. The implication of this line of reasoning is that there is no (or very little) discount for lack of control considered in the pricing of public securities. This makes sense because investors in the public markets are not investing to gain control – they invest in companies and expect management and directors to run them in the best interests of the shareholders. Otherwise, the shareholders would exercise the discretion they do have – selling their shares and putting downward pressure on market prices, creating opportunities for takeovers by financial buyers. In addition, observe that at the marketable minority level, all the cash flows of public enterprises are expected to be distributed to the shareholders or reinvested in the enterprises at their discount rates. Share prices are not discounted because minority shareholders do not control or have direct access to enterprise cash flows; because of the liquidity available to them, minority shareholders have access to the capitalized benefit of all expected future cash flows in current market prices. This reasoning suggests that the public securities markets eliminate most, if not all, of any potential discount for lack of control. The logical inference following these observations is that unless there are cash flow-driven differences between the enterprise’s financial control value and its marketable minority value, there will be no (or very little) minority interest discount.20 Market discipline

20

The capital structure of an enterprise may include voting and nonvoting shares. If the vote is perceived to decrease risk somewhat relative to the

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BUSINESS VALUATION

MIDf = 1 −

VEq(mm) VEq(fc)

EXHIBIT 2.13 The Minority Interest Discount.

causes most public companies to be run in reasonable fashion, with cash flows being optimized and either reinvested or distributed to achieve appropriate returns for shareholders. The minority interest discount for a private company will exist only if typical control financial buyers can expect to augment cash flows from their properly normalized levels.21 We defined the financial control premium in Exhibit 2.12. It is based on the difference between financial control and marketable minority values. We define the related minority interest discount from the financial control value (MIDf ) in Exhibit 2.13, also in relationship to those two conceptual values. This expression of the minority interest discount is important in that the discount is based on the differences between two values, a financial control value and a marketable minority value. Assume that VEq(mm) is $100 per share and that VEq(fc) is $105 per nonvoting shares, voting shares may trade at a small premium to nonvoting shares. Stated alternatively, nonvoting shares may trade at small discount to otherwise identical voting shares. 21 These observations are made in relationship to operating companies. The logic of the Integrated Theory suggests that there is no reason for minority interest discounts related to asset-holding entities to be of great magnitude. In practice, we have generally used minority interest discounts in the range of 0% to 10% for many years when valuing asset holding entities. Further, there is market evidence from closed-end funds suggesting that such asset-holding entities often trade at modest discounts to their underlying net asset values. The issue of minority interest discounts seldom arises when valuing operating companies, because most valuation methods, other than comparison with guideline transactions of whole companies, yield marketable minority or financial control level indications of value.

49

The Integrated Theory (Equity Basis)

MID = 1 −

1 1 + CP

EXHIBIT 2.14 The Traditional Minority Interest Discount.

share. According to Exhibit 2.13, the MIDf is 4.8% (i.e., 1 minus $100/$105). If there is no difference in the two values, then there is no minority interest discount. Because we define the minority interest discount relative to the economics of valuation at the marketable minority and financial control levels of value, it exists only to the extent that financial control buyers have different perceptions of the expected cash flows, growth, and risks of a business than do current owners. Both values can be estimated by business valuation analysts with reference to the relevant expectations for cash flow, growth, and risk. Traditionally, the minority interest discount was defined in terms of observed control premiums, as in Exhibit 2.14. Note that the critical difference between the equations for the minority interest discount in Exhibit 2.13 and Exhibit 2.14 is the difference between economics and description: ■

■

22

The definition expressed in terms of the Integrated Theory (Exhibit 2.13) is based on different perceptions of the expected cash flows, growth, and risks of a particular entity from the viewpoint of two different groups of investors. It is economic in nature and can be analyzed by valuation analysts. The traditional definition (Exhibit 2.14) is based on indirect references to averages of control premium studies. But the transactions giving rise to the observed premiums found in various control premium studies are not relevant to the minority interest discount.22

Current versions of the control premium studies relied on by appraisers in previous decades are available. Current versions of sources for control

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BUSINESS VALUATION

The Traditional Measurement of Control Premiums and Minority Interest Discounts We will briefly discuss the traditional measurement of control premiums to provide additional context to our discussion of the minority interest discount. An observed control premium is merely the difference between two prices: the price at which the sale of a public company occurred, and the price at which its shares traded shortly prior to the transaction announcement. This difference can be expressed in dollar terms or as a percentage of the pre-announcement share price. Assume a public company’s price prior to its announced acquisition was $10.00 per share and the acquisition was announced at a price of $14.00 per share. The implied control premium in dollar terms is $4.00 per share ($14.00 minus $10.00). In percentage terms, the control premium is 40.0%. The control premium merely describes the difference between the two prices. ■

■

Refer to Exhibit 2.14. As calculated using the traditional definition, the implied minority interest discount is 28.6%, [1 minus (1/(1 + 40%))]. Valuation analysts relying on observed control premiums to infer the magnitude of the minority interest discount bring no valid valuation information to their conclusions. The 40% control premium, whether an average from studies or a single premium, provides absolutely no information regarding the magnitude of an appropriate minority interest discount for any particular valuation subject.

If, as the Integrated Theory suggests, there is little or no difference between typical marketable minority and financial control values, the use of control premium studies to infer minority interest discounts would overstate the magnitude or existence of any minority interest discounts in typical valuation situations.

premium data include “FactSet Mergerstat Review, 2019,” and “FactSet Mergerstat/BVR Control Premium Study,” an online subscription service, at https://www.bvresources.com/.

The Integrated Theory (Equity Basis)

51

Levels of Value Implications The conceptual analysis thus far suggests that the traditional, three-level chart in Exhibit 2.9 should be refined to reflect the conceptual relationship between the financial control and marketable minority levels of value that we have discussed at length above. The expanded and refined chart is shown in Exhibit 2.15. The expanded and refined chart in Exhibit 2.15 depicts the more negligible difference between the financial control and marketable minority levels of value suggested by our analysis. The strategic control value will be developed to round out the firmwide equity levels of value before proceeding to the shareholder level (nonmarketable minority value). However, we pause to observe that what can be large differences between the firmwide and shareholder levels of value is not attributable to the oft-cited prerogatives of control and the minority interest discount. Buyers of companies do not pay premiums for the right to control the companies. They pay premiums for the expected benefits in terms of enhanced cash flows and their growth and, perhaps, expected reductions in risk.

STRATEGIC CONTROL LEVEL OF VALUE Equation 2.16 introduces the conceptual equation describing the strategic control level of value. As with the other levels, we define the terms in Equation 2.16: VEq(sc) is the value of the equity of a business from the viewpoint of strategic control buyers who expect to achieve unique synergistic or strategic benefits relative to the financial control value (and the marketable minority value). Strategic control value is that perceived by particular buyers, which may not reflect the perspective of typical buyers in the fair market value context. As such, VEq(sc) is generally more akin to investment value than fair market value. The strategic control value is realized by combining the operations of

Control Premium (CP)

Traditional

Expanded and Refined

Control Value

Strategic Control Value

Minority Interest Discount (MID)

Marketable Minority Value Marketability Discount/DLOM

Nonmarketable Minority Value

Strategic Control Premium

Financial Control Premium (FCP)

Financial Control Value Marketable Minority Value Marketability Discount/DLOM

Nonmarketable Minority Value

EXHIBIT 2.15 Traditional Levels of Value Chart as Expanded and Refined.

Minority Interest Discount (MID)

53

The Integrated Theory (Equity Basis)

VEq(sc) =

CFEq(sc) REq(sc) − GCF Eq(sc)

EXHIBIT 2.16 Strategic Control Level of Value.

the subject business with the legacy operations of the strategic acquirer. CFEq(sc) is the equity cash flow from the viewpoint of strategic control buyers. As with CFEq(fc) , the first step in developing CFEq(sc) is to normalize earnings to derive CFEq(mm) . Additional adjustments may then be appropriate to reflect: ■ Improvements that typical financial buyers might expect to make by running the company better (to derive CFEq(fc) ); ■ Expected synergies (generally related to cost reductions); and/or ■ Expected strategic benefits (e.g., from selling more of the acquirer’s products through the target’s existing distribution channels). In other words, in addition to expectations of running the existing company more efficiently, strategic control buyers may take into consideration expected benefits related to adding the company to the buyer’s existing portfolio. REq(sc) is the equity discount rate of potential strategic buyers.23 REq(sc) can be lower than REq(mm) or REq(fc) for at least two reasons. First, many strategic buyers are considerably larger in size than the companies they acquire, and therefore have lower costs of capital than their smaller targets

23 As will be discussed in Chapter 6, strategic buyers normally make acquisition decisions based on their weighted average costs of capital (reflecting the cost of both debt and equity capital). Nevertheless, the conceptual discussion of their equity discount rates is relevant here.

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BUSINESS VALUATION

(see Chapter 6).24 Second, other strategic acquirers may expect business risk to decrease as the result of a strategic combination, and therefore be willing to accept a lower expected return. GCF Eq(sc) is the expected growth rate of cash flow for the strategic control buyer. In addition to the static (one-time) cash flow benefits from a transaction, strategic buyers may anticipate dynamic, or ongoing, cash flow benefits in the form of enhanced growth. In other words, expected synergies can impact both the level of cash flow (CFEq(sc) ) and the expected future growth of those cash flows. The conceptual model of the Integrated Theory now includes the strategic control level of value. It builds on the base created by the other two firmwide levels, marketable minority and financial control. The relationship between the three firmwide levels of value is illustrated in Exhibit 2.17. The strategic control value will be greater than the marketable minority (and financial control) value if one or more of the following conditions hold: CFEq(sc) is greater than CFEq(mm) . We use the marketable minority level as the base from which we define the strategic control value. Strategic buyers expect to achieve synergies or strategic benefits unavailable to financial control buyers. However, a lone strategic buyer has no incentive to pay any more than necessary to outbid the most aggressive financial buyer.25 In other words, there may be a considerable

24 Whether strategic buyers should give benefit to their lower costs of capital in strategic acquisitions is a separate question. However, if the market consists of numerous, competing strategic buyers, some or all of that benefit may be transferred to the seller. 25 Mr. Gilbert A Matthews, CFA, an investment banker with a long and distinguished career, made this observation years ago. He said that a sole strategic buyer would not pay “more than the proverbial one dollar more”

The Integrated Theory (Equity Basis)

55

difference in what a particular strategic buyer is able to pay and what that buyer is willing to pay in an acquisition. GEq CF(sc) is greater than GEq CF(mm) . If a strategic control buyer expects to augment the future growth of cash flows and will share that benefit with the seller, then strategic control value can exceed the financial control or marketable minority levels. REq(sc) is less than REq(fc) . If a strategic buyer considers its own cost of equity, which may be lower than that of a target, in pricing an acquisition, strategic control value can exceed the other firmwide levels. If a strategic control buyer is willing to consider expected cash flow enhancements (whether static increases in magnitude or dynamic increases in growth from that new level) and its own lower discount rate in pricing an acquisition, VEq(sc) can be substantially higher than VEq(mm) . If multiple strategic buyers are seeking to acquire the same business, then strategic value is more likely to be achieved by that seller, and pricing can sometimes seem almost irrational.26

Strategic Control Premium The premium that a strategic control buyer might pay (CPs ) relative to the marketable minority value can now be defined. We specify the premium in this way because there is no observable market for financial control values (unless, of course, we are correct than the best-situated financial buyers. The conceptual analysis presented here should confirm the relevance of this observation in the context of fair market value determinations. 26 Mercer has often said in speeches that there are three kinds of buyers of businesses: financial buyers, strategic buyers, and irrational buyers. What every seller wants to find is an irrational buyer. Unfortunately, when they are really needed, they are hard to find. However, fair market value is a rational concept, not an irrational one. Appraisers need to keep these concepts in mind when determining fair market value at the financial control level.

Conceptual Math

Strategic Control (Equity Basis)

Financial Control (Equity Basis)

Marketable Minority Value (Equity Basis)

CFEq(sc) REq(sc) – GCF Eq(sc)

CFEq(fc) REq(fc) – GCF Eq(fc)

CFEq(mm) REq(mm) – GCF Eq(mm)

Relationships

Value Implications

CFEq(sc) ≥ CFEq(mm) GCF Eq(sc) ≥ GCF Eq(mm)

VEq(sc) ≥ VEq(mm)

REq(sc) ≤ REq(mm)

CFEq(fc) ≥ CFEq(mm) GCF Eq(fc) ≥ GCF Eq(mm)

VEq(fc) ≥ VEq(mm)

REq(fc) ≈ REq(mm)

GCF Eq(mm) = REq(mm) –

EXHIBIT 2.17 The Three Firmwide Levels of Value Summarized.

CFEq(mm) VEq(mm)

VEq(mm) is the benchmark for the other equity levels of value ("as-if-freely-traded")

57

The Integrated Theory (Equity Basis)

CPs =

VEq(sc) − VEq(mm) VEq(mm)

EXHIBIT 2.18 The Strategic Control Premium.

in concluding that public companies are trading at prices largely indistinguishable their financial control values).27 Note that this premium includes any financial control premium. CPs is specified in Exhibit 2.18. The strategic control premium is the excess of strategic control equity value over the marketable minority equity value as a percentage of the marketable minority equity value. Strategic control premiums exist only if one or more of the following conditions hold: ■

■

■

■

■

The strategic buyer expects to be able to enhance cash flows from the normalized, marketable minority level. The strategic buyer is willing to accept a lower return than that available at the marketable minority level. There is a single, motivated strategic buyer who is willing to share the expected synergistic or strategic benefits with a seller.28 There are multiple strategic buyers who will compete in a bidding process. Elements of motivation or irrationality enter into the bidding process.

27 We can observe the net pricing of private companies in the acquisition markets; however, the marketable minority base is not observable, and therefore the extent of any control premium cannot be observed directly. 28 Note that owners that are not particularly motivated to sell may be able to extract some or all of any potential strategic control premium if there is only a single strategic buyer – if that buyer is motivated and the subject business is unique.

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BUSINESS VALUATION

For public companies, the marketable minority value is the base from which strategic control prices are negotiated. In reality, prices are negotiated between public buyers and sellers. The observed strategic control premium is merely the difference between the price negotiated for the buyer and the previously observed (marketable minority) trading price. Recall the preceding discussion of control premiums and minority interest discounts. Private company transactions tend to be negotiated directly, because there is no observable freely traded value to serve as a base. These same principles are manifest, however, within negotiated private company transactions. Having developed the strategic control premium, we can briefly discuss the discount that would translate strategic control value to marketable minority value. Note that no name has been given to the difference between the strategic control and financial control levels of Exhibit 2.15. No name has been given to this difference in the valuation literature because it is just that, a difference between two values, and it has no valuation implications not captured in the economics of developing value at the strategic control level.

FIRMWIDE LEVELS VERSUS THE SHAREHOLDER LEVEL OF VALUE Thus far, three firmwide levels of value – marketable minority, financial control, and strategic control – have been addressed. We call these conceptual levels firmwide levels because each is determined on the basis of (potentially) differing market perceptions and valuations of the equity cash flows of businesses as a whole. As illustrated repeatedly in this chapter, the fundamental valuation model posits that value is a function of the expected cash flows of the businesses, all of which are available for distribution or for reinvestment.29

29 We will reconcile any apparent inconsistencies in referring to the marketable minority level of value as a firmwide level of value in more detail in Chapter 4.

59

The Integrated Theory (Equity Basis)

Strategic Control Value Firmwide Equity Levels of Value

Financial Control Value

Value is a function of the expected cash flows to equity of businesses (as well as the expected risks and growth associated with those cash flows). Value at the firmwide level is a perpetuity concept, with cash flows projected (or capitalized) into perpetuity

Marketable Minority Value Shareholder Level of Value (Equity Basis)

Nonmarketable Minority Value

Value is a function of the cash flows expected by shareholders from their ownership interests in businesses. Shareholder cash flows are derived from the businesses, but except in cases of fully distributing enterprises, will be less than firmwide equity cash flows. Value is a function of these shareholder level cash flows, the risks associated with them, and their expected growth over relevant expected and finite holding periods

EXHIBIT 2.19 Firmwide Levels of Value Relative to the Shareholder Level of Value: Equity Basis.

The fourth conceptual level of value is the nonmarketable minority level, or the lowest level in Exhibit 2.19 above. In contrast to a firmwide level of value, this level can be referred to as the shareholder level of value. Value to a shareholder is determined based on the expectation of cash flows to the shareholder, the expected growth of those cash flows, and the risks associated with those cash flows over a relevant investment or holding period. This important distinction is, unfortunately, often overlooked by business valuation analysts. For years, valuation analysts have called the difference between the marketable minority and nonmarketable minority levels of value the marketability discount, or the discount for lack of marketability. The marketability discount is defined in the ASA Business Valuation Standards as:30

30

ASA Business Valuation Standards, page 26.

60

BUSINESS VALUATION

An amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability. We now proceed to discuss the nonmarketable minority level of value and the associated marketability discount.

THE NONMARKETABLE MINORITY LEVEL OF VALUE Exhibit 2.20 introduces the conceptual math describing the shareholder – or nonmarketable minority – level of value. As with the other levels of value, we define the terms in the conceptual definition of value at the nonmarketable minority level. Vsh is the value of minority equity interest in a business that lacks an active market for its shares. Value is expressed from the viewpoint of the shareholder, or other owner of the interest (hence the subscript, “sh”). We use the same notation for partnerships and limited liability entities. Valuation analysts typically develop indications of value at this level by subtracting a marketability discount from a marketable minority interest value. As we will see, however, the marketability discount is not something that has any independent existence. This discount merely describes the difference between two values, one at the marketable minority level of value and the other at the nonmarketable minority level of value. CFsh is the portion of the firmwide equity cash flows expected to be received pro rata by the shareholders, including both interim distributions and any expected terminal value. CFsh is a symbolic notation to describe all expected interim cash flows and any expected terminal value at the end of the holding period for the investment. In other words, Equation 2.20 cannot be used literally to determine the value of a nonmarketable minority business interest. Actual notation for the two-stage, shareholder level DCF model can be shown as in Exhibit 2.21. The left portion of the equation represents the present value of interim cash flows for a finite expected holding period ending in year f. The right portion of the equation represents the present value of the terminal value, which is the marketable minority value at the end of year f.

61

The Integrated Theory (Equity Basis)

Vsh =

CFsh Rhp − Gv

EXHIBIT 2.20 Nonmarketable Minority (Shareholder) Level of Value.

[ Vsh =

CFsh,1 (1+Rhp

)1

+

CFsh,2 (1+Rhp

)2

+

CFsh,3 (1+Rhp

)3

+···+

Present Value of Interim Cash Flows (PVICF) Interim “Economic Distributions” to Shareholders Discounted to Present at Rhp

]

CFsh,f (1+Rhp

)f

⎡ +⎢ ⎢ ⎣

(

CFEq(mm),f+1 REq(mm) −GCF Eq(mm) (1+Rhp )f

)

⎤ ⎥ ⎥ ⎦

PV of Terminal Value (PVTV) Veq(mm),f – Marketable Minority Value Discounted to Present at Rhp

EXHIBIT 2.21 Shareholder Level Discounted Cash Flow Model.

Rhp is the discount rate of the minority investor in a nonmarketable equity security for the expected holding period, or the required holding period return. The concept of holding period risk is discussed in more detail in the context of the Quantitative Marketability Discount Model (QMDM) in Chapter 9. The holding period concept is important, because illiquid minority investments in business enterprises are made for finite expected holding periods, which must be estimated by valuation analysts. Logic suggests that Rhp will be equal to or greater than REq(mm) . This required return can be stated symbolically as in Equation 2.22, where HPP is the indicated holding period premium. Note that if HPP is equal to zero, meaning there are no expected holding period risks, as with a liquid, publicly traded security, then Rhp is equal to REq(mm) . Gv is the expected growth rate in value of the enterprise over the finite expected holding period of the illiquid investment. This growth rate yields the terminal value of the enterprise at the end of

62

BUSINESS VALUATION

Rhp = REq(mm) + HPP

EXHIBIT 2.22 The Required Holding Period Return. the expected holding period for the investment. In other words, Gv is applicable only for the expected holding period of an investment. In the absence of any expected non–pro rata distributions or suboptimal reinvestment, the expected growth rate in value is equal to REq(mm) less the dividend yield. If not all enterprise cash flows are distributed to, or reinvested for the benefit of minority shareholders (if, for example, above-market compensation is paid to a controlling shareholder), then Gv will be less than REq(mm) (adjusted for the dividend yield). The same result will occur if a company’s expected reinvestment rate is less than its discount rate (e.g., as with the accumulation of low-yielding cash assets, vacation homes, or other assets providing no yield or a yield less than the discount rate). Firmwide valuation is a perpetuity concept. Value today is the present value of all expected future cash flows attributable to an enterprise (into perpetuity) discounted to the present at an appropriate discount rate. In contrast, shareholder level values depend on expected holding periods. Investors expect finite holding periods, even if the holding period cannot be known with precision. The expected growth in value is the means of estimating the future exit value of a nonmarketable investment. We now have a conceptual model to describe the nonmarketable minority level of value. The model anticipates that valuation analysts will initially develop indications of value at the marketable minority level of value. In so doing, we develop a thorough understanding of the expected firmwide equity cash flows, expected growth, and risk. Grounded in this analysis, valuation analysts can then assess the expected benefits to be derived by the minority shareholder of the enterprise.31 We will further develop this 31

Forecasting shareholder cash flows is analogous to forecasting firmwide cash flows for the business, an essential task in any valuation. There is an

The Integrated Theory (Equity Basis)

63

conceptual model in Chapter 9. These relationships are symbolized in Exhibit 2.23. Relying on the framework presented in Exhibit 2.23, we can analyze the conceptual differences between the marketable minority and nonmarketable minority levels of value. The nonmarketable minority value, or value to the shareholder Vsh , will be less than the marketable minority value, or VEq(mm) if, all else equal, one or more of the following conditions hold: ■

■

■

CFsh is less than CFEq(mm) . The expected shareholder cash flows will be less than the expected firmwide equity cash flows if the firm’s cash flows are distributed on a non–pro rata basis to certain shareholders.32 GV is less than REq(mm) . The expected growth rate in value is a function of expected reinvestment of enterprise cash flows. If the reinvestment rate is equal to the discount rate, then GV will be equal to the discount rate, or REq(mm) (adjusted for dividend yield). To the extent that cash flows are distributed on a non–pro rata basis or are reinvested suboptimally (at rates less than the discount rate), then GV will be less than Requity , resulting in a lower expected terminal value and lower nonmarketable minority value.33 Rhp is greater than Requity . The owner of an illiquid asset bears greater risk than the owner of an otherwise identical asset with

implicit forecast in any firmwide valuation, and in the application of any marketability discount. The Integrated Theory makes that forecast explicit. 32 Recall that the benchmark marketable minority value is determined under the assumption that all cash flows are paid out to shareholders pro rata or reinvested in the enterprise to achieve a return equal to the discount rate. After estimates of reinvestments of future cash flows are made, valuation analysts can then estimate CFsh , which may be less than the firmwide equity cash flow if a portion of those cash flows are diverted to select shareholders on a non–pro rata basis. 33 Note that the expectation of suboptimal reinvestment, and the accompanying reduction of expected growth in value, impact both controlling and noncontrolling shareholders. The difference between the two situations is

Conceptual Math

Marketable Minority Value (Equity Basis)

Nonmarketable Minority Value (Equity Basis)

CFEq(mm) REq(mm) – GCF Eq(mm)

CFsh Rhp – Gv

Relationships

GCF Eq(mm) = REq(mm) –

Value Implications

CFEq(mm) VEq(mm)

VEq(mm) is the benchmark for the other equity levels of value ("as-if-freely-traded")

CFsh ≤ CFEq(mm) Gv ≤ (REq(mm) – Dividend Yield)

Vsh ≤ VEq(mm)

Rhp ≥ REq(mm)

EXHIBIT 2.23 Comparison between the Benchmark Marketable Minority and Nonmarketable Minority Levels of Value: Equity Basis.

The Integrated Theory (Equity Basis)

65

an active, public market. We refer to the compensation necessary for an investor to accept this incremental risk as the holding period premium, or HPP. HPP accounts for numerous risks, including the potential for a long and indeterminate holding period and other risks that flow from the holding period or from the factual situation in any valuation. Other things being equal, greater risk implies lower value. Since the HPP cannot be directly observed for investments in private companies, it must be estimated. As demonstrated in Chapter 8, the observable restricted stock discounts confirm the existence of HPP. We discuss methods for estimating this important premium in Chapter 10. We have clarified the circumstances under which the nonmarketable minority value will be less than the marketable minority value. We now examine the marketability discount, which is the name given to the difference between these two conceptual equity values.

The Marketability Discount The marketability discount (MD) that investors demand when purchasing nonmarketable minority interests in enterprises is defined in Equation 2.24. The marketability discount we refer to is identical to what other valuation analysts call the discount for lack of marketability (DLOM). Exhibit 2.24 defines the marketability discount with reference to the relationship between two values, VEq(mm) , or the value of the equity of a business at the marketable minority level of value, and Vsh , or the value of an illiquid interest in a business. This is analogous to the derivation of the minority interest discount, the financial that the controlling shareholder can change the reinvestment and/or distribution policies in order to maximize value while the noncontrolling shareholder cannot make those changes. Said another way, the value, today, of a business to a controlling shareholder can exceed the value of the expected business plan.

66

BUSINESS VALUATION

MD = 1 −

Vsh VEq(mm)

EXHIBIT 2.24 The Marketability Discount.

control premium, and the strategic control premium. Conceptually, this equation confirms that if the shareholder level value (Vsh ) is equal to the marketable minority value (VEq(mm) ), then there is no marketability discount. Assume both values are equal to $10.00 per share. The equation calculates to a 0% marketability discount (1 minus $10.00/$10.00 equals zero). Valuation analysts and owners of nonmarketable securities should consider each source of potentially diminished value at the nonmarketable minority level of value: 1. Cash flow to the shareholder (CFsh ) less than that of the company as a whole (CFEq(mm) ) 2. Expected growth in value less than the discount rate (adjusted for dividend yield) 3. Incremental risks associated with illiquidity during the expected holding period In some cases, the appropriate marketability discounts can be large. In other cases, however, as with fully distributing entities, or in cases where the expected growth rate in value is relatively high and holding period risks are not significant, the appropriate marketability discounts can be small. Conceptually, the marketability discount is unrelated to the presence or absence of the prerogatives of control. The marketability discount reflects, rather, differences between the expected firmwide equity cash flows and those to shareholders, expected growth in value less than the cost of equity on a marketable minority interest basis (adjusted for dividends), and holding period risks in excess of the risks associated with the enterprise.

The Integrated Theory (Equity Basis)

67

Note that the minority investor in a public company has no more direct control over the enterprise than does the minority investor in a private company. However, as previously noted, the public minority shareholder does have an important measure of discretion that the private minority shareholder lacks. He has the ability to sell his investment and receive cash in three days through the public securities markets at the marketable minority level (the present value of all expected firmwide equity cash flows).

THE INTEGRATED THEORY OF BUSINESS VALUATION ON AN EQUITY BASIS We have now examined the four conceptual levels of value in depth. Exhibit 2.25 incorporates all four levels into a single chart to present the conceptual math of the levels of value and summarizes the Integrated Theory of Business Valuation on an equity basis.

SUMMARY The Integrated Theory, as presented on an equity basis, accomplishes several objectives. It enables business valuation analysts to: ■

■

■

■

Explain each level of value in the context of financial and valuation theory. Define the conceptual adjustments relating the various levels of value in terms of that theory. Specifically, the financial control premium and the related minority interest discount, the strategic control premium, and the marketability discount have been defined in financial, economic, and behavioral terms. Explain the pricing behavior observed in public and nonpublic markets for equity interests. Understand the value of control and, conversely, the economic consequences of lack of control. Specifically, it clarifies that a nonmarketable minority interest in a business is worth less than

Conceptual Math Firmwide Levels of Value

CFEq(sc)

Strategic Control (Equity Basis)

REq(sc) – GCF Eq(sc)

Financial Control (Equity Basis)

REq(fc) – GCF Eq(fc)

Marketable Minority Value (Equity Basis)

REq(mm) – GCF Eq(mm)

The Shareholder Level of Value Nonmarketable Minority Value (Equity Basis)

CFEq(fc)

CFEq(mm)

CFsh Rhp – Gv

Relationships

Value Implications

CFEq(sc) ≥ CFEq(mm) GCF Eq(sc) ≥ GCF Eq(mm)

VEq(sc) ≥ VEq(mm)

REq(sc) ≤ REq(mm) CFEq(fc) ≥ CFEq(mm) GCF Eq(fc) ≥ GCF Eq(mm)

VEq(fc) ≥ VEq(mm)

REq(fc) ≈ REq(mm)

GCF Eq(mm) = REq(mm) –

CFEq(mm) VEq(mm)

VEq(mm) is the benchmark for the other equity levels of value ("as-if-freely-traded")

CFsh ≤ CFEq(mm) Gv ≤ (REq(mm) – Dividend Yield) Rhp ≥ REq(mm)

EXHIBIT 2.25 The Integrated Theory on an Equity Basis Summarized.

Vsh ≤ VEq(mm)

The Integrated Theory (Equity Basis)

■

69

its actual or hypothetical marketable minority value not because of the inability to control the enterprise, but rather because of the lack of marketability. Confirm Eric Nath’s observation in 1990 that the public market pricing of securities offers, at least in many instances, a controlling interest level of pricing. The Integrated Theory on an equity basis does not, however, confirm Nath’s conclusion that valuation analysts should apply both minority interest and marketability discounts from the publicly traded/financial control price to arrive at the nonmarketable minority level of value. There is no incentive for financial buyers to exercise control over well-managed public companies to achieve greater earnings and value. In other words, as Nath suggests, the implied minority interest discount is in the typical case equal to zero. As a result, the Integrated Theory suggests that valuation analysts need apply only a marketability discount to guideline public company indications to derive valuation conclusions on a nonmarketable minority interest basis.

CHAPTER

3

The Integrated Theory (Enterprise Basis)

INTRODUCTION In Chapter 2, we developed the Integrated Theory on an equity basis. The equity basis deals with cash flows to equity owners. The marketable minority level of value is the base level from which other levels are developed. Four conceptual levels of value were developed. On an enterprise basis, there are only three conceptual levels of value in the Integrated Theory. As with the equity basis, the beginning point is the marketable minority level of value. The conceptual math for the marketable minority level is shown in Exhibit 3.1 for both the equity basis and the enterprise basis. The conceptual math in Exhibit 3.1 uses the subscript “Eq(mm)” to denote the components of the Integrated Theory on an equity basis at the marketable minority level of value. The conceptual math for the enterprise basis uses the subscript “Ent(mm)” to denote the marketable minority level of value. Exhibit 3.2 defines the components for both the equity basis and the enterprise basis.

71 Business Valuation, First Edition. Z. Christopher Mercer and Travis W. Harms. © 2021 Z. Christopher Mercer and Travis W. Harms. Published 2021 by John Wiley & Sons, Inc.

72

BUSINESS VALUATION Equity Basis VEq(mm) =

CFEq(mm) REq(mm) – GCF Eq(mm)

Integrated Theory Enterprise Basis VEnt(mm) =

CFEnt(mm) REnt(mm) – GCF Ent(mm)

EXHIBIT 3.1 The Fundamental Valuation Model. Equity Basis

Enterprise Basis

VEq (mm)

Value from perspective of equity holders (Market Value of Equity)

VEnt (mm)

Value from perspective of equity and debt holders (Enterprise Value, or Market Value of Equity plus net debt)

CFEq (mm)

Cash flow to holders of equity (net income or net cash flow)

CFEnt (mm)

Cash flow to holders of equity and debt (debt-free net cash flow or debt-free net income)

REq (mm)

Equity discount rate

REnt (mm)

Weighted average cost of capital (WACC)

GCF Eq (mm)

Long-term expected growth rate in cash flow to equity (includes impact of leverage on growth rate)

GCF Ent (mm)

Expected growth rate in unleveraged (debt-free) cash flows.

EXHIBIT 3.2 Comparison of Valuation Components. The conceptual math for all levels of value for both the equity and enterprise bases will be compared later in this chapter. For now, we focus on the marketable minority level of value. The differences between the Integrated Theory on an equity basis and on an enterprise basis can be seen in Exhibit 3.2. The differences pertain to their perspectives on value. The equity basis provides the market value of equity. The enterprise basis provides enterprise value, inclusive of net debt (i.e., total debt less cash).

The Integrated Theory (Enterprise Basis)

73

Over the past decade or so, business appraisers and market participants have begun to shift the focus of their value estimates from the equity basis to the enterprise basis. Therefore, it is necessary to develop the Integrated Theory on an enterprise basis, as well.

COMPARING THE LEVELS OF VALUE: EQUITY AND ENTERPRISE BASES We compare the conceptual levels of value of the Integrated Theory on an equity basis (left) and an enterprise basis (right) in Exhibit 3.3. This section will address the equity basis and set up a numeric example to illustrate the levels of value in numeric and conceptual terms. The example will continue to the next section when we will address the Integrated Theory on an enterprise basis.

The Equity Basis There are, as shown in Chapter 2, four conceptual levels of value on an equity basis on the left of Exhibit 3.3. There are four conceptual adjustments between the levels of value there: ■

■

Marketability Discount. To adjust from the marketable minority level of value to the nonmarketable minority level. The reasons for this adjustment relate to differences in expected cash flows, their growth, and their risks between these two levels. FCP (Financial Control Premium). The FCP is a potential adjustment between the marketable minority and financial control equity levels. To the extent that it is present, this adjustment reflects differences in expected cash flows, their growth and their risks between these two levels.

74

BUSINESS VALUATION

Levels of Value Based on Enterprise Values

Levels of Value Based on Equity Values

$320 Million

Strategic (Synergistic) Level of Value (Enterprise Basis)

SCP* = $80 Million (33.3% SCP)

$280 Million

0% FCP and $0

Strategic (Synergistic) Level of Value (Equity Basis)

Financial Control Level (Enterprise Basis)

$240 Million

FCP*

Financial Control Level (Equity Basis)

$200 Million

$40 Million Shift (plus $60 Million of Debt and minus $20 Million of Cash)

$0 MID and 0% MID

*Financial Control and Strategic Control Premiums on an enterprise basis are identical to the corresponding equity premiums in dollar amounts

FCP MID $200 Million

MARKETABLE MINORITY LEVEL BASE LEVEL OF VALUE (Equity Basis)

MARKETABLE MINORITY LEVEL BASE LEVEL OF VALUE (Enterprise Basis)

$240 Million

SCP = $80 Million (40% SCP)

Firmwide Levels of Value Shareholder Level of Value * Marketability Discount = $50 million (25% DLOM)

$150 Million

Nonmarketable Minority Level (Equity Basis)

There is no Nonmarketable Minority Level at the Enterprise Level

EXHIBIT 3.3 Comparison of the Conceptual Levels of Value: Equity and Enterprise Bases.

■

■

MID (Minority Interest Discount). The MID is the inverse of the FCP and is the result of the same differences noted regarding the FCP. SCP (Strategic Control Premium). The SCP is the conceptual adjustment between the financial control and the strategic control levels of value. The reasons for this adjustment, once again, are differences in expected cash flows, growth, and risk between the two control levels of value on the equity side of Exhibit 3.3.

The Integrated Theory (Enterprise Basis)

75

Each of these premiums and discounts can be expressed in absolute dollar terms or in percentage terms. Assume the following for a hypothetical company: ■

■ ■ ■

■

Marketable Minority Value equals $200 million, which is coincident with Financial Control Value of equity of $200 million. Total debt is equal to $60 million. Cash is equal to $20 million. Strategic Control Value of equity based on an announced transaction is $280 million. The Nonmarketable Minority Value is $150 million.

The Financial Control Premium can be expressed as $0 (financial control value minus marketable minority value, or $200 million minus $200 million), or as 0% (the $0 difference divided by the $200 million marketable minority base value). The Minority Interest Discount is correspondingly $0, or 0%. The Strategic Control Premium is 40% ($280 million / $200 million minus 1), or $80 million ($280 million minus $200 million). The marketability discount is represented by the difference in value at the marketable minority and nonmarketable minority levels of value and is $50 million ($200 million minus $150 million). The marketability discount (or discount for lack of marketability is therefore 25% ($150 million / $200 million minus 1). Each of the preceding values and premiums and discounts are reflected on the left side of Exhibit 3.3.

The Enterprise Basis We continue to refer to Exhibit 3.3 above to discuss the levels of value on an enterprise basis, but now we look at the right side of the figure. First, however, look at the line crossing both the equity and enterprise portions of the figure. Above the line, the levels of

76

BUSINESS VALUATION

value are all firmwide levels and their values, either conceptually or in practice, are based on expectations for 100% of firmwide cash flows and risks. The nonmarketable minority level of value on the equity (left) side of Exhibit 3.3 is referred to as the shareholder level of value. There is no nonmarketable minority level of value on an enterprise basis, since this basis considers all of the cash flows of the enterprise, both to equity holders and to debt holders. Refer again to Exhibit 3.3. Visually, the levels of value shift upward to move from an equity basis on the left to an enterprise basis on the right. How large is the shift? The net debt of an enterprise (total debt less cash) is added to its marketable minority value on an equity basis to move to the marketable minority value on an enterprise basis. Corresponding additions are made at each of the control levels, and the entire levels of value chart shifts accordingly. Continuing the example from above, we can observe the following based on the conceptual chart at the right of Exhibit 3.3 on an enterprise basis: ■

■

■

The marketable minority value on an equity basis is $200 million. To achieve the marketable minority value on an enterprise basis, we add total debt ($60 million) and subtract cash ($20 million), to conclude that marketable minority value on an enterprise basis is $240 million. Since there is no financial control premium, the financial control value is also $240 million. To this marketable minority and financial control level of $240 million, the observed strategic control premium (equity) of $80 million is added, yielding a strategic control value of $320 million. Note that this is the same $80 million control premium that was observed on an equity basis on the left. The strategic control premium on an enterprise basis, however, is 33.3%

The Integrated Theory (Enterprise Basis)

77

because it is calculated from the enterprise basis marketable minority and financial control value of $240 million, rather than the marketable minority equity value of $200 million.1 The strategic control premium at the enterprise level is the same in dollar terms as the corresponding premium on an equity basis. The percentage strategic control premium will be lower to the extent that there is positive net debt at the enterprise level. The same concept holds at the financial control level.

FINAL COMPARISONS OF THE EQUITY AND ENTERPRISE BASES In this section, we reproduce the conceptual math of the firmwide levels of value on an equity basis from Chapter 2 with the conceptual math of the integrated theory on an enterprise basis. The rationale for each of the differences on an enterprise basis of value remain the same as discussed in Chapter 2: differences in expected cash flows, growth, and risk relative to the other levels of value. The conceptual math at the enterprise levels of value is provided in Exhibit 3.4. The conceptual math begins at the marketable minority level of value at the lower left of the exhibit, which repeats the same version of the fundamental valuation formula as shown in Exhibit 3.1. 1

This observation of the equality of strategic control premiums in dollar terms on an equity basis and an enterprise basis is made clear in Valuations in Financial Reporting Valuation Advisory 3: The Measurement and Application of Market Participant Acquisition Premiums (Washington, D.C., The Appraisal Foundation, 2017). In this publication, the strategic control premium of this chapter is referred to as the market participant acquisition premium (MPAP). Like the strategic control premium, the MPAP is caused by differing expectations of strategic acquirers regarding expected future cash flows, growth, and risk relative to pre-acquisition pricing.

Conceptual Math

Strategic Control (Enterprise Basis)

Financial Control (Enterprise Basis)

Marketable Minority (Enterprise Basis)

CFEnt(sc) REnt(sc) – GCF Ent(sc)

CFEnt(fc) REnt(fc) – GCF Ent(fc)

CFEnt(mm) REnt(mm) – GCF Ent(mm)

Relationships

Value Implications

CFEnt(sc) ≥ CFEnt(mm) GCF Ent(sc) ≥ GCF Ent(mm)

VEnt(sc) ≥ VEnt(mm)

REnt(sc) ≤ REnt(mm) CFEnt(fc) ≥ CFEnt(mm) GCF Ent(fc) ≥ GCF Ent(mm)

VEnt(fc) ≥ VEnt(mm)

REnt(fc) ≈ REnt(mm)

GCF Ent(mm) = REnt(mm) –

EXHIBIT 3.4 The Integrated Theory at the Enterprise Level.

CFEnt(mm) VEnt(mm)

VEnt(mm) is the benchmark for the other equity levels of value ("as-if-freely-traded")

The Integrated Theory (Enterprise Basis)

79

SUMMARY We have extended the Integrated Theory to the enterprise basis of value to reflect the growing use of enterprise valuation methods by valuation analysts and market participants. Our discussion in this chapter has moved from the equity value to the enterprise value (i.e., from left to right in Exhibit 3.3). We did so because we have previously described the Integrated Theory in the context of equity values in Chapter 2. As will become evident in the next section of this book, the movement in the real world is in the opposite direction. Market participants determine the value of operating businesses with reference to enterprise cash flows and the weighted average cost of capital. In other words, the enterprise value comes first. Then, firmwide equity value is a residual concept. In the next section of this book, our focus will be on applying the Integrated Theory in the context of the income and market approaches to value on an enterprise basis.

PART

Two

Valuing Enterprise Cash Flows n Part One of the book, we described the Integrated Theory conceptually. Our discussion was rooted in careful definitions of cash flow, risk, and growth at the various levels of value. In Part Two, we take a more practical turn, exploring how the conceptual framework of the Integrated Theory manifests itself in the primary methods analysts use to derive indications of value for the business as a whole.

I

■

■

■

In Chapter 4, we examine how valuation analysts calculate enterprise cash flows for use in the income approach. In terms of our three fundamental valuation factors, our focus in this chapter will be on cash flow and growth. Our attention in Chapter 5 turns to risk, specifically how market participants assign and quantify risk in deriving the discount rates used in the income approach. Chapter 6 addresses the guideline public company method under the market approach. Using the conceptual framework provided by the Integrated Theory, we explain how to draw proper analogies between the cash flow, risk, and growth

81 Business Valuation, First Edition. Z. Christopher Mercer and Travis W. Harms. © 2021 Z. Christopher Mercer and Travis W. Harms. Published 2021 by John Wiley & Sons, Inc.

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■

BUSINESS VALUATION

attributes of the subject enterprise and those same attributes of the selected guideline companies. This section closes with Chapter 7, in which we consider the unique challenges market participants face when confronted with guideline transaction data. Specifically, we will address what guideline transaction data does and does not tell us about how the transacting parties were evaluating the cash flow, risk, and growth attributes of the target company.

CHAPTER

4

Income Approach (Cash Flows)

INTRODUCTION The conceptual math used to define the Integrated Theory is presented in the form of a single-period capitalization method under the income approach, so it is natural that we start this section on the practical application of the Integrated Theory with two chapters on the income approach. Before addressing discount rates in Chapter 5, our focus in this chapter will be on estimating and projecting cash flows. The specific questions that we will address in this chapter include the following: 1. How do the single-period capitalization and discounted cash flow methods relate to one another? What distinguishes the models from each other? Are they fundamentally different? How do market participants assess which is the “right” model to use? 2. What are the components of enterprise cash flows? What are the reconciling steps from “income” to cash flow? What are common pitfalls in defining enterprise cash flows?

83 Business Valuation, First Edition. Z. Christopher Mercer and Travis W. Harms. © 2021 Z. Christopher Mercer and Travis W. Harms. Published 2021 by John Wiley & Sons, Inc.

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BUSINESS VALUATION

3. What are the components of equity cash flows? Why are equity and enterprise cash flows different? Does the selection of an equity or enterprise basis for estimating cash flows cause the resulting valuation conclusion to be higher or lower? 4. How do management decisions regarding reinvestment interact with projections for cash flow growth (both interim and terminal)? What are the implications of assumed reinvestment at rates of return above or below the weighted average cost of capital? 5. How do market participants evaluate terminal growth rates? What evidence, if any, is available from market transactions to permit analysts to observe market participant expectations with regard to terminal growth rates? 6. When transitioning from observable, historical cash flows for the subject enterprise to projected cash flows at the marketable minority interest level, what normalizing adjustments are appropriate? Are normalizing adjustments optional or essential to deriving reasonable indications of value? 7. At the financial control level of value, what cash flow adjustments do market participants typically consider? What is the relationship between such adjustments and observed acquisition premiums? 8. Finally, what cash flow adjustments are appropriate at the strategic control level of value? What is the relevance of acquisition premium data in evaluating the reasonableness of such adjustments? 9. How can analysts better assess the overall reasonableness of cash flow forecasts? What are the significant reference points that market participants use to avoid biased forecasts?

RECONCILING SINGLE-PERIOD CAPITALIZATION AND DISCOUNTED CASH FLOW METHODS In our own practice as well as in the appraisal reports of others that we review, analysts increasingly rely on the discounted cash flow method while the use of the single-period capitalization method

85

Income Approach (Cash Flows)

has diminished somewhat. This observation raises some interesting questions. Are analysts migrating to the discounted cash flow method because of some inherent superiority to the single-period capitalization method? Does a change from the single-period capitalization method to the discounted cash flow method mean that indications developed using the single-period capitalization method are therefore unreliable? Does one of the methods naturally yield lower or higher indications of value than the other method? We will return to these questions at the end of this section.

The Fundamental Equivalence of the Methods The single-period capitalization and discounted cash flow methods are conceptually identical. In fact, the single-period capitalization method is a special case of the discounted cash flow method. Since the Integrated Theory is articulated in terms of the single-period capitalization method, it is essential that we first demonstrate the fundamental equivalence of the two methods in order to confirm the validity and applicability of the Integrated Theory to the actual behavior of market participants. Exhibit 4.1 presents the general form of the discounted cash flow method. Importantly, the cash flow forecast for each period is derived by applying a growth rate to the cash flow for the preceding period. The growth rate is unique for each period, and can be positive, zero, or negative. We will defer our discussion of the discount rate to Chapter 5, but we do note that a single discount rate is applicable to all periods.

Value0 =

CF0 × (1 + g1 ) (1 + R)1

+···+

+

CF1 × (1 + g2 ) (1 + R)2

CFf−1 × (1 + gf ) (1 + R)f

EXHIBIT 4.1 Discounted Cash Flow Models.

+

CF2 × (1 + g3 ) (1 + R)3

86

BUSINESS VALUATION

Value0 =

CF1 R − GCF

EXHIBIT 4.2 Single-Period Capitalization Model. Professor Myron J. Gordon is credited with demonstrating that, in the special case under which growth is constant in each period, the expression in Exhibit 4.1 reduces to the much simpler expression in Exhibit 4.2. Since it is a bit cumbersome to depict a discounted cash flow model that extends into perpetuity, we illustrate the equivalence of single-period capitalization and discounted cash flow methods in Exhibit 4.3 by summarizing the present value of future cash flows in ten-year increments. When cash flows grow at a constant annual rate, the discounted cash flow method yields the same conclusion as the single-period

Year 1 Cash Flow

$1,000

Discount Rate

12.5%

Growth Rate

2.5%

Capitalization Rate

10.0%

Single-Period Capitalization Value

Discount rate less growth rate $10,000

Year 1 Cash Flow divided by capitalization rate

Discounted Cash Flow Analysis

Years

Sum of

Sum of

Cumulative

Sum of

Sum of

Cumulative

Projected

Discounted

Present

Projected

Discounted

Present

Cash Flows Cash Flows

Value

Years

Cash Flows Cash Flows

Value

1 - 10

11,203

6,058

6,058

51 - 60

38,507

58

9,962

11 - 20

14,341

2,388

8,446

61 - 70

49,293

23

9,985

21 - 30

18,358

941

9,387

71 - 80

63,099

9

9,994

31 - 40

23,500

371

9,759

81 - 90

80,772

4

9,998

41 - 50

30,082

146

9,905

91 - 100

103,394

1

9,999

1

$10,000

101 - ∞

EXHIBIT 4.3 Discounted Cash Flows in Ten-Year Increments.

87

Income Approach (Cash Flows) Discount Rate Growth Rate

12.5% 2.5% Year 1

Annual Cash Flow Discounting Periods Present Value Factors PV of Cash Flows Total Present Value

Year 2

Year 3

Year 4

Year 5

Terminal

$1,000

$1,025

$1,051

$1,077

$1,104

1.0

2.0

3.0

4.0

5.0

5.0

0.8889

0.7901

0.7023

0.6243

0.5549

0.5549

$889

$810

$738

$672

$613

$6,279

$10,000

Year 6 Cash Flow

$11,314

$1,131

divided by: Discount Rate less: Growth Rate

12.5% –2.5%

Capitalization Rate Terminal Value

10.0% $11,314

EXHIBIT 4.4 Discounted Cash Flow Model with Terminal Value.

capitalization method. Given the impracticality of indefinite cash flow forecasts, valuation analysts and market participants typically use a single-period capitalization method as a shorthand technique for deriving the present value of all remaining cash flows that occur subsequent to a discrete forecast period. As a result, a single-period capitalization method is embedded in most discounted cash flow methods. Exhibit 4.4 demonstrates the equivalence of the single-period capitalization method with a discounted cash flow model based on a five-year forecast period. The preceding illustrations have confirmed the fundamental equivalence of the single-period capitalization and discounted cash flow methods. In the next section, we address the practical application of the two methods.

The Practical Application of the Methods Having demonstrated the fundamental equivalence of the two methods under the income approach, we address the practical questions raised at the beginning of this section.

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BUSINESS VALUATION

1. Are analysts migrating to the discounted cash flow method because of some inherent superiority to the single-period capitalization method? No. The discounted cash flow method is not inherently superior to the single-period capitalization method. It is, however, more flexible. As valuation analysts and users of appraisal reports have grown more comfortable with the mechanics of the discounted cash flow method, analysts increasingly favor use of the method because it more naturally mirrors the underlying valuation narrative than the single-period capitalization method does. The inputs to the discounted cash flow model correspond to the assumptions market participants make in evaluating investment targets. Advocates of the single-period capitalization method occasionally cite the lack of a forecast for the future as an advantage of the method. This is misguided, since the single-period capitalization method is no less a forecast of the future than a cash flow forecast for the discounted cash flow method. Doubtless, predicting the future is hard (and we are naturally overconfident in our ability to do so accurately), yet making such predictions is essential to any valuation using the income approach. Opting to use the single-period capitalization method rather than the discounted cash flow method in no way relieves the analyst of making a prediction of future cash flows. Exhibit 4.5 illustrates this concept. The left side of the chart presents historical earnings for a business, as adjusted by the appraiser. Based on the analysis, the “ongoing” earnings are those expected for the next year. Assuming a 3.5% growth rate in the single-period capitalization method implies the forecast of future earnings on the right side of the chart. 2. Does a change from the single-period capitalization method to the discounted cash flow method mean that prior indications developed using the single-period capitalization method are therefore unreliable? No. Changing from a single-period capitalization method to a discounted cash flow method is best

89

Income Approach (Cash Flows) Adjusted Historical and Projected Net Cash Flow $7

Historical (Adjusted)

Projected

$6

Millions

$5 $4 $3 $2 $1

ar

5

4 Ye

ar Ye

ar

3

2 Ye

ar

1 Ye

ng

ar Ye

oi

19

ng O

20

18 20

17 20

16 20

20

15

$0

EXHIBIT 4.5 Cash Flow Forecast Implied by Single-Period Capitalization Model.

conceived of as a change in assumptions rather than a change in methodology. As we have demonstrated, the single-period capitalization method is simply a special case of the more general discounted cash flow method. Adopting the discounted cash flow method is neither more nor less than substituting potentially variable annual cash flow growth rates for the constant rate assumed in prior valuations. The relative reliability of the conclusions is wholly dependent upon how faithfully the assumptions reflect those made by market participants at the valuation date. 3. Does one of the methods naturally yield lower or higher indications of value than the other method? No. There is a constant annual growth rate that corresponds to any discrete cash flow forecast. The relative magnitude of the indications derived using the two methods is a function of the respective assumptions. Neither method is more or less likely to yield higher or lower conclusions than the other.

90

BUSINESS VALUATION

The Integrated Theory is defined using the conceptual math of the single-period capitalization method. By reconciling the single-period capitalization and discounted cash flow methods, we can now proceed to explain and apply the income approach in the context of the Integrated Theory using the discounted cash flow method.

DEFINING ENTERPRISE CASH FLOWS As described previously, substantially all transactions of private businesses occur at the enterprise level. In other words, buyers negotiate with sellers to determine the value of all the capital used to finance the business, whether debt or equity. In general, buyers are indifferent to how sellers have elected to finance the operations in the past; buyers evaluate the business as a whole, and will finance the purchase using whatever mix of sources they prefer, irrespective of how the business has been financed historically. This has implications for how we define enterprise cash flows under the discounted cash flow method. Exhibit 4.6 illustrates the components of enterprise net cash flows. Enterprise cash flow represents the net cash flows available for distribution to capital providers (both debt and equity). Exhibit 4.7 depicts the disposition of operating cash flows at the enterprise level. Enterprise cash flows are available for a variety of uses, as noted on the right side of Exhibit 4.7. The value of the enterprise is unaffected by how enterprise cash flows are actually used (i.e., to repay debt, pay dividends, or accumulate marketable securities). This is because market participants assess the value of the enterprise with regard to how much net cash flow will be available to capital providers as a whole, and are indifferent as to how the existing owner elects to allocate those cash flows.

91

Income Approach (Cash Flows) Year X Earnings before Interest, Taxes, Depreciation & Amortization less: Depreciation & Amortization

Year X+1

$15,000 (3,000)

Earnings before Interest & Taxes

$12,000

less: Pro Forma Income Taxes

25.0%

Net Operating Profit After Tax plus: Depreciation & Amortization less: Capital Expenditures less: Investment in Working Capital

Memo: Working Capital

$12,000

(3,100) $12,900

(3,000)

(3,225)

$9,000

$9,675

3,000

3,100

(3,500)

(5,000)

(500)

(750)

plus/less: Other Items, net Enterprise Cash Flow

$16,000

0

0

$8,000

$7,025

$12,500

$13,250

EXHIBIT 4.6 Derivation of Enterprise Cash Flow.

Operating Cash Flow

NOPAT + Depreciation & Amortization

Capital Expenditures

Working Capital

Other Investments

Enterprise Cash Flows Interest Debt Repayment Dividends Share Redemptions Non-Operating Assets

EXHIBIT 4.7 Disposition of Operating Cash Flow (Enterprise Basis).

In the following sections, we describe the individual components of enterprise cash flow.

EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization) EBITDA is the standard measure of operating income for private businesses. While EBITDA’s detractors (among them legendary

92

BUSINESS VALUATION

investor Warren Buffett) identify several shortcomings of the measure as a true barometer of a company’s performance, it is, for better or worse, the benchmark for private business performance measurement. The principal strengths of EBITDA as a measure of performance are twofold. First, EBITDA isolates the elements of corporate performance for which operating managers are responsible. Operating managers do not generally elect depreciation methods, nor do they make corporate financing decisions or tax elections. Measuring EBITDA keeps the focus on factors that are “controllable” by a company’s operating managers. Second, EBITDA promotes comparability across companies within an industry. EBITDA for two firms will be comparable regardless of whether one has grown organically or through acquisition, thereby incurring amortization charges. Similarly, differing accounting elections with regard to fixed asset depreciation do not influence EBITDA. EBITDA is also unaffected by a given company’s financing mix or tax status. EBITDA does not, however, measure enterprise cash flow. Indeed, this is the thrust of critics’ complaints. Operating businesses do require ongoing capital expenditures to maintain productive capacity and grow. Likewise, incremental investments in working capital to support growth do consume cash. Not every dollar of EBITDA is equal. Nonetheless, EBITDA is a natural starting point for measuring enterprise cash flow.

Depreciation and Amortization The next step in deriving enterprise cash flow is estimating depreciation and amortization. Isolating depreciation and amortization from the operating performance of the business is appropriate because

Income Approach (Cash Flows)

93

future depreciation and amortization charges are a function of capital expenditures and acquisition activity. As a result, these charges are fixed relative to revenue and EBITDA.

EBIT (Earnings before Interest and Taxes) EBIT, or operating income, reflects the net earnings of the business after taking account of depreciation and amortization charges. Importantly, EBIT is unaffected by how a business is financed. It is, therefore, a relevant performance measure from the perspective of the enterprise as a whole.

Pro Forma Income Taxes Pro forma income taxes are calculated as if EBIT were taxable income for the company. Taxes actually paid will reflect the deductibility of interest charges. However, when deriving enterprise cash flows, the relevant measure of income taxes is the amount that would be paid in the absence of any debt financing. Doing so preserves the perspective of the enterprise as whole. The tax deductibility of interest charges is reflected in the discount rate applied to enterprise cash flows (i.e., the WACC).

NOPAT (Net Operating Profit After Tax) NOPAT measures the net earnings attributable to all capital providers. While important for measuring the financial performance of the enterprise, especially in calculating return on invested capital, NOPAT is not synonymous with enterprise cash flow.

Depreciation and Amortization Depreciation and amortization appear a second time when measuring enterprise cash flows. Similar to the treatment on the statement

94

BUSINESS VALUATION

of cash flows in the company’s financial statements, depreciation and amortization is added when reconciling NOPAT to cash flow because it is a noncash expense. However, it is not appropriate to simplify the calculation of cash flow by dispensing with both the subtraction and addition. Keeping both components in the calculation preserves the cash flow benefit arising from the tax deductibility of the items.

Capital Expenditures Operating cash flow allocated to capital expenditures is not available for distribution to capital providers. Capital expenditures may be classified in two categories. Maintenance capital expenditures are necessary to sustain the existing productive capacity of the business. Growth capital expenditures support expansion of the business by supporting entry into new geographic markets or by extending the suite of products available for sale by the business.

Investment in Working Capital As noted in Exhibit 4.6, investment in working capital is the incremental change in working capital balances during a period. Investment in working capital can be negative (an increase in working capital) or positive (a decrease in working capital). Growing businesses generally require increasing balances of accounts receivable and inventory. Conversely, shrinking businesses may gradually liquidate working capital balances over time. Alternatively, management of a growing business may identify strategies to use working capital assets more efficiently, thereby providing a (one-time) boost to enterprise cash flow.

Other Items, Net Finally, there may be other items that influence enterprise cash flow. These items may include the disposition or acquisition of business

Income Approach (Cash Flows)

95

units, or changes in other asset or liability balances not reflected in earnings. Any cash flows assigned to this category should be carefully scrutinized to confirm that they are actually necessary to operate the business and generate the subsequent projected cash flows. Referring back to Exhibit 4.7, it is critical to understand that expected accumulation of excess liquidity or other nonoperating assets should not be included in this category. Accumulating nonoperating assets is a discretionary use of enterprise cash flow, not an element in deriving enterprise cash flow. Using EBITDA as the starting point for calculating enterprise cash flow ensures that future investment earnings that may be anticipated from such nonoperating assets are properly excluded from the enterprise cash flow forecast.

Conclusion We have discussed the components of enterprise cash flow without regard to the various levels of enterprise value described in the Integrated Theory. We will address how the Integrated Theory intersects with the components of enterprise cash flow in subsequent sections of this chapter.

DEFINING EQUITY CASH FLOWS Analysts face two structural decisions when applying the income approach: (1) whether to use a single-period capitalization or discounted cash flow method, and (2) whether to adopt an enterprise or equity perspective. Exhibit 4.8 depicts the four resulting structural possibilities. Since market participants tend to view private operating business from an enterprise value perspective, we prefer to do so as well when selecting methods under the income approach. Nonetheless, there are circumstances in which an analyst may prefer to adopt an

96

BUSINESS VALUATION

Enterprise

Selected Perspective

DCF

Single-Period Capitalization Method (Enterprise Value)

Discounted Cash Flow Method (Enterprise Value)

Equity

Selected Method Single-Period Cap

Single-Period Capitalization Method (Equity Value)

Discounted Cash Flow Method (Equity Value)

EXHIBIT 4.8 Structural Possibilities for Income Approach.

equity perspective for valuation. Doing so requires that cash flows be measured accordingly. Exhibit 4.9 summarizes the measurement of cash flow from an equity perspective. Several components of the calculation are identical to those used when measuring enterprise cash flows in Exhibit 4.6. In the following sections, we address the components that are unique to measuring equity cash flows.

Interest Expense Since we are measuring cash flow from the perspective of equity, cash flows payable as interest expense to lenders are not available

97

Income Approach (Cash Flows)

Earnings before Interest, Taxes, Depreciation & Amortization less: Depreciation & Amortization Earnings before Interest & Taxes less: Interest Expense Pre-tax Income less: Income Taxes 25.0% Net Income plus: Depreciation & Amortization less: Capital Expenditures less: Investment in Working Capital plus: Incremental Borrowings less: Repayment of Debt plus/less: Other Items, net Equity Cash Flow Memo: Working Capital

$12,000

Year X $15,000 (3,000) $12,000 (1,000) $11,000 (3,000) $8,000 3,000 (3,500) (500) 0 (750) 0 $6,250

Year X+1 $16,000 (3,100) $12,900 (1,100) $11,800 (3,225) $8,575 3,100 (5,000) (750) 2,000 0 0 $7,925

$12,500

$13,250

EXHIBIT 4.9 Derivation of Equity Cash Flow.

for distribution to equity holders. As a result, analysts must deduct projected interest expense from EBIT to derive taxable income. The amount of interest expense deducted should reflect the terms and balances of debt projected to be outstanding over the forecast period. For example, in Exhibit 4.8 projected interest expense in the second year increases by $100, reflecting incremental borrowings of $2,000 at a 5% interest rate.

Pre-tax Income and Income Taxes In contrast to the pro forma taxes calculated to measure enterprise cash flow (which are calculated on the basis of EBIT), the income taxes deducted when measuring equity cash flows are calculated on the basis of taxable income.

98

BUSINESS VALUATION

Incremental Borrowings and Repayment of Debt While often striking analysts as counterintuitive, incremental corporate borrowings are cash inflows from the perspective of equity holders. That is, all else equal, amounts borrowed during the year increase the quantity of cash flow available for distribution to equity. Likewise, cash flows earmarked for debt repayment reduce the amount of cash flow available for distribution to equity holders.

Conclusion Exhibit 4.10 illustrates the allocation of operating cash flow to corporate reinvestment, debt service, and equity cash flows. In contrast to the depiction in Exhibit 4.7, equity cash flows exclude interest payments and the repayment of debt. In our view, it is generally preferable for valuation analysts to adopt an enterprise value perspective, which conforms to how market participants evaluate private businesses. Nevertheless, when the cash flows and discount rates are adjusted appropriately, methods under the income approach will yield the same indication of value regardless of which perspective is adopted. In the balance of this chapter, we will adopt the enterprise perspective.

Operating Cash Flow

Equity Cash Flows

Net Income + Depreciation & Amortization

Capital Expenditures

Working Capital

Other Investments

Debt Servicing

Interest Debt Repayment Dividends Share Redemptions Non-Operating Assets

EXHIBIT 4.10 Disposition of Operating Cash Flow (Equity Basis).

Income Approach (Cash Flows)

99

Having defined cash flow from both enterprise and equity perspectives, we turn our attention in the next section of this chapter to a careful assessment of the relationship between operating cash flows that are reinvested in the business and the expected growth of the enterprise cash flows.

REINVESTMENT RATES AND INTERIM GROWTH RATES From a corporate finance perspective, the decision to reinvest rather than distribute cash flow to capital providers hinges upon the relationship between the anticipated return on the investment (internal rate of return, or IRR) and the weighted average cost of capital (WACC) for the enterprise. If the anticipated IRR exceeds the WACC, reinvestment is favored. If instead the anticipated IRR is less than the WACC, cash flow should be returned to capital providers. As we observed in the prior sections of this chapter, the decision to reinvest cash flows in the business is captured in measuring enterprise cash flow. When developing or assessing cash flow projections, analysts and market participants must be careful to confirm that expected returns from investments assumed to be made in one period are appropriately reflected in the cash flows for subsequent periods. ■

■

If outflows are not accompanied by the anticipated future inflows, the discounted cash flow analysis will result in an undervaluation of the business. If anticipated future inflows require investment that is not included in the model, the discounted cash flow analysis will result in an overvaluation of the business.

100

BUSINESS VALUATION

Illustration of the Impact of Reinvestment on Forecast Cash Flows Exhibit 4.11 presents the discounted cash flow method for Steady Company. Steady Company is expected to maintain a constant level of NOPAT by making capital expenditures equal to depreciation in each period. Assume SteadyCo identifies an investment opportunity that will be available at the end of Year 2 and is expected to generate an IRR of 10%. Exhibit 4.12 summarizes the discounted cash flow analysis for Steady Company reflecting the anticipated investment in Year 2. The investment has changed the projected cash flows for Year 2 and each subsequent period. Yet, because the expected return on the investment is equal to the WACC, the enterprise value is unchanged. What if the Year 2 investment is expected to generate a return in excess of the WACC (i.e., have a positive net present value, or NPV)? Exhibit 4.13 demonstrates the impact of positive NPV projects on the indicated value.

Weighted Average Cost of Capital Annual Growth in NOPAT Terminal Cash Flow Growth Rate

10.0% 0.0% 0.0% Year 1

Net Operating Profit After Tax plus: Depreciation & Amortization less: Capital Expenditures

Year 2

$1,000

Year 3

$1,000

Year 4

$1,000

Year 5

$1,000

Terminal

$1,000

200

200

200

200

200

(200)

(200)

(200)

(200)

(200)

less: Investment in Working Capital

0

0

0

0

0

plus/less: Other Items, net

0

0

0

0

0

$1,000

$1,000

$1,000

$1,000

$1,000

1.0

2.0

3.0

4.0

5.0

5.0

0.9091

0.8264

0.7513

0.6830

0.6209

0.6209

PV of Cash Flows

$909

$826

$751

$683

$621

$6,209

Enterprise Value

$10,000

Enterprise Cash Flow Discounting Periods Present Value Factors

EXHIBIT 4.11 Projected Cash Flows: No Net Reinvestment.

$10,000

101

Income Approach (Cash Flows) Weighted Average Cost of Capital

10.0%

Return on Incremental Investment

10.0%

Annual Growth in NOPAT

0.0%

Terminal Cash Flow Growth Rate

0.0% Year 1

Net Operating Profit After Tax plus: Depreciation & Amortization

Year 2

$1,000

Year 3

$1,000

Year 4

$1,100

Year 5

$1,100

Terminal

$1,100

200

200

220

220

220

(200)

(1,000)

(220)

(220)

(220)

less: Investment in Working Capital

0

(200)

0

0

0

plus/less: Other Items, net

0

0

0

0

0

$1,000

$0

$1,100

$1,100

$1,100

1.0

2.0

3.0

4.0

5.0

5.0

0.9091

0.8264

0.7513

0.6830

0.6209

0.6209

PV of Cash Flows

$909

$0

$826

$751

$683

$6,830

Enterprise Value

$10,000

less: Capital Expenditures

Enterprise Cash Flow Discounting Periods Present Value Factors

$11,000

EXHIBIT 4.12 Projected Cash Flows: Effect of Reinvestment in Year 2 (IRR = WACC).

Weighted Average Cost of Capital

10.0%

Return on Incremental Investment

20.0%

Annual Growth in NOPAT

0.0%

Terminal Cash Flow Growth Rate

0.0% Year 1

Net Operating Profit After Tax plus: Depreciation & Amortization less: Capital Expenditures

Year 2

$1,000 200 (200)

less: Investment in Working Capital

0

plus/less: Other Items, net

0

Enterprise Cash Flow Discounting Periods Present Value Factors

Year 3

$1,000 200 (1,000) (200)

Year 4

$1,200

Year 5

$1,200

Terminal

$1,200

220

220

220

(220)

(220)

(220)

0

0

0

0

0

0

0

$1,000

$0

$1,200

$1,200

$1,200

1.0

2.0

3.0

4.0

5.0

5.0

$12,000

0.9091

0.8264

0.7513

0.6830

0.6209

0.6209

PV of Cash Flows

$909

$0

$902

$820

$745

$7,451

Enterprise Value

$10,826

EXHIBIT 4.13 Projected Cash Flows: Effect of Reinvestment in Year 2 (IRR > WACC).

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BUSINESS VALUATION

Weighted Average Cost of Capital Return on Incremental Investment

10.0% 5.0%

Annual Growth in NOPAT

0.0%

Terminal Cash Flow Growth Rate

0.0% Year 1

Net Operating Profit After Tax plus: Depreciation & Amortization less: Capital Expenditures

Year 2

$1,000 200 (200)

less: Investment in Working Capital

0

plus/less: Other Items, net

0

Enterprise Cash Flow Discounting Periods

$1,000

Year 3

$1,000 200 (1,000) (200)

Year 4

$1,050

Year 5

$1,050

Terminal

$1,050

220

220

220

(220)

(220)

(220)

0

0

0

0

0

0

0

$0

$1,050

$1,050

$1,050

$10,500

1.0

2.0

3.0

4.0

5.0

0.9091

0.8264

0.7513

0.6830

0.6209

0.6209

PV of Cash Flows

$909

$0

$789

$717

$652

$6,520

Enterprise Value

$9,587

Present Value Factors

5.0

EXHIBIT 4.14 Projected Cash Flows: Effect of Reinvestment in Year 2 (IRR < WACC).

Conversely, if the Year 2 investment is a negative NPV project, the resulting indication of enterprise value will decrease, as illustrated in Exhibit 4.14. What conclusions can we draw from these examples? ■

First, if proposed capital investments are projected to earn a return equal to the weighted average cost of capital, the value of the enterprise is unaffected by the decision to distribute or reinvest interim cash flows. This is the implicit assumption in traditional valuation methodologies that capitalize some measure of accounting net income rather than cash flow. Such techniques are predicated on the assumption that all of the company’s net income (or debt-free equivalent) inures to the benefit of the company’s capital providers, who are indifferent to the decision to distribute or reinvest those earnings. While conceptually coherent, the success or failure of the traditional techniques depends upon the valuation analyst’s ability to properly specify the “core” growth rate of earnings that can be anticipated in the absence of any (net) reinvestment in the business.

103

Income Approach (Cash Flows)

■

Income approach methods that are focused on cash flows rather than accounting net income are increasingly prevalent because they allow valuation analysts to more specifically replicate the behavior of actual market participants. Second, the subject company’s ability to identify and execute positive-NPV projects is manifest in the ratio of market value to invested capital. When market participants believe that a subject company has a portfolio of positive-NPV projects and the ability to execute such projects successfully, the market value of the company is bid up so that it exceeds the level of historical invested capital. Exhibit 4.15 depicts the relationship between projected returns and the weighted average cost of capital. The relationship between invested capital (historical book value) and market value is a function of the relationship between the projected returns on existing invested capital (and anticipated future investments) and the weighted average cost of capital. ■ If the projected IRR is equal to the WACC, market value will approximate invested capital. In this case, market value is not ultimately dependent on the amount of future investment relative to distributions. ■ If the projected IRR is less than the WACC, market value may be less than invested capital. In the context of the Integrated Theory, whether this will prove to be the case depends upon the level of value for the subject interest. We will address this

Invested Capital

Projected returns on historical and future capital investments (IRR) Net CF1

Market Value

Net CF2

Net CF3

Net CF4

Net CFn

Discount rate applied to projected future cash flows (WACC)

EXHIBIT 4.15 Relationship between Invested Capital and Market Value.

104

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BUSINESS VALUATION

scenario in subsequent sections of this chapter. In this case, the market value of the business today may actually exceed the present value of the business plan to the current owners. ■ If the projected IRR is greater than the WACC, market value will exceed invested capital. By our recent count, over 80% of the companies in the S&P 1500 Index traded at prices in excess of historical book value. This observation does not suggest that the market value of any particular subject company will exceed invested capital. It does, however, reveal the behavior of market participants, which can be rationally modeled by valuation analysts within the context of the Integrated Theory. Third, the examples in this section underscore the need for robust assessment of the overall reasonableness of projected cash flows under the income approach. We return to the topic of assessing reasonableness in the final section of this chapter.

Conclusion The corporate reinvestment decision is at the root of valuation methods under the income approach. In this section, we have illustrated the relationship between the anticipated return on reinvestment, the weighted average cost of capital, and value. In subsequent sections of this chapter, we will relate the observations to practical application of the Integrated Theory.

TERMINAL GROWTH RATES Forecasting specific cash flows on an indefinite basis is impractical. As a result, both valuation analysts and market participants estimate terminal values for use in the discounted cash flow method. The terminal value is the present value, as of the end of the discrete forecast period, of all cash flows expected after the discrete forecast

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period. In our experience, valuation analysts are more likely to use a single-period capitalization method while market participants are more likely to apply market multiples to one or more of the projected performance measures at the end of the forecast period. Reasonable valuation indications can be derived using either method. While our analysis in this section will largely be undertaken assuming a single-period capitalization, we conclude the section by discussing application to market multiples.

What Does a Terminal Growth Rate Mean? Recalling the analysis in the prior section regarding the relationship between returns on projected reinvestment and the weighted average cost of capital, we can define the terminal growth rate as that applicable to the cash flows of the business when the supply of potential positive-NPV projects available to the subject company has been depleted. As we demonstrated in that section, when the expected return on available projects equals the WACC, the value of the enterprise is unaffected by the decision to reinvest or distribute operating cash flows. So, our definition of the terminal growth rate also underscores the appropriate rationale for selecting the length of the discrete forecast period: the discrete forecast period should extend so long as positive-NPV projects are expected to be available to the company. This is functionally equivalent to the period at which the operations of the subject company may be assumed to be stabilized. Just how long the availability of positive-NPV projects will persist for a given company is a famously difficult question. Since the task of most valuation analysis is descriptive, analysts are spared the burden of divining prescriptive answers to that question. In other words, valuation analysts have the luxury of examining available evidence regarding market participant behavior to discern how relevant parties are in fact judging the durability of a company’s competitive advantage rather than the responsibility to assert how

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Valuation Date Market participant assessment of competitive advantages gives rise to…

Discrete Forecast Period

…expectation that current positive-NPV projects will mature and a dwindling supply of positive-NPV projects will be exploited until…

Terminal Period

…reinvestment opportunities no longer offer returns in excess of the WACC.

EXHIBIT 4.16 Conceptual Meaning of Terminal Growth Rate. market participants should answer our question. Further, valuation analysts solicit input from management regarding the expected period over which one would expect operations to stabilize. Exhibit 4.16 illustrates the conceptual meaning of the terminal growth rate. The terminal growth rate is therefore the rate at which cash flow can be expected to grow in the absence of incremental reinvestment in the business. But why should market participants assume that the supply of positive-NPV projects available to a subject company will diminish over time? Most simply, because competition is intense, which causes returns on incremental investment to revert inevitably to the mean. Amazon founder Jeff Bezos epitomizes this observation with his famous warning to unwary potential competitors: “Your margin is my opportunity.” In the eventual absence of positive-NPV projects, what are appropriate benchmarks for the terminal growth rate? In our experience, the two most reliable guardrails for valuation analysts are expected inflation and the expected nominal growth rate in the economy. ■

Setting the terminal growth rate equal to expected inflation assumes that the company will not experience any real growth during the terminal period.

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Specifying expected terminal growth equal to expected nominal growth in the economy assumes that the company will be able to maintain its share of the overall economy.

Assuming a terminal growth rate below inflation expectations is appropriate if market participants believe that forthcoming structural changes in the economy or industry will deplete the supply of available capital projects offering a return equal to the weighted average cost of capital. In other words, this assumption is consistent with a gradual liquidation of the subject company (in real terms, at least). On the other hand, assuming a terminal growth rate in excess of nominal economic growth implies that some supply of positive-NPV projects is expected to be available to the subject company at the end of the discrete forecast period. Perhaps such an assumption can be useful as a practical expedient in certain circumstances, but we believe it is preferable to simply extend the discrete forecast period further as appropriate. Given the sensitivity of the single-period capitalization rate to expected growth, we believe that incorporating “extra-normal” growth in the terminal value should be done with caution.

Using Market Multiples As we noted in the opening to this section, market participants are in our experience more inclined to apply a market-derived multiple in deriving terminal value. When valuation analysts do so, however, it is important to recognize that (though not explicitly specified) growth expectations are embedded in market multiples. As a result, it is necessary to consider what adjustment, if any, is required to eliminate expectations for ongoing positive-NPV project availability from observed market multiples. Applying “normal” market multiples to terminal year financial measures implicitly assumes that

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the availability of positive-NPV projects at the end of the forecast period will be no different than at the valuation date. Given our observations above, that is unlikely to be an appropriate assumption. Nonetheless, we are not suggesting that the practice of developing terminal values through application of a valuation multiple is “wrong.” Rather, we are simply emphasizing that valuation analysts need to recognize that applying a valuation multiple does not relieve one of the obligation to think about terminal growth rates.1

Conclusion Estimating terminal growth rates is necessary if application of the discounted cash flow method is to be practical. The pervasive and corrosive effects of competition and time on a company’s competitive advantages confirm that the supply of positive-NPV projects will eventually run out, signaling the conceptual end of the discrete forecast period. Whether using a single-period capitalization method or applying valuation multiples, valuation analysts can estimate terminal growth rates with reference to the guardrails provided by expected inflation rates and nominal economic growth.

EXPECTED CASH FLOWS AND THE INTEGRATED THEORY In this section, we more directly orient our discussion of projected cash flows in the income approach to the Integrated Theory. As we described in Chapter 1, the Integrated Theory defines differences in the various levels of value with respect to differences in

1

If an analyst uses the single-period capitalization method to determine a terminal value, that conclusion can be readily converted into relevant valuation multiples which may be compared and reconciled to current market multiples. Alternatively, when an analyst uses a market multiple, the implied growth rate can be inferred and assessed for reasonableness.

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expected cash flows, risk (as manifest in the discount rate), and growth. Growth is ultimately a subset of expected cash flows, so we will address both factors in this chapter. We consider potential risk-driven differences in discount rates in Chapter 5.

Available Cash Flow Perspectives At the enterprise level, there are four basic (and potentially overlapping) perspectives on cash flow available to market participants and valuation analysts, as depicted in Exhibit 4.17. The four perspectives can be classified as either minority or control. Minority Perspectives 1. Expected cash flows from the perspective of a minority investor as the subject company operates under current stewardship. The first perspective reflects that of a minority investor that

Minority Perspectives

Control Perspectives

Under current stewardship

Normalized, or well-run public company equivalent

Private equity or other nonstrategic owner expectations

Strategic acquirer expectations

Not Relevant to Enterprise Value

Marketable Minority Value

Financial Control Value

Strategic Control Value

Shareholder Cash Flows

Enterprise Cash Flows

EXHIBIT 4.17 Available Cash Flow Perspectives (Enterprise Basis).

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does not have any influence over the current operations of the business. Subject to whatever legal protections may be available under shareholder oppression statutes, minority investors depend on the actions and decisions of the current majority shareholders (or group of minority shareholders that together represent a controlling block). Dividend policy, capital structure, and capital allocation decisions are made by others, and the subject minority interest is a passive participant in the economic outcomes of those decisions. Furthermore, the controlling shareholder(s) may make operational decisions regarding management compensation or other transactions with insiders that effectively divert enterprise cash flows to certain individuals on a non–pro rata basis. It is natural to assume – and many valuation analysts do – that this is the appropriate perspective for estimating enterprise cash flows on a minority interest basis. This is not correct. As noted in Exhibit 4.17, this perspective on cash flow is not relevant when measuring the value of the enterprise. At this point many object that a market participant contemplating the purchase of a minority interest would most certainly be interested in the actual cash flows that will be available to her under the current stewardship of the business. This objection, while accurate, is misplaced. The expected minority cash flows under current stewardship are relevant when determining the value of the subject minority interest at the nonmarketable minority interest (i.e., shareholder) level of value. However, the expected cash flows of the business under current stewardship do not determine the value of the business itself. This concept is treated more fully in Part Three of this book on shareholder level cash flows. At this point we will simply point out that rational market participants distinguish between the interim cash flows they expect to receive during their expected holding period and the terminal value they expect to receive at the end of their expected holding period. In most cases, market participants appropriately assume that their terminal value will reflect the future value of the enterprise as unencumbered by the actions and policies of the current

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stewardship. In order to estimate that value in the future, it is necessary to estimate enterprise value on the same basis at the valuation date. 2. Expected cash flows from the perspective of a minority investor as if the company operated on the same basis as well-run public companies. Minority investors in public companies have a reasonable expectation that the same corporate finance and operational decisions we described above will be made with a view toward maximizing the value of their minority shares. This expectation is reasonable because of the ready liquidity of their minority shares. In contrast to private companies in which incumbent management is generally free from any anxiety about hostile takeover, public company management teams have to be solicitous of minority shareholder approval in order to keep their jobs. If minority investors disapprove of how a public company is treating them, they can sell their shares, thereby depressing the price of the stock, and increasing the likelihood that activist investors will accumulate a position enabling them to exert significant influence over the operations of the business and/or coordinate a hostile takeover. As a result, the base expectation of minority investors is that public companies will be run efficiently and that the resulting enterprise cash flows will accrue to their benefit. Control Perspectives 1. Expected cash flows from the perspective of a controlling private equity or other nonstrategic owner.2 Minority investors in public companies reasonably expect that the corporate finance and operational decisions made on their behalf by others will be

2

Note that we are using the term “private equity” owner broadly to refer to any controlling owner of a standalone private company, whether or not that owner is a traditional private equity fund. The primary attribute of this category of owner for our purposes is the absence of strategic considerations involving combination of the subject business with another.

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appropriate and reflect the minority investors’ economic interest. In contrast, controlling private equity owners have the discretion to make those same corporate finance and operational decisions directly for themselves. When valuing the enterprise on a financial control basis, it is appropriate to adopt this perspective when projecting enterprise cash flows. 2. Expected cash flows from the perspective of a strategic acquirer. Controlling private equity owners are generally constrained as to the magnitude of operational improvements or changes that they can make to the subject company. Since financial buyers are assumed, by definition, not to own complementary businesses into which the operations of the subject company could be integrated, the opportunities for substantial operational improvements are limited. Strategic acquirers, on the other hand, are assumed to be able to combine the subject company with existing operations, which gives rise to the potential for material synergistic cash flow benefits. As a result, the strategic perspective on enterprise cash flows may look very different from the private equity perspective, even though they are both controlling interest levels of value.

Potential Cash Flow Adjustments Whether relying upon a single-period capitalization method or the discounted cash flow method, a fundamental component of analysis under the income approach is considering what, if any, adjustments to historical and prospective cash flows are appropriate to reflect the expected performance of the subject company from the relevant perspective. Exhibit 4.18 depicts the four broad categories of potential adjustments, and the relevance of each to the available perspectives outlined in the previous section. Before proceeding to a more detailed discussion of cash flows from the various enterprise perspectives, we briefly define the nature of each category.

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Minority Perspectives Current stewardship

Public company equivalent

Control Perspectives Private equity owner

Strategic acquirer

Unusual or non-recurring events Normalizing corporate finance and operational decisions Financial control adjustments Strategic control adjustments

EXHIBIT 4.18 Potential Cash Flow Adjustments. ■

Unusual or nonrecurring events. When analyzing historical financial statements it is always appropriate to adjust for unusual or one-time events that have influenced historical performance but are not expected to affect the future performance of the business. Since valuation is a forward-looking exercise, it is important not to cloud one’s perspective on the future cash flows of the enterprise with historical events that are not reasonably expected to recur. Examples might include casualty losses (and the subsequent receipt of insurance proceeds), the discrete impact of unusual and temporary economic, market, or industry dislocations, or the results of a division or product line that have been divested. These are not typically controversial adjustments, but two words of caution are in order. First, valuation analysts must apply a healthy dose of common sense, reasonableness, and informed judgment when evaluating whether a proposed adjustment reflects an economic event that is truly nonrecurring. Financial statement analyses that reflect a series of recurring/nonrecurring adjustments may not reflect the diligent skepticism of market participants. Second, adjustments that are appropriate on a historical basis are not necessarily appropriate on a prospective basis. For example, assume that

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an extreme weather event disrupted business operations and gave rise to receipt of proceeds from an associated insurance claim. If the insurance proceeds were received in a historical period, it is appropriate to adjust the historical cash flow to eliminate the receipt of insurance proceeds. If, however, the insurance proceeds are expected to be received in the coming year, it is not appropriate to remove the insurance proceeds from the prospective cash flows used in the discounted cash flow method. The public markets often illustrate the proper treatment of unusual or nonrecurring items. When earnings for a public company are depressed by an unusual event, the stock price may be unaffected, resulting in what appears to be an abnormally large multiple of trailing earnings. In such cases, the public markets have adjusted the actual results for the unusual event and are focusing on forward earnings, which are unaffected by the unusual event. Normalizing corporate finance and operational decisions. As explained in the preceding section, when measuring the value of the enterprise on marketable minority interest basis, it is necessary to consider normalizing adjustments to convert the financial results of the subject company under current stewardship to reflect the results as if the company were run in a manner comparable to well-run public companies. The fact that not all public companies are in fact well run does not undermine the need for normalizing adjustments. In other words, it is appropriate to normalize financial results to reflect corporate finance and operational decisions made in the best interests of minority investors. These potential adjustments are applicable to both historic and future periods. We discuss normalizing adjustments in greater detail in the following section of this chapter. Financial control adjustments. At the financial control level of value, it is appropriate to consider potential adjustments to both historical and prospective cash flows to reflect cash

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flows expected by controlling private equity owners that are incremental to public-company equivalent cash flows. In the case of a well-run public company, such adjustments are likely to be small, or nil. Strategic control adjustments. On a strategic control basis, additional adjustments may be appropriate to reflect potentially significant operational changes that strategic acquirers may expect to make through integrating the subject company with the acquirer’s existing operations. Strategic control adjustments are applicable to both historical and prospective cash flows. As a practical matter, it may not be feasible or necessary to quantify or apply such adjustments historically, but they are always appropriate on a prospective basis.

Conclusion The Integrated Theory provides the necessary conceptual framework to estimate cash flows from the perspective of the various enterprise levels of value. Having laid the preliminary foundation, we proceed in the following sections to a more detailed exposition of expected cash flows at each of the enterprise levels of value.

MARKETABLE MINORITY INTEREST LEVEL: PUBLIC COMPANY EQUIVALENT The starting point for financial analysis is the subject company’s historical financial statements, as they exist. Deriving adjusted cash flows applicable to measuring value at the marketable minority interest level is a two-stage process. 1. Adjust historical results for unusual or nonrecurring events. 2. Normalize historical and prospective results for corporate finance and operational decisions that would be consistent with a well-run public company.

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In this section, we will examine both types of potential adjustments more closely.

Adjusting Historical Results for Unusual or Nonrecurring Events Historical financial statements record the results of the subject company’s operating performance. That historical record includes elements that are both essential and accidental. In support of their investment decisions, market participants seek to strip away the accidental features of the subject company’s operating history to reveal the essential nature of the company. Discriminating between the essential wheat and the accidental chaff in the subject company’s historical financial statements is a skill that market participants and valuation analysts hone over decades of experience. We find that, with regard to identifying adjustments to historical statements, valuation analysts adopt a posture that falls along a spectrum. We will refer to the respective extremes of this spectrum as the minimalist and maximalist postures. ■

■

The minimalist posture assumes that occasional bad or good fortune is part of the nature of the business. While the specific favorable or unfavorable events that have influenced historical earnings may be unlikely to recur, it is more likely that equally unexpected – though different – favorable or unfavorable events will happen again in the future. As a result, market participants and valuation analysts assuming a minimalist posture will reserve adjustments for events that are either (1) clearly extreme as to magnitude, or (2) cannot recur by definition, such as the revenues and expenses of a divested business unit. The maximalist posture assumes that more accurate forecasts of future performance are likely when one adjusts away all events that do not directly relate to the ongoing core operations of

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the subject business. Market participants and valuation analysts adopting the maximalist posture will therefore identify more granular items for adjustment. The point of this discussion is not to suggest that either posture is inherently superior to the other. Rather, it underscores the inescapable role of common sense, informed judgment, and reasonableness in developing valuation conclusions. At a superficial level, adjustments for unusual or nonrecurring items may have a veneer of absolute objectivity. In reality, however, even this class of adjustments will be subject to the judgment of the valuation analyst. Neither making, nor declining to make, a particular adjustment necessarily makes the resulting analysis “wrong.” It is essential to bear in mind that adjustments to historical financial statements are made to provide better context to the forecast of future financial performance which is relevant to valuation. Enterprise value is a function of future, not historical, cash flows – even when the historical cash flows have been meticulously adjusted. Valuation analysts can evaluate the overall reasonableness of the earnings adjustments made in a particular valuation by calculating the margins on an adjusted basis and comparing those margins to guideline public company and other available benchmark data.

Normalizing Adjustments As alluded to earlier, the general consensus that prevails regarding the propriety of adjustments for unusual or nonrecurring events dissolves when we shift our focus to normalizing adjustments. As a result, we begin this section by explaining why normalizing adjustments are appropriate when deriving enterprise value on a marketable minority interest basis. The Marketable Minority Interest Level of Value The principal objection to the use of normalizing adjustments at the marketable minority level of value is that the subject interest is powerless to effect the

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changes to corporate finance or operational decisions implied by the adjustment. This is a simple and intuitive objection to which the necessary response is somewhat complex and subtle, so we will attempt to lay out our position carefully. In order to meet this objection, we need to identify a crucial distinction between owning a minority interest in a public company and a minority interest in a private company. While it is true that neither minority owner has the ability to unilaterally change noxious policies or decisions implemented by management and the board of directors, the critical difference between the two is the ready liquidity available to a minority shareholder in a public company. ■

■

Beyond whatever statutory protections may exist, controlling shareholders of private companies have no economic incentive to change discretionary policies that are unfavorable to the economic interests of the minority investor. So, for example, if the subject company pays a handsome salary and bonus to a member of the controlling shareholder’s family with dubious work habits, the minority investor cannot sell her shares, nor can she reasonably expect that the “excess” compensation will inure to her economic benefit. In contrast, managers and directors of public companies are keenly aware of minority investor preferences. Why? Because the liquid market for minority shares in the company allows dissatisfied shareholders to sell their holdings, which puts downward pressure on the share price. Managers and directors of public companies exhibiting persistent underperformance and having policies that do not favor minority shareholder interests are graded harshly by the public markets. Managers and directors of public companies with depressed share prices are under constant threat of dismissal or takeover.

As a result, those responsible for making corporate finance and operating decisions at public companies have a much greater

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incentive to make those decisions for the benefit of minority shareholders than do their counterparts at private companies. This is where the second objection arises. Even if the available liquidity for public company shareholders does change the incentives for managers and directors and their posture toward minority shareholders, the stubborn fact remains that the subject minority interests for which most valuations are required are, at the end of the day, in private rather than public companies. And, as we acknowledged above, private company managers and directors do not operate with the same incentives. So why should normalizing adjustments be made for private companies? To meet this objection, we need to carefully distinguish between the marketable minority and nonmarketable minority levels of value. As the Integrated Theory clarifies, the value of the enterprise on a marketable minority basis is a function of all of the expected cash flows to the enterprise. The value of a minority shareholder interest on a nonmarketable minority basis is, in contrast, a function of the expected cash flows to the shareholder. Exhibit 4.19 illustrates this difference. The economic burden of suboptimal corporate finance and operational decisions is borne by the minority shareholders only for the duration of their expected holding period. At the point of a liquidity event, the minority shareholders will participate pro rata with the controlling shareholders. The controlling shareholders, for their part, are motivated to maximize the liquidity event for their own economic benefit. And how do controlling shareholders maximize the liquidity event? By highlighting the very normalizing adjustments we are discussing in this section to reveal the ongoing cash flows of the enterprise to buyers. Since the future liquidity event will capitalize normalized enterprise cash flows, it is appropriate to project normalized cash flows at the valuation date in order to derive the base value which is anticipated to grow into the future.

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Marketable Minority Value of the Enterprise Enterprise Cash Flow1

Enterprise Cash Flow2

Enterprise Cash Flow3

Enterprise Cash Flown

On a marketable minority basis, the value of the enterprise is a function of all expected future cash flows of the enterprise. Nonmarketable Minority Value of the Shareholder Interest Shareholder Dividend1

Shareholder Dividend2

Shareholder Dividend3

Liquidity Event

On a nonmarketable minority basis, the value of the shareholder interest is a function of all expected shareholder dividends during the expected holding period and the liquidity event at the end of the holding period.

EXHIBIT 4.19 Conceptual Differences between Marketable Minority and Nonmarketable Minority Levels.

Finally, normalizing adjustments are necessary to establish an appropriate base value of equity from which to deduct a marketability discount.3 No discount or premium has meaning unless the base value to which it is applied is clearly defined. An enterprise value that does not reflect appropriate normalizing adjustments is neither a marketable minority value nor a nonmarketable minority value, but rather some tertium quid that has neither a theoretical basis nor a marketplace equivalent. We are not suggesting that an appropriate nonmarketable minority value for a subject shareholder interest cannot be derived 3

As discussed in Chapter 3, the discount for lack of marketability is applicable only to the value of equity. Normalizing adjustments, however, influence enterprise cash flows. In the following paragraphs of this discussion, we are referring to the marketable and nonmarketable minority interest values on an equity, rather than firmwide, basis.

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Income Approach (Cash Flows) With Normalizing Adjustments Enterprise Marketable Minority

Value of the enterprise on an "as if freely traded" basis Marketability discount reflects burden of unfavorable corporate finance and operating decisions over holding period

Shareholder Nonmarketable Minority

Reflects shareholder cash flows over expected holding period

Without Normalizing Adjustments

Enterprise Undefined Base

No theoretical basis or market equivalent concept No conceptual basis for reliably estimating appropriate discount to apply to ill-defined base value

Shareholder Nonmarketable Minority

Appropriate shareholder value only by chance

EXHIBIT 4.20 Conceptual Basis for Normalizing Adjustments. if normalizing adjustments are not made to the historical and prospective enterprise value of the cash flows. A reasonable conclusion is possible if the valuation analyst makes two offsetting errors of approximately the same magnitude. Exhibit 4.20 compares valuation conclusions reached with and without normalizing adjustments. The principal risk faced by valuation analysts when not making appropriate normalizing adjustments is that there is no reliable way to estimate the future exit value for the shareholder. As a result, an appropriate marketability discount will be applied only by chance. In other words, whether to consider normalizing adjustments is not a matter of appraiser judgment based on “facts and circumstances.” Having established the need to make normalizing adjustments to historical and prospective enterprise cash flows, we proceed in the next section to discuss the nature of such adjustments. Examples of Normalizing Adjustments The purpose of normalizing adjustments is to remove the effect of corporate finance and operating decisions that are made without regard to the economic interest of the subject minority shareholders. As a shorthand expression for this, we often refer to normalizing adjustments as those which

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would reflect the performance of the subject enterprise as if it were managed like a well-run public company. One potential misconception that can arise with this shorthand definition is that normalizing adjustments transform the subject enterprise into a best-in-class performer. This is not the case. Normalizing adjustments do not address the subject company’s competitive strengths or weaknesses, growth opportunities, operational challenges, or industry headwinds. These “facts on the ground” do indeed rightly influence the value of the subject enterprise. If a company suffers from a weak strategy, stale technology, poor customer retention, or other fundamental factors, it is worth less than a better performing company on an enterprise basis. Not all companies are created equal. Normalizing adjustments can be classified into two broad categories: those relating to corporate finance decisions and those relating to operational decisions. ■

The most common corporate finance decision that does not advance the economic interests of minority shareholders is retention of operating cash flow to support the accumulation of low-yielding or nonoperating assets. In other words, operating cash flow that should be available for distribution to capital providers (for the benefit of minority investors) is instead diverted to accumulate cash, marketable securities portfolios, vacation properties, and the like. When measuring the value of the enterprise, it is necessary to normalize future enterprise cash flows to reflect the amounts available for distribution to capital providers regardless of whether such cash flows will in fact be distributed. The fact that the enterprise cash flows will be diverted instead to nonoperating assets affects the value of the illiquid shareholder interest, but not the value of the enterprise itself at a point in time. Such decisions do, however, negatively affect the future returns even to controlling shareholders who make such decisions. Current value is unimpaired, however, because the controlling owners retain the discretion to cease making such decisions.

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The most common operational decision that requires a normalization adjustment is for excessive owner compensation. Excess owner compensation is ultimately a diversion of enterprise cash flows away from capital providers as a whole to select shareholders. From the perspective of an illiquid shareholder interest, excess compensation is a very real burden that should be reflected in the value of the interest, but excess compensation payments do not negatively affect the value of the enterprise itself. Why? Because those adjustments will ultimately be made at the time of a future liquidity event.

As with adjustments for unusual or nonrecurring events, judgment is required in quantifying and applying appropriate normalizing adjustments. The goal of such adjustments is not to distort the fundamental characteristics of the subject enterprise. In other words, normalizing adjustments are not used to “fix” strategic or competitive deficits that cause the subject company to post uninspiring financial results. Normalizing adjustments are not a Lake Wobegon tool to transform every enterprise into an above-average performer. Rather, normalizing adjustments are used to place a private company on a public company footing, adjusting for corporate finance and operating decisions that are not made to the detriment of minority shareholders. As with adjustments for unusual or nonrecurring items, valuation analysts do well to calculate margins on an adjusted basis for comparison to available benchmarks for assessing the reasonableness of the adjustments made. Normalizing historical performance is also essential for evaluating the reasonableness of projected future performance in light of historical performance. See Exhibit 4.21. Historical

Prospective

Reported Financial Results plus/less: Impact of Unusual or Non-Recurring Events plus/less: Impact of Normalizing Adjustments Enterprise Cash Flows :: Marketable Minority

EXHIBIT 4.21 Applicability of Historical and Prospective Adjustments (Marketable Minority).

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Conclusion As discussed in this section, enterprise cash flows on a marketable minority interest basis should be adjusted for both unusual or nonrecurring events and normalizing adjustments to historical and prospective cash flows that place the subject enterprise on a public company–equivalent basis. In the next section, we address the nature of adjustments to consider when estimating enterprise cash flows on a financial control basis.

FINANCIAL CONTROL LEVEL: PRIVATE EQUITY CASH FLOWS By emphasizing the unique cash flow, risk, and growth attributes of each level of value, the Integrated Theory highlights the cumulative nature of the various attributes. So with respect to cash flows at the financial control level, we can assume that appropriate adjustments have already been made to derive enterprise cash flows on a marketable minority basis. As a result, we restrict the discussion in this section to the incremental cash flow adjustments to be considered when converting marketable minority enterprise cash flows to financial control enterprise cash flows.

The Characteristics of Financial Control Buyers In the previous section, we examined the perspective of public stock market investors to define enterprise cash flows on a marketable minority interest basis. To estimate enterprise cash flows on a financial control basis, we consider the perspective of private equity funds. This is not to suggest that private equity funds are the only financial control buyers, but they are representative of the class. Private equity funds are focused on generating financial returns over an expected holding period. There are three principal techniques private equity investors use to generate premium returns.

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1. Aggressive leverage or other financial engineering. Private equity funds often use more aggressive capital structures than public companies. This increases both the risk and potential return to private equity investors. To the extent their financing strategies reduce the weighted average cost of capital, doing so has the potential to increase the financial control value relative to the marketable minority level. We address this in more detail in Chapter 5. 2. Enhance the operational efficiency or fix the strategy of the subject enterprise. Private equity funds may identify “low-hanging fruit” from an operational or strategic perspective that will result in greater profitability or enhanced growth relative to the current operations of the business. Note that these are not “normalizing” adjustments that address inequities among shareholders, but rather represent discrete plans to address fundamental performance issues. Nor do these adjustments reflect the benefit of combining the business with existing operations. The private equity fund may believe that they can simply run the business better than incumbent management does. 3. Make the subject company more attractive to motivated strategic buyers. Once an initial investment has been made, private equity funds will often identify other targets in the same industry to “bolt on” to the initial investment in a bid to increase scale, improve margins, and generally increase the attractiveness of the combined businesses to potential strategic buyers. The first strategy does not relate to enterprise cash flows, and we will address it more extensively in Chapter 5. Under the third strategy, the private equity fund essentially becomes a strategic acquirer on subsequent acquisitions; we address these considerations in the next section of this chapter. In this chapter, we focus on the second strategy above, that of enhancing operational efficiency.

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Increasing Operational Efficiency Opportunities for financial control buyers to enhance enterprise cash flows by increasing operational efficiency are generally limited to modest administrative cost savings. It is possible that a financial control buyer may be able to generate some level of (nonstrategic) cost savings through preferred relationships with service providers or other vendors that they use across multiple portfolio companies. For example, a private equity buyer may examine the administrative burden at a target company and determine that, with appropriate investment in software and systems, the human resources function could be staffed with ten rather than fifteen employees. The net cost savings from such a one-time change is an example of a financial control adjustment.

Changing the Strategy of the Subject Enterprise In some cases, the investment thesis of financial control buyers may include a belief that the existing strategy of the company is defective in some respect, and the financial control buyer has a plan for improving the strategic position of the subject company in the relevant markets. This should not be confused with strategic or synergistic benefits that arise when two operating businesses are combined; rather, we are in this instance referring to potential changes to the operating strategy of the subject enterprise on a standalone basis. While financial control buyers may perceive such opportunities, making these changes entails execution risk. For example, a private equity buyer may – on the basis of comparing the subject company’s historical profit margins with industry peers – conclude that they can cure persistent underperformance by reorganizing the structure of the sales force or automating certain elements of the production process. The net expected cash flow enhancements from such strategy shifts applicable to the subject business on a standalone basis are an example of financial control adjustments.

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Conclusion Of the three avenues for generating returns employed by financial control buyers, improving enterprise cash flows is probably the least likely to contribute to a material premium relative to the marketable minority interest value. As discussed in the first section of this book, the Integrated Theory accommodates our experience that the financial control premium is often either nonexistent or quite small. If significant opportunities for cash flow enhancements were regularly available to financial control buyers, there would be little incentive for companies to remain public. In terms of fair market value measurements, financial control adjustments should be made only when it is likely that the buyer would anticipate making such adjustments and the dynamics of a hypothetical transaction would be expected to result in the benefits of the adjustment being shared with the seller. Private equity buyers are naturally motivated to retain as much of the benefit from the types of adjustments described above as possible. Nonetheless, the Integrated Theory highlights the conceptual role of such adjustments and helps define the factors to which such potential adjustments, when applied, are properly ascribed. Exhibit 4.22 illustrates the cumulative nature of financial control adjustments. In the following section, we address the nature of adjustments to consider when estimating enterprise cash flows on a strategic control basis.

Historical

Prospective

Reported Financial Results plus/less: Impact of Unusual or Non-Recurring Events plus/less: Impact of Normalizing Adjustments Enterprise Cash Flows :: Marketable Minority plus: Impact of Financial Control Adjustments Enterprise Cash Flows :: Financial Control

EXHIBIT 4.22 Applicability of Historical and Prospective Adjustments (Financial Control).

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STRATEGIC CONTROL LEVEL: STRATEGIC ACQUIRER CASH FLOWS The Integrated Theory follows market participant behavior by distinguishing between strategic and financial buyers. Exhibit 4.23 summarizes the most relevant differences between financial and strategic buyers from a valuation perspective. The differences noted in Exhibit 4.23 provide the context for evaluating the function and nature of potential strategic control adjustments.

Function of Strategic Control Adjustments to Enterprise Cash Flows The strategic control level of value describes the value at which strategically motivated buyers are expected to acquire a controlling interest in the subject enterprise. When a strategic control conclusion of value is appropriate to the purpose of the valuation, the

Financial Buyers

Strategic Buyers

Investment Horizon

Generally have a finite expected holding period

Indefinite

Existing Operations in Industry

None

Existing presence in industry as either competitor, customer, or supplier of subject business

Typical Financing Structure

Often rely on debt financing to boost investment returns

More conservative financing profile; may issue equity as consideration in transactions

Opportunities for Cash Flow Enhancement

Generally limited to potential administrative efficiencies or modest operational improvements

Often substantial, depending on unique operating characteristics of buyer and seller

Typical Motivation

Generate financial returns over holding period of limited duration

Enhance value of newly combined entity through cost savings and/or revenue synergies

Quantity of Buyers

Large number of such buyers with similar profile and motivations

Smaller number of such acquirers for subject company, each likely having unique attributes and motivations

Relevance to Fair Market Value

Typical benchmark for fair market value conclusions on a controlling interest basis

Could be relevant to fair market value if strategic buyers are plentiful and have common attributes

EXHIBIT 4.23 Attributes of Financial and Strategic Buyers.

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Income Approach (Cash Flows)

Standalone buyer cash flows

Standalone target cash flows

Pro forma combined cash flows

Potential strategic adjustments

EXHIBIT 4.24 Conceptual Dynamics of Strategic Transactions.

valuation analyst should carefully distinguish, at least at a conceptual level, between the expected cash flows of the pro forma combined entity and the expected cash flows that strategic acquirers are willing to ascribe to the subject enterprise. Consider the strategic transaction dynamics depicted in Exhibit 4.24. Knowing the pro forma cash flows of the combined entity does not necessarily reveal the magnitude of strategic cash flow adjustments applicable to the enterprise cash flows of the target, or subject company. While sellers are motivated to extract as much value as possible in a strategic combination, buyers are motivated to pay as little as possible. The relative “sharing” of the potential strategic adjustments between buyer and seller in a real-world transaction is ultimately a function of the relative negotiating leverage of the two parties to the transaction. At the most basic level, negotiating leverage among parties to a transaction depends on the scarcity of the asset and the number of potential buyers, as illustrated in Exhibit 4.25. Whether the valuation analysis is being prepared to measure the potential transaction value for a business that is owned or the potential purchase price for a particular target, analysts should be careful not to ascribe all potential cash flow adjustments to the subject company automatically without assessing how the aggregate cash flow benefits from the proposed strategic combination are likely to be

130

Buyer has greatest leverage Few buyers Generic asset

BUSINESS VALUATION

Seller has greatest leverage Many buyers Unique asset

EXHIBIT 4.25 Factors Influencing Relative Negotiating Leverage. shared between the buyer and the seller. Having clarified the function of strategic cash flow adjustments, we provide examples of the most common such adjustments in the following section.

Examples of Common Strategic Control Adjustments to Enterprise Cash Flows Strategic control adjustments are incremental to adjustments previously identified in this chapter. In other words, the strategic control adjustments we discuss in this section are made to the financial control enterprise cash flows. Referring back to Exhibit 4.23, strategic acquirers typically anticipate enhanced cash flows from a proposed transaction through some combination of cost savings and revenue synergies. The nature and magnitude of strategic cash flow adjustments depends on, and reflects, the strategic rationale for the proposed transaction. Strategic cash flow adjustments for a given enterprise will be different from the perspective of an existing competitor, comparable firm in an adjacent geography, supplier, or a customer. While there are other potential target/acquirer relationships, these are the most common and we focus on them in the following discussion. Exhibit 4.26 identifies some of the potential areas of emphasis for cash flow adjustments for different types of strategic acquirers.4

4 The potential strategic benefits identified in this chart are by no means exhaustive, but are illustrative of common strategic motivations for transactions.

131

Income Approach (Cash Flows) Existing Competitor

Geographic Expansion

Existing Supplier

Existing Customer

Revenue less: Cost of Production Inputs less: Manufacturing Overhead Gross Margin less: Distribution Expenses less: Selling & Marketing Expenses less: General & Administrative Operating Profit Capital Expenditures Investment in Working Capital

EXHIBIT 4.26 Illustrative Potential Strategic Adjustments. Revenue Revenue synergies include the ability to charge higher prices to existing customers and access to new customers for the acquirer’s existing products or services. Increasing pricing power is most likely when the strategic acquirer is an existing competitor while access to new customers is most likely for strategic targets in adjacent markets. Cost of Production Inputs Reducing the cost of production inputs is a common strategic motivator when the target is an existing supplier of the acquirer. Other strategic acquirers may also anticipate the ability to improve input pricing through increased purchasing power created by the scale of the combined operations. Manufacturing Overhead A strategic combination may be predicated upon increasing capacity utilization at existing production facilities of either the buyer or seller. While possible for each potential class of buyer, this motivation is likely to be most pronounced when the target is an existing competitor. Distribution Expenses Strategic transactions have the potential to create efficiencies in product distribution, whether through elimination of redundant facilities or by increasing the throughput of existing distribution infrastructure. Acquiring an existing supplier or customer may present opportunities for streamlining the relevant supply chains.

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Selling and Marketing Expenses For targets in adjacent markets, reducing selling and marketing expenses may be an important strategic rationale, as the acquirer’s existing salesforce infrastructure and marketing content can be effectively leveraged in the new territory. General and Administrative Expenses In contrast to potential financial control adjustments discussed in a prior section of this chapter, the magnitude of potential cost savings related to general and administrative expenses from the perspective of a strategic acquirer may be greater, as such savings could encompass eliminating substantial redundancies in finance, information technology, human resources, and other corporate functions. These expense savings can be important to all classes of strategic buyers. Capital Expenditures Potential strategic cash flow adjustments are not limited to revenue and expense categories on the income statement. Beyond the direct benefit to the income statement, facilities consolidation can reduce the level of ongoing maintenance capital expenditures required to support the combined enterprise. If the target company has excess capacity that can be leveraged by a strategic acquirer, the buyer may be able to decrease future capital expenditures that would otherwise be required. Working Capital Finally, market participants and valuation analysts should not overlook the impact of a strategic combination on incremental investments in working capital. If the target is an existing supplier or customer, there may be opportunities to manage inventories, receivables, and payables more efficiently on a combined basis. Importance of Relative Sharing The preceding discussion is intended to illustrate the potential categories of strategic cash flow adjustments to enterprise cash flows, and is neither exhaustive nor exclusive. When evaluating potential strategic cash flow adjustments, market participants and valuation analysts need to consider not just the absolute magnitude of the associated cash flow benefit, but also the likely relative sharing of that benefit between the buyer and the target subject company. Before closing this section on strategic control

Income Approach (Cash Flows)

133

cash flows, we relate strategic control adjustments to observable transaction data in the following discussion.

Meaning of Strategic Cash Flow Adjustments to Enterprise Cash Flows Having discussed the nature of strategic cash flow adjustments and given common examples, we turn to more adequately situating such adjustments within the Integrated Theory. The fundamental insight of the Integrated Theory, as described in the first section of this book, is that valuation conclusions at the various levels of value depend upon the cash flow, risk, and growth expectations of market participants applicable to each level. Accordingly, the traditional valuation discounts and premiums are ultimately functions of differences in expectations regarding cash flow, risk, and growth among adjacent levels. Therefore, in the context of the Integrated Theory, strategic cash flow adjustments reflect the difference in cash flow expectations between the financial control and strategic control levels. In other words, strategic cash flow adjustments account for (at least a significant portion of) the difference between financial control and strategic control values. As we discuss more fully in Chapter 5, differences in the discount rate used can also have a secondary effect on the resulting premium. When private companies are acquired by strategic buyers, there is no base financial control value from which one can calculate in implied valuation premium. While financial control values for public companies are not directly observable either, we have discussed compelling reasons to conclude that the financial control value is unlikely to be materially higher than the public share price in most cases. As a result, strategic acquisitions of public companies do provide an opportunity to calculate implied valuation premiums by comparing the transaction price to the enterprise value calculated with respect to the public share price, prior to being influenced by the strategic transaction. In the context of the Integrated Theory, the difference between the as-if-freely-traded price and the strategic price is the strategic control premium.

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The observed transaction premiums from strategic acquisitions of public companies provide valuable indirect evidence regarding the magnitude of potential strategic control adjustments credited to sellers in the transactions. When analyzed relative to the likely negotiating leverage of the parties, and the attributes of the specific acquirer (competitor, supplier, customer, etc.), the observed premium for a given transaction can provide important guidance for a market participant or valuation analyst estimating enterprise cash flows on a strategic control basis. Notwithstanding, it is difficult to generalize as to what a “typical” strategic buyer might be willing to pay. For this reason, the strategic control value is in many cases akin to the investment value standard of value rather than fair market value.

Conclusion In contrast to the financial control level of value, the strategic control level of value is predicated on the fact that a combination of existing businesses may result in greater cash flows than the buyer and seller could generate on a standalone basis.5 The increase in cash flows may result from cost savings or revenue synergies arising from the combination. Strategic cash flow adjustments should reflect not only the magnitude of the potential strategic benefit, but also the degree to which a strategic acquirer is likely to credit that benefit to the seller. Strategic cash flow adjustments can be estimated by reference to both the source of the anticipated strategic benefit and the class of strategic buyer in view. As indicated in Exhibit 4.27, it may not always be practical to make strategic control adjustments to historical enterprise cash flows, but clearly defining the strategic control adjustments applied to prospective cash flows is essential to

5

Fair market value is inherently a going-concern concept. A strategic combination generally results in the acquired entity ceasing to have an ongoing, independent existence. In the context of fair market value determinations, valuation analysts need to exercise caution when employing guideline transaction data that may be strategic in nature.

135

Income Approach (Cash Flows) Historical

Prospective

Reported Financial Results plus/less: Impact of Unusual or Non-Recurring Events plus/less: Impact of Normalizing Adjustments Enterprise Cash Flows :: Marketable Minority plus: Impact of Financial Control Adjustments Enterprise Cash Flows :: Financial Control plus: Impact of Strategic Control Adjustments Enterprise Cash Flows :: Strategic Control

EXHIBIT 4.27 Applicability of Historical and Prospective Adjustments (Strategic Control).

deriving enterprise values at the strategic control level of value in the context of the Integrated Theory. We have now described the components of enterprise cash flow, and the associated adjustments at each of the three enterprise levels of value in the context of the Integrated Theory. ■

■

■

At the marketable minority level, we demonstrated and confirmed the need to adjust reported cash flows for not only unusual and nonrecurring events but also to normalize corporate finance and operational decisions that are not made for the benefit of minority shareholders. For the financial control level, we explored the nature of appropriate cash flow adjustments, concluding that the magnitude of such adjustments relative to an appropriately normalized level of enterprise cash flows on a public-company equivalent basis will often be modest. Finally, we reviewed potential adjustments to derive enterprise cash flows at the strategic control level of value, considering the importance of negotiating leverage in allocating strategic benefits to the transaction parties, the source of potential strategic benefits, and the characteristics of different types of strategic buyers.

We conclude this section by offering some thoughts on assessing the overall reasonableness of projected enterprise cash flows.

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ASSESSING THE REASONABLENESS OF PROJECTED ENTERPRISE CASH FLOWS Assuming that a market participant or valuation analyst has faithfully adhered to the conceptual framework of the Integrated Theory and the guidance presented in the previous sections of this chapter, does it follow that the resulting forecast of enterprise cash flows is reasonable? Not necessarily. Adhering to the Integrated Theory does not relieve the market participant or valuation analyst of the responsibility of assessing the overall reasonableness of the cash flow forecast. In this concluding section of the chapter, we provide some brief thoughts on how best to assess the overall reasonableness of the projected enterprise cash flows. Before beginning that discussion, however, we contrast the precision of a cash flow forecast with the accuracy of that forecast. In our experience, valuation analysts occasionally go to great lengths in attempts to increase the precision of a cash flow forecast without any conscious regard to the potential accuracy of the forecast. Any economic model necessarily abstracts a great deal from the underlying economic reality being modeled. Enterprise cash flow forecasts are no different. A cash flow forecast necessarily requires a host of simplifying assumptions. Since the purpose of a cash flow forecast created for valuation is to replicate the expectations of market participants, the model should be judged accordingly. As a result, we define accuracy as general conformity to market participant expectations. The goal of the model is not, and indeed cannot be, detailed precision with regard to any particular component of the model. Rather, the quality of the model should be evaluated by the degree to which the resulting cash flows conform to the reasonable expectations of market participants. The degree of precision required in the model will vary according to the business model of the subject enterprise. In the remainder of this section, we offer a functional checklist for valuation analysts seeking to confirm the overall reasonableness of an enterprise cash flow forecast.

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137

Projected Revenue ◽ How do projected revenue growth rates compare to historical performance for the subject enterprise? Available peer data? Can the projected growth rate be qualitatively reconciled to the historical growth rate? ◽ How do projected revenue growth rates compare to published industry-wide revenue growth forecasts? If the forecast implies growing market share for the subject enterprise, is there a compelling rationale? Is the increasing market share reasonable in light of the competitive environment? ◽ Does anticipated revenue growth approach the terminal growth rate over the forecast period? ◽ Does the revenue forecast conform to the subject company’s strategy regarding changes in product pricing and sales volume? ◽ How does the selected (or implied) terminal growth rate compare to the guardrails of expected inflation and nominal economic growth discussed previously in this chapter?

Projected Operating Margin ◽ How do projected operating margins compare to adjusted historical operating margins achieved by the subject enterprise? ◽ Do the adjustments made to historical results for unusual or nonrecurring events provide an appropriate base from which to forecast future results? Or does a series of recurring nonrecurring adjustments suggest that the ongoing operating performance of the subject enterprise is being overstated or understated? ◽ If normalizing adjustments are applied, how do the resulting normalized margins compare to available data from public guideline companies or other peer data? Are the margin differences reconcilable with the relative size, competitive strengths, and operating efficiency of the public guideline companies or other sources of peer data?

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BUSINESS VALUATION

◽ If financial control adjustments are applied, is there a compelling rationale for the nature and magnitude of the adjustments relative to the normalized marketable minority interest forecast? How do the operating margins on a financial control basis compare to observable public guideline margins? ◽ If strategic control adjustments are applied, has the valuation analyst considered the degree to which expected strategic benefits would be shared with the seller in a transaction? Do the strategic control adjustments reasonably reflect the attributes of the relevant strategic acquirers? How does the magnitude of the assumed strategic cash flow adjustments compare to available data regarding observed transaction premiums for similarly situated targets?

Capital Expenditures and Depreciation ◽ Is the projected level of capital expenditures sufficient to support the expected revenue and profit growth over the forecast period? ◽ Does the trend in effective return on projected capital expenditures reflect competitive forces and reversion to the mean over the forecast period? ◽ Does the relationship between capital expenditures and depreciation over the forecast period imply improving or decreasing asset efficiency? In either case, is there a compelling rationale in support of the change? ◽ How do capital expenditures and depreciation compare in the terminal year cash flow? Is the excess of capital expenditures over depreciation (if any) reasonable and consistent with terminal growth expectations? ◽ On a strategic control basis, does the capital expenditure forecast take into account potential duplicative assets or excess/idle capacity that can be used by the strategic buyer?

Income Approach (Cash Flows)

139

Working Capital ◽ What does the working capital forecast imply about changes in the subject enterprise’s cash conversion cycle? Are changes consistent with market participant expectations regarding inventory management, customer collections, or disbursement strategies? ◽ On a strategic control basis, does the working capital forecast reflect the likely strategic rationale(s) for the transaction? The preceding list is by no means exhaustive, and the items presented will not apply to every subject enterprise or valuation purpose. However, the noted items do provide market participants and valuation analysts with a broad roadmap for assessing the overall reasonableness of the enterprise cash flows for use in the income approach.

CONCLUSION The Integrated Theory emphasizes the need to specify the expected cash flow, growth, and risk attributes of the subject enterprise. The income approach is the most natural starting point for describing how the Integrated Theory shapes and informs valuation practice. In this chapter, we have focused on the cash flow and growth components of the Integrated Theory. Specifically, we demonstrated the fundamental equivalence of the single-period capitalization and discounted cash flow methods, highlighted the importance of the reinvestment assumption, and reviewed the importance and meaning of terminal growth rates in the discounted cash flow method. We then proceeded to provide a detailed exposition of the various adjustments to cash flow applicable at each level of value before concluding with a review of factors to be considered when assessing the overall reasonableness of the cash flow forecast. In Chapter 5, we turn our attention to the role of risk assessment in estimating discount rates at the enterprise level.

CHAPTER

5

Income Approach (Discount Rate)

INTRODUCTION The Integrated Theory is expressed in terms of the three fundamental components of valuation: cash flow, risk, and growth. In Chapter 4, we explored the cash flow and growth components of the Integrated Theory as they intersect with valuation methods under the income approach. In this chapter, we examine the remaining component of risk, which manifests itself in the discount rate used to reduce projected cash flows to present value. We will address the following questions in this chapter: 1. What is the relationship between historical realized returns and expected future returns? 2. What are the components of the weighted average cost of capital (WACC)? 3. Why do market participants focus on the WACC when developing indications of enterprise value? 4. Is there a relationship between the size of the subject enterprise and the WACC? 5. What influence does the level of value have on the WACC? 6. How can valuation analysts assess the overall reasonableness of the WACC used in the income approach?

141 Business Valuation, First Edition. Z. Christopher Mercer and Travis W. Harms. © 2021 Z. Christopher Mercer and Travis W. Harms. Published 2021 by John Wiley & Sons, Inc.

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RETURN BASICS: REALIZED VERSUS REQUIRED RETURNS The fundamental valuation component of risk is represented in the Integrated Theory as the discount rate. From an equity perspective, the relevant discount rate is the required return on equity, while from the perspective of the enterprise as whole, the weighted average cost of capital is the relevant discount rate. The equity discount rate is one component of the WACC, but in this chapter we will continue to adopt the enterprise value perspective and will therefore focus on the WACC. Before we address the WACC in greater detail, we first must attempt to clarify the important distinction between realized and required (or expected) returns. Failure to distinguish properly between realized and required returns can become a source of great confusion when market participants and valuation analysts estimate discount rates.

Measuring Realized Returns Return is the reward for making an investment per unit of time (traditionally one calendar year). Realized returns, also referred to as historical returns, can be calculated for any investment if three data points can be observed: 1. The value of the investment at the beginning of the measurement period 2. Interim cash flows that are attributable to the investment, which may be positive or negative 3. The value of the investment at the end of the investment period Realized investment returns can be measured over any period and with any number or frequency of interim cash flows. However, for the ease of discussion, Exhibit 5.1 depicts the calculation of realized investment returns over a one-year holding period. Since daily stock prices and dividend payments are readily available, public equity markets provide a daily stream of data points that analysts use to calculate realized returns. This realized

143

Income Approach (Discount Rate)

(Valueending − Valuebeginning ) + Cash FlowInterim Valuebeginning

EXHIBIT 5.1 Calculation of Periodic Returns. return data, which is available for long historical periods, is of great interest to both market participants and valuation analysts. Realized returns measure the reward to investors for holding a given asset over a particular holding period. However, realized returns do not directly influence value under the income approach. Instead, the relevant measure of return for valuation is the expected future return, also referred to as the required return.

Relationship between Realized and Required Returns Exhibit 5.2 summarizes the key elements of the relationship between realized and required returns. Valuation Date Realized Returns

Relates historical cash flows to future asset value

Required Returns

Relates expected future cash flows to present asset value

May be positive or negative

May only be positive

Directly observable from market participant behavior

Not observable, must be inferred from market participant behavior

No direct impact on valuation under income approach

Significant influence on valuation under income approach

Inversely related to changes in required returns

Changes in required return have inverse effect on realized returns

EXHIBIT 5.2 Relationship between Realized and Required Returns.

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These differences are important for valuation analysts to bear in mind as we discuss discount rates in the remainder of this chapter. ■

■

■

Relationship to asset value. Realized returns tell the story of how historical cash flows (beginning values and interim cash flows) relate to the future value of the asset (i.e., the ending asset value). In contrast, required returns translate expected future cash flows, both interim cash flows and projected terminal value, to present value. Range of potential outcomes. There are no limits on realized returns. If future cash flows fail to meet expectations, realized returns for an asset are likely to be negative. Likewise, when the cash flows from an investment exceed initial expectations, the realized return over a given holding period can be enormous. Required returns, on the other hand, are range-bound. Since they relate expected future cash flows to present value, required returns cannot be negative.1 Under normal circumstances, rational investors do not make investments with the expectation of receiving less cash flow in the future. Though not subject to precise quantification, market discipline and the scarcity of attractive investments place a conceptual ceiling on the magnitude of expected returns for an investment. Observability. For assets that transact in a liquid market, realized returns are directly observable over any holding period. For assets that transact less frequently, precise realized return calculations can be made only at transaction dates. In contrast, required returns cannot be directly observed. Exhibit 5.3 illustrates the fundamental opacity of required returns.

Only one of the three variables in Exhibit 5.3 (Value0 ) can be directly observed. In other words, one is confronted with an equation in three variables, two of which are unknown. As a result,

1 While historically true, global credit markets are testing this assertion as of the drafting of this edition. It remains to be seen how sustainable this trend will ultimately prove to be.

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Income Approach (Discount Rate)

Value0 =

CF1 (1 + r)1

+

CF2 (1 + r)2

+

CF3 (1 + r)3

+···+

CFn (1 + r)n

Value0 is the value of the asset at the valuation date CFx is the series of expected future cash flows r is the required return for the asset

EXHIBIT 5.3 Relationship between Value, Cash Flow, and Return. neither of the unknown variables can be definitively specified. At best, one can specify pairs of variables (CFx and r) that satisfy the equation for a known Value0 . This has important implications for how valuation analysts should think about required returns from a conceptual perspective, as we will discuss in the remainder of this chapter. ■

■

Impact on valuation. In Exhibit 5.3, there is no term for realized returns. Rather, the discount rate is the required return on the subject asset. Realized returns are informative, and may provide valuable context for estimating required returns, but they do not appear in the valuation equation. Directional relationship. This is the most underappreciated element of the relationship between realized and required returns: rather than realized returns serving as a direct proxy for required returns, the two are in fact inversely related to one another. This is not necessarily intuitive, so Exhibit 5.4 provides an example to illustrate (for simplicity, assumed growth at all times is 0%).2 ■ Over the first holding period (from Time to Time ), neither 0 1 the expected cash flow nor the required return for the asset changed, and the realized return for the period was equal to the required return at the beginning of the period.

2 The calculations in Exhibit 5.4 are readily made for any public company; for a private company, the calculations can be made only if there are annual appraisals.

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BUSINESS VALUATION Time0

Historical Dates

Time1

Time2

Time3

Time4

Dec-15

Dec-16

Dec-17

Dec-18

Dec-19

Expected Cash Flow

$500

$500

$500

$500

$528

Required Return

10.0%

10.0%

11.0%

Value

$5,000

9.0%

9.5%

$5,000

$4,545

$5,556

$5,556

Interim Cash Flow Received

$500

$500

$500

$500

Annual Capital Appreciation Annual Distribution Yield Annual Realized Return

0.0% 10.0% 10.0%

–9.1% 10.0% 0.9%

22.2% 11.0% 33.2%

0.0% 9.0% 9.0%

Cumulative Realized Return Change in Required Return

10.0% 0.0%

5.4% 1.0%

13.9% –2.0%

12.7% 0.5%

Change in Expected Cash Flow Difference between Realized and Required Return

$0

0.0%

$0

–10.1%

$0

24.2%

$28

–0.5%

EXHIBIT 5.4 Impact of Changes in Required Return on Realized Return. ■

■

■

■

Moving from Time1 to Time2 , the required return increased from 10.0% to 11.0%, perhaps because of an increase in Treasury rates. In response, the value of the asset fell from $5,000 to $4,545, nearly offsetting the interim cash flow, resulting in a realized return during the period of just 0.9%. During the third holding period, required returns fell from 11.0% to 9.0% as market perceptions of risk changed, causing the value of the subject asset to increase to $5,556 and resulting in an annual holding period return of 33.2%. In the last period, the realized return of 9.0% matched the required return on the beginning of the holding period, but only because the increase in required return during the period happened to offset the increase in cash flow expectations during the period. The bottom row of Exhibit 5.4 illustrates the conceptual disconnect between required and realized returns. As required returns increase, realized returns fall, and vice versa.

Income Approach (Discount Rate)

147

The point of this example is twofold. First, the example demonstrates that realized returns depend on both the initial required return and changes in the required return during the holding period. When the required return increases, the realized return will be lower than it otherwise would have been. Second, the example illustrates the peril of looking to historical realized returns to provide “proof” as to required returns. The realized return over the period analyzed was 12.7%, yet the required return at the end of the period was 9.5%. Realized returns over time are influenced by a host of factors that may not be relevant to investor expectations at the valuation date.

Conclusion The purpose of this section is not to induce despair that reliable discount rates can ever be developed. Rather, the goal is to prepare the reader for the inevitable role of common sense, reasonableness, and informed judgment in developing discount rates. The difference between observable realized returns and unobservable required returns is logical rather than quantitative; as a result, no amount of data can bridge the gap. Valuation analysts who sift through mountains of realized return data to develop ever more precise estimates of required returns should be chastened by the fact that relationship between realized and required returns is far from straightforward. Conversely, valuation analysts who believe that required returns can simply be read off of observable market prices should acknowledge that, in the absence of a perfect window into expected cash flows (which does not exist), required returns are not susceptible to direct observation. In this chapter, we do not deny the contributions of either approach to estimating required returns. However, we do seek to provide a workable way forward that acknowledges the inherent limitations of both approaches. We believe it is possible to develop reasonable valuation indications under the income approach using

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reasonably estimated discount rates; we also believe that the blind pursuit of precision in discount rate development terminates in a conceptual and practical dead end.

COMPONENTS OF THE WEIGHTED AVERAGE COST OF CAPITAL Despite the inherent limitations to estimating discount rates with precision, it is certainly a useful exercise to identify and assess the individual components of the weighted average cost of capital. The WACC is the relevant discount rate when using enterprise cash flows in the income approach. As its name suggests, the WACC is the average of the required returns on debt and equity capital for the subject enterprise, weighted according to the relative proportion of each source of funding in the capital structure. Exhibit 5.5 identifies the individual components that comprise the weighted average cost of capital. WACC = (ke × we ) + (kd × wd ) ke = Rf + (𝛽 × ERP) + SP + CSRP kd = PTkd × (1 − T) In the remainder of this section, we provide brief observations regarding each of these components.

Cost of Equity Capital The cost of equity capital eludes direct observation. While specific models for estimating equity returns may differ slightly in their particulars, most follow the same general outline. Since one of the fundamental axioms of corporate finance is that return follows

149

Income Approach (Discount Rate) Cost of Equity Capital (ke) Rf : Risk-Free Rate ERP : Equity Risk Premium β : Beta SP : Size Premium CSRP : Company Specific Risk Premium

Cost of Debt Capital (kd) PTkd : Pre-tax Cost of Debt T : Marginal Tax Rate Capital Structure we : Equity as % of Total Capital wd : Debt as % of Total Capital

EXHIBIT 5.5 Components of Weighted Average Cost of Capital. risk, the conceptual basis of all equity return models is to identify components of incremental risk applicable to the subject company, adding appropriate risk premiums for each. Typically, valuation analysts “build up” discount rates from these components, using some version of the capital asset pricing model. Regardless of the specific variation used (adjusted capital asset pricing model, modified capital asset pricing model, buildup method, etc.), the underlying intuition is the same: return follows risk.3 Risk-Free Rate The starting point for any type of “buildup” analysis is the prevailing long-term, risk-free rate at the valuation date. Regardless of the holding period expectations for a particular investor, equity investments themselves have long durations (i.e., there is no contractual maturity date). As a result, most market participants and valuation analysts prefer to reference long-term

3 Mercer was perhaps the first published advocate of using a variation of the capital asset pricing model in the valuation of private companies. See “The Adjusted Capital Asset Pricing Model for Developing Capitalization Rates: An Extension of Previous ‘Build-Up’ Methodologies Based Upon the Capital Asset Pricing Model,” Business Valuation Review, December 1989, Volume 8, pp. 147–156. The literature has grown substantially since that time.

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Treasury securities when identifying the risk-free rate. While presumably free of credit risk, long-term Treasury securities are of course not truly risk-free in that changing market yields can cause realized returns over particular holding periods to vary widely. Nonetheless, the yield to maturity is the return that will be realized as long as the Treasury security is held until its maturity and all contractual cash flows are received. During the period of historically low interest rates beginning in late 2008, some valuation analysts have advocated using a higher “normalized” risk-free rate. In our view, such techniques, while not necessarily fatal to the resulting valuation conclusion, are misguided. The market for U.S. Treasury securities is the largest and most liquid in the world, and the pricing data from that market should be respected. Exhibit 5.6 compares 20-year Treasury yields to a selected “normalized” rate of 4.0%.4 Treasury yields fell below 4.0% in 2008 and have remained there for well over a decade. The temptation to normalize when yields first fell to what appeared to be unsustainable lows was understandable.5 After all, analysts concluded, surely such conditions reflected a temporary aberration brought on by the Great Recession. However, 10-plus years into economic recovery, it seems clear that disregarding the market evidence from Treasury yields was misguided. Equity Risk Premium: General The equity risk premium (“ERP”) is generally defined as the premium in return of large capitalization stocks over some measure of U.S. Treasury returns. It is universally acknowledged that investments in the shares of large public 4

A normalized Treasury rate of 4.0% was “recommended” by Duff & Phelps for several years, although that recommendation was lowered to 3.5% beginning in late 2016. See Duff & Phelps Cost of Capital Navigator, available (subscription) at https://dpcostofcapital.com/. 5 As shown in Exhibit 5.6, there was, in fact, precedent for sustained periods of “low” interest rates, as experienced during much of the 1950s and early 1960s.

151

Income Approach (Discount Rate) 16% 14%

Yield to Maturity

12% 10% 8%

Yields dipped below 4% in late 2008, and have remained below that level since June 2011

Yields below 4% until March 1963. Yields remained above 4% until late 2008.

6% 4% 2%

Apr-53 Aug-55 Dec-57 Apr-60 Aug-62 Dec-64 Apr-67 Aug-69 Dec-71 Apr-74 Aug-76 Dec-78 Apr-81 Aug-83 Dec-85 Apr-88 Aug-90 Dec-92 Apr-95 Aug-97 Dec-99 Apr-02 Aug-04 Dec-06 Apr-09 Aug-11 Dec-13 Apr-16 Aug-18

0%

Long-Term Treasury Yields

4.0% "Benchmark"

EXHIBIT 5.6 Long-Term Treasury Yields (April 1953 to December 2019). Note: Yield on 20-year Treasury, except for December 1986 through September 1993 (10-yr).

companies present the investor with greater risk than long-term Treasury securities. Yet the magnitude of the resulting equity risk premium eludes precise calculation. The greatest academic minds in finance have labored without end since at least the middle of the twentieth century to quantify the equity risk premium. The result of their tireless labors is a vast technical literature and nothing remotely approaching a consensus on the question. It is the foolhardy valuation analyst who concludes that they have anything substantial to add to the decades-long academic conversation or that they have identified the “right” equity risk premium. Should this hard truth cause valuation analysts to forgo using valuation methods under the income approach? Of course not, but it should engender a degree of epistemic humility when selecting the equity risk premium (or critiquing the premium selected by other valuation analysts, or courts, for that matter).

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The equity risk premium is an expectational concept. Investments in equity securities are made today, based on the expectations of future cash flows or benefits from the securities. So the equity risk premium is a forward-looking concept at its core. The problem is that there are no forward-looking, observable indications of the equity risk premium. There are two broad approaches to quantifying the equity risk premium, each equally flawed, and each equally useful: ■

■

Analysis of realized returns. While this approach has intuitive appeal, we have demonstrated that there is neither a logical nor a necessary link between realized and expected returns for an asset. Analysts generally take comfort in the belief that over a sufficiently long period of time the ups and downs of market cycles will even out and the realized return will – according to some variation on the law of large numbers – approximate the required return. Aside from probably just not being true, one is still left with the prickly problem of deciding which historical period over which to measure realized returns. Over different equally reasonable historical periods, realized returns differ materially. We will examine a variety of historical return information in the next section. Analysis of market prices. This approach, often referred to as the “supply-side” model, is gaining traction among practitioners and is also equally intuitive. Yet as we demonstrated in the prior section of this chapter, this approach represents – at its essence – attempting to solve an equation with three variables, of which two are unknown. This approach can yield valuable insights (and we will explore it in more depth below), but cannot provide a precise or unassailable estimate of the equity risk premium.

At this point, how should the thoroughly discouraged valuation analyst proceed? One way is to begin to understand the nature of some of the calculations that valuation analysts and market participants employ in developing equity risk premiums.

Income Approach (Discount Rate)

153

Realized Equity Risk Premiums – Calculations for Perspective Calculated equity risk premiums will vary depending on the assumptions made regarding historical time periods and equity and Treasury yields. Most analysts use historical returns on large capitalization stocks as the historical measure to use in developing the ERP. However, which Treasury return should be subtracted from it to develop the ERP? Two respected providers of cost of capital “calculators” make different assumptions: ■

■

Duff & Phelps Cost of Capital Navigator (subscription required). This online calculator develops the equity risk premium based on large capitalization common stock returns less the income return on long-term Treasury rates. The rationale is that the income return is the only truly risk-free component of returns on Treasury securities – the other returns being price appreciation or depreciation and reinvestment of income. Given the inherent riskiness of the latter two portions of Treasury returns, Duff & Phelps estimates the equity risk premium based on the income returns only. BVR Cost of Capital Professional (subscription required). This online calculator develops the equity risk premium based on large capitalization common stock returns less the total return on long-term Treasury securities.

Exhibit 5.7 summarizes the potential range of equity risk premiums from these two data providers over the same potential historical periods. All of the data in Exhibit 5.7 reflects arithmetic mean returns. A similar range of potential equity risk premiums could be calculated using geometric mean returns. There simply is no single “correct” equity risk premium. We recommend selecting a reasonable equity risk premium that sits comfortably in the range of the available data points. What this approach lacks in superficial analytical rigor it more than makes up for in intellectual honesty and simplicity. In our view, the futility of identifying the “correct” equity risk premium does not undermine the process of estimating the weighted average cost of capital, but does underscore the unavoidable need for valuation analysts to

Arithmetic Mean Returns BVR Cost of Capital Professional

Historical Equity Risk Premiums Based on Indicated Base Years to 2018 1928 1969 1979 1989 1999 2009 91 6.39% 5.80% 6.26% 7.74%

10-Year Treasury 20-Year Treasury Damodoran Historical ERP Damodoran Implied ERP

50 3.66% 2.71% 4.00% 6.68%

40 4.98% 3.69% 5.04% 7.05%

30 4.60% 2.81% 4.80% 6.96%

20 2.20% 0.20% 2.48% 7.00%

10 11.18% 9.72% 11.22% 6.88%

Damodoran ERP Sustainable Payout

7.33%

7.09%

6.64%

6.55%

6.59%

6.47%

BVR Cost of Capital 20-Year Treasury

5.80%

2.71%

3.69%

2.81%

0.20%

9.72% 10.60%

D&P Arithmetic Mean LT Treasuries Difference: BVR Much Lower

Damodoran Historical ERP D&P Arithmetic Mean LT Treasuries Difference: BVR/Damodoran

Lower

6.91%

4.66%

6.37%

6.30%

3.05%

–1.11%

–1.95%

–2.68%

–3.49%

–2.85%

–0.88%

6.26% 6.91%

4.00% 4.66%

5.04% 6.37%

4.80% 6.30%

2.48% 3.05%

11.22% 10.60%

–0.65%

–0.66%

–1.33%

–1.50%

–0.57%

0.62%

Note: All calculations of historical equity risk premiums above were performed using the BVR Cost of Capital Professional online platform. This service begins with 1928, so the longest historical period is 91 years to 2018 (versus 93 years for the Duff & Phelps Cost of Capital Navigator) Equity risk premiums are the difference between historical returns on large capitalization stocks and the total returns of indicated Treasury series

EXHIBIT 5.7 Historical Equity Risk Premiums: Calculated from Base Years to 2018.

155

Income Approach (Discount Rate)

exercise a healthy dose of common sense, informed judgment, and reasonableness at every point along the way.

Beta The concept of beta for a given security traces its roots to the groundbreaking Capital Asset Pricing Model, or CAPM. The fundamental insight of the CAPM is that the ability of investors to hold diversified portfolios means that the total risk of a security is not relevant to the required return for that security. Only a portion of the total risk (referred to as systematic risk) should theoretically influence security prices. Beta is the measure of systematic risk for a security. The concept of beta has great intuitive appeal and broadly conforms to the conclusions of market participants that the required returns for companies having differing risk profiles should in fact differ. Beta functions as a scaling factor for the selected equity risk premium. A beta less than 1.0 dampens the equity risk premium applicable to that security while a beta greater than 1.0 amplifies the equity risk premium applicable to that security, as seen in Exhibit 5.8. For any assumed equity risk premium, the selection of beta is important in that it adjusts the ERP for the implied riskiness of the security being valued.

Assumed Equity Risk Premium

Selected beta Coefficients and Implied beta-Adjusted ERPs

0.8

0.9

1.0

1.1

1.2

1.3

1.4

4.5

3.6

4.1

4.5

5.0

5.4

5.9

6.3

5.0

4.0

4.5

5.0

5.5

6.0

6.5

7.0

5.5

4.4

5.0

5.5

6.1

6.6

7.2

7.7

6.0

4.8

5.4

6.0

6.6

7.2

7.8

8.4

6.5

5.2

5.9

6.5

7.2

7.8

8.5

9.1

7.0

5.6

6.3

7.0

7.7

8.4

9.1

9.8

EXHIBIT 5.8 Impact of Beta on Assumed ERP.

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BUSINESS VALUATION

In practice, most models for estimating required equity returns include beta.6 Beta is not observable for private companies, so market participants and valuation analysts generally select beta for the subject company from observed betas for a guideline public company group. The actual calculation of beta depends on a number of assumptions, including the time period analyzed and calculation technique used. For example, for a given security, the historical beta calculated on the basis of returns for the preceding five years could be quite different than that calculated over a two-year horizon. Neither time period is conceptually superior to the other. Exhibit 5.9 summarizes some of the assumptions that can influence the calculated betas used by market participants and valuation analysts. There are as many ways to calculate beta as there are data providers. In addition to a beta calculated strictly with reference to historical stock prices, some data providers make proprietary Measure of Beta Selected

Time Period for Estimation

Frequency of Observation

Index for Comparison

Unlever and Relever

36 months

Daily

S&P 500 Index

Yes

60 months

Weekly

NYSE Composite Index

No

120 months

Monthly

Any Broader Index

“Standard” beta Sum beta Smoothed beta Other betas

EXHIBIT 5.9 Selected Choices in Beta Calculations.

6 Some valuation analysts argue that versions of the Capital Asset Pricing Model referred to as “buildup methods” do not include a beta. They do; however, the assumed beta is 1.0, or the beta of the broad market. There are sources for so-called “industry risk premiums (or discounts)” to be included in the buildup methods. These industry premiums imply betas of greater than 1.0, and the discounts imply betas of less than 1.0. Industry risk premiums are calculated with reference to a group of public companies; valuation analysts using the industry risk premiums would do well to know which companies are used in the calculation and be prepared to make relevant comparisons to the subject company.

Income Approach (Discount Rate)

157

adjustments to reflect what they believe to be a more relevant expectational perspective. Still others convert an implied beta measure into an industry risk premium or discount. In short, there is no single indisputable beta for any public company at any given date, much less for a private company. Beta is sensitive to the subject company’s capital structure. Various models have been developed to adjust beta for financial leverage. These models can be useful, but valuation analysts should be wary of ascribing an exaggerated sense of precision to the results of such models.7 However calculated, historical betas inform, but do not define, the expected betas that are the relevant inputs to CAPM-based models. As with the equity risk premium, precision is not possible, so valuation analysts should be content with general reasonableness and coherence with the risk profile of the subject company. The valuation analyst is left to make his or her best judgment in the context of the valuation assignment. Size Premium Despite the brilliance of the CAPM and its theoretical rigor, academics and valuation practitioners have long observed that market participants seem to assign a risk premium to smaller companies that cannot be fully explained with reference to the systematic risk of those companies (i.e., beta). As a result, most academics and nearly all valuation analysts recommend an additional premium based on the size of the subject company. Attempts to quantify the size premium precisely – and they are legion – founder on the same conceptual and practical obstacles as the equity risk premium. As a result, our recommendation for the size premium echoes what we offered for the equity risk premium: select a premium that is within the range of observable data points, knowing that the ultimate accuracy of one’s required return estimate is a function of the overall 7

We have seen “battles of the experts” regarding the “right” beta to be used in disputed valuation contests in court. In the heat of battle, one or both experts (and courts) often fail to address the threshold question – the reasonableness of the concluded equity discount rate or WACC in light of market evidence.

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BUSINESS VALUATION

reasonableness of the aggregate components, and not the precision with which a single component is specified. As shown in Exhibit 5.10, observed historical size premiums depend on the assumed calculation period for measurement and the assumed ranking measure. The exhibit shows size premiums for two periods, 1981–2018 and 1990–2018, either of which might be reasonable, for the smallest companies (highest portfolio size rankings) using the Duff & Phelps Cost of Capital Navigator. In addition to size premiums based on the market value of equity (upper left of Exhibit 5.10), premiums based on average total assets, five-year average EBITDA and net income are shown. Looking vertically, calculated size premiums almost uniformly increase as the porfolio size rankings increase, or, as the underlying companies become smaller. However, looking horizontally at the two different time periods for calculation, premiums for the latter time period are about 0.8% on average higher than for the earlier period. The differences are potentially significant and beg the question of which of these two periods, relative to other potential periods, should be preferable. The calculations in Exhibit 5.10 confirm the conclusion of the preceding paragraph regarding making selection decisions for size premiums within a range of reasonable data points, realizing that precision is not feasible. Company-Specific Risk Premium Valuation analysts have traditionally concluded that – for many subject companies – the size-adjusted equity return understates the returns implied by observed pricing for smaller private companies. As a result, inclusion of a final buildup component, referred to as the company-specific risk premium, has been commonplace in deriving the cost of equity in the valuation of private companies.8 While there is no direct observable market

8

The company-specific risk premium has a long pedigree. See, for example, Mercer’s 1989 article, “The Adjusted Capital Asset Pricing Model for Developing Capitalization Rates: An Extension of Previous ‘Build-Up’ Methodologies Based Upon the Capital Asset Pricing Model,” Business Valuation Review, December 1989.

159

Income Approach (Discount Rate)

Portfolio Premium of CAPM Ranking Average MVE 1981-2018 1990-2018 ($Millions) by Size 21 22 23 24 25

$1,243 $981 $754 $512 $157

Portfolio Ranking by Size

Net Income ($Millions)

21 22 23 24 25

$41 $32 $24 $16 $6

1.9% 3.1% 1.5% 4.7% 7.1%

2.3% 4.4% 2.1% 5.3% 8.1%

Premium of CAPM 1981-2018 1990-2018 3.1% 2.2% 3.3% 3.4% 5.6%

2.6% 2.9% 4.1% 4.7% 7.0%

Portfolio Ranking by Size

Avg Total Assets ($Millions)

21 22 23 24 25

$1,060 $809 $608 $418 $156

Portfolio Ranking by Size

5-Yr Avg EBITDA ($Millions)

21 22 23 24 25

$126 $98 $76 $52 $17

Premium of CAPM 1981-2018 1990-2018 2.8% 2.3% 2.9% 4.0% 5.3%

3.7% 2.8% 3.7% 4.3% 6.7%

Premium of CAPM 1981-2018 1990-2018 3.2% 3.6% 4.0% 2.9% 4.9%

3.9% 3.9% 4.7% 3.8% 6.3%

Source: Duff & Phelps Cost of Navigator - Provided by Duff & Phelps

EXHIBIT 5.10 Size Premium over Different Measurement Periods. evidence for the magnitude of the company-specific risk premium implied by observed market transactions, experienced valuation analysts have found the premium to be useful in deriving conclusions that more closely mimic what they have observed to be market behavior in transactions for private companies. Although the concept has been around for a long time, the company-specific risk premium elicits two fundamental reactions among valuation analysts. ■

Empiricists recoil at what could seem to be an injection of unalloyed judgment into the estimation of the required equity return. These observers reason – not incorrectly – that a set of expected cash flows for the subject enterprise exists such that inclusion of a company-specific risk premium is not necessary. From this perspective, the company-specific risk premium is nothing more than an admission that the projected cash flows have been overstated. This is a logical and internally consistent position that is gaining advocates in some corners of the valuation community, especially at large accounting firms.

160 ■

BUSINESS VALUATION

Pragmatists, on the other hand, see the company-specific risk premium as an opportunity to adapt the other components of the discount rate buildup to what they believe to be observable market behavior. These analysts believe that identifying the “correct” set of expected cash flows for a subject enterprise is ultimately a fool’s errand, and view the company-specific risk premium as the point at which valuation analysts make use of the professional judgment that accrues over decades of experience. Of course, as we have already demonstrated, market participant behavior as it regards cash flow expectations and discount rates is not actually as transparent as we might wish; this can undermine claims to mimic market participant behavior.9

We do not share the empiricists’ confidence that companyspecific risk premiums can simply be eliminated. Our experience in the market for small and middle-market private companies tells us that market participants do in fact harbor return expectations in excess of even size-adjusted returns from the CAPM. At the same time, we are increasingly sympathetic to the empiricists’ position, and acknowledge that market participant behavior is susceptible to a variety of interpretations. In short, we continue to apply company-specific risk premiums where appropriate, but in doing so strive to ensure that we are in fact mimicking a market participant perspective, and not simply “fixing” overly ambitious cash flow forecasts by using insupportably high discount rates.10 9

Mercer has been saying in speeches for many years that, when developing discount rates, valuation analysts and market participants need to keep actual markets for private and public companies in their mental rearview mirrors. Properly conceived, developing discount rates sits at the intersection of the income and market approaches. While the discount rate is used in the income approach, it comes from the market. 10 In practice, this can lead to prickly situations. If management is adamant that its forecast is appropriate despite valuation analyst misgivings, the path of least resistance for the valuation analyst seeking a reasonable valuation conclusion may well be to apply an offsetting company-specific risk premium to account for the perceived projection risk. While this is not conceptually ideal, it is one path valuation analysts can use to reach a reasonable valuation conclusion.

Income Approach (Discount Rate)

161

Cost of Debt Capital Relative to the cost of equity, the cost of debt for a subject company is more observable. While still not reducible to precise quantification, the range of reasonable judgment surrounding the pre-tax cost of debt is generally somewhat narrower than that for the cost of equity. Pre-tax Cost of Debt In practice, the specific technique we use to derive the cost of debt largely depends on the availability of company-specific data regarding borrowing costs. ■

■

■

■

■

If the subject company has considerable debt, one data point to examine in terms of estimating the pre-tax cost of debt is the actual average cost of debt experienced in recent periods. If the subject company has recently issued long-term fixed-rate debt, the coupon rate on that issuance is likely to provide a sufficient approximation of the relevant pre-tax cost of debt. If the subject company has recently issued floating-rate debt, we generally use the spread (the fixed premium to the floating rate component of the coupon rate) as a proxy for the credit risk of the subject company. To convert the current floating coupon rate to a long-term fixed-rate equivalent cost, we replace the floating rate component with a long-term swap rate (adjusting for basis if necessary). When rates are low, some companies can be aggressive in using short-term debt to reduce their current borrowing costs. Valuation analysts and market participants should not neglect the refinancing risk inherent in this strategy and focus on the long-term cost of debt, which may be higher than the current coupon rate on short-term borrowings used by the company. If the subject company has no debt, or has not issued debt recently, we will look to available benchmark yields for rated corporate debt. When doing so, one must make an assumption regarding the credit rating that would be applicable to the subject company. This requires judgment, but in the context of other judgments being made in estimating the WACC, is not an insuperable obstacle.

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BUSINESS VALUATION

When estimating the pre-tax cost of debt, valuation analysts must understand that the cost of debt for a subject company is not static, but dynamic with respect to the amount of financial leverage employed. For example, the pre-tax cost of debt for a company using debt equal to 50% of total capital will generally be higher than if that same company had borrowed only 20% of total capital. Ultimately, regardless of the specific data points referenced, the assumed pre-tax cost of debt should correspond, from a market participant perspective, to the risk of the subject company and the assumed capital structure. Marginal Tax Rate Unlike the dividends and capital appreciation that are the sources of return to equity holders, interest paid to lenders is deductible for income tax purposes. As a result, the relevant cost of debt for calculating the WACC is stated on an after-tax basis. Since the interest deduction is assumed to reduce taxable income at the margin, the appropriate tax rate is the applicable (blended federal and state) marginal rate, which may not necessarily be equal to the company’s effective, or average, tax rate. Valuation analysts engaging in historical valuations should be sure that the marginal tax rates assumed are appropriate for their historical valuation dates. For example, the Tax Cut and Jobs Act of 2017 reduced the marginal federal tax rate from 35% to 21%. Further discussion of this change is beyond the scope of this book; however, valuation analysts must realize that when the federal tax rate was changed, expected cash flows for subject companies also changed. It may seem obvious to point this out, but a company with a given level of pre-tax earnings (cash flow) is worth more at a lower tax rate than at a higher rate. Why? Because net cash flows to the enterprise are increased by the lower tax rates. After-Tax Cost of Debt The after-tax cost of debt is equal to the pre-tax cost of debt, multiplied by (1 minus the marginal tax rate). The after-tax cost of debt is then used, together with the cost of equity, to derive the weighted average cost of capital.

Income Approach (Discount Rate)

163

Capital Structure The final component required when estimating WACC is the assumed capital structure of the subject company. For purposes of calculating the WACC, capital structure is measured with regard to the market values of the debt and equity components, rather than book values. In practice, the book value of debt is often assumed to approximate the market value. There are two basic methods to developing the capital structure assumption: ■

■

Iterative Method. The first approach is to attempt to match the existing capital structure of the subject enterprise. While this may sound straightforward, the practical application is complicated by the iterative nature of the calculation. Since the assumed capital structure influences the WACC, which in turn influences the market value of equity, the calculation of the existing capital structure for a subject company is inherently circular. This circularity can be resolved only through a process of trial and error in which the valuation analyst selects a capital structure and compares the resulting enterprise value to the actual balance of debt outstanding. This approach has a veneer of objectivity that is appealing to some, but the subjectivity that is supposedly avoided with this technique is not truly eliminated, but rather resurfaces elsewhere in the valuation analysis, as we discussed in the development of the equity discount rate. Target Capital Structure Method. The second approach consists of selecting a target capital structure for the subject enterprise without regard to the actual capital structure of the company at the valuation date. The target capital structure is generally selected with regard to available benchmarks for guideline public companies, private company transaction data, or other sources. When adopting this approach, it is important for the valuation analyst to consider whether an adjustment to the observed cost of debt for the subject company is the appropriate benchmark for the cost of debt if the assumed capital structure differs materially from the company’s actual capital structure. The assumed capital

164

BUSINESS VALUATION

structure can then be compared to the company’s actual capital structure to help assess the reasonableness of the valuation inputs and conclusion. We tend toward the second approach, which is also the one we encounter most frequently in practice and among market participants. We will explore the reasons for this preference in the next section of this chapter.

Conclusion In this section, we have reviewed the basic components of the weighted average cost of capital, highlighting the inherent role of professional judgment and false comfort of seemingly precise calculations. Exhibit 5.11 illustrates the cumulative impact that small differences in the selection of various components can have on the overall WACC. At the level of individual components, there are no points in the respective buildups at which one valuation analyst would be able to demonstrate that his or her assumption is “right” and that of their counterpart is “wrong.” Yet the estimated WACCs of the two analysts are markedly different (9.34% for Analyst A and 11.34% for Analyst B). From our perspective, this confirms that the “truth” of a valuation cannot be found in the degree of precision with which a particular WACC component is derived. If we assume that the valuation analysts agree that the long-term growth rate is 3.0%, Analyst A will develop a cash flow multiple of 15.8x, compared to 11.6x for Analyst B. This is a difference of 36%. The reasonableness of either conclusion will not be proven by demonstrating the reasonableness of individual components of the WACC. Each component could be within a reasonable range of judgment, yet the cumulative effect of small differences in the assumptions has a profound effect on the resulting valuation conclusion. The ultimate test of reasonableness in this case will have to be through comparison to relevant and available market evidence. In the concluding section of this chapter, we return to this conundrum when we discuss how to assess the overall reasonableness of a discount rate.

165

Income Approach (Discount Rate)

Analyst A Cost of Equity Capital Risk-free rate Equity risk premium Beta Beta-adjusted ERP Size premium Company-specific risk premium Cost of Equity Capital Cost of Debt Capital Pre-tax cost of debt Marginal tax rate Cost of Debt Capital Capital Structure Equity Capital Debt Capital Estimated WACC Less: Long Term Growth Debt-Free Cap Rate Debt-Free Multiple (1 / Cap Rate)

Analyst B

Absolute Diff. A From B

2.50% 5.50% 0.90 4.95% 3.00% 1.00% 11.45%

2.50% 6.00% 0.95 5.70% 3.50% 2.00% 13.70%

Same –0.50% 0.05

4.00% 25% 3.00%

4.50% 25% 3.38%

–0.50%

75% 25%

80% 20%

–5.00% 5.00%

9.34% –3.00% 6.34% 15.8

11.64% –3.00% 8.64% 11.6

–0.50% –1.00%

Same 36.3% % Difference

EXHIBIT 5.11 Cumulative Effect of Assumptions on WACC.

MARKET PARTICIPANTS AND THE WACC Our emphasis throughout this chapter is on the weighted average cost of capital. We have elected to emphasize the WACC over the cost of equity because real-life market participants focus on the enterprise value of private businesses, and not the equity value. As valuation analysts, we strive to emulate the behavior of market participants. But why do market participants favor the WACC? We identify two principal reasons in this section: (1) private company transaction structure, and (2) the dynamic relationship of capital component costs and capital structure.

Private Company Transaction Structure In most private company transactions, the acquirer purchases the net assets of the business rather than the equity (i.e., the common

166

BUSINESS VALUATION

stock). While obviously true in asset deals, this is functionally the case even in stock deals. Most stock purchase agreements denominate the purchase price for the subject interest in terms of enterprise value, with an adjustment for debt outstanding (generally net of cash) at the transaction date. To illustrate, consider the two private companies in Exhibit 5.12. As shown in the top panel of the exhibit, the capital structures of Company A and Company B are quite different. Company A has little debt, and Company B uses substantial debt financing. However, market participants considering an acquisition of either company will plan to replace the existing capital structure with one of their own choosing. As depicted in the bottom panel, the post-transaction capital structures are identical (assuming the same acquirer). As a result, market participants are focused on the value of the net operating assets of the business (enterprise value), and are largely indifferent to the existing capital structure. The existing capital structure directly influences the net proceeds received by the existing shareholders, but does not influence the value of the enterprise from the perspective of market participants. This behavior of real-world market participants is the primary reason we conclude that an iterative process to match the existing capital structure when estimating the WACC is generally unnecessary.

Dynamic Relationship between Capital Costs and Capital Structure The costs of both debt and equity capital are sensitive to the relative proportions of each in the capital structure. As financial leverage increases, the costs of both debt and equity capital increase. For any given capital structure, the cost of equity always exceeds the cost of debt. However, since the costs of both sources increase with increasing leverage, the rising costs eventually overwhelm the benefit of adding (relatively) low cost debt to the capital structure. In other words, the capital structure assumption is not independent of the cost of equity and cost of debt assumptions. Since the costs of equity and debt capital increase with increasing leverage,

Before Transaction

Company A

Company B Existing Debt Existing Debt

Enterprise Value (Net Operating Assets)

Equity

Enterprise Value (Net Operating Assets) Equity

After Transaction

Company A

Company B Acquirer Debt

Enterprise Value (Net Operating Assets)

Acquirer Debt Enterprise Value (Net Operating Assets)

Equity

EXHIBIT 5.12 Comparison of Existing and Pro Forma Capital Structures.

Equity

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BUSINESS VALUATION

Required Return

valuation analysts cannot blithely apply materially different capital structure assumptions using the same cost inputs. If the cost of equity is 14% when equity is 80% of total capital, it is higher when equity is 50% of total capital.11 Exhibit 5.13 illustrates this dynamic relationship. The chart in Exhibit 5.13 confirms that, while tinkering with capital structure does influence the WACC, the influence of capital structure on the WACC (the middle line) is relatively insensitive over a wide swath of capital structures. This statement, of course, assumes that the valuation analyst has properly adjusted the costs of debt (the bottom line) and equity (the top line) for increasing amounts of leverage when making such calculations. From our perspective, the dynamic relationship between capital structure and the cost of debt and equity capital is actually good news for valuation analysts since the net result of the interaction is a relatively stable WACC. The capital structure dynamics illustrated in Exhibit 5.13 do not suggest that market participants are indifferent to capital structure.

Debt / Equity Cost of Equity

Cost of Debt

WACC

EXHIBIT 5.13 Effect of Capital Structure on WACC.

11

This discussion assumes that lenders are pricing risk appropriately.

169

Income Approach (Discount Rate)

Buyers are finely attuned to the financing available to support their purchases. However, the financing mix actually employed in a transaction primarily influences the prospective return on equity (the top line), and has less effect on the WACC (the middle line). This further confirms the analysis in Exhibit 5.12 suggesting that market participants focus on enterprise value (using the WACC) without regard to the actual pre-transaction capital structure of the seller.

Conclusion In the real world, market participants contemplating the purchase of a private operating business focus on the enterprise value rather than the value of the existing equity. As a result, the weighted average cost of capital is the discount rate of concern to market participants. Market participants use capital structure as a tool to share risk and potentially drive equity returns, as illustrated in Exhibit 5.14. But the WACC ultimately reflects the operating risk of the enterprise as a whole, which is the focal point for market participants.

THE LEVELS OF VALUE AND THE WACC The Integrated Theory explains differences in valuation conclusions at the various levels of value with reference to differences in expected cash flows (including expected growth) and risk (as manifest in the discount rate). Setting aside the nonmarketable minority level of value, which is addressed in Part Three of this book, the enterprise value perspective is applicable to the marketable

Cost of Debt The WACC reflects the operating risk of the enterprise as a whole

Weighted Average Cost of Capital Cost of Equity

Capital structure determines the risk sharing - and costs - of debt and equity capital, but has less effect on the WACC itself

EXHIBIT 5.14 Relationship of WACC to Capital Components.

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minority, financial control, and strategic control levels of value. When expressing the conceptual math undergirding the Integrated Theory, we allow for the possibility that the WACC for a given enterprise may be different at each of the various levels. In this section, we explore what – if any – differences market participants are likely to assign to the WACC at the various levels of value.

Marketable Minority Level of Value The marketable minority level of value provides the base with respect to which the other levels of value are defined. As discussed in preceding sections of this chapter, the richest available data set of realized equity returns is that available from public securities markets. This data is directly applicable to the marketable minority level of value. Even supply-side models that do not rely on realized equity returns rely on pricing data and analyst expectations for cash flows from public companies. Having defined the marketable minority level as the relevant base, we proceed to examine whether, or to what extent, market participants at the financial and strategic control levels of value adjust WACCs applicable at the marketable minority interest level.

Financial Control Level of Value We identified the three principal strategies employed by financial control buyers to enhance their investment returns in Chapter 4: 1. Aggressive leverage or other financial engineering. 2. Enhance the operational efficiency or fix the strategy of the subject enterprise. 3. Make the subject company more attractive to motivated strategic buyers. We addressed the second strategy at length in Chapter 4. Financial buyers relying on the third strategy are effectively strategic buyers. We address the implications of the first strategy here.

Income Approach (Discount Rate)

171

Available transaction data suggests that lower-middle-market private equity acquirers routinely use debt financing to account for 50% or more of the aggregate purchase price. This compares to market-weighted capital structures for public companies that in most industries rarely exceed 30% debt. At first glance, this discrepancy might suggest that, since debt is less expensive than equity, the WACC for a subject company is lower for financial control buyers than at the marketable minority interest level. However, as we demonstrated in Exhibit 5.13, the dynamic nature of the costs of debt and equity capital with reference to capital structure results in a relatively flat cost of capital as capital structure changes. In our view, this suggests that the higher leverage levels employed by financial buyers do not result in material reductions to the WACC applicable at the financial control level of value. Rather than reducing the WACC, the use of greater leverage by financial buyers reflects a strategy of increasing expected equity returns (by taking on greater financial risk). From the perspective of private equity investors this shift in risk-sharing and reward-sharing among the capital providers is judged to be desirable, but it does not result in a materially lower WACC.

Strategic Control Level of Value In contrast to financial control buyers, strategic acquirers anticipate material cash flow benefits from integrating the target company into their existing operations. We reviewed the nature of such adjustments in Chapter 4. The question before us in this chapter is whether strategic acquirers apply a different WACC to expected target cash flows than financial control buyers (or public market investors do). The question of the WACC at the strategic control level ultimately refers us back to the size premium. On the basis of long-term public market returns and our experience with the market for private companies, the size premium seems to be a component of real-world market participant behavior. Since strategic acquirers tend to be larger than their acquisition targets, they are likely to have lower WACCs than their targets, all

172

Discounting Periods

BUSINESS VALUATION Year 1 1.0

Year 2 2.0

Year 3 3.0

Year 4 4.0

1,000 0.9174 917

1,150 0.8417 968

1,250 0.7722 965

1,300 0.7084 921

Long-term growth 155 165 0.6587 0.5935

Long-term growth

Acquirer - Standalone Expected Cash Flow PV Factors 9.0% PV of Cash Flows Indicated Value

1,325 0.6499 861

2.5% 20,894 0.6499 13,580

$18,213

Target - Standalone Expected Cash Flow PV Factors 11.0%

100 0.9009

120 0.8116

140 0.7312

PV of Cash Flows Indicated Value

90 $1,671

97

102

Sum of Indicated Values

Year 5 Terminal 5.0 5.0

102

98

2.5% 1,990 0.5935 1,181

$19,883

EXHIBIT 5.15 Target and Acquirer Cash Flows: Stand-alone Basis.

other things being equal. Exhibit 5.15 summarizes expected future cash flows for a strategic acquirer and target on a standalone basis. As a result of its greater size, the WACC applicable to the acquirer is 9.0% while the WACC appropriate to the target is 11.0%. Setting aside for the moment any possibility of strategic cash flow benefits, Exhibit 5.16 presents the post-combination value of the combined entity at the acquirer’s 9.0% WACC. Since the combined cash flows are discounted at the acquirer’s lower WACC, the combined value of the entity is $538 greater than the sum of the standalone values (a 32% premium relative to the standalone value of the target). This represents the aggregate value created by the transaction. This establishes the ceiling for how much the strategic acquirer can pay, but should it pay that much? Consistent with our discussion in Chapter 4 regarding potential strategic cash flow benefits, the relative sharing of the total value creation should reflect the attributes of the acquirer and target, as illustrated in Exhibit 5.17.

173

Income Approach (Discount Rate)

Discounting Periods

Year 1 1.0

Year 2 2.0

Year 3 3.0

Year 4 4.0

1,150 120 0

1,250 140 0

1,300 155 0

1,325 165 0

1,270 0.8417 1,069

1,390 0.7722 1,073

1,455 0.7084 1,031

1,490 0.6499 968

Long-term growth

Post-Combination Cash Flows Acquirer - Standalone Target - Standalone Strategic Benefits Total Cash Flows PV Factors 9.0% PV of Cash Flows Indicated Value less: Standalone Values Incremental Value

Year 5 Terminal 5.0 5.0

1,000 100 0 1,100 0.9174 1,009 $20,421 (19,883)

2.5%

23,496 0.6499 15,271

from Exhib it 5.15

$538

EXHIBIT 5.16 Post-Combination Cash Flows and Incremental Value.

PV of expected cash flows at acquirer WACC

PV of expected cash flows at target WACC

Range of Strategic Value

Relative Negotiating Leverage

Generic asset/ few buyers

Unique asset/many buyers

EXHIBIT 5.17 Range of Potential Strategic Values.

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The ultimate sharing of the potential value creation depends on the relative negotiating leverage of the parties. The mere fact that a strategic acquirer has a lower WACC than the subject enterprise does not mean that value at the strategic control level of value is calculated using the lower WACC. However, that possibility is one that valuation analysts need to consider when measuring enterprise value at the strategic control level or interpreting data from observed strategic control transactions. Our discussion in this section is oriented toward describing market participant behavior in strategic transactions. Valuation analysts should bear in mind that fair market value is not generally measured on a strategic control basis.

Conclusion The Integrated Theory posits that differences in the various levels of value can be attributed, at least in part, to differences in risk, as manifest in the discount rate. We defer discussion of the discount rate applicable to the nonmarketable minority interest level to Part Three of this book. In this section, we reviewed the potential differences in the WACC at the marketable minority, financial control, and strategic control levels. ■

■

■

The base WACC estimate applies to enterprise cash flows at the marketable minority interest level. At the financial control level, there is little reason to assume that the WACC applied by market participants is materially different than the base (marketable minority) WACC for the subject enterprise. At the strategic control level, strategic acquirers may be motivated to apply their own, potentially lower, WACC when evaluating the subject enterprise. The degree to which they credit the resulting value enhancement to the seller depends on the relative negotiating leverage of the parties and determines whether the acquirer earns a return in excess of their WACC from the transaction.

Income Approach (Discount Rate)

175

ASSESSING OVERALL REASONABLENESS Throughout this chapter, we have emphasized the objective of developing reasonably accurate – rather than misleadingly precise – estimates of the WACC. Since required returns are not directly observable in market transactions, the need for professional judgment in estimating the WACC is inescapable. Given the large number of individual components in the traditional WACC buildup, market participants and valuation analysts have to evaluate not just the reasonableness of the individual components, but the cumulative reasonableness of the WACC estimate as a whole. Adopting a supply-side perspective does not remove the need for professional judgment, either, as the expected cash flows required for such calculations are not directly observable. But isn’t that easier said than done? How can valuation analysts assess the overall reasonableness of the estimated WACC? We suggest that valuation analysts evaluate the overall reasonableness of the WACC with reference to available market data from relevant transactions. ■

■

■

At the marketable minority level, how do the implied valuation multiples that correspond to the estimated WACC compare to comparable public market multiples? Given differences in size, profitability, and operating risk, do the valuation multiples “fit” the observed guideline multiples? Valuation analysts develop an estimated WACC for a subject private company. Using the same building methods direct estimates of the WACCs for available guideline possible companies can also be developed. Direct comparisons of the subject private company WACC can then be made with the WACCs of the guideline public companies for another perspective on reasonableness. At the financial control level, how does the resulting conclusion of value compare to available data from private equity markets? Is there a concise explanation for significant variations in implied multiples? Valuation analysts must contend with the paucity of reliable underlying financial metrics for private market acquisition targets.

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At the strategic control level, how does the implied premium to the marketable minority value compare to observed premiums in strategic transactions? How do the implied valuation multiples compare to those observed in strategic transactions? On a pro forma basis (i.e., including strategic benefits), how do relative value measures compare to available guideline public company data? Does the relative sharing of potential strategic cash flow and WACC benefits make sense in light of the characteristics of the subject enterprise and potential strategic acquirers?

As the preceding list suggests, the income and market approaches do not stand alone. Instead, experienced valuation analysts use the two methods to refine the assumptions underlying both. One simply cannot perform a credible valuation under the income approach analysis without referencing available market data. Experience and professional judgment are required to draw appropriate analogies to available market data. In Chapter 6, we turn our attention to the market approach, examining the intersection of the Integrated Theory with the guideline public company method.

CHAPTER

6

Market Approach (Guideline Public Companies)

INTRODUCTION In Part One of this book, we described the Integrated Theory using the language of the income approach: cash flow, growth, and risk. Chapters 4 and 5 dealt with the income approach directly, examining how the Integrated Theory can help valuation analysts forecast cash flows and estimate discount rates. In this chapter, we turn our attention to the market approach, considering how valuation analysts can incorporate insights from the Integrated Theory in the practical application of the guideline public company method. We will address the following questions in this chapter: 1. How do the market and income approaches relate to each other? 2. What do observed valuation multiples mean? 3. How should observed valuation multiples be adjusted to account for fundamental differences between the guideline companies and the subject enterprise? 4. How should guideline public company multiples be applied at the different levels of value? 5. How can valuation analysts evaluate the reasonableness of selected guideline public company multiples?

177 Business Valuation, First Edition. Z. Christopher Mercer and Travis W. Harms. © 2021 Z. Christopher Mercer and Travis W. Harms. Published 2021 by John Wiley & Sons, Inc.

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RELATIONSHIP OF THE INCOME AND MARKET APPROACHES Since the conceptual math we use to describe the Integrated Theory corresponds to the single-period capitalization method under the income approach, one might reasonably ask whether the Integrated Theory has any application to the market approach. Our goal in this chapter is to demonstrate that it does, and the best place to start in that endeavor is by considering what relationship, if any, exists between the two valuation approaches. While it is convenient to distinguish between the income and market approaches to value, one should be careful not to overstate the differences. In both approaches, analysts are attempting to describe how a transaction for the subject asset would occur on an arm’s-length basis at the valuation date. ■

■

When developing indications of value using methods under the income approach, the principal tasks of the valuation analyst are (1) predicting future cash flows for the subject enterprise, and (2) reducing those future cash flows to present value through use of an appropriate discount rate. Use of methods under the market approach requires that the analyst draw an appropriate analogy between the subject company and another company (or companies) for which (reasonably) contemporaneous transaction data can be observed. This process of drawing appropriate analogies has two primary components: (1) identifying companies that are similar as to business activity or other relevant attributes, and (2) making appropriate adjustments to the observed data to make it “fit” the subject enterprise.

On a surface reading, the underlying conceptual basis for these two approaches may seem entirely independent of each other.

Market Approach (Guideline Public Companies)

179

Income Approach

Market Approach

Expected Financial Performance Near-term performance, normalized to place on public-company equivalent basis

Expected Financial Performance Near-term performance, normalized to place on public-company equivalent basis

Expected Growth

Observed Valuation Multiples

Estimated relative to subject company strategy, resources, and historical performance, industry conditions, and

Reflect consensus market participant expectations regarding expected growth of subject company, and an appropriate

economic outlook

discount rate based on risk of subject company relative to alternative investments available in the market

Discount Rate Based on analysis of subject company, risks and available returns on alternative investments in the market

EXHIBIT 6.1 Relationship between Income and Market Approaches. However, when we consider how the various components of the two approaches relate, the organic connection between the two approaches becomes more apparent. Exhibit 6.1 illustrates the relationship among the core components of the income and market approaches. Valuation analysts must develop estimates of normalized cash flow for subject enterprises under both the income and market approaches. Under the income approach, valuation analysts convert these estimates to indicated values by assessing the growth prospects (i.e., future cash flows) and risk (as manifest in the discount rate) of the subject company. Under the market approach, valuation analysts convert these same normalized cash flows to indicated values by applying valuation multiples. These valuation multiples in turn should represent the consensus view of relevant market participants regarding the growth prospects of subject companies and the applicable discount rates. In light of the underlying affinities between the income and market approaches, it should not be surprising to discover that the core

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concepts of the Integrated Theory are equally applicable to valuation methods under the market approach. In the remaining sections of this chapter, we explore more specifically how the Integrated Theory applies to the guideline public company method. We will apply the Integrated Theory to the guideline transaction method in Chapter 7.

WHAT DO OBSERVED PUBLIC COMPANY VALUATION MULTIPLES MEAN? To apply the Integrated Theory to the guideline public company method, we must first clarify just what observed valuation multiples from the public markets mean.1 In its most generic form, a valuation multiple is a ratio that relates the value of a business to a data point pertinent to a business. As illustrated in Exhibit 6.2, the value of a business is traditionally the numerator in the ratio. With public companies, the value of the equity of each company is readily available every day. Multiply the price per share times the shares outstanding and develop the market value of the equity of any public company. We use the values of public companies to

Valuation Multiple =

Value of the Business Selected Data Point

EXHIBIT 6.2 Structure of Valuation Multiples.

1

See “SBVS-1 Guideline Public Company Method,” ASA Business Valuation Standards, American Society of Appraisers, 2009. SBVS stands for Statements on ASA Business Valuation Standards. SBVS-1 provides overview guidance for employing the guideline public company method.

Market Approach (Guideline Public Companies)

181

calculate valuation multiples, which are in turn used in the guideline public company method to infer the values of subject private companies. There are many potential data points or metrics that can be used as the denominator when calculating valuation multiples. These include revenue, gross profit, EBITDA, EBIT, pre-tax earnings, and net income from the income statement. Physical measures can also be used to develop valuation multiples. These normally relate to units or volumes. Exhibit 6.3 provides select valuation multiples for Publico, Inc., a smallish publicly traded company. Publico has 2.0 million shares outstanding and its recent common stock price was $25 per share; therefore, the market value of its equity is $50 million. Adding net debt of $25 million, from the most recent balance sheet for Publico, we derive the enterprise value of $75 million. We then develop valuation multiples for the trailing twelve months (LTM multiples) and for expected performance for the next twelve months (forward multiples). We will use these multiples to illustrate the market approach under the guideline public company method as this chapter proceeds.

Influence of Capital Structure on Multiples The first thing to notice about Exhibit 6.3 is that it is essential to match the numerator and denominator appropriately. For performance measures above the dotted horizontal line, the appropriate numerator is enterprise value. In other words, it is appropriate to calculate the multiple of enterprise value to revenue, but a multiple of equity value to revenue is meaningless and should not be calculated. ■

Performance measures that are unaffected by a company’s capital structure should be calculated using enterprise value as the numerator. A company’s revenue is independent of how that company is financed.

LTM Period Physical Activity Measure

Next 12-Months (Forward)

Numerator

Measure

Multiple

$75,000

40,000

$1.88

Measure 44,500

Multiple $1.69

$75,000

$125,000

0.60x

$145,000

0.52x

Enterprise Value

(Cases, gallons, barrels, etc.) Revenue less: Cost of Goods Sold Gross Profit

(100,000) $75,000

less: Cash Operating Expenses EBITDA

$75,000

Equity Value

$8,000

$75,000

$6,500

9.4x

$50,000

$5,690

2.5x

$10,000

7.5x

(2,250) 11.5x

(810)

less: Income Taxes

$30,000 (20,000)

(1,500)

less: Interest Expense Pre-tax Income

3.0x

(17,000)

less: Depreciation & Amortization EBIT

$25,000

(115,000)

$7,750

9.7x

(1,620) 8.8x

25.0%

$6,130

8.2x

25.0%

Net Income

$50,000

$4,268

11.7x

$4,598

10.9x

Shareholders' Equity

$50,000

$30,482

1.64x

na

na

EXHIBIT 6.3 Select Valuation Multiples for Publico, Inc.

Market Approach (Guideline Public Companies) ■

183

In contrast, some performance measures are a function of a company’s capital structure. For example, pre-tax income is affected by interest expense, which depends on the amount of debt outstanding. All else being equal, a company having a greater proportion of debt in its capital structure will have higher interest expense and lower pre-tax income. As a result, the market value of equity is the appropriate numerator for the multiples of pre-tax income and net income.

As we discussed in Chapter 5, market participants tend to measure value for private companies with respect to the enterprise as a whole. As a result, we will focus our discussion in this chapter on enterprise value multiples.

Influence of Measurement Period on Multiples The second thing to notice in Exhibit 6.3 is that multiples can be calculated relative to two different measurement periods. Trailing multiples compare current value to historical performance measures, and forward multiples compare current value to expected future performance measures. The relationship between trailing and forward multiples is analogous to that between realized and required returns. ■

■

LTM multiples. LTM multiples are calculated based on the last twelve months of reported performance. Trailing multiples can be calculated with precision. Unfortunately, trailing multiples– like historical realized returns – are not strictly relevant to the value of the business today. This is not to say that trailing multiples are not useful, but rather only to indicate that trailing multiples, despite the precision with which they can be calculated, do not yield valuation “truth.” Forward multiples. Forward multiples, on the other hand, are more relevant to measuring value because they are forward-looking. However, the fact that they are forward-looking means that they cannot be defined with

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BUSINESS VALUATION

precision. While consensus performance measures are available for many guideline public companies, the consensus figures often conceal a wide divergence of market participant perspectives on future performance. The fact that a data aggregation service identifies a consensus figure does not mean that the pricing of the company’s shares actually corresponds to the consensus figure. Likewise, the projected performance of the subject enterprise is subject to the potential errors and cognitive biases native to all forecasts of future events. The result is that, despite the greater logical connection of forward multiples to value, application of forward multiples does not automatically yield valuation “truth.” How do we find valuation “truth” if neither of the two commonly calculated types of valuation multiples necessarily yield it? A simple example drawn from Exhibit 6.3 highlights the relationship between trailing and forward multiples, and the potential pitfalls of relying exclusively on trailing multiples. As noted in Exhibit 6.3, the EBITDA multiples for the guideline company are 9.4x (trailing) and 7.5x (forward). Assume for the moment that Exhibit 6.3 omits one relevant fact: the guideline company made a significant acquisition, funded by debt, late in the trailing period. At our valuation date, the observed enterprise value includes the value of the acquired business (via the higher debt balance), but includes only a few weeks’ worth of EBITDA contribution. As a result, the trailing EBITDA multiple is distorted and overstated. If applied to the valuation subject without adjustment, use of the trailing EBITDA multiple will result in overvaluation. In contrast, the denominator of the forward multiple includes a full year of expected results from the acquired business, eliminating the distortion present in the trailing multiple. Another simple example can illustrate the fact that the public securities markets “normalize” for nonrecurring events. Assume in the example above that EBITDA for the trailing twelve months was $4.0 million instead of the $8.0 million in Exhibit 6.3 because of

Market Approach (Guideline Public Companies)

185

a one-time write-down of assets, and that forward EBITDA is, as in the exhibit, $10.0 million. The trailing period multiple would therefore be 18.8x, which would be an anomaly and not useful for valuation purposes. The market price is based on forward EBITDA and the forward multiple of 7.5x.

Valuation Multiples and Market Expectations Valuation multiples are composite reflections of the risk assessment of the market (as manifest in the required return) and market growth expectations. Some valuation multiples also embed expectations regarding capital intensity, profit margins, and unit pricing. By making one simplifying assumption, we can reduce any valuation multiple to its component market participant expectations. The simplifying assumption is that net operating profit after tax (NOPAT) is equal to net enterprise cash flow. While this precise relationship will rarely hold in practice, the potential distortions do not detract from the underlying conceptual math. Exhibit 6.4 summarizes the conceptual math corresponding to each of the enterprise value multiples from Exhibit 6.3. As demonstrated in Exhibit 6.4, each valuation multiple includes a unique set of embedded market expectations regarding the company. This has important implications for interpreting valuation multiples, making appropriate adjustments to them, and applying them to the valuation subject. Although we did not present NOPAT, or Net Operating Profit After Taxes, in Exhibit 6.3, and it is rarely cited by market participants, we started with that multiple in Exhibit 6.4 because it reflects the most uncluttered conceptual math and is the starting point for all the other multiples. As we move up the income statement from NOPAT, the valuation multiples embed a cumulatively broader set of market participant expectations regarding the company. Before we proceed to a brief discussion regarding how to interpret each multiple, we will take the opportunity to demonstrate the inherent ambiguity in observed valuation multiples. For example, assume we know the NOPAT multiple for a business to be 12.5x. Referring to Exhibit 6.4, we note that the NOPAT multiple is a

Multiple

Conceptual Math EV

EV / NOPAT

EV / EBIT

EV / EBITDA

EV / Gross Profit

EV / Revenue

EV / Activity

NOPAT EV EBIT

=

=

Components 1

WACC, growth prospects

WACC – g

EV NOPAT

× (1 – tax rate)

WACC, growth prospects, tax rate

D&A EV EV = × 1– EBITDA EBITDA EBIT

WACC, growth prospects, tax rate, capital intensity

EV

WACC, growth prospects, tax rate, capital intensity, operating efficiency

GP

=

EV EBITDA

× 1–

Cash OpEx GP

EV EV × (Gross Margin) = Rev GP

WACC, growth prospects, tax rate, capital intensity, operating & production/purchasing efficiency

EV

WACC, growth prospects, tax rate, capital intensity, operating & production/purchasing efficiency, unit pricing

Activity

=

EV Rev

× (Unit Pricing)

EXHIBIT 6.4 Conceptual Math Underlying Enterprise Valuation Multiples.

Market Approach (Guideline Public Companies)

187

function of the WACC and expected growth for the company. While the observed multiple does tell us something about the relationship between the two components, it does not and cannot reveal certain knowledge regarding either component individually. Assume that the NOPAT multiple is 12.5x, and that multiple is calculated as (12.5 = 1 / (WACC – g). Specifically, a NOPAT multiple of 12.5x reveals that the WACC exceeds expected growth by 8.0%, because the combination of (r – g) is 8.0%, which is the capitalization rate that equates to a multiple of 12.5x. One cannot infer, however, whether the WACC is 10.0% (with a corresponding growth rate of 2.0%) or 12.0% (with a corresponding growth rate of 4.0%). In order to infer an implied growth rate, the valuation analyst must make an assumption regarding the WACC. Conversely, the implied WACC can be inferred only by making an assumption about the market’s expected growth rate for the company. NOPAT Multiple The relationship of enterprise value to NOPAT reveals the composite expectations of market participants regarding the required return (WACC) for the subject enterprise and the expected growth rate for that enterprise. Market participants do not typically refer to NOPAT multiples, but as shown in Exhibit 6.4, the NOPAT multiple lies at the root of all of the other enterprise value multiples. EBIT Multiple In addition to the WACC and expected growth, the EBIT multiple takes into account the effective tax rate for the subject company. In general, the indifference of market participants to the existing tax status of the subject company is comparable to their indifference to existing capital structure. Following a change of control transaction, it is usually easy for acquirers to adjust the tax attributes of the subject company. We suspect that this explains why market participants are much more likely to reference EBIT multiples than NOPAT multiples. EBITDA Multiple The EBITDA multiple is the lingua franca of market participants for private companies. For the EBITDA multiple, the list of relevant factors expands to include capital intensity, as

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BUSINESS VALUATION

measured by the portion of EBITDA attributable to depreciation and amortization. In light of these factors, analysts may elect to “build up” EBITDA multiples directly.2 All else being equal, the greater the need for capital reinvestment to sustain ongoing earnings growth, the lower the EBITDA multiple applicable to the business. Reference to the EBITDA multiple also removes potential distortion in earnings arising from amortization of intangible assets acquired in prior business combinations. While depreciation typically provides a proxy for required ongoing capital expenditure requirements, amortization expense rarely corresponds to future capital investment. Focusing on the EBITDA multiple sets companies that have grown organically on a comparable footing with those that have grown through acquisition. Exhibit 6.5 illustrates how valuation analysts can develop the EBITDA multiple for a subject company by reference to the WACC, expected growth, tax rate, and proportion of depreciation and amortization to EBITDA. We begin with an assumed equity discount rate of 15.0% (Line 1) and proceed to develop a WACC of 11.6% (Line 8) and the related NOPAT capitalization rate of 11.6x (Line 11). Note that in the development of WACC and the related NOPAT multiple, there are no changes in the typical method used by appraisers in developing WACCs. The first step in developing EBITDA multiples is to recognize that, given the NOPAT capitalization rate (Line 10) and the NOPAT multiple (Line 11), we can develop the capitalization rate for Operating Profit Before Taxes, or the EBIT capitalization rate. We do so by tax-effecting the NOPAT capitalization rate. To be clear, the EBIT capitalization rate is calculated as the NOPAT Cap Rate/ (1 – Assumed Blended Tax Rate), or as 8.6% / (1 – 25%), which equals 11.5% (Line 12). The implied EBIT multiple is calculated as 1 / EBIT Cap Rate, or 1 / 11.5%, which is 8.7x as shown on Line 13 above. Now we 2 Mercer, Z. Christopher, “EBITDA Single Period Capitalization Under the Income Approach,” Business Valuation Review, Volume 35, Number 3, December 2016, pp. 86–102. Mercer initially published this method on his blog, www.ChrisMercer.net in 2015.

Developing WACC and NOPAT Multiple Equity Discount Rates Pre-Tax Debt Assumed Blended Tax Rate Tax Benefit of Debt @ Line 3 Rate After-Tax Cost of Debt

1 2 3 4 5

Range of Assumptions (No Changes Thru Line12) Lower Upper Range Range 15.0% 15.0% 5.0% 5.0% 25.0% 25.0% –1.3% –1.3% 3.8% 3.8%

Assumed Equity as % of Capital Structure Assumed Debt as % of Capital Structure

6 7

70.0% 30.0%

70.0% 30.0%

Assumed by appraiser - industry norms 1 - Line 6

Weighted Average Cost of Capital (WACC) Expected Long-Term Growth (g) NOPAT Cap Rate NOPAT Multiple

8 9 10 11

11.6% –3.0% 8.6% 11.6

11.6% –3.0% 8.6% 11.6

Line 6 x Line 1 + Line 7 x Line 5 Assumed range of expected growth Line 8 + Line 9 1 / Line 10 (Seldom calculated or used)

Developing EBITDA Multiple Operating Income (EBIT) Cap Rate EBIT Multiples (1 / EBIT Cap Rate) EBITDA Depreciation Factors EBITDA Multiples(Row 11 / Row 12)

12 13 14 15

11.5% 8.7 1.30 6.7

11.5% 8.7 1.20 7.2

Line 10 / (1 - Line 3) 1 / Line 12 Assumed by appraiser based on analysis Line 13 / Line 14 (often used)

EXHIBIT 6.5 Developing EBITDA Multiples from WACC.

Assumed from build-up using ACAPM Developed by appraiser Marginal federal/state blended rate - (Line 2 x Line 3) Line 2 + Line 4

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BUSINESS VALUATION

want to develop the EBITDA multiple. The question is, how do we do that? Think of it simplistically. For every EBIT, there is a D&A (depreciation and amortization). Recall the formula for the EBITDA multiple from Exhibit 6.4: ( ) EV EV D&A = × 1− EBITDA EBIT EBITDA Given an assumed enterprise value (EV), the EBITDA multiple, the left side of the equation, or EV / EBITDA, is a function of the relationship between EBIT and D&A (since EBITDA is simply the sum of EBIT + D&A). Recall the following values from Exhibit 6.3 for Publico: enterprise value is $75,000, forward EBIT is $7,750, forward D&A is D&A is $2,250, and forward EBITDA is $10,000. ■

■ ■ ■

EV / EBIT. $75,000 / $7,750 = 9.7x (the forward EBIT multiple from Exhibit 6.3) D&A / EBITDA. $2,250 / $10,000 = 22.5%. 1 – D&A / EBITDA. 1 – 22.5% = 77.5% EV/EBIT × (1 – D&A / EBITDA). 9.7x times 77.5% = 7.5x (which is the forward EBITDA multiple from Exhibit 6.3).

The relationship between D&A and EBITDA determines the difference between any company’s EBITDA and EBIT multiples. Mercer called this relationship the EBITDA Depreciation Factor in the above-referenced article. The math of the above equation can be reduced to show that the EBITDA Depreciation Factor is defined by the ratio of EBITDA and EBIT, or EBITDA / EBIT. The EBITDA Depreciation Factor for Publico is therefore 9.7x / 7.5x, or 1.3. This may seem trivial since we have the information to calculate both the EBITDA and EBIT multiples for Publico in Exhibit 6.4. However, it becomes less trivial when we are attempting to determine the fair market value (or any other standard of value) for a private company when there is no reliable guideline public company group for reference. Refer again to Exhibit 6.5 above. Valuation analysts and market participants can analyze the EBITDA depreciation factor for any

191

Market Approach (Guideline Public Companies)

company over time and based on its outlook. Industry financial results can also be examined for guidance regarding the relationship between EBITDA and EBIT at a point in time or over time. The point is that the assumption reflected on Line 14 in Exhibit 6.5 of 1.20 to 1.30 for the EBITDA depreciation factor need not be made in a vacuum. This assumption is likely more readily analyzable than several of the other assumptions used in developing the WACC. See, for example, the analysis of the EBITDA depreciation factor for the nonfinancial, non–real estate companies in the S&P 1000 (mid-cap and small-cap companies) in Exhibit 6.6.

Industry Sector Communication Services Consumer Discretionary

# of Companies

Median EBITDA Depreciation Factor

24

1.62

152

1.34

Consumer Staples

37

1.35

Energy

43

1.92

Health Care

94

1.42

Industrials

152

1.36

Information Technology

112

1.46

Materials

61

1.46

Utilities

21

1.64

Source: S&P Capital IQ, Mercer Capital analysis, data for calendar 2018

EXHIBIT 6.6 EBITDA Depreciation Factors for S&P 1000 Index. We developed this EBITDA single-period income capitalization method here in Chapter 6, which relates to the Market Approach, to illustrate once again the critical relationships between the Income and Market Approaches to valuation. Gross Profit Multiple Gross quently, but we include comprehensive review of most commonly referenced

profit multiples are cited only infrethem in Exhibit 6.4 to provide a the potential alternatives. They are by market participants in the beverage

192

BUSINESS VALUATION

industry. In addition to all of the factors relevant to the EBITDA multiple, the gross profit multiple incorporates the operating efficiency of the subject enterprise. In other words, the gross profit multiple is sensitive to the portion of gross profit consumed as operating expenses before arriving at EBITDA. The gross profit, revenue, and activity multiples tend to be favored by strategic control buyers, who can use the multiples as a form of shorthand to reflect potential strategic benefits. For example, consider a beverage wholesaler contemplating the purchase of a smaller, less efficient neighboring distributor. While the target’s EBITDA is depressed by its operating inefficiencies, the strategic acquirer believes that following the proposed combination, the operating efficiency of the target will improve to the level of the buyer. In such a case, the buyer may evaluate the gross profit multiple to proxy normalization of the target’s distribution expenses. Revenue Multiple Whereas gross profit multiples take into account only operating efficiency, revenue multiples reflect the overall profitability of the company. ■

■

The revenue multiple can be useful when the current earnings of the subject company are temporarily depressed. In such cases, the revenue multiple reveals the value of the subject company were it operating at normal levels of profitability. The revenue multiple applicable to the subject enterprise can then be selected with reference to the likelihood that profitability will recover to normal levels, and the time over which the recovery is expected to occur. For strategic control buyers, focusing on the revenue multiple can be a means of quantifying potential strategic benefits that may be available from enhancing the overall profitability of the target.

Activity Multiples Some industries favor activity-based valuation multiples. Denominators for activity multiples can be anything from cases sold for a beer wholesaler to assets under management

193

Market Approach (Guideline Public Companies)

for a wealth manager. Regardless of the specific measures employed, the purpose of activity multiples is to normalize unit pricing. For example, in the asset management industry, the multiple of assets under management reflects not only the profitability per dollar of revenue, but also the amount of fee revenue per dollar of assets under management. In other words, activity multiples are a further extension of revenue multiples, and may be of interest to strategic control buyers who anticipate changing not only the profitability of the target, but also its pricing strategy. In fair market value determinations, for which the financial control level of value is more likely to be relevant than the strategic control level, valuation analysts should be wary of overstating value through inappropriate application of gross profit, revenue, or activity multiples.

Illustrative Example Exhibit 6.7 illustrates application of the observed guideline public company enterprise value multiples to the expected results of a hypothetical subject company.

Enterprise Value

Publico Forward Multiples

Subject Company Performance Measure

Indicated Value

Physical Activity Measure

$1.69

16,000

$26,966

Revenue

0.52x

$48,000

$24,828

less: Cost of Goods Sold Gross Profit

(39,360) 2.5x

less: Cash Operating Expenses EBITDA

$21,600

(5,443) 7.5x

less: Depreciation & Amortization EBIT

$8,640 $3,197

$23,976

(959) 9.7x

$2,238

$21,656

Note - Publico forward multiples from Exhibit 6.3

EXHIBIT 6.7 Application of Guideline Multiples to Private Company. The indicated enterprise values for the subject company range from $21,600 (using the gross profit multiple) to $26,966 (using

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BUSINESS VALUATION

the activity-based multiple). The average of the five indications, for perspective, is $23,805. Exhibit 6.8 summarizes relevant performance metrics for Publico and the subject company. For purposes of this discussion, we assume that the risk and growth profiles of the two companies are similar. Note that we are referencing a single guideline company for simplicity of illustration. We make a few observations regarding the example in Exhibits 6.7 and 6.8 to illustrate the concepts we have discussed throughout this section. ■

■

■

■

The indicated value from capitalizing EBITDA ($23,976) is 11% higher than that obtained from capitalizing EBIT ($21,656). This occurs because the subject company has greater capital intensity (as manifest in depreciation and amortization charges) than the guideline company. If depreciation and amortization is a genuine proxy for capital intensity for the subject company, application of the guideline EBITDA multiple without further analysis or adjustment could result in overvaluation. Applying a gross profit multiple to the subject company yields a lower indicated value ($21,600) than derived from the EBITDA multiple ($23,976), because of the greater operating efficiency of the subject company. As discussed previously, gross margin multiples are most relevant when the (generally strategic) acquirer expects to enhance the subject company’s operational performance materially. In this example, the subject company actually operates more efficiently. Since the EBITDA margins for the two companies are similar, the indicated value resulting from application of the revenue multiple ($24,828) is closer to that derived from using the EBITDA multiple ($23,976). Finally, the indicated value derived from applying the activity-based multiple ($26,966) exceeds that from using the revenue multiple ($24,828) by 9% because the effective unit pricing for the guideline company is greater than that of the subject company. So, the sale of a given unit of product generates more revenue and cash flow for the guideline company

Guideline Company

Subject Company

Effective Unit Pricing

$3.26

$3.00

Privateco earns less revenue

Revenue / Activity Measure Gross Margin

20.7%

18.0%

per unit sold Privateco generates less gross

Gross Profit / Revenue Operating Efficiency

66.7%

63.0%

profit per dollar of revenue Privateco operates more efficiently than

Cash Operating Expenses / Gross Profit Capital Intensity

1.23

1.43

the pub lic peer Privateco has greater capital intensity

EBITDA / EBIT EBITDA Margin

6.9%

6.7%

than Pub lico EBITDA margins are comparab le for the

EBITDA / Revenue

Comparison

two companies

EXHIBIT 6.8 Comparison of Performance Metrics for Publico and Subject Company.

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BUSINESS VALUATION

than for the subject company. The unit sales multiple may be relevant to a strategic acquirer that anticipates having the ability to extract a higher effective unit price prospectively than the subject company has historically.

Conclusion The objective of this section has been to demonstrate the economic meaning of the most commonly cited valuation multiples. We have done so by defining the conceptual math for each valuation multiple and discussing what attributes of the subject company are relevant to each multiple, and discussing the role of the various multiples in the thinking of real-world market participants. The illustrative example, which has been constructed so that there are no extreme observations, demonstrates that valuation analysts cannot simply take observed multiples as a given, but rather must critically evaluate how the attributes of the subject company compare to the guideline company (or companies), and how market participants are likely to treat those differences at the various levels of value. Exhibit 6.9 continues the illustrative example, demonstrating that in reaching a valuation conclusion – regardless of what that valuation conclusion is – valuation analysts apply (or infer) adjustments to the observed valuation multiples. This adjustment process occurs whether the valuation analyst makes explicit adjustment to the various multiples or assigns different weights to the various indications of value. Recall that, at this point, we are assuming that the risk and growth attributes of the subject company and Publico are similar. We will address differences in risk and growth attributes in the following section on the fundamental adjustment. Focus on the dashed line in the exhibit above at an assumed conclusion of $23,000. First, note that none of the valuation indications are on that line. When indications are above the dashed line, negative adjustments to the subject company’s valuation multiples are implied. The activity-based indication is $27,000 (rounded). The assumed conclusion of $23,000 represents a 14.7% discount to

197

Market Approach (Guideline Public Companies) $29,000

Indicated Values

$27,000 $25,000 Concluded Value

$23,000 $21,000 $19,000 $17,000 $15,000 Activity-Based

Revenue

Gross Profit

EBITDA

EBIT

Valuation Multiples

EXHIBIT 6.9 Comparison of Indicated Values to Conclusion. the activity-based indication, and an implied 14.7% discount to the indicated forward multiple of $1.69 per unit from Exhibit 6.5, or an implied multiple of $1.44 per unit. To illustrate, physical units from Exhibit 6.5 totaled 16,000. Multiply 16,000 units times the implied $1.44 per unit multiple and the conclusion is $23,000 (rounded). Conversely, when indications are below the dashed line, there is an implied premium to the subject company’s valuation multiples. This point is so important that we illustrate it somewhat differently in Exhibit 6.10. We provide this further illustration as an introduction to the concept of the fundamental adjustment, which is discussed in the next section of this chapter. Adjustments to the subject company’s valuation multiples are calculated for a range of conclusions of value from $21,000 to $25,000. Look at an implied conclusion of $21,000 in Exhibit 6.10 and simultaneously imagine that the dashed line in the previous exhibit is moved to this level. The conclusion represents a discount to every one of the subject company’s valuation multiples. These discounts are calculated in the table. Look at a conclusion of $25,000 in Exhibit 6.10 and imagine moving the dashed line in the previous exhibit to that level. A conclusion at that level would represent premium to all but the activity-based measure.

Multiples

Indicated Enterprise Values

Subject Company Multiples

Implied Adjustments to Subject Co. Multiples at Values $21,000 $22,000 $23,000 $24,000 $25,000

From previous exhibits Activity-Based

$26,966

1.69

–22.1%

–18.4%

–14.7%

–11.0%

Revenue

$24,828

0.52

–15.4%

–11.4%

–7.4%

–3.3%

–7.3% 0.7%

Gross Profit

$21,600

2.50

–2.8%

1.9%

6.5%

11.1%

15.7%

EBITDA

$23,976

7.50

–12.4%

–8.2%

–4.1%

0.1%

4.3%

EBIT

$21,656

9.68

–3.0%

1.6%

6.2%

10.8%

15.4%

EXHIBIT 6.10 Implied Adjustments at Different Conclusions of Value.

Market Approach (Guideline Public Companies)

199

Imagine a different conclusion of $24,000. There would be a different adjustment (premium or discount to the guideline multiples) at that level. The same would be true of a lower conclusion of $22.0 million. The availability of putatively objective valuation multiples does not relieve the valuation analyst of the need to exercise subjective professional judgment, informed by experience, common sense, and reasonableness. Our analysis in this section has been focused on “horizontal” adjustments to valuation multiples arising from fundamental differences in capital intensity, profit margins, and unit pricing between the subject and guideline companies. In the following section, we will examine more closely the “vertical” adjustments to valuation multiples that are attributable to differences in risk and growth prospects.

ADJUSTING VALUATION MULTIPLES FOR DIFFERENCES IN RISK AND GROWTH The “horizontal” adjustments described in the preceding section describe how indicated values from different valuation multiples relate to one another conceptually. The analysis in that section assumed that the risk profile and growth expectations of the subject company were comparable to those of the guideline company. In practice, however, such is rarely the case. In this section, we describe how to adjust valuation multiples for differing risk and growth characteristics. We use the term fundamental adjustment to describe the “vertical” adjustment illustrated in Exhibit 6.11. Guideline companies, both individually and as a group, vary in terms of the aptness and strength of analogy that can be drawn to the subject company. Selecting guideline public companies requires no small amount of professional judgment, but that process is outside the scope of this theoretical book. In most cases, differences in risk profile and growth expectations render direct application of the observed guideline multiples to the subject company inappropriate.

200

BUSINESS VALUATION

"Vertical" Adjustment

Indicated Values

"Horizontal" Adjustments Explicit, or implied, adjustment to individual valuation multiples to derive a correlated indication of value, accounting for differences in unit pricing, profitability, and capital intensity

Explicit, or implied, adjustment to correlated indication of value to account for relative risk and growth attributes of subject enterprise

Activity-Based

Revenue

Gross Profit

EBITDA

EBIT

Valuation Multiples

EXHIBIT 6.11 Conceptual Bases for Adjustments to Observed Valuation Multiples.

Qualitative Factors Not Giving Rise to Fundamental Adjustments Before discussing the factors that give rise to fundamental adjustments, we believe it is important to clarify which relative attributes of a subject enterprise do not trigger fundamental adjustments. ■

■

■

Unit pricing. The effective unit price of the subject enterprise relative to the guideline group will determine how the implied activity-based multiple relates to the implied revenue multiple for a given correlated indication of value, but does not directly influence the magnitude of the correlated indication. Gross margin. The relative purchasing and production efficiency of the subject company, as manifest in the gross margin, determines how multiples of revenue and gross margin relate to one another, but does not directly influence the correlated indication of value itself. Operating efficiency. The relative efficiency with which the subject company converts gross margin to EBITDA determines the relationship between implied multiples of gross margin and

Market Approach (Guideline Public Companies)

■

201

EBITDA, but does not directly influence the magnitude of the correlated indication of value. Capital intensity. Relying on the proportion of EBITDA represented by depreciation and amortization expense as a proxy for capital intensity reconciles implied EBIT multiples to corresponding multiples of EBITDA. This measure of capital intensity does not, however, directly influence the correlated indication of value itself.

In the preceding list, we were intentional in stating that the enumerated factors do not “directly influence” the magnitude of the correlated indication of value. As described in the prior section of this chapter, market participants at different levels of value may assign different weights to the indicated values derived from different valuation multiples. However, such differences of emphasis are ultimately proxies for different cash flow expectations, and are therefore not, properly speaking, components of the fundamental adjustment. We return to this topic in greater detail in the next section of this chapter.

Qualitative Factors Giving Rise to Fundamental Adjustments Fundamental adjustments are ultimately attributable to relative differences in risk profile and growth expectations (i.e., future cash flow differences) between the subject company and the selected guideline group. Risk Profile Differences in risk profile are ultimately manifest in the applicable discount rate. We discuss some of the most common qualitative factors contributing to risk differentials below. ■

Systematic risk (beta). As discussed in Chapter 5, beta is a measure of systematic, or non-diversifiable, risk used to estimate the cost of equity capital. While not directly observable for the subject enterprise, beta is often estimated relative to that observed for the guideline public companies. In other words, valuation

202

■

■

■

3

BUSINESS VALUATION

analysts commonly judge whether the systematic risk profile of the subject is less risky, more risky, or of comparable risk to the guideline public companies. All else being equal, if systematic risk for the subject enterprise is judged to be greater than that of the guideline public companies, a negative fundamental adjustment (i.e., a downward adjustment) to the observed guideline valuation multiples is appropriate.3 Size. We discussed the size premium applicable to weighted average cost of capital in Chapter 5. Size differentials generally encompass a range of underlying considerations regarding operating concentrations (a negative feature of many smaller companies) and diversification (which is less likely to be a positive feature of smaller companies). Since discount rates and valuation multiples are inversely related, smaller subject companies will often merit a downward adjustment to observed guideline company valuation multiples. Other unique risk factors. When estimating discount rates, the specific company risk premium acknowledges that market participants for private companies often require expected returns on equity capital in excess of those attributable solely to systematic risk and the size of the company. The same risk factors giving rise to the company-specific risk premium also contribute to the appropriate fundamental adjustment to the observed guideline valuation multiples. Access to capital markets. Guideline public companies naturally have greater access to public markets for incremental financing needs. Furthermore, depending on private company shareholder risk tolerances and preferences, the guideline public companies may rely on lower-cost debt financing to a

Valuation analysts will occasionally examine guideline public company data and conclude that, because of large size differences or other factors, direct application of the observed guideline multiples is not appropriate for the subject company. Nevertheless, it may be appropriate to make other comparisons between the subject company and the guideline group, such as the selection of beta, as the best available proxy.

Market Approach (Guideline Public Companies)

203

greater degree than the subject private company. These factors may contribute, all else being equal, to a lower-weighted average cost of capital for the guideline public companies, and therefore contribute to downward adjustment to the valuation multiples applicable to the subject enterprise. Hearkening back to our discussion of the iterative nature of capital costs in Chapter 5, however, we caution valuation analysts not to overestimate the potential influence of capital structure on the WACC. Growth Expectations Beyond the impact of differing risk profiles, growth expectations for the subject company may differ from those of the guideline public companies. As we discussed in Chapter 4, future growth in revenue and profits for a business is a function of both organic growth (attributable to existing competitive strengths and market positioning) and reinvestment of interim cash flows. Since, in the market approach, the performance measures being capitalized are not adjusted for future reinvestment, relative growth analysis should focus on organic growth attributes of the subject and guideline companies. Valuation analysts can help support estimated differentials in growth expectations with reference to a number of specific factors. ■

■

Historical growth. As we have observed throughout this book, valuation is a forward-looking exercise. That said, examining the historical growth trends of the subject company relative to the guideline public companies can provide insight into relative competitive strengths and market opportunities available to the respective companies. Historical reinvestment patterns. Valuation analysts should examine historical reinvestment patterns in concert with historical growth measures. Superior revenue and profit growth that is attributable solely to greater reinvestment of cash flows does not necessarily indicate superior organic growth attributes. However, a greater historical willingness to reinvest enterprise cash flows may signal a perception that more attractive growth opportunities are available to a business.

204 ■

■

BUSINESS VALUATION

Historical returns on invested capital. Return on invested capital measures the efficiency with which a subject business converts a dollar of invested capital into net operating profit after tax. The ratio reflects both profit margin and asset utilization and, among other things, can be viewed as a proxy for relative competitive advantage within an industry. The efficiency of cumulative historical capital investment can provide a signal regarding the organic growth attributes of the subject enterprise. Analyst expectations for future performance. Finally, valuation analysts can estimate organic growth differentials with reference to public stock analyst expectations for future growth in revenue and EBITDA. Where available, detailed forecasts that include capital expenditures and other corresponding reinvestment needs are most relevant, and superior to estimates of near-term earnings per share growth, which can distort organic growth potential at the enterprise level.

Direct Quantification of the Fundamental Adjustment In practice, valuation analysts will either quantify a specific fundamental adjustment for direct application to median (or average) observed valuation multiples or select valuation multiples with an eye toward the implied fundamental adjustment relative to the median valuation multiples and/or the multiple for a specific company or subset of companies within the group. We address the first technique in this section. Exhibit 6.12 presents the formula for quantifying fundamental adjustments, along with an example to illustrate. As shown in Exhibit 6.12, quantifying the applicable fundamental adjustment requires four inputs: 1. Guideline WACC. The guideline WACC can be estimated in two ways: (1) by using the individual buildup components described in Chapter 5, or (2) by inferring the WACC implied by the current enterprise value of the guideline companies and the analyst forecasts for future cash flow. As with estimating the WACC

205

Market Approach (Guideline Public Companies) Guideline WACC Guideline Growth Rate

WACCPublic gPublic

10.0% 4.0%

SubjectCo WACC SubjectCo Growth Rate

WACCSubject gSubject

12.0% 3.0%

Fundamental Adjustment

Fundamental Adjustment =

–33.3% WACCPublic – gPublic –1 WACCsubject – gsubject

EXHIBIT 6.12 Quantifying the Fundamental Adjustment.

for the subject company, the valuation analyst should prioritize consistency of approach and overall reasonableness above exaggerated precision. 2. Guideline Growth Rate. Two techniques for estimating the guideline company growth rate are also available to the valuation analyst: (1) blending expectations for near-term super-normal growth with sustainable long-term growth rates, or (2) inferring growth from implied valuation multiples and the WACC. 3. Subject Company WACC. The WACC for the subject company developed for use in the income approach is applicable here. This usage again illustrates the intersection of the income and market approaches. 4. Subject Company Growth Rate. The growth rate for the subject company can be estimated using the same techniques outlined above for the guideline companies. If the single-period capitalization method has been used under the income approach, the growth rate applied in that technique is applicable here, as long as reinvestment has been normalized to a sustainable, long-term level. If the discounted cash flow method has been used, the effective growth rate can be inferred by comparing the conclusion of value to the WACC.

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BUSINESS VALUATION

Exhibit 6.13 illustrates the sensitivity of the indicated fundamental adjustment to the inputs identified above. Since the analysis references the WACC and enterprise value, the implied multiples in Exhibit 6.13 are EV / NOPAT, not Price / Earnings. We offer the following observations with respect to the analysis in Exhibit 6.13: ■

■

■

When quantifying the fundamental adjustment, valuation analysts may elect to differentiate between the portion of the adjustment attributable to risk differences (as manifest in the WACC) and differing growth expectations. The exhibit is divided into three parts. The left portion reflects relatively higher public multiples, with the middle portion reflecting mid-range public multiples and the right portion reflecting relatively lower public multiples. Looking at the left portion with higher public multiples, in Scenario [1], the calculated fundamental adjustment of 46% is attributable to the subject company having both a higher WACC (10.0% versus 8.0% for the publics) and lower expected growth (3.5% versus 4.5% for the publics). Scenario [3] reveals that a fundamental adjustment of 27% would apply even if expected growth were identical and the 2.0% spread in WACCs (10.0%–8.0%) remained the same. Scenario [2] falls in between at 36%, with a 2.0% spread between the WACCs and a growth adjustment in between adjustment Scenarios [1] and [2]. From this, the valuation analyst can infer that more than half of the overall fundamental adjustment is applicable to the higher WACC of the subject company. Look now at the middle portion of Exhibit 6.13. The fundamental adjustment is sensitive to the level of guideline public multiples, not just the absolute spread between the WACC and growth components. In Scenarios [4] to [6], the spread between the private and public company WACCs is reduced to 1.0%. Expected growth differences remain the same as at the left. With these changes, the implied fundamental adjustments are lower than in the left portion of the exhibit (because the total risk/growth differences are lower).

Guideline Attributes WACC

Higher Public Multiples [1] [2] [3] 8.0% 8.0% 8.0% 3.5% 22.2 4.5%

2.5% 18.2 5.5%

Mid-Range Public Multiples [4] [5] [6] 10.0% 10.0% 10.0%

Lower Public Multiples [7] [8] [9] 12.0% 12.0% 12.0%

4.5% 18.2 5.5%

4.5% 13.3 7.5%

Growth Rate Implied Multiples (1 - (r - g)) WACCPublic - gPublic Subject Company Attributes WACC

4.5% 28.6 3.5%

3.5% 15.4 6.5%

2.5% 13.3 7.5%

3.5% 11.8 8.5%

2.5% 10.5 9.5%

10.0%

10.0%

10.0%

11.0%

11.0%

11.0%

12.0%

12.0%

12.0%

Growth Rate Implied Multiples (1 - (r - g)) WACCSubject - gSubject

3.5% 15.4 6.5%

3.0% 14.3 7.0%

2.5% 13.3 7.5%

3.5% 13.3 7.5%

3.0% 12.5 8.0%

2.5% 11.8 8.5%

3.5% 11.8 8.5%

3.0% 11.1 9.0%

2.5% 10.5 9.5%

Differences in Risk and Growth WACC Growth Rate Fundamental Adjustments Using equation from Exhibit 6.12

2.00%

2.00%

2.00%

1.00%

1.00%

1.00%

0.00%

0.00%

0.00%

–1.00%

–0.50%

0.00%

–1.00%

–0.50%

0.00%

–1.00%

–0.50%

0.00%

–46%

–36%

–27%

–27%

–19%

–12%

–12%

–6%

0%

EXHIBIT 6.13 Fundamental Adjustments Under Different Scenarios.

208 ■

■

■

BUSINESS VALUATION

The right portion of Exhibit 6.13 equates the guideline public and private company WACCs, still reflecting the same growth differentials as in the other portions. The implied fundamental differences are lower still. In Scenario [9], where there are no differences in WACCs and expected growth, the implied fundamental adjustment is 0%. In a few instances, we have applied fundamental premiums to guideline public multiples when the subject private company had better risk and/or growth characteristics than available guideline companies. The fundamental adjustment is appropriate if (and when) the subject company has either a different WACC than the guideline companies or different growth expectations (or both). One important conclusion of the analysis of Exhibit 6.13 is that even with the market approach, value is a function of expected cash flow, risk, and growth.

Exhibit 6.14 illustrates the impact of the fundamental adjustment. In contrast to the “horizontal” adjustments that reconcile indications from different valuation multiples that arise because of differences in capital intensity, profitability, and unit pricing, the fundamental adjustment applies to each indication to reflect differences in risk and growth attributes. $29,000

Indicated Values

$27,000 $25,000 $23,000 $21,000 $19,000

Preliminary Value

Concluded Fundamental Adjustment of 19% for differences in WACC & g (Scenario 5 in Exhibit 6.10)

Concluded Value

$17,000 $15,000 Activity-Based

Revenue

Gross Profit

EBITDA

EBIT

Valuation Multiples

EXHIBIT 6.14 Effect of Fundamental Adjustment on Conclusion of Value.

Market Approach (Guideline Public Companies)

209

The principal benefit of quantifying the fundamental adjustment, as described in this section, is that the valuation analyst is able to isolate the specific components giving rise to the fundamental adjustment, and offer support for the magnitude of the adjustment by reference to differences in the WACC and expected growth. On the other hand, the technique may be viewed by cynics as a sleight-of-hand maneuver by which the valuation analyst replaces the market approach with the income approach. However, we believe we have shown that even when analysts eschew direct quantification of the fundamental adjustment, they still rely on the concept of the fundamental adjustment if they select valuation multiples other than at the median or average observations from their selected guideline groups.

Implied Fundamental Adjustment from Selection of Valuation Multiples The procedure for quantifying the fundamental adjustment outlined in the previous section presumes that the valuation analyst will apply the calculated adjustment to some measure of central tendency for the guideline public company group. For purposes of discussion, we will assume use of the median. The dispersion of observed multiples around the median varies by group. In some cases, the individual multiples are tightly clustered, but in others the group displays a wide dispersion of individual observations. If individual observations are not tightly clustered, the companies in the guideline group may have different risk profiles and/or growth expectations. ■

■

From one perspective, this is a disheartening observation, as it implies that the companies in the group are not ultimately very similar to one another. If observed valuation multiples are merely random artifacts that are “out there” for valuation analysts to use (or not) as the occasion warrants, a guideline group that does not exhibit much uniformity can be judged useless. But when the market approach is viewed from the perspective of the Integrated Theory, valuation multiples are no longer

210

BUSINESS VALUATION

merely random artifacts, but are instead composite views of the risk and growth attributes of the guideline companies. When a group exhibits a diversity of observed multiples, that means that the companies within the group possess diverse risk and growth attributes. Rather than a source of analytical discouragement, from this perspective, a diversity of observed multiples increases the likelihood that an appropriate analogy may be drawn from the subject company to at least one of the guideline companies. Faced with this reality, many market participants and some valuation analysts prefer to select a valuation multiple with reference to the observed multiples derived from the group, rather than quantify a specific fundamental adjustment to apply to the group median. Regardless of the selected procedure, the underlying conceptual framework is the same: applying a valuation multiple that corresponds to the risk and growth characteristics of the subject company. Exhibit 6.15 illustrates the direct multiple selection approach, where the selected multiples are based on analysis of the relevant attributes of the guideline companies compared to the subject company. We offer the following observations regarding the analysis in Exhibit 6.15: ■

■

■

While all participating in the same industry, the individual guideline companies vary with regard to size, profitability, capital intensity, and growth prospects. As a result, EBITDA multiples for the components companies range from 7.2x to 13.0x. The subject company is smaller than all of the guideline public companies, and has growth expectations modestly below the guideline group median. Accordingly, the appropriate multiples to apply to the subject company will be below the guideline median (i.e., a negative fundamental adjustment is required). With regard to size and growth expectations, the subject company is most directly comparable to Company E. That said, the subject company is still only half the size of Company E (as

Revenue

EBITDA

EBITDA Margin

EBIT

Expected Growth

EBITDA / EBIT

Guideline Company A

$360,000

$36,000

10.0%

$34,000

3.0%

1.06x

Guideline Company B

400,000

45,000

11.3%

35,000

1.5%

1.29x

Guideline Company C

300,000

22,500

7.5%

19,500

3.0%

1.15x

Guideline Company D

90,000

5,750

6.4%

5,000

5.0%

1.15x 1.38x

Guideline Company E Median Subject Company

80,000

9,000

11.3%

6,500

2.5%

$300,000

$22,500

10.0%

$19,500

3.0%

1.15x

$40,000

$3,600

9.0%

$2,880

2.5%

1.25x

Enterprise Value

Enterprise Value to: Revenue EBITDA EBIT

Guideline Company A

$425,000

1.18x

11.8x

12.5x

Guideline Company B

350,000

0.88x

7.8x

10.0x

Guideline Company C

225,000

0.75x

10.0x

11.5x

Guideline Company D

75,000

0.83x

13.0x

15.0x

Guideline Company E

65,000

0.81x

7.2x

10.0x

0.83x

10.0x

11.5x

Selected Multiple Implied Fundamental Adj - Median Implied Fundamental Adj - Company A

Median

$225,000

0.65x –22% –45%

7.5x –25% –36%

9.0x –22% –28%

Implied Fundamental Adj - Company E

–20%

4%

–10%

EXHIBIT 6.15 Illustration of Direct Multiple Selection Approach.

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■

■

■

BUSINESS VALUATION

measured by revenue). As a result, it is likely that the WACC for the subject company exceeds that of Company E, suggesting modestly lower valuation multiples for the subject company. The selected EBIT multiple implies a 10% fundamental adjustment to the observed multiple for Company E. However, the greater capital intensity (measured as the ratio of EBITDA to EBIT) of Company E (1.38x, compared to 1.25x for the subject company) suggests that the effective discount to the EBITDA multiple relative to Company E should be smaller than for the EBIT multiple. Indeed, the selected EBITDA multiple for the subject company actually represents a modest premium to the observed multiple for Company E. The subject company’s EBITDA margins are inferior to those of Company E, causing the selected revenue multiple to imply a more substantial fundamental adjustment to Company E’s observed revenue multiple. Since the strength of the analogy to the guideline median observations is weaker, the implied fundamental adjustment is larger. Company A presents a much weaker analogy to the subject company than Company E does, and the corresponding implied fundamental adjustments are much larger.

The selected valuation multiples are reasonable when compared to Company E as the most directly comparable company, as well as when compared to the overall group median multiples. Even when the valuation analyst selects multiples directly, one should calculate the implied fundamental adjustments to the median (or other relevant benchmarks). In this case, the implied fundamental adjustments, when calculated relative to the median, are on the order of 20% to 25%. Exhibit 6.16 summarizes the application of the selected valuation multiples to the corresponding performance measures of the subject company. The resulting indications of enterprise value are within a tight range. This is not accidental, as the valuation analyst has selected

213

Market Approach (Guideline Public Companies)

Subject Company Performance Measure times: Selected Multiple Indicated Enterprise Value

Revenue $40,000

EBITDA $3,600

EBIT $2,880

0.65x $26,000

7.5x $27,000

9.0x $25,920

EXHIBIT 6.16 Application of Selected Valuation Multiples to Performance Measures.

the individual multiples with an eye toward not just risk and growth differences (the fundamental or “vertical” adjustment), but also differences in capital intensity and profitability (the “horizontal” adjustments).

Conclusion Unless the selected guideline companies present uniformly perfect analogies to the subject company, a fundamental adjustment to the observed multiples will be required under the guideline public company method. The valuation analyst may choose either of two equally acceptable analytical procedures for making the appropriate adjustments to the valuation multiples. ■

■

Under the direct quantification method, the valuation analyst calculates the appropriate fundamental adjustment with reference to the estimated WACC and growth expectations for the subject company relative to the guideline public company median (or other base). The principal virtue of this procedure is that the factors giving rise to the fundamental adjustment are clearly specified. The other procedure is to select an appropriate valuation multiple from within (or outside) the range of observed multiples in the guideline group with reference to the resulting implied fundamental adjustments. The principal virtue of this procedure is that it focuses attention on identifying and drawing the most apt analogy to the available guideline data.

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We note that some courts have viewed the specific company risk premium and/or fundamental adjustment with suspicion. These courts have suggested that these techniques are applied by valuation analysts in pursuit of desired outcomes. While we acknowledge that these techniques can be misused, we are convinced of the conceptual basis for the adjustments, and believe we have demonstrated that – when properly applied – these techniques correspond to economic reality when there are demonstrable differences in expected growth or risk between the subject and guideline companies. The fundamental adjustment underscores the need for valuation analysts and readers of valuation reports to assess the reasonableness of overall conclusions rather than isolated components of any valuation method.

GUIDELINE PUBLIC COMPANY MULTIPLES AND THE ENTERPRISE LEVELS OF VALUE The applicability of the observed guideline public company multiples at the marketable minority level of value is obvious. In this section we consider how, or to what extent, analysts may refer to guideline public company multiples when deriving conclusions at the other enterprise levels of value.

Marketable Minority Level of Value When applied to normalized earnings measures, guideline public company multiples (net of appropriate fundamental adjustments) yield indications of value at the marketable minority level of value. The discussion regarding the necessity of normalizing adjustments in Chapter 4 is equally applicable to valuation methods under the market approach.

Financial Control Level of Value The conceptual math of the Integrated Theory confirms that differences in value at the various levels of value are attributable solely to differences in cash flow, risk (WACC), and growth.

Market Approach (Guideline Public Companies) ■

■

■

215

We discussed potential financial control adjustments to normalized marketable minority cash flows in Chapter 4. It is essential that earnings measures not only be normalized, but adjusted to reflect any cash flow enhancements expected by financial control market participants. As discussed in Chapter 5, differences in the WACC at the financial control level are likely either not to exist or to be quite small. As a result, the portion of the fundamental adjustment attributable to differences in the WACC is likely to be no different than at the marketable minority interest level. Finally, there is rarely occasion to conclude that a financial control buyer will expect to augment the growth opportunities otherwise available to the subject company. Therefore, the portion of the fundamental adjustment attributable to differing growth expectations will, in most cases, be small or nil relative to the marketable minority level.

When applied to normalized financial control cash flows, valuation analysts may apply guideline public company multiples to derive indications of value at the financial control level. In most cases, the appropriate fundamental adjustment will be comparable to that applied (or implied) at the marketable minority level.

Strategic Control Level of Value While the Integrated Theory suggests that the difference between the marketable minority and financial control values are likely modest, the strategic control level of value introduces the possibility of a more substantial value premium. This does not, however, mean that guideline public company multiples are not relevant at the strategic control level of value. The following discussion is most applicable to market participants evaluating strategic investment opportunities, rather than valuation analysts measuring fair market value on a controlling interest basis. As we have noted previously, fair market value is generally not a strategic control concept.

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Applicable Earnings Measures To use the guideline public company method at the strategic control level, it is essential that the earnings measures used represent normalized enterprise cash flows with appropriate strategic control adjustments. As we discussed in Chapter 4, the strategic control adjustments applied to the earnings measures of the subject company should reflect the anticipated sharing of all potential benefits between the buyer and seller, reflecting in part the relative negotiating leverage of the parties. Applicable Fundamental Adjustments The fundamental adjustment is a function of differences in the WACC and growth expectations for the subject company relative to the guideline companies. At the marketable minority and financial control levels of value, the WACC is that of the subject company on a standalone basis. As we discussed in Chapter 5, however, strategic acquirers may in fact apply their own potentially lower WACCs when establishing the value range for the target. Further, unlike financial control buyers, strategic control buyers may reasonably expect to alter the growth trajectory of the subject company. As a result, the applicable fundamental adjustment at the strategic control level may be lower than at the marketable minority or financial control levels. From a practical perspective, the observations in the preceding paragraph are broadly consistent with the willingness of some strategic control market participants to apply EBITDA multiples as high as their own multiples to targets under the theory that doing so will be nondilutive to the acquirer’s value. Of course, nondilutive does not mean accretive. Alternatively, strategic acquirers may place greater emphasis on multiples of gross profit, revenue, or activity measures as a shorthand means of “normalizing” the operating performance of the target. A Word of Caution Valuation analysts must carefully distinguish between valuation multiples applied to normalized strategic control cash flow measures and the multiples reported in change of control transactions. Our discussion in this section has been from the

217

Market Approach (Guideline Public Companies) Economics of Observed Transaction The Buyer's Perspective Normalized EBITDA (w/ Strategic Benefits) times: Multiple Paid Strategic Transaction Price

$1,800 10.0x

Buyer Buyer

$18,000

The Seller's Perspective Normalized EBITDA (Marketable Minority) times: Multiple Received Strategic Transaction Price

$1,200 15.0x $18,000

Seller Seller

$1,800

Buyer

Application to a Valuation Analysis The Unwary Analyst's Perspective Normalized EBITDA (w/ Strategic Benefits) times: Multiple Received Strategic Transaction Price

15.0x $27,000

Seller Overvaluation

EXHIBIT 6.17 Impact of Differing Perspectives on Transaction Multiples. perspective of the buyer; reported strategic transaction multiples, when available, are inevitably calculated from the perspective of the seller. Exhibit 6.17 illustrates the potential for overvaluation when these two perspectives are mixed. Applying the multiple received by the seller (and reported in the press) to normalized strategic control cash flows expected by the buyer can result in significant overvaluation.

Conclusion The Integrated Theory guides valuation analysts regarding the proper use of guideline public company data at each of the enterprise levels of value. Exhibit 6.18 summarizes the guidance at each level of value.

Strategic Control Cash Flow Strategic cash flows Risk Standalone or Acquirer WACC Growth Strategic perspective

Since applicable WACC may be lower / expected growth higher, fundamental adjustment may be smaller than at marketable minority or financial control levels

Financial Control Cash Flow Normalized, with financial control Risk Growth

Financial buyer WACC Financial buyer perspective

Financial control cash flow benefits are typically modest. Absence of significant differences in WACC/growth from marketable minority suggests comparable fundamental adjustment applicable

Marketable Minority Cash Flow Risk Growth

Normalized earnings measures Base, standalone WACC Base, standalone expectations

The appropriate fundamental adjustment reflects differences in WACC and growth expectations relative to guideline publics

EXHIBIT 6.18 Use of Guideline Public Company Multiples at Different Levels of Value.

Market Approach (Guideline Public Companies)

219

Guideline public company data is abundant, accessible, and of high quality. When used properly, guideline public company data is valuable even at the financial control or strategic control levels of value.

ASSESSING OVERALL REASONABLENESS We conclude this chapter where we began, by considering the relationship between the income and market approaches. Moving from the income approach to the market approach does not relieve the valuation analyst of the responsibility of making informed judgments. ■

■

Under the income approach, the necessary assumptions relate to cash flow, growth expectations, and the components of the discount rate. As we discussed in Chapter 5, no component of the WACC is without controversy, and no component of the WACC is a matter of objective proof, but rather requires the valuation analyst to weigh available evidence to reach a reasonable estimate of the overall WACC. Under the market approach, the necessary assumptions relate to the selection of valuation multiples to apply to the subject enterprise. The fundamental adjustment describes the difference between the multiple applied to the subject enterprise and the observed multiples from the guideline public companies. The fundamental adjustment reflects differences between the subject company and the guideline group with regard to the WACC and growth expectations.

The Integrated Theory demonstrates that, while the required judgments have different names under the different approaches, the underlying judgments are ultimately identical. Rather than rendering one of the approaches redundant, however, this understanding helps the valuation analyst use observations and data from each approach to refine and support the application of the other approach. For example, the best way to assess the overall

220

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reasonableness of the selected WACC is by comparing the resulting indication of value under the income approach with market observations. In the same way, the best way to assess the overall reasonableness of a selected market multiple is to compare the return and growth expectations implied by the multiple with available rate of return data from the income approach. We believe this is a virtuous, not vicious, cycle. We would even go so far as to say that acknowledging the mutually reinforcing coherence of the income and market approaches is the only path toward developing reasonable conclusions of value. The conceptual framework provided by the Integrated Theory is a reliable guide along that path. Guideline public companies are not the only sources of market data for valuation analysts. In the next chapter, we explore how the Integrated Theory can assist valuation analysts when applying the guideline transaction method under the market approach.

CHAPTER

7

Market Approach (Guideline Transactions)

INTRODUCTION In Chapter 6, we explored how the Integrated Theory informs the market approach in the context of the guideline public company method. Specifically, we reviewed how the income and market approaches relate to one another, how to interpret various enterprise valuation multiples, and the concept of the fundamental adjustment. Each of these topics is equally applicable to the guideline transactions method. The guideline public company and guideline transactions methods differ from one another only with regard to the relevant data set for market observations. In this chapter, we will use the Integrated Theory to demonstrate how to interpret and use guideline transaction market data appropriately. By way of outline, we will address the following questions in this chapter: 1. How does the data available for use in the guideline transaction method differ from that available for use in the guideline public company method? 2. What can valuation analysts infer regarding expected cash flows, risk, and growth from guideline transaction data? 3. What can valuation analysts infer regarding expected cash flows, risk, and growth from observed control premiums?

221 Business Valuation, First Edition. Z. Christopher Mercer and Travis W. Harms. © 2021 Z. Christopher Mercer and Travis W. Harms. Published 2021 by John Wiley & Sons, Inc.

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4. What do guideline transaction data reveal regarding the minority interest discount? 5. How should guideline transaction multiples be applied at the different levels of value? 6. How can valuation analysts evaluate the reasonableness of indicated values under the guideline transaction method?

ATTRIBUTES OF GUIDELINE TRANSACTION DATA In order to apply the guideline transactions method appropriately, valuation analysts must first understand the nature of the data available. The available guideline transaction data is best evaluated relative to the data available for use in the guideline public company method.

Available Guideline Public Company Data Valuation analysts occasionally lament the dearth of public companies that are truly comparable to the business being valued. For many small, niche businesses, this is undoubtedly true. However, when appropriate guideline public companies are available, the quality and quantity of available data are generally of the highest quality. After all, guideline public companies present the valuation analysts with the following data set: 1. Annual audited financial statements with extensive footnotes for every year since the company has been publicly traded 2. Detailed quarterly financial statements with corresponding footnotes 3. Daily transaction pricing, often over a period of many years 4. Detailed business descriptions, updated annually 5. Management discussion and analysis of quarterly and annual operating results 6. Full texts of merger agreements, credit facilities, and other major corporate documents 7. Transcripts (and corresponding investor relations presentations) of quarterly earnings calls with professional analysts covering the shares

Market Approach (Guideline Transactions)

223

8. Limited management guidance regarding the future performance of the business 9. For many companies, detailed analyst forecasts regarding the future performance of the business When relevant guideline public companies are available, all of the items listed above are available to the valuation analyst at the push of a (computer keyboard) button through Bloomberg, CapitalIQ, SNL, Tagnifi, or other data providers.

Available Guideline Transaction Data In contrast to the embarrassment of riches available to the valuation analyst for public companies, available guideline transaction data often disappoints. The availability of data depends on whether the acquired company is public or private. Acquisitions of Public Companies When the acquired company in a guideline transaction is publicly traded, the entire data set regarding its historical operations noted above is available. In addition, valuation analysts will generally have access to the actual merger agreement and one or more fairness opinions rendered by investment banks on behalf of the selling shareholders. Furthermore, since there is a database of trading history for the acquired company’s shares, valuation analysts can compare the transaction price to the prior trading prices. This comparison yields what has historically been referred to as a control premium. The uses and potential misuses of control premium data are addressed in a subsequent section of this chapter. Acquisitions of Private Companies For smaller businesses, acquisitions of private companies are likely more relevant to the valuation. However, as summarized in Exhibit 7.1, the quality and quantity of available data for such transactions is often limited. The available data regarding private company acquisitions can limit the applicability of the method. However, if and when reliable private company transaction data is available, it can provide important perspective to valuation analysts. In the following section, we

Data Point

Public Acquiree

Private Acquiree

Comments

Audited Financial Statements

Rudimentary data points (revenue, EBITDA, assets) occasionally available, but without necessary context

Quarterly Financial Statements

Rarely available

Daily Stock Trading History

Not available

Detailed Business Descriptions

Short description / SIC code often included in transaction databases, no texture or management perspective available

Mangement Discussion & Analysis

Not available

Full Text of Merger Agreements

Summary description of basic terms (price, etc.) may be available in transaction databases / press releases

Quarterly Earnings Call Transcripts

Not available

Management Earnings Guidance

Not available

Analyst Earnings Forecasts

Not available

Fairness Opinion on Behalf of Seller

Not available

EXHIBIT 7.1 Potential Data Points: Guideline Public Companies versus Guideline Transactions.

Market Approach (Guideline Transactions)

225

address how to interpret available guideline transaction data in the context of the Integrated Theory.

DRAWING VALUATION INFERENCES FROM GUIDELINE TRANSACTION DATA In Chapter 6, we used the conceptual math of the Integrated Theory to identify the relevant components of the various valuation multiples. Exhibit 7.2 summarizes the analysis from Chapter 6. Guideline transactions can generally be classified as reflecting financial or strategic motivations, corresponding to the financial and strategic control levels of value.

Financially Motived Guideline Transactions Financially motivated guideline transactions include those in which the acquirer is a private equity fund or other buyer that does not have legacy operations in, or adjacent to, the industry in which the subject company operates. As we discussed in Chapter 4, private equity buyers can have the characteristics of strategic acquirers when they are making an acquisition to “bolt on” to an existing portfolio company. There is often an element of judgment in classifying a transaction as financial or strategic. Exhibit 7.3 summarizes each of the principal components of observed guideline transaction multiples when the transaction is financially motivated (i.e., provides evidence of value at the financial control level). As the analysis in Exhibit 7.3 suggests, the relevant components of value implied by observed guideline transaction multiples are conceptually comparable to guideline public company multiples in financially motivated transactions. As a result, when reliable data from financially motivated transactions is available, it is applicable at the financial control level. Furthermore, there is no conceptual basis for more than a token minority interest discount to derive a marketable minority interest value. Since there is no reliable indication of value for the subject company on a marketable minority basis to compare to the transaction price, it is not possible

Multiple

Conceptual Math EV

EV / NOPAT

EV / EBIT

EV / EBITDA

EV / Gross Profit

EV / Revenue

EV / Activity

NOPAT EV EBIT

=

=

Components 1

WACC, growth prospects

WACC – g

EV NOPAT

× (1 – tax rate)

WACC, growth prospects, tax rate

D&A EV EV = × 1– EBITDA EBITDA EBIT

WACC, growth prospects, tax rate, capital intensity

EV

WACC, growth prospects, tax rate, capital intensity, operating efficiency

GP

=

EV EBITDA

× 1–

Cash OpEx GP

EV EV × (Gross Margin) = Rev GP

WACC, growth prospects, tax rate, capital intensity, operating & production/purchasing efficiency

EV

WACC, growth prospects, tax rate, capital intensity, operating & production/purchasing efficiency, unit pricing

Activity

=

EV Rev

× (Unit Pricing)

EXHIBIT 7.2 Conceptual Math Underlying Enterprise Valuation Multiples.

Integrated Valuation Multiple Components

Theory Elements

Weighted Average Cost of Capital

WACCFC ≈ WACCMM

Growth Prospects

gFC ≈ gMM

Comments As discussed in Chapter 5, the WACC for financial buyers is likely commensurate with the marketable minority level Financial buyers are unlikely to perceive opportunities to significantly augment target's standalone growth trajectory

Tax Rate

Tax RateFC ≈ Tax RateMM

Effective tax rates unlikely to be materially different. Tax benefits from transactions structured as assetpurchases may be significant

Capital Intensity

(D&A / EBITDA)FC ≈ (D&A/ EBITDA)MM

Financial buyers likely to evaluate capital intensity from standalone perspective

Profitability

MarginFC ≈ MarginMM

There are limited opportunities for material earnings improvement from normalized marketable minority base for financial control buyers

EXHIBIT 7.3 Transaction Multiple Components: Financial Buyers.

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to calculate control premiums or minority interest discounts for such transactions. Applicable Fundamental Adjustment Before applying an observed multiple from a financially motivated transaction to normalized earnings measures for the subject company, valuation analysts must consider whether a fundamental adjustment to the observed multiples is appropriate. The conceptual basis for the fundamental adjustment was reviewed in detail in Chapter 6. As discussed in that chapter, the fundamental adjustment arises from differences in the risk profile and growth prospects of the subject company relative to the guideline companies. ■

■

Differences in risk profile. Making relative risk assessments between the subject and guideline transaction companies is harder when the acquired company is private. In the absence of detailed historical financial statements and accompanying management discussion and analyses, valuation analysts must seek other means of establishing relative risk. The website of the acquired company may provide some perspective, trade publications may provide indications of relative size, or management of the subject company may have insight regarding the relative risk profile of the acquired company. Differences in growth prospects. Without access to historical financial results and associated management commentary, assessing relative growth prospects of the subject and guideline companies is difficult. Where available, valuation analysts should rely on the same data sources used to make relative risk assessments.

Revenue multiples are more likely to be available for guideline transactions involving private companies than are multiples of EBITDA or earnings-based measures. When revenue multiples are the only available data points, valuation analysts should bear in mind that those multiples are influenced by the profitability of the acquired company in addition to expectations regarding the company’s risk profile and growth prospects.

Market Approach (Guideline Transactions)

229

Assume, for example, that the reported revenue multiple for a guideline transaction is 1.5x. If the company sold in the guideline transaction earned an EBITDA margin of 20%, the multiple of EBITDA in the transaction was therefore 7.5x (revenue multiple of 1.5x, divided by the EBITDA margin of 20%). Assume that the risk and growth profile of the acquired company is comparable to that of the subject company of the valuation. ■

■

Suppose that the subject company of the valuation generates an EBITDA margin of 25%. If the valuation analyst applies the reported guideline transaction revenue multiple of 1.5x, the resulting indication of value will understate the value of the subject company. Applying the revenue multiple to the subject company’s more profitable revenue will result in an implied EBITDA multiple of 6.0x (1.5x divided by 25%). If the margin differences are not considered, the valuation analyst will inadvertently apply a negative fundamental adjustment relative to the implied guideline EBITDA multiple of 7.5x that is not warranted. Conversely, if the subject company’s EBITDA margin is 15% (lower than the guideline company), application of the 1.5x revenue multiple implies an EBITDA multiple of 10.0x (1.5x divided by 15%). As in the preceding example, the unwary valuation analyst has effectively applied an unsupportable positive fundamental adjustment to the implied guideline EBITDA multiple of 7.5x.

The point of this example is that when a guideline transaction revenue multiple is the only available data point, valuation analysts must carefully evaluate potential margin differences between the subject and guideline companies. Sometimes, there is not enough information to conduct that analysis.

Strategically Motivated Guideline Transactions A guideline transaction is strategically motivated if the acquirer has legacy operations in, or adjacent to, the industry in which the acquired company operates. Exhibit 7.4 summarizes the conceptual components of observed valuation multiples from strategically motivated transactions.

Valuation Multiple Components

Weighted Average Cost of Capital

Growth Prospects

Tax Rate

Capital Intensity

Profitability

Integrated Theory Elements

WACCSC ≤ WACCMM

gSC ≥ gMM

Comments Strategic buyers may apply their own (potentially lower) WACC in deriving strategic control value. However, doing so increases the likelihood that the transaction will not ultimately be accretive to value for the buyer Strategic acquirers may have access to growthaugmenting strategies

Tax RateSC ≈ Tax RateMM

Absent unusual circumstances, the effective tax rates for strategic control buyers are unlikely to be materially different. Tax benefits from transactions structured as asset purchases may be significant

(EBITDA / EBIT)SC ≤ (EBITDA / EBIT)MM

Depending on overlap/excess capacity at existing facilities, strategic buyers may anticipate being able to operate with less capital intensity at the margin

MarginSC ≥ MarginMM

Strategic buyers may anticipate realizing significant cost savings and/or revenue synergies from the business combination

EXHIBIT 7.4 Transaction Multiple Components: Strategic Buyers.

Market Approach (Guideline Transactions)

231

In contrast to the corresponding analysis in Exhibit 7.3 for financially motivated transactions, the comments in Exhibit 7.4 suggest that the elements of value implied by observed strategic guideline transactions may differ materially from those relevant at the marketable minority level of value. This makes proper use of observed strategic control transactions more challenging, particularly when working under the fair market value standard. Two additional characteristics of strategic transactions can further complicate proper application of strategic guideline transaction multiples: ■

■

As discussed in Chapters 4 and 5, the portion of anticipated strategic benefits (whether attributable to enhanced cash flows or a lower WACC) shared with the seller through a higher price is determined by the relative negotiating leverage of the parties. In other words, interpreting observed guideline strategic transactions involves assessing not only the magnitude of potential strategic benefits not available to financial control buyers, but also the degree to which those benefits were allocated between the buyer and seller in the transaction. It is not always obvious from the reported data whether the quoted transaction multiples are calculated relative to historical standalone (i.e., nonstrategic) earnings measures, or prospective earnings that have been adjusted for strategic benefits. We provided an example in Exhibit 6.17 of the mischief that can arise when multiples calculated relative to standalone earnings measures are applied to subject company earnings to which strategic control adjustments have been applied. When the acquirer in a strategic transaction is a public company, they will occasionally disclose the cost synergies expected in the transaction, which allows the valuation analyst to calculate valuation multiples on both a standalone and strategic basis.1

As with guideline public company and financially motivated transaction multiples, valuation analysts must also consider the 1

For example, it is fairly standard when reporting on acquisitions of banks that an estimate of anticipated synergies, usually expense savings, will be provided.

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fundamental adjustment appropriate to the observed multiple to account for differences in risk profile and growth prospects. The relevant considerations when evaluating the appropriate fundamental adjustment applicable to observed guideline strategic transaction multiples depend on the level of value for the subject interest. Strategic Control Level of Value When deriving the fundamental adjustment applicable to derive a conclusion of value at the strategic control level of value, the appropriate comparisons are between the WACC that a market participant strategic acquirer would apply to the subject business and the WACC that the strategic acquirer applied to the acquired company in the observed transaction. If the acquirer in the observed transaction is of a comparable size and risk profile to the relevant set of market participants for the subject company, the portion of the fundamental adjustment attributable to differences in the WACC may be modest, or not material. With regard to growth prospects, the appropriate comparison is between the expectations of a strategic acquirer for the subject company and the acquirer expectations in the observed guideline strategic transaction. The relevant growth prospects are likely to be a function of both the standalone attributes of the target and the specific strategic motivations for the transaction. Financial Control Level of Value If the objective of the valuation engagement is to derive a conclusion of fair market value at the financial control level, the appropriate fundamental adjustment should be estimated relative to standalone expectations for the subject company. In other words, the standalone WACC for the subject company should be compared to the WACC that the strategic acquirer applied to the acquired company in the observed transaction. Depending on the nature of the transaction, that difference could be material. With respect to growth prospects, the relevant comparison is between the standalone growth prospects of the subject company and the strategically augmented growth prospects for the acquired company in the guideline strategic transaction. The preceding discussion of fundamental adjustments applicable to guideline transactions presumes a level of information

233

Market Approach (Guideline Transactions)

regarding the guideline transaction that is rarely available in practice. In light of this information deficit, one technique that valuation analysts have historically relied upon to make guideline transaction data more meaningful is to calculate the control premium implied in the acquisition of public companies. We turn our attention in the next section of this chapter to best practices in the interpretation of control premium data.

Drawing Valuation Inferences from Control Premium Data Observed control premiums in public company acquisitions are perhaps the most precisely quantifiable data points available to valuation analysts. As shown in Exhibit 7.5, the control premium describes the difference between two prices, the pre-transaction price and the transaction price. Exhibit 7.5 illustrates three different ways to express the control premium. ■

Observed control premiums have traditionally been calculated on a per-share basis. The trading price of the company’s shares on a date prior to the transaction announcement ($36.50 per share in the example in Exhibit 7.5) is compared to the transaction price ($50.00 per share), and the difference ($13.50 per share) is expressed as a percentage of the pre-announcement price (37.0%).

Share Price

Market Capitalization

Enterprise Value

Pre-Transaction Value

$36.50

$73,000

$103,000

Transaction Price

$50.00

$100,000

$130,000

Control Premium ($)

$13.50

$27,000

$27,000

Control Premium (%)

37.0%

37.0%

26.2%

EXHIBIT 7.5 Calculation of Control Premiums from Different Bases.

234 ■

■

BUSINESS VALUATION

Alternatively, the control premium can be measured with reference to the aggregate equity market capitalization of the acquired company (as shown in the middle column of Exhibit 7.5). Since this involves simply multiplying both pershare values by the same number of shares outstanding, the percentage control premium is unaffected. However, the dollardenominated control premium under this method ($27,000) corresponds to the actual incremental value assigned to the target company by the acquirer. Finally, as shown in the rightmost column of Exhibit 7.5, the control premium can be expressed relative to enterprise value. Since the same amount of debt (net of cash) is added to the pre-transaction and transaction values, the dollar-denominated control premium is unaffected. However, the larger base of enterprise value yields a lower percentage control premium (26.2%, compared to 37.0%). Valuation analysts are beginning to recognize that this is the appropriate basis for measuring the control premium, since it neutralizes the impact of pre-transaction seller debt on the calculated premium. As we discussed in Chapter 5, the analytical focus of control buyers is on enterprise value rather than equity value. Furthermore, the economic factors giving rise to the control premium pertain to the enterprise as a whole, not just the equity value.

The calculation of the control premium is straightforward and uncontroversial. But what do observed control premiums mean? We turn our attention to this more difficult question below.

The Economic Meaning of Observed Control Premiums As shown in Exhibit 7.5, observed control premiums relate two values for the same company. While control premiums have a veneer of objectivity, the analysis in Exhibit 7.6 illustrates that surface objectivity of the control premium measurement evaporates when the control premium is analyzed at the level of individual valuation components.

235

Market Approach (Guideline Transactions) Basic Expression Enterprise ValueTrans Enterprise ValuePre–Trans

–1

Expanded Expression EarningsControl × MultipleControl EarningsStandalone × MultipleStandalone

–1

EXHIBIT 7.6 Alternative Expressions of the Control Premium.

In moving to the expanded expression in Exhibit 7.6, the apparent objectivity of the basic expression is lost as the observable enterprise values are exchanged for unobservable earnings expectations and valuation multiples. Is that too high a price to pay? No, because the benefits of “objectivity” in the basic expression are illusory at best. Consider what information the “objective” basic expression really provides: ■

■ ■

■

■

■

■

■

The pre-announcement price of the acquired company was $36.50 per share. The announced transaction price was $50.00 per share. The announced transaction price is $13.50 per share higher than the pre-announcement price. The announced transaction price exceeds the pre-announcement price by 37.0%. The pre-announcement transaction price is 27.0% lower than the announced transaction price. The announced transaction price implies an enterprise value of $130 million, which is $27 million higher than the pre-announcement enterprise value of $103 million. The implied enterprise value for the transaction is 26.2% higher than the pre-announcement enterprise value. The pre-announcement enterprise value is 20.8% lower than the enterprise value implied by the transaction.

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While the preceding observations possess objectivity, they fail to actually offer much in the way of relevant economic meaning for valuation analysts. Consider what the basic expression in Exhibit 7.6 cannot reveal: ■

■

■ ■

■

■ ■

The views of market participants regarding the expected earnings, risk profile, and growth prospects for the acquired company on a standalone basis The degree to which either party to the transaction was subject to economic compulsion The sale process leading up to the transaction The nature or magnitude of strategic cash flow benefits anticipated by the acquirer in the transaction The degree to which those strategic cash flow benefits were shared with the seller in the announced transaction price The weighted average cost of capital used by the buyer The growth prospects from the perspective of the buyer, and whether, or how, those prospects differed from those applicable to the acquired company on a standalone basis

For some transactions, press releases or other regulatory filings in support of the transaction may provide some limited insight regarding these questions. But such insights cannot simply be read off the surface of the “objective” control premium data, and are most certainly not available with respect to annual averages or medians of observed control premiums. In short, valuation analysts should not confuse the data provided by observed control premiums with meaningful information directly relevant for valuation. The next section provides a short case study from a litigation we were involved in that illustrates the danger of assuming that control premium data is actually information.

Case Study: The (Mis)Use of Control Premium Data Many years ago, we were asked, as part of a substantial litigation, to review an appraisal report that employed the guideline

Market Approach (Guideline Transactions)

237

public company method and added a control premium to derive a controlling interest indication of value. Our conclusion was that the methodology was incorrect and misleading based on information found within the report. The numbers in the following example are orders of magnitude similar to those in the report in question. The appraiser selected guideline public companies having an average EBITDA multiple of 9.2x. Normalized EBITDA was $20 million, so enterprise value was $184.8 million. As the subject company had no net debt, the equity value was also $184.8 million. The appraiser then analyzed two transactions (involving publicly traded Company A and Company B) with reported control premiums. The average of the two premiums as reported in Mergerstat Review at the time was 70%. That was a large control premium and amounted to $128.9 million (MVE of $184.8 million times 70%). The resulting control value of equity (and enterprise value) was $314.2 million. Exhibit 7.7 summarizes the pertinent facts of the case study. Normalized EBITDA for the company being valued was $20 million. With that information, we calculated the implied EBITDA multiple of 15.6x at the bottom left of the exhibit. The median EBITDA multiple for the 40-plus guideline transactions from the past five years in the appraiser’s report was 12.7x. However, pricing and the number of transactions were down in the most recent three years, so the median EBITDA multiple for transactions during that more recent period was 11.1x. It turned out that the transactions giving rise to the control premiums shown for Company A (55%) and Company B (85%) were also included in the appraiser’s guideline transaction method. The reported EBITDA multiple for Company A’s transaction was 11.2x, and the reported EBITDA multiple for Company B’s transaction was 10.8x. The average (or median) of the two multiples was 11.0x, which was about the median for transactions during the past three years (11.1x). The valuation multiples corresponding to the guideline transactions giving rise to the observed control premiums were relevant valuation information for the subject interest. The observed control premiums from those same transactions were simply distracting data.

Guideline Public Company Method + Control Premium

EBITDA Multiples from Actual Sales of Co A and Co B

As Presented (Non-Economic) Normalized EBITDA Median Price/Earnings Multiple (Public Co. Group) Enterprise Value

$20,000

Company A Control Premium

55.0%

Company B Control Premium

85.0%

Selected Control Premium Indicated Marketable Minority Value

70.0% $184,000

Apply Selected Control Premium

128,800

Concluded Enterprise Values (no debt)

$312,800

Implied Enterprise Value / EBITDA Multiple

Normalized EBITDA

$20,000

9.2 $184,000

15.6

No economics in these CPs

Co A and Co B EBITDA Multiples from Transactions

Every CP comes from a transaction

EXHIBIT 7.7 Misleading Results from Application of Average Control Premium.

11.2 10.8 11.0

$220,000 11.0

42.2%

$92,800

EBITDA Multiple Overstated

Enterprise Value Overstated

Market Approach (Guideline Transactions)

239

Applying the median EBITDA multiple of the two transactions (rather than the average of their control premiums) to the $20 million of normalized EBITDA yielded an enterprise value of $220 million, as shown at the bottom right of Exhibit 7.7. Comparing the conclusion of the guideline public company method (gross up by the misapplied control premium data) of $312.8 million on the left side to the indicated value of $220 million derived by applying the relevant EBITDA multiple, we see: ■

■

The implied EBITDA multiple resulting from misapplication of the control premium data was 42.2% higher than the average multiple from the actual transactions applied to normalized EBITDA. Enterprise value was increased by $92.8 million by the misuse of noneconomic control premium data rather than economic EBITDA multiples.

When confronted with evidence similar to (and substantially in addition to) that presented in this brief analysis, the other side in the litigation agreed to a settlement favorable to our client. Consistent with the Integrated Theory defined in Part One of this book, strategic control premiums should be rooted in an analysis of anticipated strategic cash flow benefits, the WACC applied by strategic acquirers, and the ability of strategic acquirers to augment the growth prospects of the subject company. Naïve reliance on observed control premium data will result in a reasonable conclusion of value only by chance. As a result, we advocate estimating strategic control values directly with reference to the expected cash flows, risk profile, and growth prospects from the perspective of a strategic acquirer. The valuation analyst may then calculate the implied control premium relative to the marketable minority value for the subject company and make any comparisons deemed appropriate.

Conclusion Following the Integrated Theory, a control premium is not properly a valuation input, but rather an output of the valuation process.

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Observed control premiums reflect the difference between the guideline transaction price and the pre-announcement value of a publicly traded company. While the observed premium is an objective data point, it is ultimately a composite of the (unobservable) differences in expectations regarding cash flow, risk, and growth on the part of the acquirer and those same variables for the acquired company on a standalone basis. Simply applying a selected premium to a marketable minority value will result in a reasonable conclusion only by chance, and runs the risk of materially overstating the controlling interest value. Since most acquisitions of public companies are strategic, observed control premiums are not applicable at the financial control level of value.

MINORITY INTEREST DISCOUNTS INFERRED FROM OBSERVED CONTROL PREMIUMS A further malign consequence of treating observed control premiums as valuation inputs, rather than outputs, is the resulting conclusion that the mathematical inverse of the observed control premium provides market evidence of the discount attributable to the lack of control. But if, following the Integrated Theory, observed control premiums are simply descriptions of the difference between strategic control transaction values and pre-announcement standalone marketable minority values, the observed discounts traditionally ascribed to the lack of control (the so-called “minority interest” discount) describe that same difference, with the only difference being the denominator in the expression. Exhibit 7.8 recasts the observed guideline transaction data from Exhibit 7.5 in terms of the “minority interest” discount. In Exhibit 7.8, we have not renamed the dollar difference, because it really is the premium paid by a specific buyer for the right to implement strategic enhancements to the standalone business. In other words, the observations run in a specific direction: from

241

Market Approach (Guideline Transactions) Share Price

Market Capitalization

Enterprise Value

Pre-Transaction Value

$36.50

$73,000

$103,000

Transaction Price

$50.00

$100,000

$130,000

Control Premium ($)

$13.50

$27,000

$27,000

“Minority Interest” Discount (%)

27.0%

27.0%

20.8%

EXHIBIT 7.8 Calculation of “Minority Interest” Discount from Different Bases.

an observable pre-announcement value to a guideline transaction value. The increase in value exists because a particular buyer perceives – and is willing to pay a transaction price based on – different expected cash flows, a different risk profile, and/or different growth prospects. The opposite movement – from a guideline transaction value to an observable pre-announcement value – simply does not carry the same conceptual freight. It is not a penalty or discount for the lack of control, but rather the negative image of the benefits perceived by a particular control buyer. Consider the following example. On a standalone basis, Company A is worth $10 million on a marketable minority interest basis ($1 million per 10% interest). Strategic Acquirer B has the opportunity to enhance cash flows materially, and is therefore willing to pay a strategic control value of $15 million. In the process of negotiating the transaction, the parties conclude that Company B will pay $13.5 million for 90% of ownership interest in Company A, with Company A’s shareholders retaining a 10% stake. What is the value of the 10% minority interest in Company A following the transaction? The “minority interest discount” implied by the transaction would suggest a value of $1.0 million. Yet the 10% minority interest will participate pro rata in the enhanced cash flows and eventual terminal value that contributed to the $15 million enterprise value. Whatever the appropriate minority interest discount might be, it has no conceptual or actual relationship to the “minority interest” discount implied by the observed control premium.

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In the context of the Integrated Theory, the minority interest discount is the difference between financial control value and marketable minority value, as depicted in Exhibit 2.13. Control premiums observed for strategic acquisitions of public companies are not relevant to the minority interest discount as it is typically applied in valuations. Despite traditional practice, valuation analysts should stop using observed control premiums to do so. They simply have nothing to do with the oft-cited prerogatives of control, which have limited value apart for the expectation that future cash flows will be higher, growth prospects will be enhanced, or risk will be reduced.

GUIDELINE TRANSACTION MULTIPLES AND THE LEVELS OF VALUE There are four potential types of observed guideline transaction multiples, and the use of the observed multiple at each level of value is different for each type: 1. Multiple from a financially motivated transaction that is calculated using a pro forma measure of earnings as the denominator 2. Multiple from a financially motivated transaction that is calculated using an historical measure of earnings as the denominator 3. Multiple from a strategically motivated transaction that is calculated using a pro forma measure of earnings as the denominator 4. Multiple from a strategically motivated transaction that is calculated using an historical measure of earnings as the denominator Exhibit 7.9 provides guidance for applying each type of guideline transaction multiple to derive indications of value at the marketable minority, financial control, and strategic control levels of value. As the guidance in Exhibit 7.9 indicates, correct use of the guideline transaction method is not straightforward. Valuation analysts relying on the method need to carefully consider what type of valuation multiple is available, and apply the multiple to the appropriate earnings measure.

Sources of Guideline Transaction Multiples Financial Control / Marketable Minority

Strategic Control

Financially-Motivated Transactions Multiple of Pro Forma Earnings Directly applicable (after fundamental adjustment) to normalized financial control/marketable minority earnings of subject

Strategically-Motivated Transactions Multiple of Pro Forma Earnings Can be applied (after appropriate fundamental adjustment) to normalized financial control/marketable minority earnings of subject company, but not recommended

Multiple of Historical Earnings Directly applicable (after fundamental adjustment) to normalized financial control / marketable minority earnings of subject

Multiple of Historical Earnings Not applicable without removing strategic control benefits, which is likely impractical

Multiple of Pro Forma Earnings Can be applied (after appropriate fundamental adjustment) to normalized strategic control earnings of subject

Multiple of Pro Forma Earnings Directly applicable (after appropriate fundamental adjustment) to normalized strategic control earnings of subject

Multiple of Historical Earnings Can be applied (after appropriate fundamental adjustment) to normalized strategic control earnings of subject, may need to adjust for financial control benefits

Multiple of Historical Earnings Directly applicable (after appropriate fundamental adjustment) to normalized marketable minority earnings of subject. Will reflect unique strategic benefits that may not be applicable to subject

EXHIBIT 7.9 Applying Guideline Transaction Multiples from Different Sources at Different Levels of Value.

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ASSESSING OVERALL REASONABLENESS Compared to the guideline public company method, the guideline transaction method presents numerous challenges for the valuation analyst: ■

■

■

Quality and reliability of data. The terms of many guideline transactions are not publicly disclosed, or are disclosed only partially. Furthermore, if the target company is private, the quality of historical financial performance measures may be impossible to verify. Quantity of data. In contrast to the daily pricing indications available for public companies, guideline transactions occur only sporadically, and available data, even if it is of high quality, may be chronologically remote from the valuation date. Interpretation of data. For strategically motivated guideline transactions, available data is subject to potential mis-interpretation and reflects a host of transaction-specific characteristics that may or may not be relevant to the subject company.

Despite these shortcomings, available guideline transaction data may be the most relevant market evidence of value available for a small business. In light of these shortcomings, we are often hesitant to put significant weight on indications of value from the guideline transaction method. Rather, we are inclined to cite available data when assessing the overall reasonableness of the concluded value derived using other methods. Doing so helps ensure that the selected income approach assumptions and guideline public company multiples remain rooted in the actual behavior of market participants. In the same manner, even though observed control premiums are not valuation inputs, they do provide a composite view of the magnitude of strategic benefits perceived by actual strategic buyers. When appropriate, calculating the control premium implied by our conclusion of strategic control value can help provide meaningful context to the individual assumptions made in the valuation.

Market Approach (Guideline Transactions)

245

This chapter concludes Part Two of the book, in which we have focused on how the Integrated Theory applies in practice to the valuation of enterprises as a whole. In Part Three, we demonstrate application of the Integrated Theory to the valuation of minority shareholder interests at the nonmarketable minority interest level of value.

APPENDIX

7-A

A Historical Perspective on the Control Premium and Minority Interest Discount

INTRODUCTION Business appraisers and market participants have long observed that when publicly traded companies are acquired, the price most often reflects a premium over the previous market price for the target company. Since the acquirer gained control of the formerly public target, it was logical to call this premium a control premium. The shares of the target public companies were minority shares and lacked control to run the businesses. It was generally understood that there were certain prerogatives of control that belonged to controlling shareholders that were not available to minority owners. These prerogatives included a number of elements, such as:1 1. Appoint or change operational management. 2. Appoint or change members of the board of directors. 3. Determine management compensation and perquisites. 1

Pratt, Shannon P., with Niculita, Alina V., Valuing a Business, 5th ed. (New York: McGraw-Hill, 2008), p. 385. The entire discussion of the “elements of control” (“prerogatives of control” in previous editions of the book, reads as follows: “Control shares are normally more valuable than minority shares because they contain a bundle of rights that minority shares do not enjoy. The following is a partial list of some of the rights that go with control shares that minority shares do not have:” The list above follows.

247 Business Valuation, First Edition. Z. Christopher Mercer and Travis W. Harms. © 2021 Z. Christopher Mercer and Travis W. Harms. Published 2021 by John Wiley & Sons, Inc.

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4. Set operational and strategic policy and change the course of the business. 5. Acquire, lease, or liquidate business assets, including plant, property, and equipment. 6. Select suppliers, vendors, and subcontractors with whom to do business and award contracts. 7. Negotiate and consummate mergers and acquisitions. 8. Liquidate, dissolve, sell out, or recapitalize the company. 9. Sell or acquire Treasury shares. 10. Register the company’s equity securities for an initial or secondary public offering. 11. Register the company’s debt securities for an initial or secondary public offering. 12. Declare and pay cash and/or stock dividends. 13. Change the articles of incorporation or bylaws. 14. Set one’s own compensation (and perquisites) and the compensation (and perquisites) of related-party employees. 15. Select joint venturers and enter into joint venture and partnership agreements. 16. Decide what products and/or services to offer and how to price those products or services. 17. Decide what markets and locations to serve, to enter into, and to discontinue serving. 18. Decide which customer categories to market to and which not to market to. 19. Enter into inbound and outbound license or sharing agreements regarding intellectual properties. 20. Block any or all of the above actions. Since the acquirers paid premiums to the minority public price, observers assumed that the prerogatives of control were valuable. Valuation analysts used this conclusion as the basis for estimating the minority interest discount. After all, if one paid for control, then when control was not present, the dollar amount of the observed premium was considered to also be the discount for lack of control. This was clear in the early levels of value charts, which showed control premiums being paid over and above the marketable minority level of value. Exhibit 7.10, reproduced from Chapter 2, shows the control premium as it was understood about 1990.

Controlling Interest Basis

Obtain indirectly by reference to freely tradable values via Control Premiums

Control Premium (CP)

Obtain indirectly by reference to control valuation via a Minority Interest Discount

Obtain directly by reference to actual change of control transactions or other control methodologies

Minority Interest Discount (MID)

Marketable Minority Interest Basis

Obtain directly by reference to "freely tradable" comparable companies or by "build-up" methodologies that develop capitalization rates by estimating required rates of return in relation to public markets

Marketability Discount / DLOM

Obtain indirectly from Marketable Minority valuation by application of Marketability Discount

Nonmarketable Minority Interest Basis

EXHIBIT 7.10 Levels of Value Chart (1990).

Obtain directly from actual transactions

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Valuation analysts developed indications of value on a marketable minority interest basis, using either the guideline public company method or versions of the Capital Asset Pricing Model under the income approach. The standard practice was to then apply control premiums by reference to the various control premium studies (or by reference to actual change of control transactions). The control premium was thought to be paid for the prerogatives of control. It was natural to conclude that the minority interest discount was equivalent to the elimination of a control premium. Unfortunately, that conclusion was incorrect. We will examine both of these assumptions in this appendix.

CONTROL PREMIUM STUDIES: MERGERSTAT REVIEW In 1981, W.T. Grimm & Co. (“Grimm”) began publishing an annual study of merger and acquisition activity in the United States called Mergerstat Review (Year). Grimm and various successors have published the study annually since then. Each Mergerstat Review publication covered both private company and public company merger and acquisition transactions, and the publication provided a good overview of activity by industry, by sector, by size (when available), and more. The most important information in the publication for business appraisers was, however, the results of the annual study of control premiums paid in public company acquisitions. The primary control premium tracked by Mergerstat Review was (and is) the following, as shown in Exhibit 7.11. The premiums measured in public company acquisitions were based on the announcement date pricing of targets in relationship to their closing prices five days prior to the announcements. Five days prior was used as a measure of pricing “unaffected” by the merger announcement. Both of these prices were observed prices for the equity securities of public companies.

251

A Historical Perspective on the Control Premium

Control Premium =

Announcement Date Price per Share of Target Price per Share of Target 5 Days Prior to Announcement

−1

EXHIBIT 7.11 Definition of Control Premium per Mergerstat Review. Average and median premiums for the 237 transactions recorded in Mergerstat Review 1987, together with historical premiums back to 1968, are shown in Exhibit 7.12. The average of the average annual control premiums from 1968 to 1987 was 40%, and the median of the annual medians available

PERCENT PREMIUM PAID OVER MARKET PRICE 1968—1987 Year

DJIA High

DJIA Low

Average

Median

Base*

1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987

985.21 968.85 842.00 950.82 1,036.27 1,051.70 891.66 881.81 1,014.79 999.75 907.74 897.61 1,000.17 1,024.05 1,070.55 1,287.20 1,286.64 1,553.10 1,955.60 2,722.42

825.13 769.93 631.16 797.97 889.15 788.31 577.60 632.04 858.71 800.85 742.12 796.67 759.13 824.01 776.92 1,027.04 1,086.57 1,184.96 1,502.30 1,738.74

25.1 25.7 33.4 33.1 33.8 44.5 50.1 41.4 40.4 40.9 46.2 49.9 49.9 48.0 47.4 37.7 37.9 37.1 38.2 38.3

na na na na na na 43.1 30.1 31.1 36.2 41.5 47.6 44.6 41.9 43.5 34.0 34.4 27.7 29.9 30.8

271 191 80 74 93 145 147 129 168 218 240 229 169 166 176 168 199 331 333 237

*Base: The number of transactions where a premium over market was paid. Premiums can only be calculated on acquisitions of publicly traded companies. Source: W. T. Grimm & Co.

EXHIBIT 7.12 Figure 41 from Mergerstat Review 1987.

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for the period was 35%. Observed control premiums were substantial, and valuation analysts often cited this data when estimating control premiums and minority interest discounts.2 The published data has evolved over the years. In Factset Mergerstat Review 2018 and subsequent editions, for example, there is a new table that looks at control premiums based on enterprise value. The definition used in the new table is the market value of equity plus the market value of debt. The new table reflects a growing recognition that most market participants and many, if not most, business appraisers tend to view valuation on an enterprise basis – consistent with the Integrated Theory presented on an enterprise basis in Chapter 3, and with the following discussion regarding the Market Participant Acquisition Premium.

THE MARKET PARTICIPANT ACQUISITION PREMIUM The Appraisal Foundation published its Valuations in Financial Reporting Valuation Advisory 3: The Measurement and Application of Market Participant Acquisition Premiums in 2017 (“the MPAP Advisory”).3 This publication is the third in the Valuation Advisory series published by The Appraisal Foundation and pertains to the control premium we have been discussing. Readers of this book should find substantial independent validation of the Integrated Theory in a careful reading of the MPAP Advisory, which begins as follows:4

2

The annual studies have been published annually. As of the publication of this book, BV Resources is the current publisher of the data, which is marketed as the “Factset Mergerstat Review” (an annual yearbook) and “FactSet Mergerstat/BVR Control Premium Study” (an online database). 3 Valuations in Financial Reporting Valuation Advisory 3: The Measurement and Application of Market Participant Acquisition Premiums in 2017, The Appraisal Foundation, 2017. 4 Ibid., p. 7.

A Historical Perspective on the Control Premium

253

Premiums for control have long been a focus in business valuation. Through the early 1990s, it was generally accepted that the publicly traded price of a company’s shares represented the value of a minority interest and that, if the goal was to value a control interest, a “premium for control” would be added to the value of equity indicated by that publicly traded price. That premium generally came from market evidence in which the price paid to acquire an entire company was compared to the publicly traded price of that same company’s shares prior to the acquisition. However, in the late 1990s, this concept came into question and views have since been changing. Various points have been made regarding why the [financial] control value of an entity might be no greater than that indicated by its publicly traded price. In any case, it has become widely accepted that the market evidence supplied by comparing the acquisition price to the publicly traded price does not represent a premium for conceptual control but, rather, represents a premium linked to actual changes that can be made by exercising that control. Control, and whether one has it, is not really the focal point. What matters is that, after an acquisition, the acquired company is now under different management/stewardship. A price higher than the publicly traded price might be reasonable if the new management and/or combined entity expect(s) improved cash flow or growth or reduced risk. If no improvements or risk reduction could reasonably be expected, there may be little ability for an acquirer to pay a price higher than the publicly traded price and still generate a reasonable return on its investment. In such cases, the control value may approximate the publicly traded price. A new term appears in the title of the MPAP Advisory, that of the Market Participant Acquisition Premium (MPAP). A careful reading of the MPAP Advisory makes it clear that the MPAP is

254

BUSINESS VALUATION

analogous to the strategic control premium introduced in Chapter 2 and discussed in this chapter. The MPAP is not a premium paid for the prerogatives of control. Rather it is a premium paid for the expected benefits that purchasers (market participants) can expect from the exercise of control over a company or assets that are acquired. The MPAP Advisory is about 60 pages in length. The Working Group that prepared the document discussed the MPAP and what and how it is measured with a goal of establishing best practices for fair value determinations for financial reporting purposes. The document is too lengthy for a detailed review in this book. However, the concluding Summary of the MPAP Advisory provides an excellent review of its content. We quote the Summary below and comment briefly following each paragraph (by referenced number and in italics).5 Because this VFR Advisory is intended to address best practices for the valuation of controlling interests in business enterprises under the standard of fair value for financial reporting [1], certain commentary is provided regarding this context. [1] The MPAP Advisory addresses best practices for valuation of businesses under the fair value standard for financial reporting purposes. We would contend that much of the guidance in it is pertinent to the standard of value known as fair market value, as well. In fulfilling its mandate to provide best practices in the context of measuring fair value for financial reporting purposes, the Working Group introduced the term Market Participant Acquisition Premium, or MPAP. [2] MPAP is defined here as the difference between: (1) the pro rata fair value of the subject controlling interest; and (2) its foundation. The Working Group believes that valuation 5

Ibid., p. 55.

A Historical Perspective on the Control Premium

255

specialists most commonly associate the foundation with the pro rata fair value of marketable, noncontrolling interests in the enterprise. [3] While this describes an MPAP Equity Foundation concept, a TIC Foundation may be more appropriate. The Working Group believes that best practices include expressing as well as applying the MPAP in the context of a TIC Foundation. [2] MPAP is defined as the difference between the fair value of a controlling interest and a foundation value, which is equivalent to the marketable minority level of value discussed as the benchmark level of value in Chapter 2. That difference is consistent with the strategic control premium of the Integrated Theory. [3] The relationship between conceptual control and foundation value is an “MPAP Equity Foundation” concept. In Chapter 2, we developed the Integrated Theory on an equity basis. The concepts are essentially identical. The Working Group also believed that it would be important to express the MPAP, or strategic control premium, in the context of a TIC Foundation. TIC stands for total invested capital, and is analogous to the Integrated Theory on an enterprise basis as developed in Chapter 3. [4] This Advisory asserts that MPAPs should be supported by reference to either enhanced cash flows or a lower required rate of return from the market participants’ perspective. [5] The Working Group anticipates such benefits will not in all instances exist or be reliably identifiable, thus, in such cases resulting in either no premium or a small premium. [6] Notwithstanding the emphasis on cash flow and risk differentials in supporting MPAPs in fair value measurement, the Working Group acknowledges the merit of analyzing historical data regarding observed premiums from closed transactions when reliable data is available. [4] MPAPs need to be supported by reference to enhanced cash flows (both level and growth) and recognition that acquisitions can

256

BUSINESS VALUATION

reduce risks for acquirers. This is analogous to the discussion in Chapters 2 and throughout this book that strategic control premiums are the result of enhanced expectations for cash flows and their growth, or reductions in required returns. [5] The Working Group recognized that strategic or synergistic benefits are not always available in acquisitions and that there will be instances of no MPAP, or only a small premium. This is consistent with the Integrated Theory, which suggests that the financial control value will not differ materially from the benchmark, marketable minority level of value if no (or minimal) cash flow benefits or risk reductions are available. [6] The Working Group did acknowledge that there could be some merit in analyzing control premiums from historical transactions when reliable information is available. [7] However, the Working Group cautions that exclusive reliance on observed premium data from completed transactions provides, in most cases, insufficient support for a concluded MPAP. Exclusive reliance on observed transaction premiums without careful analysis of the subject entity’s relative financial performance, valuation multiples, and other metrics can result in an unreliable fair value measurement. [7] Best practices suggest that exclusive reliance on observed control premium analysis is generally insufficient to support a concluded MPAP. This is consistent with the discussion in Chapter 7 of this book that observed premiums convey no economic information absent an analysis of expected cash flow benefits or risk reductions. Considering historical control premiums in the absence of appropriate financial and valuation analysis will lead to unreliable valuation (fair value) results and would be inconsistent with best valuation practices. [8] Various business characteristics are discussed that influence an MPAP, including characteristics of the market and industry, as well as both the subject entity and market

A Historical Perspective on the Control Premium

257

participants. [9] The exercise of prerogatives of control by acquirers may lead to economic benefits in many areas and the valuation specialist should review the typical business characteristics likely to influence the magnitude of the benefits available to market participants. [10] The Working Group believes that use of the framework discussed will provide an important context for review of the valuation results and will increase the relevance and reliability of the associated fair value measurement. [8] It is essential to focus on what we have referred to as “the economics” of valuation situations and of transactions in order to assess the how and why of MPAPs (or strategic control premiums). [9] The exercise of the prerogatives of control can lead to reduced risk or expected cash flow enhancements, but do not have any separable inherent value of their own. In other words, there is no separate allocation of purchase price to the prerogatives of control. The valuation analyst should understand the underlying business characteristics of valuation subjects in order to assess the magnitude of expected cash flow enhancements or risk reductions. [10] Using the framework outlined in the MPAP Advisory (i.e., the MPAP Equity Foundation and the MPAP TIC Foundation) will facilitate the review of fair value measurements and enhance the reliability of those measurements. [11] A credible fair value measurement should include an assessment of the overall reasonableness of the measurement, including the MPAP applied or implied by the analysis. The level of rigor of analysis would depend on the importance of the MPAP to the fair value measurement. Factors—along with examples—are offered to evaluate the reasonableness of the fair value measurement of a controlling interest in a business enterprise. [11] It is not credible to simply apply an MPAP, or strategic control premium, in fair value (or fair market value) determinations. The reasonableness of any MPAP applied (or implied) must

258

BUSINESS VALUATION

be shown by reference to basic business characteristics and expected cash benefits or risk reductions. The larger the MPAP, the more rigorous should be the analysis.

THE CASE FOR THE DISAPPEARING MINORITY INTEREST DISCOUNT Historical Background We will engage in some repetition of issues previously discussed in this section on the minority interest discount. However, the issue is of sufficient importance to warrant additional discussion. The original levels of value chart suggested that the minority interest discount was the same dollar amount as the corresponding control premium from the base marketable minority level of value. That level is named by reference to trading of minority interests in the public securities markets. The value chart had three levels as depicted in Exhibit 7.10. The chart showed relationships between three “levels” of value: ■

■ ■

The marketable minority level, which was a base level, or asif-freely-traded level, from which other levels were determined The controlling interest level (control of businesses) The nonmarketable minority level (illiquid minority interests)

The “adjustment factors” in the chart are two discounts and one premium. ■

Control Premium (CP). The control premium was an adjustment from the marketable minority level to the control level. Control premiums were observable in the market for change-ofcontrol transactions involving public companies. If a public company traded at $10 per share and sold for $14 per share, the control premium was $4 per share, or the difference between the transaction price and the pre-announcement public price. The control premium in this example is 40% if expressed as a percentage ($14/$10 – 1) of the pre-announcement price.

A Historical Perspective on the Control Premium

■

■

259

Practitioners analyzed control premiums as they were reported in predecessors to the current studies available at Business Valuation Resources.6 Valuation analysts used control premium studies to estimate minority interest discounts. Minority Interest Discount (MID). As is clear from the levels of value chart above, the MID was originally conceived as the mirror image of the control premium. In the example just noted, the control premium was $4 per share. The corresponding MID would therefore be $4 per share. We address the percentage MID shortly. Marketability Discount (DLOM). The marketability discount was the difference between the marketable minority value and the nonmarketable minority value. A proxy for the DLOM was observed in restricted stock studies. When public companies issued restricted stock (under Rule 144 of the Securities and Exchange Commission), the restricted shares generally sold at prices less than their otherwise identical publicly traded prices. For example, a restricted stock offering might be for $7 per share compared to a $10 per share public price. The dollar discount is $3 per share, or 30% of the public price for the freely traded shares. Valuation analysts used restricted stock studies as a basis to estimate marketability discounts.

In the 1980s and 1990s, valuation analysts were not keenly focused on the marketable minority level of value. Many valuation analysts developed indications of value for 100% of a business, and then, almost automatically, applied both minority interest and marketability discounts. With this background, we can look at what we refer to as the disappearing minority interest discount.

The Minority Interest Discount The math of the minority interest discount was fairly straightforward. To eliminate the control premium of 40% from the example above, we engage in a bit of basic algebra (Exhibit 7.13): 6

Available at www.bvresources.com.

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MID = 1 −

1 1 + CP

EXHIBIT 7.13 Calculation of Traditional Minority Interest Discount. The minority interest discount calculated from the 40% control premium in our example above is 28.6% [1 – (1/(1+0.40))]. The averages of control premium studies tended to be in the 35% to 40% (or more) range, so implied minority interest discounts tended to be substantial, and in the range of 25% to 30%. The reduction in value was often attributed to certain prerogatives of control (discussed earlier in this chapter) like the ability to run a company, to pick whom to do business with, to determine dividend policy, and more. The implication was that buyers of companies were paying substantial control premiums to obtain these prerogatives of control. The minority interest discount accounted for this premium by taking it away, since minority shares lack control. Then, of course, valuation analysts applied marketability discounts based on averages of restricted stock discounts in the range of 30% to 35%, plus or minus a bit, and some minority interest valuation conclusions were suspiciously low. In this appendix, we focus only on the minority interest discount. Step 1 for the Disappearing Minority Interest Discount In 1990, Eric Nath wrote an article for the Business Valuation Review of the American Society of Appraisers titled “Control Premiums and Minority Interest Discounts in Private Companies.”7 The core idea in the Nath article was considered by many valuation analysts (including Mercer) as heresy. It took some time for Nath’s novel idea to catch on, but it did begin to resonate with some valuation analysts during the 1990s. 7 Nath, Eric, “Control Premiums and Minority Interest Discounts in Private Companies,” Business Valuation Review, American Society of Appraisers, June 1990, Vol. 9, No. 2, pp. 39–46.

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Nath’s article suggested the following reasoning, which, with the benefit of hindsight, is consistent with the Integrated Theory: ■

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The markets for public securities are massive and market participants are looking to maximize their returns from investments there. In a given year, only a relatively small number of public companies are taken over by other companies. The companies that are taken over are acquired on the basis of expected synergistic and strategic benefits, or because their trading prices are sufficiently “undervalued” that they can be purchased with the acquirer benefiting from the expected enhancements in value. Given the number of large public companies, private equity investors, and other investors, if there were more opportunities where companies were trading at less than their control values, more would be taken over. The money would find these opportunities “like sharks to blood.” But most public companies are not in fact taken over in any year, so they must be trading at something close to their control levels. Since some public companies are acquired for synergistic or strategic reasons, that kind of control is a higher level of control value than that of the typical public company. While Mercer initially disagreed with Nath’s suggestion that typical public market pricing yielded (financial) control values, Nath’s article marked the first step on the path to the disappearing minority interest discount.

Step 2 for the Disappearing Minority Interest Discount By the mid-1990s, many valuation analysts had realized that most of the transactions in control premium studies involved strategic (or synergistic) intent. As a result, acquirers paid premiums, not for the bare prerogatives of control, but rather for the ability to enhance the cash flows of an acquisition through expected operating synergies, enhanced sales, and other expected strategic benefits.8 8

See, for example, Mercer, Z. Christopher, “A Brief Review of Control Premiums and Minority Interest Discounts,” Journal of Business Valuation

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This realization led to the insertion of a fourth level of value in the chart above, that of financial control, between the marketable minority level and the existing control level, which was relabeled as strategic control, as seen in the following chart. Mercer published this chart in the late 1990s, and others published similar charts during this period. For example, the chart in Figure 7.14 was reproduced in 2000 in the fourth edition of Valuing a Business along with a similar chart the authors developed showing four levels of value.9 The Control Premium (CP) on the traditional chart on the left represents a single observed premium based on change-of-control transactions of public companies. That conceptual CP from the left side is broken into two components on the right side, the Financial Traditional

Modified

Control Value

Strategic Control Value Strategic Control Premium (SCP)

Control Premium (CP)

Minority Interest Discount (MID)

Financial Control Value Financial Control Premium (FCP)

Marketable Minority Value Marketability Discount/DLOM

Nonmarketable Minority Value

Minority Interest Discount (MID)

Marketable Minority Value Marketability Discount/DLOM

Nonmarketable Minority Value

EXHIBIT 7.14 Traditional and Modified Levels of Value Charts. 1997, Canadian Institute of Chartered Business Valuators. This journal published the proceedings of the Twelfth Biennial Business Valuation Conference of the CICBV, which was held June 6–7, 1996. 9 Pratt, Shannon P., Reilly, Robert F., and Schweihs, Robert P., Valuing a Business, 4th ed. (New York: McGraw Hill, 2000), pp. 347–348.

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Control Premium (FCP) and the Strategic Control Premium (SCP), because the combined premiums on the right are identical to those discussed for the left side. In other words, CP (on left) equals (FCP + SCP) (on right). Valuation analysts learned that the SCP on the right side was paid for the ability to enhance cash flows of targets through synergies and strategic benefits. This logic led to the realization that the control premium studies were measuring something other than, and more substantial than, the so-called prerogatives of control (to measure the minority interest discount). They were primarily reflecting the value of expected enhancements to cash flow and reductions in risk. The next conclusion was that the use of control premium studies to estimate minority interest discounts would, at the very least, overstate minority interest discounts when applied to control values that did not include the types of strategic cash flow benefits contemplated in strategic transactions. The realization that observed control premiums reflected both financial and strategic components was the second step along the path of the disappearing minority interest discount. Step 3 for the Disappearing Minority Discount Further reflection led to the development of a levels of value chart that suggested that the marketable minority and financial control values were synonymous, or nearly so. That is the logical conclusion reached based on Nath’s observations back in 1990. The expanded and refined levels of value chart is shown in Exhibit 7.15, again in relationship to the traditional three-level chart. Nath’s logic is compelling and is reflected in the chart on the right side. Mercer introduced the refined chart in the early 2000s in speeches and articles and in the first edition of Business Valuation: An Integrated Theory, which was published in 2004.10 The authors

10 Mercer, Z. Christopher, Valuing Enterprise and Shareholder Cash Flows: The Integrated Theory of Business Valuation (Memphis, TN: Peabody Publishing, L.P., 2004).

Control Premium (CP)

Traditional

Expanded and Refined

Control Value

Strategic Control Value

Minority Interest Discount (MID)

Marketable Minority Value Marketability Discount/DLOM

Nonmarketable Minority Value

Strategic Control Premium

Financial Control Premium (FCP)

Financial Control Value Marketable Minority Value Marketability Discount/DLOM

Nonmarketable Minority Value

EXHIBIT 7.15 Traditional Levels of Value Chart as Expanded and Refined.

Minority Interest Discount (MID)

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enhanced the Integrated Theory in the book’s second edition, which was published in 2007.11 In the second edition of Business Valuation: An Integrated Theory, we showed that there is no reason for a departure between these two levels of value unless typical financial buyers: ■

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Expect to run a target company better than existing owners and generate more cash flows from the same assets, or Expect to be able to grow cash flows faster over the long term than existing owners, and/or Are willing to accept a lower than market (marketable minority) rate of return, and And are willing to share these expected benefits with target owners.

In short, there is no reason for the financial control value to diverge very far from public pricing for public companies or the marketable minority value for private companies. There is additional top-down pressure from potential strategic acquirers for managers and directors of public companies to run their companies effectively and for the benefit of all owners. If they do not do so, they become more likely targets for takeover. Many valuation analysts are realizing that there is congruence between the financial control level of value and the marketable minority level as shown in the chart at the right above. Virtually all valuation analysts believe there is a significant conceptual difference between financial control and strategic control values. However, in our experience, fewer valuation analysts have accepted the necessary conclusion that this relationship impacts the meaning of the minority interest discount as well. Nevertheless, the refined levels of value chart above and the growing realization of the congruence between the marketable minority and financial control levels of value mark the third step on the path of the disappearing minority interest discount. 11

Mercer, Z. Christopher, and Harms, Travis W., Business Valuation: An Integrated Theory, 2nd ed. (Hoboken, NJ: John Wiley & Sons, 2007).

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Step 4 for the Disappearing Minority Interest Discount We have said that there is congruence between the marketable minority and financial control levels of value. Nevertheless, some valuation analysts continue to maintain the traditional interpretation of the minority interest discount. Their reasoning generally proceeds along the following lines: Owners of publicly traded shares hold minority interests. A minority interest simply cannot be worth as much as a controlling interest, so there should be some minority interest discount reflected in public market pricing. If a large minority interest discount is not appropriate, then it is difficult to develop conclusions of value at the nonmarketable minority level that are appropriate for unattractive investments in illiquid interests in private companies. The problem is that minority investors in public companies do have significant elements of control relative either to financial control owners or to owners of illiquid minority interests of private companies. Consider the following regarding minority investors in securities of publicly traded companies: ■

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Public minority investors control when they invest in the shares of any public company. Investors in public companies receive pro rata dividends when paid. Investors in public company shares expect to receive the benefit of all reinvested earnings based on future earnings growth (and expected market price appreciation) based on those reinvestments. Investors in public company shares will receive their pro rata share of the purchase price if and when a public company is sold. Each investor in the stock of a public company controls his or her holding period. Investors in public company stocks can sell their minority interests in public companies at any time they desire and can

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expect to receive the capitalized value of all future cash flows (i.e., the current market price, which represents a marketable minority/financial control value) in three days. Collectively, minority investors can express dissatisfaction with management and directors of a public company by selling their shares. Collective selling pressure may depress market pricing, thereby making a particular public company a more attractive takeover target. The threat of this collective power of minority shareholders of public companies serves to encourage managers and directors to run public companies for the benefit of all shareholders.

Call the pressure from each public minority investor in a public company and the collective pressure they can bring as bottom-up pressure to assure that public market pricing reflects financial control value. This logic regarding the power held by minority investors in publicly traded companies provides the fourth step along the path of the disappearing minority interest discount.

Is There a Minority Interest Discount? It is a truism that no valuation premium or discount has any meaning unless the base to which it is applied or taken is specified. Consider the following: ■

■

The base level of value to which any control premium is applied is the marketable minority (or the marketable minority/financial control) level. Control premiums can be observed in the marketplace, as discussed above. We also know from real-world experience that strategic control buyers pay prices based on their expectations of enhanced cash flows or growth relative to standalone targets. There is economic logic underlying the reasons why strategic control (or financial control) premiums are paid. The base level of value from which any marketability discount is taken is the marketable minority (or the marketable

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minority/financial control) level. Investors in illiquid minority interests of private companies face the risk of receiving less than their pro rata share of distributable cash flow each year, anticipate additional risks not faced by public securities holders because of inability to sell quickly, and may suffer from suboptimal reinvestment decisions by controlling owners. There is economic logic underlying the reasons why investors pay less for illiquid interests in private companies than for otherwise comparable shares of public companies. The phenomenon of typically lower prices for restricted (illiquid) shares of public companies relative to their freely trading counterpart shares is observable in the marketplace as an affirmation of the economics underlying the marketability discount for private companies. The base level from which a minority interest discount would be taken has to be a control base. That base cannot reasonably be that of strategic control, which is not observable except by exception when public companies are sold. It is not observable at all for private companies. The base level could be the financial control level, but if that were the case, any minority interest discount would be zero or minimal. We are not saying that there is no such thing as a minority interest discount. We apply minority interest discounts to underlying net asset values when valuing illiquid interests of asset holding companies. We do so because we can observe market evidence that closed-end funds holding primarily liquid investment assets tend to trade at modest discounts to their underlying net asset values. But for operating companies, the case for the minority discount is far more tenuous. What we are observing is that the economic rationale for the minority interest discount that Mercer and a generation of valuation analysts employed up through the mid-1990s was illusory. Valuation analysts who continue to apply large minority discounts do so at their own risk. They cannot be supported by market evidence or economic reasoning.

PART

Three

Valuing Shareholder Cash Flows n Chapter 7, we discussed the first two of the three major valuation adjustments that were introduced in Chapter 2 in connection with the Integrated Theory. The first adjustment, the control premium (and as expanded, the financial control and strategic control premiums), was discussed in connection with the control premium studies used by appraisers historically to help in estimating control premiums. We also discussed the related minority interest discount. Since these adjustments are based on enterprise cash flows, they were addressed in Part Two of the book, “Valuing Enterprise Cash Flows.”

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With Chapter 8, “Valuing Shareholder Cash Flows,” we begin Part Three. In so doing, we start our discussion with the restricted stock discount, which measures the difference between restricted share issuance prices and the otherwise comparable freely traded shares of the same issuers. We examine the various studies of restricted stock transactions, referred to as restricted stock studies, which have been used as a basis for estimating marketability discounts for illiquid

269 Business Valuation, First Edition. Z. Christopher Mercer and Travis W. Harms. © 2021 Z. Christopher Mercer and Travis W. Harms. Published 2021 by John Wiley & Sons, Inc.

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interests of private companies. In addition, we discuss what is commonly referred to as the pre-IPO discount, which measures discounts in the shares of private companies in the months leading up to their initial public offerings, or IPOs. We introduce the Quantitative Marketability Discount Model, or QMDM, in Chapter 9. The QMDM is a tool that helps valuation analysts develop marketability discounts with reference to a handful of key factors specific to the subject interest. In Chapter 10, we provide a more detailed exposition of the inputs to the QMDM, providing guidance to valuation analysts in specifying the required parameters, including the expected holding period, anticipated dividends, expected growth in value, and required holding period return. Chapter 11 includes five condensed case studies that show the QMDM in action with a variety of different fact patterns. The appropriate valuation treatment of tax pass-through entities has proven to be one of the more durable valuation controversies of the past two decades. Chapter 12 provides a conceptual overview and practical guidance regarding the appropriate treatment of minority interests in tax pass-through entities using the framework of the QMDM.

CHAPTER

8

Restricted Stock Discounts and Pre-IPO Studies

INTRODUCTION While there is relevant evidence in some restricted stock studies that can be helpful for marketability discount determinations, comparisons with average discount observations from these studies do not provide a meaningful methodology to estimate marketability discounts. We further conclude that, because of the significant differences between pre-IPO private companies and the same post-IPO companies, comparisons with the average discounts from these studies do not provide a meaningful methodology to estimate marketability discounts for illiquid interest of private companies. These differences include changes in expected cash flows and their growth, in expected risk, and the fact that new capital generally raised in the IPOs renders IPO pricing not meaningfully comparable with pre-IPO pricing. We begin with a reminder that use of both the restricted stock studies and the pre-IPO studies is a form of the market approach, whether the guideline public company method or the guideline transactions method. We first view the studies through the lens of current business valuation standards. We then provide a discussion

271 Business Valuation, First Edition. Z. Christopher Mercer and Travis W. Harms. © 2021 Z. Christopher Mercer and Travis W. Harms. Published 2021 by John Wiley & Sons, Inc.

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of the meaning of each discount and proceed to address the studies themselves as appropriate.

The Guideline Transaction Method At the outset of our discussion of valuation adjustments, we pause to recognize that all three types of studies are a form of what is known in valuation as the guideline transactions method, which is defined1 as: A method within the market approach whereby pricing multiples are derived from transactions of significant interests in companies engaged in the same or similar lines of business. There are some important aspects of guideline transactions that should be considered as we discuss studies of transactions designed to develop adjustments to valuation ratios in order to reasonably value particular subject interests. The “Conceptual Framework” of the guideline transactions method is discussed in the referenced guideline transactions method statement (Sections II.A, II.B, and II.C): II.A. Transactions involving the sale, merger or acquisition of businesses, business ownership interests, securities and intangible assets can provide objective, empirical data for developing valuation ratios for use in business valuation. II.B. The development of valuation ratios from guideline transactions of significant interests in companies (or intangible assets, if applicable) should be considered in the valuation of businesses, business ownership interests, securities and intangible assets to the extent that sufficient and relevant information is available. 1 All references in this chapter regarding the guideline transactions method are from “SBVS-2, Guideline Transactions Method,” ASA Business Valuation Standards, American Society of Appraiders, 2009. Similar guidance is found in “SBVS-1, Guideline Public Company Method,” previously cited in Chapter 6.

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II.C. Guideline transactions are transactions involving companies (or interests) that provide a reasonable basis for comparison to the investment characteristics of the company (or interest) being valued. Ideal guideline transactions are in the same industry as the subject company. However, if there is insufficient transactional information available in that industry, it may be necessary to select transactions involving other companies having an underlying similarity to the subject company in terms of relevant investment characteristics such as markets, products, growth, cyclical variability and other relevant factors. Prior transactions in the company being valued may also be considered to be guideline transactions. Companies involved in guideline transactions are most often not comparable to typical private company valuation subjects. The primary idea underlying the guideline transactions method is that the transactions considered should provide a reasonable basis for comparing with the investment characteristics of a subject business interest. With thousands of public companies whose shares are traded each market day and for which detailed public disclosure is instantly available, it is quite often – perhaps most often – not possible for business appraisers to develop reasonable guideline public company groups for their subject private companies. With a much smaller universe of guideline transactions available, the likelihood of identifying a truly comparable transaction for which reliable information is available is diminished. With respect to control premium, restricted stock, and pre-IPO studies, this can be illustrated by considering the data available in the most commonly referenced studies: ■

Control premium studies. Per Mergerstat Review 2019, on average, 311 transactions per year for the five years from 2014 to 2018 were recorded. These transactions occurred within 20 broad industry sectors. Of this average, 94 transactions were in the financial sector involving banks, insurance companies and REITs. This means that for the remaining 19 sectors, there were only 217 transactions per year. For example, during 2018, 9 or

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fewer transactions occurred in 10 sectors, and only four sectors (other than finance) had 20 or more transactions, with the retail trade sector recording a high of 26 transactions. This is not a very large sample to search for “comparable” transactions. Restricted stock studies. As we will see, the majority of historical restricted stock studies provided little or no information regarding actual transactions. The Stout Restricted Stock Study has 751 transactions dating back to 1980, or almost 40 years ago. That means that there are fewer than 20 transactions per year on average for which information is available, and these transactions occurred in a limited number of industry sectors. This is not a very large data set from which to search for “comparable” transactions.

Additional guidance is provided in the referenced SBVS at Sections V.A.3, V.A.4, and V.A.5, which state that valuation analysts should exercise care regarding issues like: V.A.3. The computation of the valuation ratios, which may be derived by relating prices in guideline transactions to the appropriate underlying financial, operating, or physical data of the respective companies (or interests) involved in the transactions V.A.4. The timing of the price data used in the valuation ratios (in relationship to the effective date of the appraisal) V.A.5. How the valuation ratios were selected and applied to the subject’s underlying data The major valuation adjustments are not valuation ratios. Section V.A.3 addresses the computation of valuation ratios based on guideline transactions and suggests relating prices to appropriate underlying financial, operating, or physical data of the guideline companies. This is true whether using the guideline public company method or the guideline transactions method. At the outset, we note that computed control premiums, restricted stock discounts, and pre-IPO discounts are not the result of computing valuation ratios based on the underlying financial, operating, or physical

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data of guideline companies. Each of these valuation adjustments simply measures the difference between two prices, as will be seen. Section V.A.4 suggests that care be exercised regarding the timing of guideline transactions in relationship to relevant valuation dates. Often, when control premium data are examined, the transactions occurred prior to (and perhaps years prior to) a given subject’s valuation date. This raises significant questions about the usefulness of the guideline transactions method that have been discussed by numerous writers and speakers, including the authors. Most often, they are discussing transactions in whole companies, but the issue remains for transactions involving restricted stock issuances or pre-IPO transactions. It also raises questions about the timing of restricted stock and pre-IPO transactions relative current valuation dates, as indicated above and discussed in more depth later in this chapter. Section V.A.5 says that guideline transaction valuation ratios should be selected and applied to a valuation subject’s underlying data. Control premiums, restricted stock discounts, and pre-IPO discounts are in fact not valuation ratios at all. Each merely relates one price (a transaction price) to another (a public market price) at the time of the respective transactions. Another concern about the guideline transactions method not mentioned in SBVS-2 relates to the number of transactions necessary to comprise a valid sample for use of the method. Generally, more relevant transactions available at or close to a valuation date suggest a more reliable use of the method. If few or no relevant transactions are available, the use of the guideline transactions method (or the guideline public company method) can be called into question. With this introduction to the guideline transactions method, we are now ready to discuss the restricted stock discount and related studies and the pre-IPO discount and related studies. The control premium and the related control premium studies were addressed in Chapter 7.

AN OVERVIEW OF RESTRICTED STOCK DISCOUNTS Beginning in the late 1960s and early 1970s, a number of publicly traded closed-end mutual funds began investing in restricted

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shares issued by publicly traded companies. The prevalence of these transactions and the availability of publicly disclosed pricing led to a number of studies that examined the phenomenon. In the second edition of this book, which was published in 2008, we spent little time addressing the various restricted stock studies and their use as evidence to support the development of marketability discounts for private companies. Given that the studies continue to be used by business appraisers to develop marketability discounts, we will examine the concept of restricted stock of public companies and the measurement of transactions in a number of studies to evaluate their effectiveness for use in inferring the magnitude of marketability discounts for illiquid interests in private companies.

What Is Restricted Stock of a Public Company? What is restricted stock? Restricted stock is the term used to describe shares of publicly traded companies that are subject to limitations (restrictions) on transfer or trading. The limitations generally relate to legal restrictions on resale placed on the shares by the application of relevant portions of the Securities Exchange Act of 1934. It is important to understand that a publicly traded company’s restricted stock is identical in every respect to its publicly traded shares except for applicable restrictions under SEC Rule 144. Under Rule 144 of the Securities Exchange Act of 1934 (“SEC Rule 144” or “Rule 144”) in existence prior to April 29, 1997, restricted stock was generally subject to a two-year base period of restriction. We will focus primarily on this time period (“pre-1997”) to discuss Rule 144 because many of the restricted stock studies relied upon by appraisers at the present time were conducted while the rules applicable prior to April 1997 were in effect. Those restricted stock transactions occurred, and the studies were published, more than 20 years ago, as we will see in Exhibit 8.15. The following review of the requirements of Rule 144 is necessary to develop a reasonable understanding of restricted stock

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transactions. The restricted stock transactions being studied were, for the most part, shares of otherwise identical public companies.

What Is a Restricted Stock Discount? Closed-end funds investing in restricted shares had to report the prices at which they purchased those shares, as well as the then-current market price of each issuer’s unrestricted shares. This made information available regarding what came to be called restricted stock discounts. This public disclosure requirement provided the basic transactional evidence found in the published restricted stock studies. What does a restricted stock discount measure? Like the control premium studies discussed in Chapter 7, a restricted stock discount measures the difference between two prices. In Exhibit 8.1, we define a restricted stock discount (RSD) and then show how the discount is calculated using pricing assumptions as noted in the exhibit. The purchase price per share for the restricted shares is the price at which the restricted shares were issued. The market price for the issuer’s unrestricted shares is observed for the same day. In the example, a closed-end fund made an investment in restricted shares of PubliCo at $15.00 per share. The freely traded closing price on the day of the transaction was $20.00 per share. As we see in Exhibit 8.1, this transaction would have been recorded as showing a restricted stock discount (RSD) of 25.0%. The restricted stock discount of 25.0% measures the difference between two prices, and nothing more. The primary inferences we can draw based on the available information are that:

RSD = 1 −

Purchase Price per Share for Restricted Shares Market Price per Share for Issuer’s Unrestricted Shares $15.00 = 25% RSD = 1 − $20.00

EXHIBIT 8.1 Definition and Calculation of Restricted Stock Discount.

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The restricted stock transaction occurred at $15.00 per share. PubliCo’s unrestricted shares traded at $20.00 per share at the time of the transaction. The restricted stock transaction price was $5.00 per share lower than the freely traded price. The restricted stock transaction price was 25% lower than the price of PubliCo’s otherwise identical but freely tradable shares on that date. PubliCo’s unrestricted shares closed at a price $5.00 higher than the transaction price in its restricted shares on that date. PubliCo’s unrestricted shares closed at a 33.3% premium to the restricted stock transaction on that date.

The bottom line is that there is no direct economic information in a restricted stock discount. An RSD simply measures the difference between two prices. The data points required to calculate a restricted stock discount reveal nothing regarding the underlying economics of the restricted stock transaction. ■

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There is no information in the observed discount that will tell any valuation analyst that the announced price of $15.00 per share for restricted shares of PubliCo was reasonable or why the price was $15.00 per share rather than $12.00 per share or $17.00 per share. There is no information that will help any valuation analyst infer the reasonableness of a marketability discount (or pricing) for illiquid minority interests of any private company that might be examined. There is in fact no information in this single discount we are examining for PubliCo, or, for that matter, in any average of similar restricted stock discounts for other companies, that can assist in assessing the reasonableness of a marketability discount (or resulting value) for the illiquid minority shares of any private company being examined.

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What information might be economic in nature? Information that would help us to understand the meaning of the observed 25% restricted stock discount might include: ■

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The historical performance of PubliCo and its outlook for the future as assessed by market participants The size of the block of restricted shares sold in relationship to all other shares outstanding (often, relatively large blocks were sold) The expected use of the restricted stock proceeds and the impact of the new investment on the outlook for future performance The historical stock performance of PubliCo and its pricing relative to similar public companies The required returns of investors in the restricted shares of Publico The length of the period of restriction before PubliCo’s shares would become freely tradable And on . . .

There is a great deal of information we do not know about any particular restricted stock discount, but one thing we know for sure. The observed discounts fail to reveal any direct economic information.

Institutional Background: SEC Rule 144 Applicable Prior to 1997 Restricted shares of public companies are restricted under the applicable requirements of Rule 144 of the Securities and Exchange Act of 1934 at the time of the transactions. Since the majority of studies relied upon by appraisers are quite dated (being published between 1971 and 2000), we will focus on the historical requirements of Rule 144 prior to 1997. We do so because most of the restricted stock studies referenced by business appraisers involve transactions that occurred during or before 1997. The holding period restriction was lowered to one year in 1997. The current base holding period restriction period is six months.

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Rule 144 consisted of a Preliminary Note followed by paragraphs (a) through (k). When all conditions of Rule 144 had been met, an investor could dispose of securities without compliance with the registration requirements of the Securities Act of 1933. The following discussion of Rule 144 should be considered a layman’s attempt to explain this important statute and its implications for restricted stocks prior to April 1997. According to the Preliminary Note of Rule 144: Rule 144 is designed to implement the fundamental purposes of the Act, as expressed in its preamble, To provide full and fair disclosure of the character of the securities sold in interstate commerce and through the mails, and to prevent fraud in the sale thereof * * * The rule is designed to prohibit the creation of public markets in securities of issuers concerning which adequate current information is not available to the public. At the same time, where adequate current information concerning the issuer is available to the public, the rule permits the public sale in ordinary trading transactions of limited amounts of securities owned by persons controlling, controlled by or under common control with the issuer and by persons who have acquired restricted securities of the issuer. The exemptions of Rule 144 are generally not applicable to anyone deemed an underwriter under the rule or to anyone who is deemed to be involved with a distribution of the securities in question. In determining when a person is deemed not to be engaged in a distribution, Rule 144 suggests that several factors be considered: First, the purpose and underlying policy of the Act to protect investors requires that there be adequate current information concerning the issuer, whether the resales of securities by persons result in a distribution or are effected in trading transactions. Accordingly, the availability of the rule is conditioned on the existence of adequate current public information.

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Secondly, a holding period prior to resale is essential, among other reasons, to assure that those persons who buy under a claim of a section 4(2) exemption have assumed the economic risks of investment, and therefore, are not acting as conduits for sale to the public of unregistered securities, directly or indirectly, on behalf of an issuer.... A third factor, which must be considered in determining what is deemed not to constitute a distribution, is the impact of the particular transaction or transactions on the trading markets....The larger the amount of securities involved, the more likely it is that such resales may involve methods of offering and amounts of compensation usually associated with a distribution rather than routine trading transactions. The two-year holding period was in place to make sure that investors were investing for a period of time and accepting the risks of the holding periods. With regard to the holding period for restricted securities, several provisions applied. While the provisions go into much greater detail than we will discuss here, at paragraph (d)(1), we find the following general rule: (d)(1) General rule. A minimum of two years must elapse between the later of the date of the acquisition of the securities from the issuer or from an affiliate of the issuer, and any resale of such securities in reliance on this section for the account of either the acquiror or any subsequent holder of those securities, and if the acquiror takes the securities by purchase, the two-year period shall not begin until the full purchase price or other consideration is paid or given by the person acquiring the securities from the issuer or from an affiliate of the issuer. In general, a purchaser of restricted shares of a public company had a minimum two-year holding period before the restrictions placed by Rule 144 would lapse. Investors in restricted securities

282

BUSINESS VALUATION

therefore considered themselves subject to the risks of equity ownership for at least two years without a practical means of selling those shares. Even when the two-year minimum holding period for restricted shares had elapsed, the shares were generally subject to additional restrictions on the volume of securities that could be sold. Paragraph (e) discusses limitations on the sale of securities by affiliates of a company. If restricted securities are sold by an affiliate of an issuing public company, the number of shares that can be sold are subject to the following rules: If restricted securities are sold by an affiliate of a publicly traded issuer, the volume of sales within the preceding three months of a sale or series of sales cannot exceed the greater of: (e)(1)(i) One percent of the shares or other units of the class outstanding as shown by the most recent report or statement published by the issuer; or, (e)(1)(ii) The average weekly reported volume of trading in such securities on all national securities exchanges and/or reported through the automated quotation system of a registered securities association during the four calendar weeks preceding the filing of notice required by paragraph (h)... or, (e)(1)(iii) The average weekly volume of trading in such securities reported through the consolidated transaction reporting system contemplated by Rule 11A3-1 under the Securities Exchange Act of 1934 (§240.11A3-1) during the four-week period specified in paragraph (e)(1)(ii) of this section. These rules came to be called the “dribble out rules,” because they specified the manner in which restricted shares could be sold, slowly, in order to minimize any potential impact on the normal public market for a company’s shares. Generally, sales by non-affiliated persons had to follow the same rules, unless otherwise excepted by paragraph (k), which states:

Restricted Stock Discounts and Pre-IPO Studies

283

(k) Termination of certain restrictions on sales of restricted securities by persons other than affiliates. The requirements of paragraphs (c), (e), (f), and (h) of this rule shall not apply to restricted securities sold for the account of a person who is not an affiliate of the issuer at the time of the sale and has not been an affiliate during the preceding three months, provided a period of at least three years has elapsed since the later of the date the securities were acquired from the issuer or from an affiliate of the issuer. In other words, the restrictions of Rule 144 lapse for nonaffiliates three years after the purchase date. Affiliates were also subject to Rule 144A, which deals with private resales of securities to qualified institutional buyers (who are deemed to be knowledgeable and not in need of the protections of Rule 144). Affiliates are also subject to Rule 145, which is designed to provide protection by registration under the Securities Act of 1933 to persons offered securities in certain business combinations. An affiliate can also sell if its shares are the subject of an effective registration filed by the issuing company with the SEC. The bottom line of this analysis of Rule 144 prior to changes made in 1997 is that for a period of years, investments in restricted stock were subject to restrictions under Rule 144, with the restrictions being modified at the end of two years. At that point, the restricted shares could be sold, subject to the volume limitations noted above. The restrictions lapsed completely after the end of the third year following purchase for non-affiliates. The restricted stock studies discussed below involved the purchase of restricted shares by non-affiliated, closed-end mutual funds. Therefore, the restrictions were expected to lapse within two to three years. In other words, the restricted shares were expected to become at least partially marketable within two years of their purchase, and freely tradable within three years. We have provided this discussion of Rule 144 as it existed when the majority of restricted stock studies were published as an important point of differentiation with nonmarketable minority interests

284

BUSINESS VALUATION

of closely held companies. This point of comparison should become clear as we proceed.

Freely Traded Shares versus Restricted Shares Before we talk about any specific restricted stock studies and what they might mean, we should be sure to understand the similarities and differences between restricted shares and freely traded shares. As we noted at the outset of this discussion, a publicly traded company’s restricted stock is identical in every respect to its publicly traded shares except for applicable restrictions under SEC Rule 144. There are a number of similarities between restricted shares and freely traded shares. Exhibit 8.2 spells out the ways in which the two types of shares are otherwise identical. We then examine the important ways in which they are different. First, we focus on the similarities. Available Information for Investors on Dates of Restricted Stock Transactions Shares of Freely Tradable Stock

Restricted Shares

Historical operating performance

Same

Historical stock performance

Same

Available analysts' expectations/outlook

Same

Available public disclosure

Same

Expectations for future performane imbedded in current stock price

Same

Inferences regarding public required returns based on current stock price

Same

Knowledge that freely traded shares can be sold at any time for their then-current market prices (no enforced holding period, so no holding period premium return)

Same

EXHIBIT 8.2 Restricted versus Freely Traded Shares.

Restricted Stock Discounts and Pre-IPO Studies

285

Except for the restrictions on trading imposed by Rule 144, restricted shares of publicly traded companies are identical to their freely traded counterparts. Exhibit 8.2 focuses on the similarities between the shares from the viewpoint of market participants and valuation analysts. What is clear about the restricted shares is that, on transaction dates, investors had access to all information available to the public investors in each company’s publicly traded shares. The restricted shares that were issued represented ownership in the very same public companies that public investors had invested in and were investing in on the various transaction dates. To understand why restricted shares usually traded at discounts, and often steep discounts, to their freely traded counterparts, we have to understand how restricted shares differ. The answer lies in information available to the managers of issuing public companies and to investors purchasing restricted shares, as seen in Exhibit 8.3.

Available Information for Investors on Dates of Restricted Stock Transactions What Else is Known by Both Parties? Issuers of Restricted Shares

What Else is Known by Both Parties? Purchasers of Restricted Shares

The proceeds from issuing restricted shares are needed to finance operations, repay debt, or fund growth, and are not available from a cheaper source (otherwise, they would have used those sources)

Restricted shares are subject to restrictions on transfer for two to three years (or longer, for large blocks), and the discount to the price of unrestricted shares enhances the prospective return to compensate for the incremental risk of illiquidity.

As when selling anything, performance matters. More attractive investments likely to trade at lower restricted stock discounts than poorer performing companies

When buying, better performing companies are more attractive to a wider spectrum of buyers, and price may be bid up, and a smaller restricted stock discount is paid to obtain them

EXHIBIT 8.3 Restricted versus Freely Traded Shares.

286

BUSINESS VALUATION

Like all transactions, restricted share issuances are the product of negotiation between two or more parties with adverse interests. The issuer of restricted shares is motivated to receive the highest issuance price (i.e., the smallest discount) while buyers of the shares are motivated to pay the lowest price (i.e., the largest discount). The observed discounts reflect the relative negotiation leverage of the parties. Restricted stock transactions were an important source of funding for small public companies for a number of years. We will discuss performance of issuing companies below in more detail. However, if other sources of financing had been available, managers would have sought less expensive (i.e., undiscounted) funding. Both buyers and sellers were aware of this circumstance. And both buyers and sellers were aware that the investors’ shares would be restricted for a period of two years or more. The investors certainly knew that their funds would be tied up and not be freely tradable, and they took this restriction into account. Why? An expected holding period of two or more years with no ability to sell their investments in the public marketplace exposed them to risks that were not faced by investors in public shares. The sellers and buyers were aware of the restrictions, and that was an important element in pricing of restricted stock transactions. There was another important element in the pricing of restricted stock transactions. Simply put, performance mattered with these transactions as it does for any investment. What is not well-known about the restricted stock studies is that the operating performance of many restricted share issuers was less than stellar, as we will see. In this analysis of restricted shares versus freely traded shares, we see that there are only two differences that might impact negotiated purchase prices and corresponding restricted stock discounts. These factors are:

Restricted Stock Discounts and Pre-IPO Studies ■

■

287

First, holders of restricted shares had at least a two-year expected holding period before they could begin to experience liquidity from their investments. Holders of public shares could sell them at will and receive cash in three days. In contrast, the lengthy expected holding period for restricted stock investors presented risks not faced by investors in public shares, and those risks were considered by restricted stock investors in their pricing. Restricted stock discounts, then, reflected incremental risk premiums over their longer expected holding periods. These additional risk premiums, which we will call Holding Period Premiums (HPPs), accounted for discounted pricing relative to the corresponding public shares. Next, as with all investments, the expectation for future performance was important for restricted stock investors. Prior performance was one basis for future expectations. Betterperforming companies (based on history) likely had better, or less risky, outlooks than poorer-performing companies. Other things being equal, investors would tend to moderate their holding period premiums for better performing companies, because they were likely perceived as less risky than poorer performing companies.

The bottom line is that not all restricted stock discounts were created equal. The discount in each transaction was the net result of issuing companies and competing investors negotiating over all the factors outlined above in Exhibits 8.2 and 8.3. Now we understand the economic factors underlying the range of observed discounts in the various studies that we will discuss below. It should come as no surprise that this range was wide. The fundamental valuation factors of expected cash flow, risk, and growth provide the underlying rationale for the observed restricted stock discounts.

288

BUSINESS VALUATION

The Silber Study as an Introduction to Restricted Stock Discount Analysis The initial restricted stock studies did not generally provide sufficient performance data to enable business appraisers to see the impact of performance on restricted stock discounts. In Quantifying Marketability Discounts, we wrote about the Silber Study, which is found on virtually all lists of historical restricted stock studies (including the one later in this chapter). The Silber Study did provide data on the operating performance and financial condition of restricted stock issuers.2 We begin with a summary of results from the Silber Study in Exhibit 8.4. The average discount in this study was 34%, as seen above, which is in line with averages from other studies of transactions during the 1980s and 1990s when the SEC Rule 144 base period of restriction was two years. Note that the standard deviation is 24%, so the variation was wide in the sample. In fact, the range was from a negative 13% (that’s a premium to the public share price for the company) to a discount of 84%. All of the transactions were

Sample Characteristics Restricted Stock Discounts

Means

Standard Deviations

Low

Ranges High

Mean Excl High

34%

24%

–13%

84%

Dollar Size of Issue ($mm) Block Size (Issued/Total Shares) Prior Year Earnings ($mm)

$4.3 13.6% $0.9

$6.6 10.3% $11.7

$0.2 1.0% –$0.9

$40.0 56.0% $65.0

$0.0

Revenues ($mm) Market Value of Equity ($mm)

$40.0 $54.0

$106.0 $88.4

$0.0 $4.4

$595.0 $532.0

$31.8 $47.0

$3.8

Sample Size: 69 Observations

EXHIBIT 8.4 Summary Statistics from the Silber Study (data from 1981 through 1988).

2

Citation in Exhibit 8.15.

Restricted Stock Discounts and Pre-IPO Studies

289

subject to the same base period of restriction, so what caused the wide variation in restricted stock discounts? ■

■

■

We see immediately that there was a wide range in the size of the issuers. The smallest issuer was apparently a startup with no revenues. The highest revenue company in the sample was $595 million. That’s a wide range. Excluding that one company, average revenue falls from $40 million to $32 million. There are a lot of smallish companies in the sample. The average dollar size of issuances was $4.3 million, which represented an average of 13.6% of the capitalization of the companies involved in the transactions. The average of prior year earnings in the sample was $0.9 million. Excluding the highest earning issuer in the sample reduces average earnings to breakeven.

The bottom line is that, given the information in the summary table in Exhibit 8.4, we know that the average restricted stock discount was 34%, there was a wide range around that average, and there was a wide range of pre-transaction performance for issuing companies. Fortunately, the Silber Study provided additional information that enables us to examine the reasons for variation in the restricted stock discounts. The Silber Study divided the sample of 69 transactions into two groups. The first included those with observed discounts of less than 35%, and the second included those with discounts greater than 35%. The two sub-samples were of about the same size, at 34 and 35 observations each, as shown in Exhibit 8.5. Based on the discussion regarding restricted versus freely traded shares above and common sense, we would assume that companies with better performance would tend to have lower discounts than those with poorer performance. Exhibit 8.5 confirms this observation. Look first at the left side of the exhibit.

290

BUSINESS VALUATION Discounts > 35% Sample Characteristics

Discounts < 35%

Means

St Dev

Means

St Dev

Restricted Stock Discounts

54%

13%

14%

13%

Dollar Size of Issue ($mm)

$2.7

$3.9

$5.8

$8.2

16.3%

12.4%

10.9%

7.0%

Block Size (Issued/Total Shares) Prior Year Earnings ($mm)

–$1.4

$2.7

$3.2

$15.9

Revenues ($mm)

$13.9

$22.2

$65.4

$145.0

$33.8

$27.8

$74.6

$118.0

Market Value of Equity ($mm)

Sample Size: 34 Observations

Sample Size: 35 Observations

EXHIBIT 8.5 Summary Statistics from the Silber Study with Divided Sample (data from 1981 through 1988). ■

■

■

For companies with restricted stock discounts greater than 35%, the average discount is 54%. These companies are losing money, with an average loss of $1.4 million in the previous year. Average revenues were $13.9 million, and average market capitalization was $33.8 million.

The companies with larger discounts are small, speculative companies with, in all likelihood, relatively high perceived risk when viewed by investors. Compare those attributes to the transactions at the right side of Exhibit 8.5. ■

■

■

For companies with restricted stock discounts less than 35%, the average discount is 14%. Those companies are, on balance, profitable, with average prior year earnings of $3.2 million. Average revenues were $65.4 million, and average market capitalization was $74.6 million.

The companies with smaller discounts are larger, less speculative companies as a group than the companies with larger discounts.

291

Restricted Stock Discounts and Pre-IPO Studies

What we see in the Silber Study is a richer picture than a simple average from a group of transactions. The Silber Study illustrates how restricted stock discounts were the outcome of negotiations between sellers and buyers. Different situations at the companies involved resulted in different discounts. This fact alone should cause valuation analysts to be wary of relying on average discounts from any restricted stock study. The Silber Study transactions can be summarized graphically as follows. There are really three groupings and three averages, as shown in Exhibit 8.6. The picture in Exhibit 8.6 does not suggest there is much meaning in an average restricted stock discount. There is an entirely different picture when Silber breaks his sample into two relevant groups by discount size. We point out the obvious here: ■

A 14% average restricted stock discount for better performing companies is materially different than an average discount of 54% for poorer-performing companies.

69 Observations Standard Deviation = 24% Average 34% 35 Observations

34 Observations

Standard Deviation = 13%

Standard Deviation = 13%

Average 14%

0%

10%

Average 54%

20%

30%

40%

50%

60%

70%

80%

EXHIBIT 8.6 The Overall Sample and Two Sub-Samples from Silber Study.

292 ■

■

■

BUSINESS VALUATION

The 34% overall sample average tells readers nothing about the diversity of performance in the sample. In fact, the overall average reveals nothing meaningful about the transactions that make up the sample. The thought processes of investors clearly led to differing assessments of the riskiness of holding restricted shares over an expected holding period that exceeded two years. The required returns leading to average discounts of 14% for better performers were different from those leading to average discounts of 54% for the poorer performers.

We are going into this question of required returns in some detail because it is important in the valuation of restricted shares. It is also important in the valuation of illiquid minority interests of private companies.

Further Insights into the Reasons for Restricted Stock Discounts With the background of the Silber Study, we can begin to examine the reasons for restricted stock discounts in more detail. The Concept of the Holding Period Premium Unrestricted shares of public companies are freely tradable. Holders of such shares can purchase or sell at will. Buyers pay the current market price and sellers receive that price when transactions occur. The restricted shares issued are otherwise identical to the shares that trade publicly. The only difference is that these investments were restricted regarding transferability for at least two years. Exhibit 8.7 will facilitate the discussion. On the left side of Exhibit 8.7, we see the traditional Gordon Model, which is a symbolic representation of the share price of PubliCo. On the right side, we have a symbolic representation for PubliCo’s restricted share price at issuance. While the Gordon Model is equally applicable to both shares, the restricted stock

293

Restricted Stock Discounts and Pre-IPO Studies Freely Traded Shares Vft =

Restricted Shares

CFft,1

Vrs =

rft – gft

CFrs,1 rrs – grs

EXHIBIT 8.7 The Fundamental Valuation Model: Freely Traded and Restricted Shares.

discount tells us that at least one of the inputs must be different for the restricted shares. We observe that Vrs is generally less than V0 (because most transactions occur at discounts) and we can show how the two prices relate in Exhibit 8.8. The restricted stock discount, when it is observed, reconciles the difference in value between restricted and freely traded shares. Vrs = Vft − RSD

EXHIBIT 8.8 The Restricted Stock Discount. We reconcile the differential in pricing between restricted issuances and freely traded pricing with a restricted stock discount (RSD), but how does that occur? We determine what must be true to create the restricted stock discount by looking at Exhibit 8.9. Restricted shares in PubliCo are identical in every respect to their freely traded counterparts except for one thing – the shares are restricted under SEC Rule 144. More specifically:

Vrs < Vft , because

CFrs,1 = CFft,1 (rrs > rft ) − (grs = gft )

EXHIBIT 8.9 Conceptual Source of Restricted Stock Discounts.

294 ■ ■ ■

BUSINESS VALUATION

CF1 is the same for restricted and freely traded shares. g is the same for both types of shares. Vrs is lower than Vft . We know that the restricted share price is lower than the public price because we observe the difference in a transaction.

The only way to reconcile the difference between freely traded and restricted shares is to adjust the discount rate, r, for incremental risks of the mandatory period of trading restriction and illiquidity. We show this risk adjustment in Exhibit 8.10. Vrs =

CFft,1 (rft + HPP) − gft

EXHIBIT 8.10 Fundamental Valuation Model: Restricted Shares. The Holding Period Premium (HPP) that is added to the discount rate of a public company by investors generates the holding period discount, or what has been observed as the restricted stock discount. If the HPP did not exist, there would be no difference between the prices of restricted stocks and their otherwise identical, publicly traded counterparts.

Restricted Stock Discounts Are Negotiated Managers and directors of restricted stock issuers had responsibilities to their shareholders to negotiate the highest possible prices (i.e., lowest possible discounts) they could when issuing restricted shares. Purchasers of restricted shares, primarily publicly traded closed-end funds, also had responsibilities to their shareholders, and attempted to negotiate the lowest possible prices (i.e., highest possible discounts). The prices at which the restricted shares were ultimately issued were disclosed publicly to shareholders. We have shown that the only way to understand the economics of restricted stock discounts is to realize that investors in public companies issuing restricted shares require higher expected returns

295

Restricted Stock Discounts and Pre-IPO Studies

than implied in public stock pricing in order to invest in illiquid shares. The holding period premium, or incremental required return (Exhibit 8.10), gives rise to the restricted stock discount (Exhibit 8.8).

The Restricted Stock Discount and the Marketability Discount Suppose PubliCo issued restricted stock prior to 1997. The Gordon Model provides a conceptual framework to analyze that issuance. As we discussed above, expectations for future cash flows (CF1 ) and growth (g) for PubliCo are imbedded in its public pricing. There is a discount rate (r) that reconciles this consensus view of the future with the current (freely traded) market price of PubliCo (Vft ). Restricted stock investors are looking at precisely the same information that leads to Vft in the marketplace for PubliCo, and yet, they are not willing to pay Vft for its restricted shares. They are only willing to pay Vrs , or a price including a restricted stock discount, which was illustrated in Exhibit 8.9. We defined the restricted stock discount in Exhibit 8.1. Now we can define the restricted stock discount in relationship to the marketability discount in Exhibit 8.11. The restricted stock discount is shown on the right side with appropriate nomenclature, and the more generalized marketability discount is shown on the left side of the exhibit. The restricted stock discount and the marketability discount are conceptually equivalent. Recall from Chapter 2 the relationship between the marketable minority level of value (publicly traded or

MD = 1 −

Vsh VEq(mm)

Conceptually

1−

Vrs = RSD Vft

Equivalent to

EXHIBIT 8.11 Conceptual Equivalency Between Restricted Stock and Marketability Discounts.

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BUSINESS VALUATION

as-if freely tradable) and the nonmarketable minority level of value (illiquid minority shares with no market). We repeat Exhibit 2.23 as Exhibit 8.12 for ease of reference. Focus on the lower row in the “Relationships” column. We posited three conditions that would cause a nonmarketable minority value to be less than a marketable value. ■

■

■

CFsh is less than or equal to CFEq(mm) . In the case of restricted shares relative to freely tradable shares, the expected cash flows are identical. There is no basis for a differential in pricing based on cash flow. Gv is less than or equal to the public company discount rate less any dividend yield. As with cash flow, restricted shares and freely trading shares share the same growth expectations, so there is no basis for a differential in pricing based on growth. Rhp is greater than or equal to the public company discount rate. We have shown that the discount rate of purchasers of restricted shares is greater than the public company discount rate by the amount of any required holding period premium to account for holding period risks during the period of illiquidity. The HPP for restricted shares is the conceptual equivalent of the HPP for the generalized Integrated Theory, and accounts for the restricted stock discount.

This discussion confirms that the restricted stock discount and the generalized marketability discount are conceptually equivalent discounts. That is, of course, why appraisers began to look at discounts observed in restricted stock transactions for a basis to assist in estimating marketability discount rates for private companies. Unfortunately, the restricted stock studies focused solely on the observed discounts and failed to consider the actual economics of restricted stock transactions.

Measuring the Holding Period Premium The holding period premium is the only factor differentiating the value of freely traded shares from restricted shares. We have defined

Conceptual Math Marketable Minority Value (Equity Basis)

Nonmarketable Minority Value (Equity Basis)

CFEq(mm) REq(mm) – GCF Eq(mm)

CFsh Rhp – Gv

Relationships

GCF Eq(mm) = REq(mm) –

CFEq(mm) VEq(mm)

Value Implications

VEq(mm) is the benchmark for the other equity levels of value ("as-if-freely-traded")

CFsh ≤ CFEq(mm) Gv ≤ (REq(mm) – Dividend Yield)

Vsh ≤ VEq(mm)

Rhp ≥ REq(mm)

EXHIBIT 8.12 Comparison between the Benchmark Marketable Minority and Nonmarketable Minority Levels of Value: Equity Basis.

298

BUSINESS VALUATION

it conceptually as an increment to the public company discount rate charged by purchasers of restricted stock issues to account for their incremental (holding period) risks above those borne by holders of publicly traded shares. That increment gives rise to the restricted stock, or marketability discount and to lower prices for restricted share issuances. Can we measure the holding period premium in restricted stock transactions? If so, how can we measure it? How large is the premium? What is the actual expected holding period considered by investors in restricted stock issuances? To address these questions, we have to look beyond the discounts recorded in any particular restricted stock transaction, or even averages of many transactions. We begin with an example. Assume the following for a particular restricted stock transaction: ■

■

The freely traded price of PubliCo closed at $10.00 per share on the transaction date. The restricted shares were issued at $7.50 per share, or at a 25% restricted stock discount.

That is the extent of analysis found in most restricted stock studies. But this discount was the net result of thoughtful consideration by purchasers and negotiations on behalf of issuers. What will shed light on the discount and the holding period premium that caused it? We have to look at expectations as of the transaction date in order to begin to understand the underlying economics of the 25% discount in this example. Continuing, we assume: ■

■

The equity discount rate embedded in the public market pricing was inferred to be 10.0%. There are no expectations of dividends in the foreseeable future, so the expected growth in value for PubliCo is 10.0%, or equivalent to the discount rate. This assumes that all earnings are reinvested into the company at the discount rate.

Restricted Stock Discounts and Pre-IPO Studies ■

■ ■

299

We know that the restricted shares of PubliCo will be restricted from trading for a minimum period of two years under (pre-1997) SEC Rule 144. Purchasers can begin to dribble out their shares after two years. Assume that the block purchased in the restricted share issuance is sufficiently large that it will take 10 quarters to sell the shares once partial liquidity is restored. Full liquidity would be achieved in 2.5 years under these assumptions, or, 4.5 years from the transaction date. Assuming an even sale of shares, the average expected holding period is 3.25 years (2 years base period of restriction, plus an additional 1.25 years for the effective dribble-out period, the midpoint of 2.5 years).

We do not know what the actual purchasers of PubliCo’s restricted shares were thinking, but we can reasonably infer that they were expecting a holding period in the range of three to four years. They might have assumed the holding period to be a bit longer or a bit shorter, but we have a reasonable basis for our assumptions. The expectation is that the freely traded share price of PubliCo will appreciate at 10% per year. We show a graph of public share prices and expected holding periods in Exhibit 8.13. The vertical axis is not to scale to better illustrate the underlying concepts. The public price or $10 per share and the restricted share issuance price of $7.50 per share are highlighted on the vertical access. Assuming compounding, the share price of PubliCo would be expected to rise to $11.00 per share at the end of year one, and to $12.10 per share, $13.31 per share, and $14.64 per share at the ends of years two, three, and four, respectively (FV = (1 + 10%) raised to the respective years). Arrows show the expected appreciation, which is the expected value growth path for PubliCo’s publicly traded shares. The question for analysis is this: What incremental return, or HPP, or holding period premium to the 10% discount rate of PubliCo, can be inferred by the restricted transaction? The price of

300 Per Share $15.00

BUSINESS VALUATION Assumed R - Public Company

10.0% $14.64 per share

Expected Appreciation Path

$14.00

$13.31 $13.00 $12.00

HP = 4 R(HP) = 18.2% HPP = 8.2%

$12.10

$11.00 Public Price $10.00 $9.00 $7.50

$11.00

HP = 3 R(HP) = 21.1% HPP = 10.1%

Restricted Stock Price $7.00 $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 1

2

3

4

5

Expected Holding Period in Years for Restricted Stock Investors

EXHIBIT 8.13 Reconciliation of Restricted Stock Transaction Price with Public Market Price.

$7.50 per share occurred at a 25% restricted stock discount. The answer requires our assumption regarding the expected holding period, which is three to four years. Exhibit 8.14 shows the calculation of the implied required return for restricted stock investors under the assumptions of our example. The stock price is expected to grow to the future prices shown, but the price paid was not the starting point of appreciation, or $10.00 per share. The starting point is the discounted price of $7.50 per share. Restricted stock investors expected to pay $7.50 per share and to achieve the future prices of $13.31 per share or $14.64 per share, as shown in Exhibit 8.14. The rates of return that match these present and future values are the implied required investor returns for the expected holding periods of three and four years.

301

Restricted Stock Discounts and Pre-IPO Studies Public Price Beginning Value Holding Period Expected Future Value Future Price per Share Present Value per Share

$10.00 Per Share 3 Years 4 Years (1 + R%)^3 $13.31

(1 + R%)^4 $14.64

$7.50 $7.50 (Transaction Price per Share)

Implied Restricted Stock Discount Rhp (Investor Req´d Returns) less: R for PubliCo

25.0% 21.1% 10.0%

25.0% 18.2% 10.0%

HPP (Holding Period Premium)

11.1%

8.2%

EXHIBIT 8.14 Calculation of Required Returns and Expected HPP. Our analysis of required returns and holding period premiums provides meaningful information, including: ■

■

■

In order to induce the purchasers of PubliCo’s restricted shares to invest, the issuer had to provide a 25% restricted stock discount. The purchaser’s required returns for three- and four-year holding periods were about 21% and 18%, respectively. The purchaser’s holding period premium (excess return above the public R or 10%) over this expected range of periods was about 8% to 11%.

In contrast to the observed discount, this analysis helps to reveal the underlying economic considerations in the transaction and helps provide a basis for valuing illiquid minority shares of private companies. We will examine the issue of the expected holding period premium in more detail below.

Summary Discussion of Historical (Pre-1997) Restricted Stock Studies We now have a solid understanding of what a restricted stock transaction is, what the restricted stock discount measures, and,

302

BUSINESS VALUATION

importantly, what it does not measure. We have referenced only one specific restricted stock study in the discussion thus far, the Silber Study. A number of other studies were conducted, beginning with the SEC Institutional Investor Restricted Stock Study, which was published in 1971. The primary studies that tend to be referenced by business appraisers are summarized in Exhibit 8.15.

Overview of the Historical Studies Rows 1 to 12 in Exhibit 8.15 summarize information on twelve restricted stock studies published between 1971 and 2000. All of the studies were conducted based on transactions that occurred prior to April 29, 1997, the date when the SEC Rule 144 period of restriction was lowered from two years to one year. The last study, the CFAI Study, included analysis of some transactions post–April 29, 1997. There are four entries under the heading “Subscription Services” in the exhibit. FMV Opinions began developing a restricted stock database at some point in the 1990s, and offered it for sale through www.bvresources.com. The database is not a restricted stock study per se, but it enables users to conduct their own studies. The Stout Restricted Stock Study/Database is a continuation of that of FMV Opinions following its acquisition by Stout. For decades, many valuation analysts have relied on less information than that summarized in Exhibit 8.15 when drawing inferences about marketability discounts from the various restricted stock studies. What can we learn from Exhibit 8.15? ■

■ ■

There were only a few studies, which referenced a small number of observed transactions. The total shown for the top tier in the table is 1,083+ transactions. These transactions occurred over 31 years (1966 to 1997). Most of the information relied upon by many appraisers to support marketability discount is found in the shaded area on rows #1 to #6. This area shows the averages and medians of studies published in 1993 or before. The range in these studies was the source of the recurring belief that the “central tendency” of the studies was in the range of 35% to 45%. The averages of these

Trim Size: 6in x 9in

No. of Restricted Stock Studies*

Cites

Published Trans.

Reporting

Standard

Range

Dates

Medians

Means

Deviations

a

1971

398

1966–1969

24%

26%

na

Low –15%

High

1 SEC Institutional Investor Study** 2 Gelman Study**

b

1972

89

1968–1970

33%

33%

na

40%

3 Maher Study**

c

1976

34

1969–1973

33%

35%

18%

3%

76%

80%

4 Stryker/Pittock Study**

d

1983

28

1978–1982

45%

na

na

7%

91%

5 Silber Study**

e

1991

69

1981–1988

na

34%

24%

–13%

84%

18%

–30%

90%

6 Moroney Study**

f

1993

146

1968–1972

34%

35%

7 Hall/Polacek Study (FMV Opinions)**

g

1994

100+

1979–1992

8 Trout Study**

h

1997

60

1968–1972

na

34%

na

na

na

9 Management Planning Study**

i

1997

49

1980–1995

29%

na

23% 28%

14%

0%

58%

10 Johnson (BVR) Study

j

1999

72

1991–1995

na

20%

na

–10%

60%

11 Columbia Financial Advisors (pre-1997)

k

2000

23

1996–1997

14%

21%

na

1%

68%

12 Columbia Financial Advisors (post-1997)

k

2000

15 1083+

1997–1998

9%

13%

na

0%

30%

na

na

na

Subscription Databases 13 FMV Opinions Database (as of 2004)

2004

430

Mercer Analysis of Trans. Pre-April 1997

m

2005

248

1980–1997

22%

23%

22%

< –5

>51%

15

Mercer Analysis of Trans. Post-April 1997

m

2005

182

1997–2005

751

1980–2017

35% na

>68%

2019

21% na

< –20%

l

23% na

na

na

Averages (First Six Studies in Rows #1 to #6)

34%

33%

Averages (Prior to 1997)

29%

29%

16 Stout Restricted Stock Study

Range

Averages (Post-1997)

16%

17%

Minimum

Maximum

Overall Averages

27%

27%

Discount –30%

Discount 91%

Citations

(Premium)

a

Discounts Involved in Purchases of Common Stock (1966–1969), Institutional Study Report of the Securities and Exchange Commission, H.R. Coc. No. 92-64, Part 5, 92nd Congress, 1st Session, 1971, 2444-2456.

b

Gelman, Milton, "An Economic Financial Analyst's Approach to Valuing Stock of a Closely Held Company, Journal of Taxation, June 1972, pp. 353–354.

EXHIBIT 8.15 Overview of Historical Restricted Stock Studies.

Mercer583097 c08.tex V1 - 08/31/2020 11:26pm Page 303

l

14

Trim Size: 6in x 9in

c

Maher, Michael, J., "Discounts for Lack of Marketability for Closely Held Business Interests," Taxes, September 1976, pp. 562–571.

d

Pittock, William F. and Stryker, Charles H., "Revenue Ruling 77-287 Revisited," SRC (Standard Research Consultants) Quarterly Reports, Spring 1983.

e

Silber, William L., "Discounts on Restricted Stock: The Impact of Illiquidity on Stock Prices," Financial Analysts Journal, July-August 1991, pp. 60–64. This study is analyzed in Chapter 3 of this book.

f

Moroney, Robert E., "Most Courts Overvalue Closely Held Stock," Taxes, March 1993, 144–154.

g

Hall, Lance S. and Polacek, Timothy C., "Strategies for Obtaining the Largest Valuation Discounts," Estate Planning, January/February 1994, pp. 38–44.

h

Trout, Robert, R., "Estimation of the Discount Associated with Restricted Securities," Taxes, June 1997, pp. 381–384.

i

Management Planning, Inc., "Analysis of Restricted Stocks of Public Companies," Published in Chapter 12 of: Mercer, Z. Christopher, Quantifying Marketability Discounts, (Memphis, Peabody Publishing, LP, 1997), pp. 359–384. There was a detailed analysis of this study accompanying the presentation of the data for 49 transactions in this study. The MPI Study was first published in this source.

j

Johnson, Bruce, "Restricted Stock Discounts, 1991–1995," Shannon Pratt's Business Valuation Update, Vol. 5 No. 3, March, 1999, pp. 1–3, and "Quantitative Support for Discounts for Lack of Marketability," Business Valuation Review, December 1999, pp. 152–155.

k

CFAI Study, Aschwald, Kathryn F., "Restricted Stock Discounts Decline as Result of 1-Year Holding Period: Studies After 1990 "No Longer Relevant' for Lack of Marketability Discounts," Shannon Pratt's Business Valuation Update, Vol. 6, No. 5, May 2000, pp. 1–5.

l

The FMV Opinions Database was available through www.bvresources.com until its acquisition by Stout in 2017. The database is now available at the same source under the name of Stout. Mercer, Z. Christopher, Valuing Shareholder Cash Flows (Memphis, Peabody Publishing, LP, 2005), Chapter 5, "Review of the FMV Opinions Study," pp. 156–170. This analysis examined the FMV Opinions Database as it existed in early 2005 and performed restricted stock analyses for both the two-year period of restriction (prior to April 1997) and the one-year period of restriction (after April 1997). The results of the Mercer analysis are summarized in Chapter 3 of this book, with primary focus on the two-year period of restriction.

*

Previous editions of this book included an entry for a Willamette Management Associates Study. We were unable to locate any indication that this study had been published, and so, it was removed from the table. The average restricted stock discount was 31%, so there was virtually no impact on the overall analysis of the table.

**

All of the restricted stock studies published prior to the publication of Mercer's Quantifying Marketability Discount (Memphis, Peabody Publishing, LP, 1997) were reviewed in as much depth as the data allowed in Chapter 2 of that book, which was an intellectual predecessor to Business Valuation: An Integrated Theory Third Edition.

EXHIBIT 8.15 (Continued)

Mercer583097 c08.tex V1 - 08/31/2020 11:26pm Page 304

m

Restricted Stock Discounts and Pre-IPO Studies

■

■

■

305

studies were 34% (medians) and 33% (means), which was the source of the lingering belief there was something compelling about marketability discounts in the range of 35% or more for illiquid minority interests of private companies. The last two columns in Exhibit 8.15 show the ranges of restricted stock discounts in the studies. As indicated, the low end of the range was a premium of 30% (i.e., a discount of –30%) and the largest discount was 91% (summarized at the bottom right of the exhibit). The wide ranges in the studies, including the more detailed analysis available in the Silber Study (discussed above), should have caused valuation analysts to engage in a more comprehensive analysis of the studies. The average discounts (averages of averages) was 29% for the pre-1997 transactions, and 27% for all of the studies. The average for post-1997 transactions was in the range of 16% to 17%. Most valuation analysts, however, have not focused on these post-1997 transactions. All of the studies published in 1997 or before were summarized and analyzed in Mercer’s Quantifying Marketability Discounts, which was published in 1997.

The bottom line is that the discounts, whether presented as averages, medians, ranges, or in any other form, do not directly help valuation analysts assess appropriate marketability discounts for illiquid minority interest in private businesses. With additional analysis and an estimate of the effective holding period, the discounts reveal the magnitude of the holding period premium implied by the restricted share issuances, but the discounts themselves cannot be transposed into marketability discounts for private companies. The use of restricted stock discounts is a form of the market approach to valuation. Use of this information cannot meet current guidance regarding the use of guideline company comparisons.

306

BUSINESS VALUATION

Nevertheless, valuation analysts continue, quite misguidedly as this analysis demonstrates, to reference these same averages and medians of dated studies.

REVIEW OF THE FMV/STOUT RESTRICTED STOCK DATABASE The subscription studies in Exhibit 8.15 are really the same continuing study at two different points in time. The FMV/Stout Database includes transactions beginning in 1980 and continuing through 2004, and included some 430 restricted stock transactions as of 2004. Stout acquired FMV Opinions, Inc. in 2017 and the FMV Opinions database with the acquisition. Now, the FMV/Stout Database continues, and restricted share issuances are added as they occur. The Stout/FMV Database is available on a subscription basis through Business Valuation Resources (www.bvresources .com). At the present time, the FMV/Stout Database contains information on 751 transactions. Mercer’s 2005 book, Valuing Shareholder Cash Flows, included a restricted stock study by Mercer based on the 430 transactions in the FMV/Stout Database as of 2004. The Mercer study examined the 248 transactions then in the database that occurred prior to April 28, 1997, and also examined the 182 transactions in the database that occurred after that date. This analysis focuses on the pre-1997 transactions (the two-year analysis), when the SEC Rule 144 base period of restriction was two years. We will note some results from the post-1997 transactions (the one-year analysis) for perspective. The FMV/Stout Database and Time (per Mercer’s 2005 Study) The FMV/Stout Database, as noted above, is divided into a two-year study period, during which the SEC Rule 144 period of restriction

307

Restricted Stock Discounts and Pre-IPO Studies

was two years (until April 29, 1997), and a one-year study period containing transactions occurring after the change in Rule 144 to a ones-year period of restriction. Transactions in the two studies occurred as follows in Exhibit 8.16: The majority of the transactions in the two-year portion of the FMV Database occurred in the 1990s. The majority of the transactions in the one-year portion of the study occurred before the

Two-Year Portion Before 4/29/97 Year No. of Trans.

One-Year Portion After 4/29/97 Year No. of Trans.

1980 1981 1982

3 2 7

1997 1998 1999

7 23 71

1983

6

2000

79

1984 1985 1986

5 12 12

2001 2002 2003

2 0 0

1987 1988 1989

12 9 3

2004

0 182

1990 1991

9 15

1992 1993 1994 1995 1996 1997

24 32 20 39 31 7 248

Total Transactions in Database 430

EXHIBIT 8.16 FMV/Stout Database Observations Over Time (as of 2004).

308

BUSINESS VALUATION

meltdown in the market following the so-called “dot.com” bust. No transactions were reported in the database between 2001 and May 2004. It would seem that the use of transactions from the FMV Study as direct guideline public company or guideline transaction observations would not meet the customary standard of proximity to the valuation date for appraisals as of a current date. The FMV/Stout Database and Industry The FMV/Stout Database can also be stratified by industry classification. One available data point is the four-digit SIC Code for the issuer in each transaction. Exhibit 8.17 summarizes industry groupings in the FMV/Stout Database.

Two-Year Portion Before 4/29/97 2-Digit SIC Code No. of Trans. 38 35 28 28 36 27 87 24 73 21 67 16 35 12 13 11 48 11 25 Others 63 248 One-Year Portion After 4/29/97 2-Digit SIC Code No. of Trans. 73 54 38 27 28 26 87 22 36 10 17 Others 43 182

Two-Digit SIC Classification Description Measuring, Analyzing & Controlling Instruments Chemicals & Allied Products Electronic & Other Electical Equip & Components, except computers Engineering, Accounting, Research, Management & Related Svcs. Business Services Holding & Other Investment Offices Industrial & Commercial Machinery & Computer Equipment Oil & Gas Extraction Communications

Business Services Measuring, Analyzing & Controlling Instruments Chemicals & Allied Products Engineering, Accounting, Research, Management & Related Svcs. Electronic & Other Electical Equip & Components, except computers

EXHIBIT 8.17 FMV/Stout Database by Two-Digit SIC Classification (as of 2004).

Restricted Stock Discounts and Pre-IPO Studies

309

For purposes of this review, we sorted the transactions by two-digit codes. In the two-year portion of the database, nine industry classifications account for 185 (75%) of the 248 total transactions. The remaining 63 transactions are spread over 25 other industry categories. Interestingly, of the 28 transactions in SIC Classification #28, 18 represented companies in SIC Code #2834 (pharmaceutical preparations). Of the 24 transactions in SIC Classification #87, 15 are in SIC Code #8731 (services, commercial, physical and biological research). The two-year portion of the FMV/Stout Database is concentrated by industry. The one-year portion of the database is even more heavily concentrated in a few industry sectors. More than 75% of the 182 transactions occurred in only five two-digit SIC classifications. There is little industry diversification reflected by the companies involved with either portion of the FMV/Stout Database. This fact limits the usefulness of this restricted stock database as a vehicle to develop guideline transactions that are similar to given subject private companies in terms of industry. Overall Averages of the Studies We begin with a summary of the overall medians and averages for the FMV/Stout Database, looking at both the two-year and one-year portions of the database. They are reflected in Exhibit 8.18. Three discounts based on three pricing dates are shown in the table. Discounts were calculated relative to prices from the month prior to issuance, the transaction month, and the subsequent month. Based on articles and speeches by employees of FMV Opinions at that time, the primary focus was on subsequent month pricing, which will be our focus after Exhibit 8.18. The median and average discounts (SubMo) were 22.0% and 22.5% for the two-year portion of the database. The standard deviation was 21.5%, indicating the variability of the observed discounts. The one-year portion of the database had median and average discounts of 23.0% and 20.7%, respectively. Interestingly, the standard deviation of discounts in the one-year portion was

310

BUSINESS VALUATION Discounts for Two-Year Portion Prior Mo. TransMo SubMo

Medians Averages Standard Deviations

16.7% 18.2% 16.7%

Medians Averages Standard Deviations

Prior Mo. 11.7% 11.2% 29.4%

20.0% 21.9% 16.0%

22.0% 22.5% 21.5%

Discounts for One-Year Portion TransMo 21.8% 24.1% 22.4%

SubMo 23.0% 20.7% 35.2%

EXHIBIT 8.18 Overall Study Statistics (FMV/Stout Database, from 2004).

35.2%, higher than that in the two-year portion. Note also that the post-1997 transactions, with a shorter period of restriction, had somewhat higher average discounts than the two-year transactions. This caused consternation among some appraisers, who knew, based on common sense, that the shorter expected holding period transactions, other things being equal, should have had lower discounts, since they had less risk of exposure to illiquidity. This apparent anomaly is most likely attributable to the changing nature of companies that were issuing restricted stock in the post-1997 era. They were smaller, less profitable, more volatile, and riskier, on average, than the companies in the pre-1997 group. Quintile Analysis of the Two-Year Portion of the FMV Database Next, we examine the transactions in more detail to understand the operating nature of the companies involved and relationships that may be discernible with respect to operating characteristics and restricted stock discounts. To do so, we divided the two-year transactions into six groups. We segregated all transactions that occurred at premiums (i.e., negative discounts) and then divided the remaining transactions into quintiles (five groups of equal size). We made the premium adjustment because there are apparently different forces or factors at work

Restricted Stock Discounts and Pre-IPO Studies

311

with those transactions and we found it helpful to examine them separately. The quintile analysis for the two-year group is shown in Exhibit 8.19. At the upper left, we see that 23 of the 248 pre-1997 transactions occurred at a negative discount (i.e., at a premium to the market price) with a median premium of 5.4%. Premium transactions can occur because the purchase price was actually set at a premium to the market price, or because of a decrease in the stock price between the date of the announcement and the subsequent month pricing in the FMV Study, or both. We do not really know the reasons for premium transactions, so they are treated separately. The remaining 225 transactions were divided into five quintiles of 45 transactions each. As indicated at the top-middle of the table in Exhibit 8.19, the median discount for the first quintile is 4.9%, compared to 51.0% for the fifth quintile. We observe the following from the quintile analysis: ■

■

■

■

The median market capitalization declines steadily from $115 million (Q1) to $25.4 million (Q5). Restricted stock discounts tend to be negatively correlated to issuer size, as measured by market capitalization. There is no similar correlation with size, as measured by revenues. The median company in every quintile is losing money. Only 98 companies of the 248 observations in the pre-1997 study were profitable, meaning that some 60% of the transactions involved companies that were losing money. The median dividend yield is 0% for each quintile, and only 24 of the 248 transactions involved companies paying dividends.

The companies in the two-year portion are quite small by public standards (median revenues of $12.8 million). The median price/book multiple was 5.8×, indicating that a significant portion of the value of the issuing companies consisted of goodwill and other intangible assets. The bottom line of this analysis is that

Median Restricted Stock Disocunts Number of Transactions The Restricted Stock Issues Issue Amount ($mm) % of Company in Offering Pre-Transaction Operating Data ($mm) Market Capitalization of Equity Book Value Price/Book Multiple

Transactions at Premiums –5.4%

First Quintile 4.9%

23

45

$9.6 103%

$8.0 7.9%

$100.4 $8.0 6.6

$115.4 $20.2 5.7

Second Quintile 16.9%

Third Quintile 26.0%

Fourth Quintile 34.7%

45 45 45 Medians for Each Category $5.9 $4.5 $2.5 12.5% 10.1% 8.7% Medians for Each Category $72.9 $5.6 5.0

$46.8 $10.4 4.6

$31.4 $4.5 6.8

Fifth Quintile 51.0%

Overall Medians 22.0%

45

248

$2.8 14.7%

$4.7 10.8%

$25.4 $3.5 7.5

$51.6 $7.0 5.8

Total Assets

$19.4

$38.7

$14.6

$23.5

$10.1

$6.9

$15.6

Revenues EBITDA

$15.0 $0.8

$29.8 $1.3

$11.9 $0.3

$25.4 $0.8

$9.8 ($0.5)

$5.6 ($0.4)

$12.8 ($0.4)

Net Income Operating Margin Dividend Yield

($1.2) –0.4% 0.0%

($1.0) 1.7% 0.0%

($0.8) –4.5% 0.0%

($0.7) 10.0% 0.0%

($1.3) –8.0% 0.0%

($0.9) –8.1% 0.0%

($0.9) –2.8% 0.0%

EXHIBIT 8.19 Quintile Analysis of FMV/Stout Restricted Stock Database (Transactions from 1980 to April 1997).

Restricted Stock Discounts and Pre-IPO Studies

313

the two-year study comprises fairly small companies to which the market was assigning significant intangible value. This investment profile is not typical of most private companies that are the subject of valuation reports. This more detailed analysis of the FMV/Stout database suggests that typical transactions in the study are not similar to many private companies today. Implied Required Returns and Holding Period Premiums in the FMV/Stout Opinions Database The purpose of marketability discount analysis is to determine the discount that best reflects the underlying economic factors applicable to the subject company and the interest being valued. The analysis thus far suggests that the FMV/Stout Database is of limited use as a basis for guideline company analysis, where the standard is comparability in terms of business characteristics and the proximity of the pricing of guideline transactions with the valuation date. As described in the analysis above, the FMV/Stout Database, including both the two-year and one-year portions, does not provide substantive comparative information for most subject companies. We have suggested that restricted stock studies can be used as evidence of the existence of, and the wide range of restricted stock discounts in actual transactions. We looked at this issue in the context of the Silber study above. We have also suggested that the studies (whether using averages or individual transactions) can be used to infer the implied required rates of return imbedded within the various transactions. Using the quintile analysis of the two-year portion of the FMV/Stout Database, we can illustrate how implied required return analysis works. In the top portion of Exhibit 8.20, the quintile discounts are repeated from Exhibit 8.19 relative to an assumed normalized public price of $1.00 per share for issuers. We present the figure here and discuss each line below for clarity. We discuss each row in the chart in the following comments. We will examine the overall results of the table following this detailed explanation of the calculations. The example calculations below

1 2 3

Normalized Price per Share - Pub lic Median Restricted Stock Disocunts

4

Implied Transaction Price

5 6

Quarters to Dribble (Rule 144) (Calculated) Implied Holding Periods (HPs) (Years)

7 8 9 10

Expected Future Value ($1.00 base) Implied Expected (Annual) Return Less Base Required Return Implied Holding Period Premiums (HPPs)

Transactions at Premiums $1.000 –5.4%

First Quintile $1.000 4.9%

Second Quintile $1.000 15.9%

Third Quintile $1.000 25.0%

Fourth Quintile $1.000 34.7%

Fifth Quintile $1.000 51.0%

Overall Medians $1.000 22.2%

$1.054

$0.951

$0.841

$0.750

$0.653

$0.490

$0.778

3.58 2.45

5.25 2.66

5.40 2.68

7.32 2.92

7.86 2.98

10.90 3.36

5.53 2.69

$1.408 12.6% 15.0% –2.4%

$1.450 17.2% 15.0% 2.2%

$1.453 22.7% 15.0% 7.7%

$1.503 26.9% 15.0% 11.9%

$1.517 32.7% 15.0% 17.7%

$1.600 42.2% 15.0% 27.2%

$1.457 26.2% 15.0% 11.2%

Note - Assumes discount rate for restricted stock issuers (base required return) of 15%.

EXHIBIT 8.20 Implied Holding Period Premium (HPP) Analysis.

Restricted Stock Discounts and Pre-IPO Studies

315

refer to the first quintile entries. The numbers in the discussion refer to each of the ten rows in Exhibit 8.20. 1. Discount rate (base required rate of return). We have assumed that the discount rate for public companies is 15.0% for this analysis. We have to select a required return in order to estimate the holding period premium implied by restricted stock pricing. While this blanket assumption is made, we have tested the resulting premiums (on row #10) across a wide range of assumed discount rates and the resulting holding period premiums are virtually unchanged. 2. Normalized price per share. We have normalized all public company market prices at $1.00 per share for purposes of the analysis. 3. Median restricted stock discounts per quartile. Row #3 provides the median discounts for each quintile, excluding transactions with premiums, which result is shown separately. An overall median column is also provided. 4. Implied transaction price per share. The implied transaction price is the normalized price per share minus the median discount for that quintile. For example, the first quintile discount is 4.9%. The normalized price of $1.00 per share less the 4.9% discount is $0.951 per share, or the implied transaction price. 5. Quarters to dribble out. This data is provided in the FMV/Stout Database for each transaction. 6. Implied holding periods (HPs) in years. The implied holding periods for each quartile are developed as for the first quintile. First, there is a base holding period of two years required under SEC Rule 144 for all these pre-1997 transactions. The first quintile shows 5.25 quarters to dribble (row #5). The implied holding period of 2.66 years is calculated as follows: two-year base holding period, plus 5.25 quarters divided by four (to get the number of years) and divided by two (to find the midpoint). The calculation is therefore [2.0 + ((5.25/4)/2) = 2.66 as shown on row #6]. 7. Expected future values. The normalized price ($1.00 on row #2) is assumed to grow at the discount rate (15.0% on row #1)

316

BUSINESS VALUATION

for the period of the implied holding period (2.66 years on row #6). The future value is ($1.00 × (1 + 15%)^2.66 = $1.450). 8. Implied expected annual return. The expected future value for investors at the median discount of 4.9% for the first quintile is $1.45 per share. The present value is the discounted price they pay after the discount of 4.9%, or $0.951 per share as shown on row #4. Given the present value and the expected future value, we can calculate the implied rate of return over the expected holding period of 2.66 years (row #6), as follows: [(1 + 15%)HP ÷ (1 − RSD)](1∕HP) − 1 The resulting annual rate of return is 17.2% (row #9). This makes sense because the expected public (unrestricted) return is 15.0%, and the discounted pricing creates a premium in return for the restricted stock investors. 9. Less the base required return (from row #1). We show the subtraction of the base required return of public stocks for clarity. 10. Equals the implied holding period premiums (HPPs). For the first quintile, the implied holding period premium, relative to the base required return, is 2.2%, as seen on row #10. The calculation is as follows (17.2% from row #8 minus the base required return of 15.0% on row #9). Now we can discuss the overall economic and financial implications of the analysis of Exhibit 8.20. ■

■

■

The implied required returns for the first through the third quintiles, where the median discounts were 15% or less, are in the range of 17% to 27%. These required returns indicate the magnitude of the holding period risk, as assessed by restricted stock investors. The implied holding period premiums for the first, second, and third quintiles (relative to the assumed equity discount rate of 15%) are in the range of 2% to 12% or so. The overall median implied holding period return is 26.2% for the two-year portion of the study (last column, row #10), and the median holding period premium is 11.2%.

Restricted Stock Discounts and Pre-IPO Studies ■

317

The implied expected returns are lower for the premium transactions (first column) and higher for the higher-level discounts in the fourth and fifth quintiles.

These median expected required returns and expected holding period premiums (Rhp and HPP from the QMDM discussion in Chapter 9) reflect the nature of the restricted stock transactions and the general nature of the issuing companies. These implied returns can serve as useful reference points when estimating holding period premiums in the valuation of illiquid interests of private companies. It is more meaningful to examine restricted stock transactions with respect to their implied required returns rather than the observed discounts. ■

■

■

There is no direct economic information in any restricted stock discount or any average of multiple discounts. Restricted stock discounts merely measure the difference in two prices. Market participants, particularly buyers of restricted shares in public companies, do not make decisions based on the absolute levels of discounts in other transactions. While the price negotiated will always reflect a discount (positive, zero, or negative), pricing decisions, in our experience, are based on expected return requirements over expected investment horizons. The use of implied required returns in the context of quantitative models (like the QMDM) enables appraisers to simulate the thinking of hypothetical and real-life investors when determining marketability discounts.

PRE-IPO DISCOUNTS During the 1980s, valuation analysts were intuitively attracted to documented transactions of illiquid minority interests in companies prior to their initial public offerings. It was observed that these “pre-IPO” transactions occurred at discounts, and often steep discounts, to the subsequent IPO pricings. This led analysts to study what became known as the pre-IPO discounts.

318

BUSINESS VALUATION

What Is a Pre-IPO Discount? A pre-IPO discount measures the difference between the price at which a transaction occurred in an illiquid minority interest of a company relative to the price at which it subsequently went public by engaging in an initial public offering (IPO). Exhibit 8.21 illustrates how pre-IPO discounts are calculated. The pre-IPO transaction in this example occurred at a (split-adjusted) price of $6.50 per share, and the subsequent IPO price was $13.00 per share. The calculated pre-IPO discount is 50% in the example, and is consistent with the medians and averages of discounts found in several pre-IPO studies we will discuss below. What does that discount mean or imply for the valuation of illiquid minority interests in private companies? As with control premiums and restricted stock discounts, it is clear that the pre-IPO discount measures only the difference between two prices. The information we can glean from this definition and example is limited to the following: ■ ■ ■ ■

■

A transaction occurred at some point prior to an IPO. The pre-IPO price was $6.50 per share. The IPO price was $13.00 per share. The pre-IPO price was $6.50 per share, or 50% lower than the IPO price. The IPO price was $6.50 per share higher than the pre-IPO price, or 100% higher than the pre-IPO price.

There is no direct economic information in this example of a pre-IPO discount that can shed light on the appropriate Pre − IPO Discount = 1 −

Pre − IPO Transaction Price per Share

IPO Price per Share $6.50 per Share Pre − IPO Discount = 1 − = 50% $13.00 per Share

EXHIBIT 8.21 Calculation of Pre-IPO Discounts.

Restricted Stock Discounts and Pre-IPO Studies

319

marketability discount for any private company. Further, there is no direct economic information in any averages of groupings of pre-IPO discounts that can shed light on appropriate marketability discounts for any private companies.

Pre-IPO Studies There have been a number of pre-IPO studies over the years. There is a good summary of these studies in Financial Valuation: Applications and Models.3 The studies include the following: ■

■

■

■

3

Emory Studies. John Emory, who wrote a series of articles analyzing pre-IPO discounts, conducted studies of pre-IPO transactions spanning the period from 1980 to 2000, and did additional work subsequent to these studies. In general, the Emory studies examined pre-IPO transactions occurring within five months of the IPOs. The medians and means of these studies were typically in the 40% to 50% range. Willamette Studies. Willamette Management Associates conducted a series of studies of transactions covering the period from 1975 to 2002. The median discounts varied over the years, but tended to be in the range of 40% to 50%. Hitchner and Morris Studies. These studies were conducted by James Hitchner and Katherine E. Morris. The first Hitchner/Morris Study performed additional analysis of the Emory study data. The second Hitchner/Morris Study was a focused analysis on the 1995 to 1996 timeframe and was similar to the Emory studies. These studies tended to have mean pre-IPO discounts in the 40% to 50% range as well. Valuation Advisors Studies and Database. The Valuation Advisors Studies, as summarized in the Hitchner text, provided pre-IPO discounts based on transactions occurring over different time periods prior to IPOs (0 to 3 months, 4 to 6 months,

Hitchner, James R., Financial Valuation: Applications and Models, 3rd ed. (Hoboken, NJ: John Wiley & Sons, 2011), pp. 382–391.

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7 to 9 months, 10 to 12 months, and one to two years prior to IPOs). The mean discounts for 1995 to 2006 trended down from 64% to 24% and the mean discounts for 1999 to 2008 trended down from 59% to 19%. The Valuation Advisors Lack of Marketability Discount Study/Database now contains more than 14,000 transactions, including almost 1,500 non-US deals. The database includes fields for transaction industry or business, description, revenues, operating income, operating profit margin, assets, transaction date and IPO date, and NAICS or SIC code.

Institutional Aspects of Pre-IPO Transactions Managers and directors of private companies that might go public often desire to acquire interests, or additional interests, in their companies in the period of time leading to an IPO. However, the shares have to be issued at their fair market values to be in compliance with financial reporting and income tax requirements. These transactions typically occur at prices below the subsequent IPO prices. Valuation reports are often used to document the fair market value of the shares issued in the pre-IPO transactions. However, there are a number of moving parts to a pre-IPO transaction relative to the IPO pricing that make direct comparisons with other private business interests less appropriate.

The Pre-IPO Discount in Light of the Integrated Theory We can look at the pre-IPO discount in the context of the Integrated Theory. ■

■

When we looked at control premiums, we concluded that they are primarily the result of enhanced cash flows, or increases in the numerator of the Gordon Model (i.e., CF). When we examined restricted stock discounts, we noted that they are the result of increased risk relative to freely traded counterparts (over relevant holding periods), so the required increase in the denominator of the Gordon model (i.e., R).

321

Restricted Stock Discounts and Pre-IPO Studies

Now, we look at pre-IPO discounts in the same light. The pre-IPO price ($6.50 per share in the example above) is actually the result of a pre-IPO valuation of a company at the benchmark marketable minority or financial control level of value. From that base, an appropriate marketability discount was applied to get to the pre-IPO pricing. The pre-IPO discount in Exhibit 8.22 is the same as in the example at Exhibit 8.21, except that it makes clear that there was a valuation (either explicit or implicit) of the illiquid minority interest on the date of the pre-IPO transaction, and that an appropriate marketability discount was applied (or at least considered). Focus on VEq(mm),pre , or the valuation of the company that engaged in the pre-IPO transaction. What are the conceptual elements of its valuation? We look at that valuation equation now in Exhibit 8.23. In this case, we look at the marketable minority value before the application of any marketability discount. We compare this conceptual equation with the value underlying the IPO pricing, or VEq(mm),ipo . The pre-IPO valuation (VEq(mm),pre from the top portion of Exhibit 8.23) capitalizes the expected cash flows as the company exists at that date. The discount rate is that appropriate for the business on a pre-IPO basis, and expected growth is analyzed similarly. The IPO price (Vipo from the bottom portion of Exhibit 8.23) capitalizes the expected cash flows following the IPO, which reflects the benefit of any new money raised by the IPO. The discount rate is the expected required return for public investors, where risk is mitigated by new capital and more ready future access to capital.

( Pre − IPO Discount = 1 −

VEq(mm),pre × (1 − MDpre ) VEq(mm),ipo

)

( =

1−

Vsh VEq(mm),ipo

EXHIBIT 8.22 The Pre-IPO Discount in the Context of the Integrated Theory.

)

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VEq(mm),pre = Veq(mm),ipo =

CFEq(mm),pre REq(mm),pre − GCF Eq(mm),pre CFEq(mm),ipo REq(mm),ipo − GCF Eq(mm),ipo

=

$1.00 = $10.00 15% − 5%

=

$1.04 = $13.00 14% − 6%

EXHIBIT 8.23 Comparison of Valuations Before and After IPO. And the expected growth may also be different as a result of the new money from the IPO. What we have not examined yet, however, is the impact of the marketability discount on the pre-IPO valuation that we see in Exhibit 8.23. Exhibit 8.24 summarizes that analysis. For the pre-IPO valuation, we assume at the top of Exhibit 8.24 that CFEq(mm),pre is $1.00 per share. The discount rate for the pre-IPO valuation is 15.0%, and expected growth is 5.0%. The resulting capitalization rate is 10.0%, and the valuation multiple is 10.0×. We assume in the middle of the exhibit that there will be a 4% pickup in cash flow from the infusion of new capital from the

Pre-IPO

IPO Pick-up IPO

CFEq(mm),pre

REq(mm),pre

$1.00

15.0%

GCF Eq(mm),pre Cap Rate Multiple 5.0%

10.0%

10.0

Δ in CFEq(mm) Δ in REq(mm) Δ in GCF Eq(mm) $0.04

−1.00%

1.00%

CFEq(mm),ipo CFEq(mm),ipo GCF Eq(mm),ipo Cap Rate Multiple $1.04

14.00%

6.00%

8.0%

12.5 IPO Pick-up

EXHIBIT 8.24 Assumptions for Pre-IPO and IPO Valuations (Marketable Minority Interest Level).

323

Restricted Stock Discounts and Pre-IPO Studies

IPO. We further assume that there will be a 1% decrease in the pre-IPO discount rate upon going public. Finally, we assume that the expected growth rate for the business will increase by 1% because of the incremental capital supplied by the IPO. Applying these changes in the IPO valuation at the bottom of Exhibit 8.24, we now have CFEq(mm),ipo of $1.04 per share, a discount rate of 14%, and expected growth of 6%. The capitalization rate is therefore 8.0% and the valuation multiple is 12.5×. The increase in the pre-IPO multiple from 10.0× to the IPO multiple of 12.5× is the so-called “IPO pickup” that often occurs when companies go public. Comparing the pre-IPO valuation to the IPO valuation reveals the components of the so-called pre-IPO discount in Exhibit 8.25. The assumptions for these valuations correspond to those in Exhibit 8.24. In addition, we assume that a 35% marketability discount was applied in the pre-IPO valuation. These two conceptual valuations demonstrate why pre-IPO studies should not be used as a basis for estimating marketability discounts for illiquid minority interests of private companies. First, we examine the three valuation conclusions. ■

The pre-IPO valuation at the marketable minority level of value is $10.00 per share. The price/earnings multiple applied to pre-IPO cash flows is 10.0×.

VEq(mm), pre =

CFEq(mm), pre REq(mm), pre − GCF Eq(mm),pre

=

$1.00 = $10.00 15% − 5%

MDpre = 35% = $3.50 Vsh,pre = $6.50 VEq(mm), ipo =

CFEq(mm), ipo REq(mm), ipo − GCF Eq(mm),ipo

=

$1.04 = $13.00 14% − 6%

EXHIBIT 8.25 Components of Observed Pre-IPO Discount.

324 ■

■

BUSINESS VALUATION

With the application of the 35% marketability discount, the price for the pre-IPO transaction is $6.50 per share at the nonmarketable minority interest level of value. The third valuation conclusion is the $13.00 per share IPO price.

Exhibit 8.26 illustrates the components of the observed pre-IPO discount. As in Exhibit 8.21, the calculated pre-IPO discount is 50%. However, we now have a plausible set of assumptions to support this discount. As depicted in Exhibit 8.26, the magnitude of any marketability discount in the pre-IPO valuation has an impact on the resulting pre-IPO discount. It should also be clear, however, that the net result of the IPO pickup in multiple, which is the net result of changes in the discount rate and expected growth post IPO, also has an impact. And finally, the expected net increase in cash flow resulting from the IPO has an additional impact. For example, if we assume that the marketability discount is 0% rather than 35% in Exhibit 8.26, and make no other changes, the concluded pre-IPO discount is 23.1%. This suggests that, under the assumptions above, the IPO pickup and the cash flow pickup combined account for a discount of 23.1%. This further suggests that

Veq(mm),ipo = $13.00 "IPO Pickup" in marketable minority value

30%

Veq(mm),pre = $10.00 Marketability discount applicable prior to IPO

50%

Observed Pre-IPO Discount

35%

Vsh,pre = $6.50

EXHIBIT 8.26 Components of Observed Pre-IPO Discounts.

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325

the positive valuation effects of the IPO itself, rather than enhanced marketability, account for nearly half of the observed pre-IPO discount of 50%. There are a lot of moving parts to pre-IPO transactions and the pre-IPO discount. As a result, it is not appropriate to rely on observed pre-IPO discounts as a basis for estimating marketability discounts for illiquid minority interests of private companies. In the simple example we have been discussing, we calculated a pre-IPO discount of 50%. The long-term average for the Baird studies was in the range of 45%. The differences between the benchmark IPO pricing of these studies (or of any discount) and the pre-IPO subjects include: ■ ■ ■ ■

■ ■

■

Expected cash flow enhancements Expected risk reductions Higher growth expectations The selection of the marketability discount in the pre-IPO valuation Issuance of new shares in pre-IPO stock splits Sale of new shares to raise new capital for the company and resulting dilution for existing shareholders The passage of time between the pre-IPO transaction and the IPO

Valuation analysts cannot reasonably expect to hold all these factors equal or account for them in a manner that enables the pre-IPO discount studies to offer valid evidence for the development of marketability discounts for illiquid minority interests in private businesses.

CONCLUSION Restricted stock and pre-IPO studies are the most commonly cited sources of market evidence for marketability discounts applicable to illiquid minority interest in private companies. Yet, as we have demonstrated in this chapter, the observed discounts from

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these studies do not provide direct economic evidence for such application: ■

■

In the case of the restricted stock studies, the observed discounts are ultimately a function of the expected holding period and the holding period premium to the base return. These two factors give rise to observed restricted stock discounts. While the implied holding period premiums may provide a useful benchmark when estimating returns on illiquid minority interests in private companies, additional parameters (the period until liquidity is expected, future capital appreciation, and interim cash flows during the period of illiquidity) are required to develop the appropriate marketability discount. The observed restricted stock discounts are not directly applicable to illiquid minority interests in private companies. We will review the additional parameters in Chapter 9. Pre-IPO discounts relate the price at which illiquid minority shares are transacted to a subsequent initial public offering price for the same company. However, the IPO itself changes the nature of the pre-IPO company. As a result, the observed discounts include both the impact of illiquidity and the changing characteristics of the company. Since valuation analysts are generally not able to separate the two components, the observed pre-IPO discounts do not provide relevant evidence for the marketability discounts applicable to illiquid minority interests in private companies.

In the remaining chapters, we review the Quantitative Marketability Discount Model, or QMDM, which allows valuation analysts to develop marketability discounts as a result of a comprehensive analysis of the expected cash flows, risk, and growth applicable to illiquid minority interests in private companies.

CHAPTER

9

Introduction to the QMDM (Quantitative Marketability Discount Model)

INTRODUCTION In Part Two of this book, we explored the implications of the Integrated Theory for the value of the subject business as a whole at the marketable minority, financial control, and strategic control levels of value. Measuring the value of a business as a whole is the first step in valuing an ownership interest in that business. No valuation discount or premium has meaning apart from the base value to which it applies; in this section, we are examining the marketability discount, and the base value to which the marketability discount is applied is the financial control/marketable minority level. In Part Three we turn our attention to the intersection of the Integrated Theory and the value of illiquid minority ownership interests in private companies at the nonmarketable minority level of value. Since the emphasis at the nonmarketable minority level is on the perspective of a shareholder, rather than the company as a whole, we will use the term “shareholder level of value” interchangeably with the nonmarketable minority level of value.

327 Business Valuation, First Edition. Z. Christopher Mercer and Travis W. Harms. © 2021 Z. Christopher Mercer and Travis W. Harms. Published 2021 by John Wiley & Sons, Inc.

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As described in the Integrated Theory, the three factors influencing value at the shareholder level are the same as those discussed in Part Two with regard to the business as a whole: expected cash flow, risk, and growth. To develop a reasonable conclusion of value at the shareholder level, valuation analysts should evaluate each of these factors by reference to the subject interest rather than the business as a whole. All of these expectations regarding illiquid minority interests are derived from the corresponding expectations for the business as a whole. Within that context, we analyze the cash flows expected to accrue to the subject interest, the expected growth or capital appreciation of the subject interest, and the risk that the expected cash flows and growth will actually be realized over the anticipated holding period. We will address the following questions in this chapter: 1. What approaches to value should valuation analysts consider at the shareholder level? 2. What are the required inputs to a shareholder level discounted cash flow analysis? 3. What economic factors give rise to the marketability discount? We will address the inputs and application of the Quantitative Marketability Discount Model (“QMDM”) in greater detail in Chapters 10 and 11.

POTENTIAL VALUATION APPROACHES AT THE SHAREHOLDER LEVEL As with any other asset, valuation analysts should consider the applicability of valuation methods under the three different approaches to value when analyzing the value of a subject interest at the nonmarketable minority level of value.

Asset-Based Approach Within the asset-based approach, valuation analysts derive indications of value by examining the value of the underlying assets of

Introduction to the QMDM (Quantitative Marketability Discount Model)

329

the business net of liabilities. For nonmarketable minority interests in operating businesses, applying methods within the asset-based approach is generally not appropriate since the minority shareholder has no direct access to, or discretion over, the underlying assets and liabilities of the business. This is not to say that the underlying asset value does not influence the value of an illiquid minority interest; rather, the underlying asset value does not provide an appropriate basis for measuring the value of an illiquid minority interest.

Market Approach Valuation methods under the market approach compare the subject interest to similar business ownership interests or securities that have been sold. Valuation analysts often consider a range of valuation methods within the market approach to determine the value of nonmarketable minority interests. Prior Transactions in the Subject Company First, valuation analysts may attempt to develop an indication of value for the subject interest by analyzing prior transactions involving similarly situated nonmarketable minority interests in the subject company. While conceptually appealing, this method is rarely fruitful, since the number of observed transactions is typically small, the parties often bring unique motivations to the transactions, and the transactions may not have occurred sufficiently close to the valuation date. Nevertheless, valuation analysts should investigate prior transactions that have occurred and assess their relevance to the current valuation. Restricted Stock and Pre-IPO Transactions Alternatively, valuation analysts may attempt to ascertain the appropriate discount to the pro rata share of the business value for the subject interest by analyzing observations of paired market transactions involving otherwise similar assets having different marketability characteristics. We discussed the perils of relying on restricted stock and pre-IPO transaction data (both of which are forms of the guideline company transaction method) in Chapter 8.

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BUSINESS VALUATION

In our judgment, valuation methods under the market approach are rarely suitable for estimating the value of nonmarketable minority interests in operating businesses.

Income Approach Within the income approach, valuation analysts use methods that convert anticipated economic benefits into value. This approach is intuitively appealing for a broad range of assets, including nonmarketable minority interests in operating businesses. The very definition of an asset promulgated by the FASB confirms the general applicability of the income approach: “Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events” (FASB Concepts Statement 6, Elements of Financial Statements). The discounted cash flow model is the fundamental expression of the income approach. Valuation analysts can use the discounted cash flow model to estimate the value of a subject nonmarketable minority interest in the context of the value of the company as a whole. When valuation analysts use the discounted cash flow method to value the subject interest, the marketability discount describes the relationship between the shareholder and firmwide levels of value. In other words, the marketability discount is a valuation result, not a valuation input. In practice, the principal challenge to applying the discounted cash flow method is the difficulty encountered when specifying appropriate and defensible inputs to the model. While the theoretical basis for the income approach is unassailable, bad inputs will yield unreliable outputs. As we will demonstrate throughout this Part Three, we believe this challenge is readily surmountable. In our experience, techniques are available to develop reasonably accurate (not precise!) valuation inputs for the discounted cash flow method at the shareholder level. In fact, we find specifying DCF inputs preferable to the assumptions required when attempting to use the market approach. Attempting to use the market approach requires making a host of assumptions, whether or not they are explicitly stated. For example,

Introduction to the QMDM (Quantitative Marketability Discount Model)

331

when a valuation analyst applies a marketability discount from a restricted stock or pre-IPO study to a marketable minority value, that discount implies a rate of return over an effective holding period. Unfortunately, neither the rate of return nor the length of the holding period is discussed, even though these inputs are of paramount importance to any investor purchasing the subject interest. In short, we find the income approach to be the most reliable approach to measuring the value of nonmarketable minority interests in operating businesses.

A SHAREHOLDER LEVEL DISCOUNTED CASH FLOW MODEL IN OUTLINE The Quantitative Marketability Discount Model, or QMDM, is a shareholder level discounted cash flow model. The QMDM provides a standardized format for analyzing, projecting, and discounting relevant shareholder cash flows that is applicable to nearly all nonmarketable minority interests in operating businesses or asset-holding entities.1 The QMDM inputs are analogous to those used in traditional discounted cash flow models at the enterprise levels of value. Exhibit 9.1 compares the QMDM assumptions to traditional enterprise-level DCF assumptions. Each of the traditional discounted cash flow inputs is tailored to reflect the perspective of minority shareholders in private companies. Although the QMDM values the subject nonmarketable minority interest directly, it does so in the context of a contemporaneous valuation of the subject business. This is necessary because shareholder expectations regarding expected cash flow, risk, and growth regarding an interest in a business are inextricably linked to the corresponding expectations regarding the business as a whole. 1 Mercer, Z. Christopher, Quantifying Marketability Discounts: Developing and Supporting Marketability Discounts in the Appraisal and Closely Held Business Interests (Peabody Publishing, LP, 1997).

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Enterprise Level DCF Assumptions

Shareholder Level DCF (QMDM) Assumptions

Forecast Period

1.

Range of Expected Holding Periods

Projected Interim Cash Flows

2.

Expected Distribution / Dividend Yield

(during forecast period)

3.

Expected Growth in Distributions / Dividends

4.

Timing (Mid-Year or End of Year)

Projected Terminal Value

5.

Growth in Value over Holding Period

(at end of forecast period)

6.

Premium or Discount to Projected Enterprise Value

Discount Rate

7.

Range of Required Holding Period Returns

EXHIBIT 9.1 Enterprise and Shareholder DCF Assumptions.

V0 =

f ∑ i=1

(

CF0 × (1 + gCF )i (1 + r)i

(

) +

PV of Interim Cash Flows

CF0 × (1 + gCF )f +1 ∕(r − gCF )

)

(1 + r)f PV of Terminal Value

EXHIBIT 9.2 The Two-Stage Enterprise DCF Model.

Basic Structure of the QMDM We reviewed the mechanics of the discounted cash flow model in Chapter 4. Exhibit 9.2 summarizes the basic two-stage form of the model for the business as a whole. Recalling the discussion from Chapter 4, the first term in the expression (PVICF) is the present value of interim cash flows during a finite forecast period. The second term (PVTV) is the present value of the terminal value, or all cash flows expected subsequent to the finite forecast period. The discount rate (r) is the discount rate commensurate with the risk of the expected cash flow stream, which is

Introduction to the QMDM (Quantitative Marketability Discount Model)

Vsh =

f ∑ i=1

(

CFsh × (1 + gd )i (1 + Rhp )i

PV of Interim Cash Flows

)

( +

VEq(mm) × (1 + P∕D%)

333

)

(1 + Rhp )f PV of Terminal Value

EXHIBIT 9.3 The Two-Stage Shareholder DCF Model. assumed to grow at a constant rate (g) following the discrete forecast period. Exhibit 9.3 adapts the discounted cash flow model for valuing businesses to apply to the valuation of nonmarketable minority interests at the shareholder level. Exhibit 9.3 includes each of the shareholder level inputs identified in Exhibit 9.1: 1. Range of Expected Holding Periods. The expected holding period ends with the terminal year in the equation – in other words, the point at which the nonmarketable minority investor anticipates a liquidity event in which they realize the present value of their pro rata share of all remaining enterprise cash flows. The holding period is rarely known with precision. The valuation analyst must – like a potential investor in the subject interest – evaluate the relevant factors likely to influence the duration of the holding period and make an informed judgment regarding its range. 2. Expected Distribution Yield. The expected distribution yield defines the initial expected shareholder cash flow (CFsh ) in terms of the current marketable minority value (VEq(mm) ). If there is no expected distribution yield, the present value of interim cash flows is $0, and the value of the subject interest will depend entirely on the present value of the expected terminal value.

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BUSINESS VALUATION

3. Expected Growth in Distributions. The expected growth rate in distributions defines the remaining interim cash flows in terms of an annual growth rate (gd ) relative to the initial expected shareholder cash flow (CFsh ). Together, inputs 1 through 3 specify the numerator of the first term of the expression in Exhibit 9.3, which are the expected distributions during the expected holding period for the asset. 4. Timing of Distributions. The present value of the projected interim distributions depends in part on when shareholders expect to receive them. The timing assumption is manifest in the discounting periods in the denominator (i). 5. Growth in Value during Holding Period. The assumed growth in value over the holding period (gv ) defines the terminal value in terms of an anticipated annual capital appreciation rate from the current total equity value (VEq(mm) ), which is the starting point of the valuation of the interest. 6. Premium or Discount to Projected Total Equity Value. The base assumption is that the shareholder will receive his or her pro rata share of the total equity value (VEq(mm) ) on a marketable minority interest basis at the end of the holding period. In certain circumstances, however, it may be appropriate for the valuation analyst to assume that the shareholder’s actual terminal value will represent a premium or discount to the projected total equity value (1+P/D% in Exhibit 9.3). Inputs 5 and 6 define the numerator of the second term in Exhibit 9.3. 7. Range of Expected Holding Period Returns. The required holding period return (Rhp ) is the discount rate for the expected shareholder cash flows. The required holding period return is the sum of the equity discount rate and appropriate holding period premiums required to compensate the investor for accepting the incremental risks associated with holding an illiquid minority interest. Exhibits 9.2 and 9.3 together demonstrate that illiquid minority interests can be valued under the income approach using a

Introduction to the QMDM (Quantitative Marketability Discount Model)

DLOM = 1 −

335

Vsh VEq(mm)

EXHIBIT 9.4 The Marketability Discount.

discounted cash flow model analogous to that used when valuing the business as a whole. As shown in Exhibit 9.4, the marketability discount is defined by the relationship between the values determined in Exhibits 9.2 and 9.3.2 The relationships in Exhibit 9.4 confirm and substantiate the conclusion drawn from the Integrated Theory that the marketability discount is the result of valuation analysis rather than a valuation input. In Exhibit 9.4, the marketability discount describes the relationship between shareholder value (Vsh ) and the corresponding pro rata portion of total equity value (VEq(mm) ). Exhibit 9.4 also illustrates the futility of estimating the marketability discount directly on the basis of inadequate transaction data from restricted stock or pre-IPO studies. The Integrated Theory confirms the conceptual superiority of estimating shareholder value directly (within the context of total equity value), rather than attempting to determine shareholder value indirectly by application of a marketability discount.

An Illustration of the QMDM Mechanics In the following example, the discount rate for the business on a marketable minority interest basis is 16.0%, and the expected

2

Valuation analysts appear to be divided as to whether it is a “marketability discount” (“MD”) or a “discount for lack of marketability” (“DLOM”). We prefer, somewhat inconsistently, “marketability discount” and “DLOM.” In any event, the concept is the same, regardless of the selected term.

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BUSINESS VALUATION

growth rate is 6.0%. Expected cash flow is $0.10, so the base value is $1.00 ($0.10 / (16.0% – 6.0%)). The function of the various QMDM inputs is perhaps more easily demonstrated with a visual representation of the underlying discounted cash flow model using a simple example in Exhibit 9.5. In the analysis that follows, we will use this example to demonstrate the economic components of the concluded marketability discount in this example. Relative to the base value of $1.00, the concluded marketability discount is 24.6%. In practice, we compute shareholder level values and corresponding marketability discounts over a range of potential holding periods and required holding period returns. For simplicity, Exhibit 9.5 illustrates the calculations for a single holding period. 1. Expected Holding Period. The expected holding period of ten years establishes the length of the discrete forecast period and corresponds to the point at which the projected terminal value is expected to be received by the shareholder. 2. Expected Distribution Yield. For ease of exposition and illustration, we develop the shareholder value relative to a base pro rata total equity value of $1.00 (VEq(mm) = $1.00). In this example, the expected distribution yield of 10% establishes the initial shareholder cash flow of $0.10 ($1.00 Ve times 10% yield). 3. Expected Growth in Distributions. The expected growth in distributions (5%) defines the subsequent expected interim cash flows relative to the initial expected cash flow of $0.10. 4. Timing of Distributions. In this example, the end-of-year cash flow assumption defines the discount periods for the interim cash flows as 1.0 years, 2.0 years, and so on. 5. Growth in Value during Holding Period. The assumed growth in value over the holding period (5%) establishes the projected total equity value at the end of the holding period ($1.63). 6. Premium or Discount to Projected Total Equity Value. In this example, there is no assumed premium or discount to the projected enterprise value. Had there been, the specified discount or premium would have been applied to the projected total equity value.

Shareholder Level DCF (QMDM) Inputs 1. Expected Holding Period 2. Expected Distribution Yield 3. Expected Growth in Distributions 4. Timing of Distributions 5. Growth in Value during Holding Period 6. Premium/Discount to Projected Total Equity Value 7. Required Holding Period Return

10 years 10.0% 5.0% End 5.0% 0.0% 20.0%

$1.629 $1.551 $1.477 $1.407 $1.340

$1.276 $1.216 $1.158 $1.103 Total Equity Value Normalized to $1.00 (MM Value)

$1.050 $1.000

$0.100 0 Discount Periods (Interim Cash Flows) PV Factors (Interim Cash Flows) PV Factor (Terminal Value)

1

$0.105 2

65.1% 34.9% 100.0%

3

1.00 0.8333

2.00 0.6944

3.00 0.5787

$0.083

$0.073

$0.064

Interim Distributions (Interim Cash Flows) $0.116 $0.122 $0.128 $0.134 4 4.00 0.4823

5 5.00 0.4019

6 6.00 0.3349

7 7.00 0.2791

$0.141 8 8.00 0.2326

$0.148 9

$0.155 10

9.00 0.1938

10.00 0.1615 0.1615

$0.029

$0.025 $0.263

Present Value of Interim Cash Flows and Terminal Value

Nonmarketable Minority Value PVICF $0.491 PVTV $0.263 NMM Value $0.754

$0.110

$0.056

Derivation of Marketability Discount Marketable Minority Value (Total Equity Value) less: Nonmarketable Value (Shareholder Value) Marketability Discount ($) Marketability Discount (%)

$1.000 $0.754 $0.246 24.6%

EXHIBIT 9.5 Visual Representation of the QMDM.

$0.049

$0.043

$0.037

$0.033

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7. Required Holding Period Return. The required holding period return of 20% defines the present value factors applicable to each of the projected interim distributions and terminal value. The QMDM inputs define the projected cash flows and corresponding present value factors of the shareholder level discounted cash flow model. The mechanics of applying the present value factors to the various cash flows is no different than valuing the business as a whole, as the bottom portion of Exhibit 9.5 demonstrates. The indicated value of the subject nonmarketable minority interest (Vsh = $0.754) is the sum of the present value of the projected interim cash flows ($0.491) and the present value of the projected terminal value ($0.263). The corresponding marketability discount of 24.6% (the difference between the base value of $1.00 and the nonmarketable minority value of $0.754) describes, rather than defines, the relationship between the shareholder and enterprise levels of value.

ECONOMIC FACTORS GIVING RISE TO THE MARKETABILITY DISCOUNT Having demonstrated how the mechanics of the QMDM work, we turn our attention now to an essential question for valuation analysts: What are the economic factors that give rise to the marketability discount? It is critical to understand why marketability discounts exist so we can evaluate how the relevant facts and circumstances for a particular subject interest should influence the magnitude of the marketability discount. There are two fundamental economic factors giving rise to the marketability discount: agency costs and incremental holding period risk. We will explore each of these factors in greater detail in the following sections.

Agency Costs We use the term “agency costs” to describe those situations in which expected cash flow from the perspective of shareholders is less than

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339

the corresponding pro rata portion of business cash flows. As noted in Chapter 2, there are two primary agency costs borne by minority shareholders in private companies. Non–Pro Rata Distributions In some private companies, controlling shareholders have a history of receiving excess compensation relative to a market-comparable wage for their services as employees. When it exists, such compensation is effectively a non–pro rata distribution of normalized enterprise cash flows. In such cases, these payments are detrimental to the value of the subject minority interest. The funds paid as excess compensation are not available for pro rata distributions, nor are they available for reinvestment, which drives the expected growth in value over the holding period of the minority investor. Suboptimal Reinvestment Suboptimal reinvestment occurs when the management of an enterprise reinvests cash flow in projects or assets having expected returns less than the cost of capital. We illustrated the baleful effects of suboptimal reinvestment in Chapter 4. A persistent pattern of suboptimal reinvestment dampens the expected growth in value over the holding period of the minority investor.

Incremental Holding Period Risk Minority investors owning illiquid interests in private companies may bear risks that are incremental to those of the company as a whole. The required return on equity capital used as a component of the weighted average cost of capital is based upon the valuation analyst’s assessment of the risk of the company. Among the incremental holding period risks to which illiquid minority investors are potentially exposed are the uncertainties regarding the duration of the holding period, contractual restrictions on transfer, or in the case of tax pass-through entities, the risk of adverse cash flow if distributions are insufficient to cover the shareholders’ pass-through tax liabilities. These are the same risks we discussed when analyzing the restricted stock studies in Chapter 8.

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Cumulative Illustration In order to illustrate the impact of agency costs and incremental holding period risk on marketability discounts, we present a cumulative example in the remainder of this section. Base Case: No Marketability Discount First, we consider the hypothetical case in which neither of the economic factors giving rise to marketability discounts is present, such that the shareholder value equals the corresponding enterprise value. Assume that the base total equity value can be defined using a single-period capitalization model assuming an equity discount rate of 16% and sustainable growth rate of 6%. If there are no agency costs or incremental risks associated with owning a nonmarketable minority interest in the enterprise, the inputs to the shareholder level discounted cash flow model are summarized in Exhibit 9.6. The absence of agency costs is manifest by comparing the total projected sources of return to the nonmarketable minority investor (distribution yield and capital appreciation) to the base equity discount rate for the company. Non–pro rata distributions impair the distribution yield while suboptimal reinvestment reduces the anticipated rate of capital appreciation, or growth in value. In this example, the sum of the expected distribution yield (10%) and the growth in value over the holding period (6%) equals the equity discount rate (16%). If there are no incremental risks associated with ownership of a nonmarketable minority interest in the subject business, the required holding period return will equal the discount rate. In other words, investors holding the subject nonmarketable minority interest will not earn a premium return relative to the base marketable minority equity return. In this example, the required holding period return of 16% equals the base equity discount rate. In the absence of both agency costs and incremental holding period risks, the shareholder level discounted cash flow model yields a conclusion of $1.00, implying no discount to the total equity value on a marketable minority basis (as calculated at the bottom of Exhibit 9.6).

Shareholder Level DCF (QMDM) Inputs 1. Expected Holding Period 2. Expected Distribution Yield 3. Expected Growth in Distributions 4. Timing of Distributions 5. Growth in Value during Holding Period 6. Premium/Discount to Projected Total Equity Value 7. Required Holding Period Return

10 years 10.0% 6.0% End 6.0% 0.0% 16.0%

$1.791 $1.689 $1.594 $1.504 $1.419

$1.338 $1.262 $1.191 $1.124 Total Equity Value Normalized to $1.00 (MM Value)

$1.060 $1.000

$0.100 0 Discount Periods (Interim Cash Flows) PV Factors (Interim Cash Flows) PV Factor (Terminal Value)

1

$0.106 2

$0.594 $0.406 $1.000

59.4% 40.6% 100.0%

3

1.00 0.8621

2.00 0.7432

3.00 0.6407

$0.086

$0.079

$0.072

Nonmarketable Minority Value PVICF PVTV NMM Value

$0.112

Interim Distributions (Interim Cash Flows) $0.119 $0.126 $0.134 $0.142 4 4.00 0.5523

5 5.00 0.4761

6 6.00 0.4104

7 7.00 0.3538

$0.150 8 8.00 0.3050

$0.159 9

$0.169 10

9.00 0.2630

10.00 0.2267 0.2267

$0.042

$0.038 $0.406

Present Value of Interim Cash Flows and Terminal Value $0.066

$0.060

$0.055

Derivation of Marketability Discount Marketable Minority Value (Total Equity Value) less: Nonmarketable Value (Shareholder Value) Marketability Discount ($) Marketability Discount (%)

$1.000 $1.000 $0.000 0.0%

EXHIBIT 9.6 The QMDM with No Agency Costs or Incremental Risks.

$0.050

$0.046

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Effect of Agency Costs We can now isolate the effect on the marketability discount of expected agency costs over the anticipated holding period. In the example case, the valuation analyst expects a modest level of suboptimal reinvestment of enterprise cash flows, resulting in a downward adjustment to the growth in value (and distributions) to 5% from 6%. The impact of suboptimal reinvestment is seen in the projected terminal value, which is $1.629, compared to $1.791 in the absence of agency costs (Exhibit 9.6). In terms of value, the agency costs account for a marketability discount of 5.7%, excluding the effect of any incremental holding period risk (as calculated at the bottom of Exhibit 9.7). This example confirms that the effect of suboptimal reinvestment is not limited to the returns realized by nonmarketable minority investors. Unlike other agency costs against which controlling shareholders may receive an offsetting benefit (such as excess compensation), suboptimal reinvestment also reduces the returns achieved by the controlling shareholder. This negative impact on the present value of future cash flows was illustrated in Chapter 4. In other words, despite controlling the business, the realized returns of the majority owners also suffer from suboptimal reinvestment over time. This does not imply, however, that the effect of suboptimal reinvestment should not be a component of the marketability discount. The public company equivalent, or marketable minority, value relative to which marketability discounts are measured is predicated on both normalized current operations and normalized reinvestment practices. The marketability enjoyed by public company minority investors assures that suboptimal reinvestment is not anticipated. Note that this does not mean that certain investments made by public companies will not in fact turn out badly. Rather, it simply confirms that poor performance is not anticipated. If it were, the public share price would be bid down to a level at which incumbent management would be subject to removal, and new managers more responsive to the interests of shareholders installed. While one might be able to identify isolated cases of public companies engaging in persistent suboptimal reinvestment practices, we would suggest that they are merely the exceptions that prove the rule.

Shareholder Level DCF (QMDM) Inputs 1. Expected Holding Period 2. Expected Distribution Yield 3. Expected Growth in Distributions 4. Timing of Distributions 5. Growth in Value during Holding Period 6. Premium/Discount to Projected Total Equity Value 7. Required Holding Period Return

10 years 10.0% 5.0% End 5.0% 0.0% 16.0%

vs. 6.0% vs. 6.0%

$1.629 $1.551 $1.477 $1.407

$1.340 $1.276 $1.216 $1.158 $1.103 Total Equity Value Normalized to $1.00 (MM Value)

$1.050 $1.000

$0.100 0 Discount Periods (Interim Cash Flows) PV Factors (Interim Cash Flows) PV Factor (Terminal Value)

1

$0.105 2

$0.573 $0.369 $0.943

60.8% 39.2% 100.0%

3

1.00 0.8621

2.00 0.7432

3.00 0.6407

$0.086

$0.078

$0.071

Interim Distributions (Interim Cash Flows) $0.116 $0.122 $0.128 $0.134 4 4.00 0.5523

5 5.00 0.4761

6 6.00 0.4104

7 7.00 0.3538

$0.141 8 8.00 0.3050

$0.148 9

$0.155 10

9.00 0.2630

10.00 0.2267 0.2267

$0.039

$0.035 $0.369

Present Value of Interim Cash Flows and Terminal Value

Nonmarketable Minority Value PVICF PVTV NMM Value

$0.110

Derivation of Marketability Discount Marketable Minority Value (Total Equity Value) less: Nonmarketable Value (Shareholder Value) Marketability Discount ($) Marketability Discount (%)

$1.000 $0.943 $0.057 5.7%

EXHIBIT 9.7 The QMDM with Agency Costs.

$0.064

$0.058

$0.052

$0.047

$0.043

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Effect of Incremental Holding Period Risks We can also isolate the effect on the marketability discount of incremental holding period risks over the expected holding period. In the example case, the valuation analyst concludes that the incremental holding period risks justify a 4% increment to the base equity discount rate, resulting in a required holding period return of 20%. To isolate the impact of incremental holding period risks, we reset the anticipated growth in value (and distributions) to 6%. These changes are reflected in Exhibit 9.8. The effect of the incremental holding period risks is manifest in the lower present value factors. Excluding the impact of agency costs examined in Exhibit 9.7, the return premium reflecting the incremental holding period risks generates a marketability discount of 20.3% (as calculated at the bottom of Exhibit 9.8). Conceptually, the observed discounts in restricted stock transactions of public companies reflect only this component of the overall marketability discount. In practice, we are not dogmatic on this point because the sample of public companies that issue restricted shares consists primarily of small, financially distressed firms trading in relatively inefficient markets for which the discipline described earlier may not be strong enough to eliminate the potential for substantial expected agency costs. Combined Effect on Overall Marketability Discount Combining the lower anticipated growth in value and distributions with the higher required holding period return yields the initial shareholder level discounted cash flow model presented in Exhibit 9.5 above and a marketability discount of 24.6%. Note that the overall marketability discount is modestly less than the sum of the agency costs and incremental holding period risks (5.7% and 20.3%) because of the interaction of the lower present value factors and lower projected cash flows. This analysis suggests that the qualitative discussion of the marketability discount applicable to a subject nonmarketable minority interest ought to emphasize the nature and persistence of specific agency costs borne by the minority shareholders and the specific holding period risks for which the hypothetical willing buyer would demand compensation in the form of a higher required return.

Shareholder Level DCF (QMDM) Inputs 1. Expected Holding Period 2. Expected Distribution Yield 3. Expected Growth in Distributions 4. Timing of Distributions 5. Growth in Value during Holding Period 6. Premium/Discount to Projected Total Equity Value 7. Required Holding Period Return

10 years 10.0% 6.0% End 6.0% 0.0% 20.0%

$1.791 $1.689 vs. 16.0%

$1.594 $1.504

$1.419 $1.338 $1.262 $1.191 $1.124 Total Equity Value Normalized to $1.00 (MM Value)

$1.060 $1.000

$0.100 0

1

$0.106 2

$0.112 3

Discount Periods (Interim Cash Flows) PV Factors (Interim Cash Flows) PV Factor (Terminal Value) Nonmarketable Minority Value

1.00 0.8333

2.00 0.6944

3.00 0.5787

PVICF PVTV NMM Value

$0.083

$0.074

$0.065

$0.508 $0.289 $0.797

63.7% 36.3% 100.0%

Interim Distributions (Interim Cash Flows) $0.119 $0.126 $0.134 $0.142 4 4.00 0.4823

5 5.00 0.4019

6 6.00 0.3349

7 7.00 0.2791

$0.150 8 8.00 0.2326

$0.159 9

$0.169 10

9.00 0.1938

10.00 0.1615 0.1615

$0.031

$0.027 $0.289

Present Value of Interim Cash Flows and Terminal Value $0.057

Derivation of Marketability Discount Marketable Minority Value (Total Equity Value) less: Nonmarketable Value (Shareholder Value) Marketability Discount ($) Marketability Discount (%)

$1.000 $0.797 $0.203 20.3%

EXHIBIT 9.8 The QMDM with Incremental Risks.

$0.051

$0.045

$0.040

$0.035

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1. Expected Holding Period 2. Expected Distribution Yield

Years

(1) 10

(2) 10

(3) 10

(4) 10

Yield

10.0%

10.0%

10.0%

10.0%

3. Expected Growth in Distributions

Growth

6.0%

5.0%

6.0%

5.0%

4. Timing of Distributions

Timing

E

E

E

E

5. Growth in Value during Holding Period

Gv

6.0%

5.0%

6.0%

5.0%

6. Premium/Discount to Projected Value

Prem/Disc.

0.0%

0.0%

0.0%

0.0%

Low

16.0%

16.0%

20.0%

20.0%

0.0%

5.7%

20.3%

24.6%

7. Required Holding Period Return Marketability Discount (1)

Total Equity Value (Exhibit 9.6)

(2)

Suboptimal Reinvestment Only (Exhibit 9.7)

(3)

Incremental Risk Only (Exhibit 9.8)

(4)

Suboptimal Reinvestment and Incremental Risk (Exhibit 9.5)

EXHIBIT 9.9 Impact of Agency Costs and Incremental Risk on Marketability Discount.

Review of Analysis We can summarize this analysis of the QMDM with Exhibit 9.9 reordered to present the total equity value (0% marketability discount) first. Then, suboptimal reinvestment alone is presented, where the resulting impairment to growth in value generates a marketability discount of 5.7%. Next, incremental risk alone is presented where the required holding period return generates a marketability discount of 20.3%. Finally, we see the combined effect of both suboptimal reinvestment and incremental risk, in which case the calculated marketability discount is 24.6% Exhibit 9.9 illustrates that each assumption of the QMDM is important. It also illustrates that the various assumptions interact and influence calculated marketability discounts. The marketability discount in column four of 24.6% includes the combined effect of agency costs and incremental shareholder level risks.

CONCLUSION In this chapter, we have explored the relationship between the enterprise and shareholder levels of value within the context of the

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347

Integrated Theory. The QMDM is a shareholder level discounted cash flow model standardized to accommodate the valuation of substantially all nonmarketable minority interests in operating businesses and asset-holding entities. Shareholder level value is driven by the same factors as that of the business as a whole: expected cash flow, growth, and risk. Nonmarketable minority interests are generally worth less than the corresponding pro rata portion of total equity value because of a combination of agency costs and incremental holding period risks.

APPENDIX

9-A

Liquidity and Marketability

INTRODUCTION Is liquidity the same thing as marketability? Can an asset be marketable, but not liquid? Or can an asset be liquid but not marketable? Valuation analysts have traditionally applied marketability discounts to minority interests in private companies. Should they apply discounts for lack of liquidity instead? Should some business ownership interests be subject to both marketability and separate illiquidity discounts? Or should a discount for lack of liquidity be applied at the controlling interest levels? Few other valuation topics have been subject to as much sloppy reasoning in the past two decades as the concepts of liquidity and marketability. In this section, we apply the discipline of the Integrated Theory to this controversy.

DEFINITIONS We can begin our analysis by evaluating the definitions of “liquidity” and “marketability” as those terms are used in the valuation literature.

International Glossary of Business Valuation Terms The International Glossary of Business Valuation Terms (“IGBVT”) has been promulgated and endorsed by the principal North American professional associations (the American Institute of Certified Public Accountants, the American Society of Appraisers,

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Term

Definition

Liquidity

The ability to quickly convert property to cash or pay a liability.

Marketability

The ability to quickly convert property to cash at minimal cost.

EXHIBIT 9.10 Definitions of Liquidity and Marketability from IGBVT.

the Canadian Institute of Chartered Business Valuators, and the National Association of Certified Valuation Analysts). Exhibit 9.10 presents the IGBVT definitions for liquidity and marketability. The definition of marketability introduces the concept of cost to convert to cash that is not present in the liquidity definition. Accordingly, if an asset could be quickly converted to cash at great cost, the asset would presumably be liquid but not marketable. Meanwhile, the definition of liquidity – but not marketability – includes the ability to use property to pay a liability. We frankly do not know what that difference is intended to signify. The IGBVT defines a discount for lack of marketability as “an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability.” The IGBVT does not include the discount for lack of liquidity among the terms defined.

The ASA Business Valuation Standards In its business valuation standards, the glossary of the American Society of Appraisers incorporates the IGBVT, but supplements it with additional terms, and in the case of liquidity and marketability provides additional definitions.1 Exhibit 9.11 presents the definitions of liquidity and marketability unique to the ASA glossary. 1

By this we mean that the ASA Glossary includes two entries each for liquidity and marketability. One is from the IGBVT, and the other is unique to the ASA.

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351

Term

Definition

Liquidity

The ability to readily convert an asset, business, business ownership interest, security or intangible asset into cash without significant loss of principal.

Marketability

The capability and ease of transfer or salability of an asset, business, business ownership interest, security or intangible asset.

EXHIBIT 9.11 Definitions of Liquidity and Marketability from ASA Glossary.

The verbal overlap between the two definitions is limited to the various forms of property contemplated. ■

■

■

In contrast to the definition of marketability, that of liquidity explicitly references converting the property to cash “without significant loss of principal.” With reference to the covered classes of property, “loss of principal” presumably refers to a reduction in value. Whereas liquidity appears to be a binary proposition (an asset either has “the ability” or not), the definition of marketability “the capability and ease” seems to envision a continuum. In other words, individual assets could presumably possess greater or lesser “capability and ease” of transfer. In short, as with the IGBVT, it is not immediately clear to us what the definitional differences are intended to signify. For example, by situating the element of cost in the definition of liquidity, the ASA definitions suggest that an asset that could be converted to cash only with a “significant loss of principal” would not be liquid, but would perhaps retain some degree of marketability. This is actually the opposite conclusion that one would draw from the IGBVT, which associates marketability with conversion to cash “at minimal cost.”

In further contrast to the IGBVT, the ASA glossary provides a discount for lack of liquidity. Exhibit 9.12 compares the definitions of the liquidity and marketability discounts in the ASA glossary.

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Term

Definition

Discount for Lack of Liquidity

An amount or percentage deducted from the value of an ownership interest to reflect the relative inability to quickly convert property to cash.

Discount for Lack of Marketability

An amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability.

EXHIBIT 9.12 Definitions of Discounts for Lack of Liquidity and Lack of Marketability from ASA Glossary.

The definitions overlap with regard to just what a valuation discount is, and both emphasize that the discounts are intended to reflect “relative” differences. A “relative” difference implies a base or standard against which the relative attribute is measured. Significantly, neither definition identifies the corresponding base, or standard, of liquidity or marketability. ■

■

The benchmark for marketability has traditionally been the marketable minority (or as-if-freely-traded) value. In other words, how does the marketability of the subject interest compare to that of shares in the public market? As developed in Chapter 2, the Integrated Theory demonstrates that the marketability discount arises because of differences in cash flow, risk, and/or growth expectations between the subject (nonmarketable) interest and the base marketable minority interest. The public markets provide the benchmark for marketability not because the public equity markets reflect some idealized standard of marketability, but rather because the base value to which the discount is applied is the marketable minority level of value. The novel discount for lack of liquidity could presumably be applied against a base value at the marketable minority, financial control, or strategic control levels of value. However, to do so, one would need to identify what differences in cash flow, risk, or growth – relative to the corresponding base value – cause the discount for lack of liquidity to exist.

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353

In the following section, we use the Integrated Theory to discern whether there is any conceptual basis for a discount for lack of liquidity at either the marketable minority or control levels of value.

A DISCOUNT FOR LACK OF LIQUIDITY AT THE MARKETABLE MINORITY LEVEL OF VALUE Exhibit 9.13 summarizes the conceptual math for the marketable minority level of value. How would a relative inability to convert a minority interest to cash quickly be manifest? We consider each valuation input in turn. ■

■

■

Cash Flow (CFEq(mm) ). CFEq(mm) represents the normalized cash flows to equity for the business as whole. At the marketable minority level, the value of a business represents the present value of all future expected cash flow into perpetuity. Relative to the marketable minority level, differences in expected cash flow for an “illiquid” minority interest could arise if (1) the “illiquidity” gave rise to an expectation for an extended holding period, and (2) the owner of the “illiquid” minority interest would expect to receive less than their full pro rata share of the base cash flows because of non–pro rata distributions or other agency costs. Risk (REq(mm) ). Risk is manifest in the discount rate. Relative to the marketable minority level, an investor in an “illiquid” minority interest would presumably bear greater risk. The elevated risk would justify a premium return to REq(mm) applicable to interim cash flows and the terminal value at the end of the forecast period. Growth (GCF Eq(mm) ). Expected growth in cash flow contributes to expected growth in value over the anticipated holding period. In the absence of agency costs such as non–pro

Conceptual Math Marketable Minority Value (Equity Basis)

Relationships

CFEq(mm) REq(mm) – GCF Eq(mm)

GCF Eq(mm) = REq(mm) –

CFEq(mm) VEq(mm)

EXHIBIT 9.13 Conceptual Math for the Marketable Minority Level of Value.

Value Implications

VEq(mm) is the benchmark for the other equity levels of value ("as-if-freely-traded")

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355

rata distributions or suboptimal reinvestment (i.e., reinvestment of cash flow at rates less than the cost of equity), one would expect the growth in value of an “illiquid” minority interest to approximate expected growth on a marketable minority basis. The preceding discussion confirms that the factors that would contribute to a discount for lack of liquidity from a marketable minority indication of value are the same factors that generate the discount for lack of marketability. In other words, there is no discount for lack of liquidity distinct from the traditional discount for lack of marketability. Particularly in light of the definitional ambiguities noted in the preceding section, there is no conceptual basis for a discount for lack of liquidity at the marketable minority level.

A DISCOUNT FOR LACK OF LIQUIDITY AT THE CONTROLLING INTEREST LEVELS OF VALUE Perhaps, however, a discount for lack of liquidity is applicable at the controlling interest levels of value. After all, controlling interests in private businesses cannot be converted to cash as easily as minority shares that trade in the public equity markets. While this observation is undoubtedly true, it is also totally irrelevant. As we noted previously, valuation discounts are appropriate to account for differences between the subject interest and the base level of value to which the discount is applied. No valuation discount (or premium) has any meaning apart from the base value to which it is applied. Therefore, when we consider the applicability of a discount for lack of liquidity to a controlling interest, the liquidity of that interest relative to a publicly traded share is irrelevant, because that is not the base to which the discount is being applied. Instead, one should seek to identify the relative difference in liquidity between the subject controlling interest and the base controlling interest value (whether financial or strategic control makes

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no difference here). Exhibit 9.14 summarizes the conceptual math for the financial control level of value. In order to be conceptually coherent, a discount for lack of liquidity would need to account for differences in cash flow, risk, or growth relative to the base financial control value.2 ■

■

■

2

Cash Flow (CFEq(fc) ). CFEq(fc) represents the normalized cash flows to equity for the business as whole. In contrast to a minority interest, a controlling interest is not subject to the potentially adverse decisions of others with respect to non–pro rata distributions. The perceived “liquidity” of a controlling interest has no effect on the expected cash flows attributable to that interest. Furthermore, since the owner of a controlling interest has discretion over the timing of a future liquidity event, the relevant time horizon for future cash flows is indefinite, regardless of the perceived “liquidity” of a controlling interest. In short, expected cash flow expectations do not justify a discount for lack of liquidity at the controlling interest level. Risk (REq(fc) ). As with the marketable minority level, risk is manifest in the discount rate. However, because a controlling interest is able to make all relevant operational and governance decisions, there is no reason to assume a premium to the discount rate, regardless of the perceived “liquidity” of the subject controlling interest. In other words, there are no relevant differences in risk that justify a discount for lack of liquidity at the controlling interest level. Growth (GCF Eq(fc) ). Once more, since the controlling shareholder has discretion over all distribution and reinvestment decisions, perceived “liquidity” has no effect on either present cash flows or the expected growth in those cash flows over time. As a result, there is no basis for assuming that differing growth expectations would support a discount for lack of liquidity at the controlling interest level.

The following discussion is no different at the strategic control level of value.

Conceptual Math

Financial Control (Equity Basis)

CFEq(fc) REq(fc) – GCF Eq(fc)

Relationships

Value Implications

CFEq(fc) ≥ CFEq(mm) GCF Eq(fc) ≥ GCF Eq(mm) REq(fc) ≈ REq(mm)

EXHIBIT 9.14 Conceptual Math for the Financial Control Level of Value.

VEq(fc) ≥ VEq(mm)

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CONCLUSION We conclude that, on a minority interest basis, a discount for lack of liquidity is not distinct from the traditional discount for lack of marketability. If there is a discount for lack of liquidity it is precisely the same as the discount for lack of marketability. On a controlling interest basis, our analysis using the Integrated Theory reveals that there is no conceptual basis for applying a discount for lack of liquidity. When applied, they are nothing more than discounts of convenience. ■

■

If the base controlling interest value is too high, the resulting (discounted) value may, by chance, be correct. If, on the other hand, the base controlling interest value is correct, the resulting (discounted) value will be understated.

Advocates of discounts for lack of liquidity applied to controlling interests invariable cite the inherent illiquidity of such interests relative to minority shares in public companies. The base value to which any putative discount for lack of liquidity would be applied is (hopefully) estimated with reference to the market for controlling interests in businesses. If so, there is no basis in cash flow, risk, or growth differences to support such a discount. Furthermore, the potentially lengthy sales cycle for controlling interests does not support a discount for lack of liquidity. First, the seller of a controlling interest enjoys all of the benefits of ownership during the marketing period, regardless of the duration of that marketing period. Second, the hypothetical transaction is properly assumed to occur on the valuation date, with all necessary marketing activities preceding that date. The Integrated Theory confirms that there is no conceptual basis for a discount for lack of liquidity distinct from the traditional marketability discount applied to minority interests.

CHAPTER

10

The QMDM Assumptions in Detail

INTRODUCTION In Chapter 9, we demonstrated the merit of using the income approach to valuation and the discounted cash flow method to value nonmarketable minority interests. We introduced the QMDM as a concise shareholder level discounted cash flow model, and provided a brief overview of the required assumptions. In this chapter, we discuss the assumptions of the QMDM in greater detail. The objectives of this chapter include: ■

■

■

■

Discussing the background and rationale for each of the assumptions Illustrating the relative importance of each assumption in developing marketability discounts for nonmarketable minority interests of business enterprises Examining the sensitivity of conclusions drawn from the QMDM to changes in the assumptions made by business valuation analysts Providing practical guidance for valuation analysts to assist in developing assumptions in specific valuation situations

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We will address the following questions in this chapter: 1. Does the expected holding period depend on the characteristics of the subject interest or the current owner of the subject interest? 2. What factors should be considered in assessing the expected holding period? 3. Is it necessary to estimate the expected holding period with precision? 4. How are distributions from S corporations compared to dividends from C corporations? 5. How does the expected growth in value for public companies differ from that for private companies? 6. What specific factors contribute to holding period premiums? 7. How can the reasonableness of the estimated required holding period return be evaluated? 8. Is the QMDM overly sensitive to changes in assumptions?

ASSUMPTION 1: EXPECTED HOLDING PERIOD FOR THE INVESTMENT (HP) When constructing an enterprise level discounted cash flow model, the valuation analyst must first determine the forecast horizon, or length of the discrete projection period. Shareholder level discounted cash flow models are no different. In the QMDM, the forecast horizon is referred to as the expected holding period. The expected holding period is the time over which a reasonably informed buyer or seller would anticipate that the subject interest will remain nonmarketable. Alternatively, the expected holding period can be thought of as the estimated period over which the investor expects to achieve the objective of the investment, which is typically not a discounted value. Note that this is an attribute of the subject interest, and is not necessarily the same as the desired holding period of any specific buyer or seller, including the current owner.

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Marketability and the Expected Holding Period The public securities markets provide the benchmark for assessing the marketability of subject interests. Holders of actively traded stocks can place sale orders with their brokers today at the market price and have access to the sales proceeds in a matter of days. There are, of course, exceptions to this general statement. It may not be possible to match buyers and sellers immediately if the market for a company’s shares is thin or illiquid. Even for highly liquid companies, it can be difficult to sell large blocks of stock immediately, without some “blockage” discount. Large orders hanging over the market can have a depressing impact on share prices of even large market capitalization companies. Nevertheless, the general rule is that the public securities markets provide ready liquidity, and that is the general standard against which less marketable minority investments are compared. If there is no active market for a private company’s shares, investors face considerable uncertainty regarding when and how the shares will become marketable. In the presence of such uncertainty, the value of private company shares becomes a function of the present value of the future cash flows attributable to those securities, if and when they are expected to be achieved. Therefore, valuation analysts must specifically consider the expected holding period during which the subject interest is expected to remain nonmarketable. There are several avenues by which a subject interest may become marketable, including: ■

Sale of the company. Under normal circumstances, acquirers purchase all the outstanding shares at the same price and on the same terms when companies are sold. Alternatively, all of the assets are sold, followed by distribution of proceeds (net of liabilities) and liquidation of the company. In either case, sale of the company provides liquidity to shareholders. As noted in Part Two of this book, potential acquirers may include both strategic and financial buyers, such as private equity funds.

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Regular or irregular repurchase activities. Share repurchase programs have become more popular among private companies in recent years, following the example of many public companies. Many private companies “recycle” shares by repurchasing from existing shareholders and later selling to new shareholders as the company matures. Private companies with limited attractive reinvestment opportunities may initiate share repurchase programs to generate higher returns for the remaining shareholders. Sale to other investors. The shares may be sold to another investor desiring to invest in the company. While there is no market, it is occasionally possible to locate a purchaser for minority shares of a private company who will buy the shares on relatively favorable terms. Some private equity firms invest in minority interests of private companies. Offers to company or shareholders. The shares may be offered to the company or to the other shareholders, who may treat the offer with indifference (i.e., with unfavorable pricing). Buy-sell agreements. Many companies and their shareholders enter into buy-sell agreements. These agreements outline the obligations of the parties to buy or sell shares under specified circumstances. Buy-sell agreements rely on a variety of mechanisms to set the price for transactions, and often call for one or more valuations of the business.1 Initial public offering (IPO). A minority shareholder may have an opportunity to participate in the offering, or his or her shares may become marketable following the IPO. But relatively few private companies are legitimate candidates to go public. Given the declining volume of IPOs and the rising threshold for what constitutes an attractive IPO candidate, an IPO is the least likely means of achieving liquidity for private company shareholders.

There are other circumstances under which a minority investor’s shares in a private company can be sold, but few of them 1

Mercer, Z. Christopher, Buy-Sell Agreements for Closely Held and Family Business Owners (Peabody Publishing LP, 2010).

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are generally favorable to the investor. The point is that investors must accept uncertainty with respect to when (or even if) the subject investment will become marketable. Investors further expect that, because of this uncertainty, they may hold the investment for several or many years.

Factors to Consider in Estimating the Expected Holding Period Other things being equal, longer holding periods reduce the present value of the expected shareholder cash flows, resulting in higher marketability discounts. Investors develop holding period expectations by considering factors that may be more qualitative than quantitative. By considering the facts and circumstances of a particular valuation, valuation analysts may assess the likelihood that the expected holding period will be relatively short, relatively long, or somewhere in between. Although subjective, the holding period expectations are reasonably related to: ■

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Historical ownership policies. If there is a history of insider ownership, whether within families or a small group of owners and/or managers, there may be little likelihood of a market developing for the subject shares. On the other hand, if the investor group includes venture capitalists or private equity groups, there is likely to be pressure to achieve a liquidity event within a definable time frame (often three to seven years or so). Buy-sell or other shareholder agreements. Buy-sell agreements can define value from the perspective of a hypothetical willing investor, or they can significantly dampen expected future value, depending upon the nature of the agreement. Other shareholder agreements can also have an impact upon marketability, and must be examined to determine their significance. An adverse buy-sell agreement may, for example, effectively ensure that there will be no favorable liquidity opportunities until the company is sold or there is an IPO. Agreements requiring new investors to be subject to terms

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limiting future liquidity options are an example of this type of adverse agreement. Management/ownership succession. While one never knows with certainty when favorable opportunities to achieve marketability may occur, certain conditions can increase the probability that a sale or other favorable exit opportunity will arise. For example: ■ The prospects for marketability may increase if key management is in poor health. Note that while potentially favorable from a future marketability standpoint, key person dependencies could dampen overall valuation at the enterprise level unless such dependencies have been mitigated through effective succession planning. ■ Aging owners may indicate that the shares may become marketable, particularly if the owners have no children or other successors in place to carry on the business. ■ Owners who are known to have near-term liquidity needs (e.g., personal financial problems) may also indicate a greater probability of a sale of the business or other opportunities for marketability. Business plans and likely exit strategies of the controlling owner. If there is a specific plan calling for the sale of the business within a foreseeable time frame, the outer limits of an expected holding period may be reasonably defined. Even when a plan exists, investors are likely to hedge the potential for a favorable sale since such plans often change. Increasing likelihood of equity offering or acquisition. A company may be at the stage in its life cycle where opportunities for favorable exit are emerging. Attractive companies have a higher probability of being sold than other companies, even if management and ownership aver that the company will remain private. Many businesses are sold quite unexpectedly, and attractive businesses are more likely to receive unsolicited acquisition offers. History of transactions involving minority interests. If a company or certain of its shareholders have a history of purchasing shares from shareholders desiring liquidity at low relative

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valuations, the necessity of planning for a long holding period is obvious. Alternatively, a more favorable history increases the likelihood that an internal market for the subject interest may exist.

Holding Period Areas of Investigation Our example in Chapter 9 assumed a point estimate for the expected holding period to more easily demonstrate how the QMDM works. In practice, the expected holding period is a range concept. In order to estimate the expected range of probable holding periods, we suggest that an analysis of certain facts regarding the subject interest will often provide credible evidence for the valuation analyst. Questions designed to elicit these important facts can be included in the due diligence questionnaires used by valuation analysts. The key facts that might be considered by market participants and valuation analysts include: ■

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The ages of the principal owners/managers and the availability of competent successor management. The ages of the principal shareholders, if different from management. The dynamic of age among the ownership group and the management group could lead to a reasonable impression of the need to sell the company. The financial condition of the principal owners independent of the subject business. The greater the reliance of shareholders on the value of the business, rather than on current distributions, the greater the likelihood of a near-term sale of the business. This information is sometimes available, although not always, but is certainly a justifiable area of inquiry for the market participant or valuation analyst. The independent financial conditions of the partners in a family limited partnership can have a significant bearing on the pressures facing a successor general partner when a senior generation partner dies. The intentions of the principal owner or managers regarding the future of the business. If the current owner/manager has made it known that he or she plans to sell and retire in the

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next three to five years, those plans will reasonably influence expectations regarding the holding period. In the alternative, if the current owner/manager plans to “die in the saddle,” one may reasonably expect a longer holding period. Family or shareholder relationships. While tensions between existing shareholders can have a dampening effect on the interest of prospective investors in a company, those same tensions can increase the probability that a sale or other transaction will occur and provide future liquidity opportunities for minority shareholders. Conditions in the subject company’s industry. Many industries are in early or later stages of consolidation. For example, the number of banks in the United States has been declining – primarily through merger or acquisition – at about 4% per year for the last several decades. At least in part, this explains why banks tend to have relatively lower marketability discounts than nonfinancial companies. The very fact that a company is in a rapidly consolidating industry increases the probability that a sale may occur. And this is true regardless of the present, stated intentions of management or ownership. Taken into consideration with other factors in a valuation situation, industry consolidation could lead one to reasonably expect a relatively short holding period. At the other extreme, if an industry is dead or dying, opportunities for shareholder liquidity may be less likely. A history of recapitalizations or the likelihood of a recapitalization in the foreseeable future. Substantial recapitalizations provide opportunities for minority shareholders to dissent to transactions and to have courts determine the fair value of their shares, usually based upon one or more appraisals. Depending on the state in which a corporation is domiciled, judicial interpretation of dissenters’ rights statutes may call for favorable valuations. Such circumstances may allow the subject interest to become marketable on relatively favorable terms.

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Estimating Ranges for the Expected Holding Period Market participants and valuation analysts must develop holding period expectations. While it is almost never possible to define a particular holding period with certainty, it is normally possible to make an informed judgment as to whether the holding period will be relatively short (five years or less), relatively long (more than 10 years), or something in between. In practice, we tend to consider a reasonable range of expected holding periods, together with a range of required holding period returns, before making a final decision about the marketability discount to be used in a specific case. When the facts provide no indication of near-term marketability for the subject interest (for example, within the next five years), we often consider a base range of 5 to 10 years at the outset. The reasonableness of this estimate can be tested based on the implied prospective returns assuming a particular marketability discount. This is not a universally appropriate assumption; however, it does allow the valuation analyst to establish a base against which to compare shorter and longer holding periods. We are not aware of any academic studies investigating the duration of a given shareholder group for a private company. Family business experts suggest that only a minority of companies are successful in transitioning to the second generation of family management. This would imply that, as a benchmark observation, most businesses experience changes of control within at least 20 years or so. Experience with private companies has led us to conclude that the half-life of business control is probably in the range of 8 to 10 years, give or take a bit. Within this time frame many companies will sell, recapitalize, or merge with another entity in change of control transactions. Obviously, some companies transact earlier, and some later. In the final analysis, the valuation analyst must reach a conclusion regarding the expected holding period range in the context of the facts and circumstances of each case. Valuation analysts cannot

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know the unknowable. But they can make decisions regarding the likelihood of a relatively short expected holding period versus a relatively long expected holding period. And, given the particular facts of a situation, those general assessments can often be more narrowly refined. In the final analysis, the valuation analyst must make an explicit assumption regarding the expected holding period.2 The valuation analyst’s objective is to gain a sufficient understanding of the facts and circumstances regarding a particular investment to make a reasonable holding period assumption.

ASSUMPTION 2A: EXPECTED DIVIDEND YIELD (D %) Valuation analysts using a shareholder level discounted cash flow model must project interim shareholder cash flows during the expected holding period. Other things being equal, expected dividends mitigate the marketability discount relative to a similar investment with no dividend. In other words, interim cash flows offer direct access to at least a portion of firmwide equity cash flows. C corporations pay dividends, S corporations and other tax pass-through entities make distributions. We use the terms interchangeably in this book because all dividends/distributions are adjusted to a comparable basis for the QMDM.

2

As we demonstrated in Chapter 8, valuation analysts relying on restricted stock studies do not thereby avoid the question of expected holding period. Rather, by selecting a discount solely with reference to such studies, they are making implicit – even if unrecognized – assumptions regarding both the holding period and required holding period return. In short, the failure to make one’s assumption explicit does not mean that no assumption is being made. Any marketability discount implies a set of assumptions regarding the expected holding period, interim distributions, and the required return. It is misleading to users of appraisal reports to fail to make these important assumptions explicit.

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Determining Expected Dividend Yields Valuation analysts estimate the expected interim cash flows for a particular subject interest (and the resulting marketable minority yield) on the basis of several considerations: 1. The history of dividends. If a company has a long history of paying dividends, then the valuation analyst may reasonably assume that policy will continue into the future. Often, management will state its intention of continuing the historical policy for the foreseeable future. In addition, cash flow and balance sheet circumstances may suggest that an enterprise would accumulate abnormally high levels of cash in the absence of shareholder distributions. 2. Preferential dividend claims. Occasionally one ownership class will have a preferential claim on distributions that will create a clear expectation of ongoing dividends (or reduce the cash flow available for distribution to other classes of securities). 3. Other characteristics of the subject company. Sometimes a company has not paid dividends in the past because available cash flow has been used to repay accumulated debt of the enterprise. If the debt has been repaid or been reduced to target levels at the valuation date, shareholder distributions may reasonably be expected. Occasionally, a company may be expected to make a one-time distribution, either in addition to normal distributions or in their absence. If such a distribution is reasonably expected at the valuation date, the valuation analyst may separately estimate its impact on shareholder value and the corresponding future growth in value. Companies may also pay periodic, albeit irregular, distributions. The valuation analyst may need to estimate these separately, if significant, or estimate an average distribution yield based on historical, but irregular distributions. 4. Controlling shareholder characteristics. The circumstances of the controlling shareholders or their families may indicate that

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there is a high likelihood of future distributions. High cash flow or lifestyle requirements may indicate the likelihood of regular future distributions. Likewise, if the subject enterprise is controlled by a holding company, debt-service requirements of the holding company may promote payment of dividends to the minority shareholders of the subsidiary. 5. Tax characteristics of the subject company. With tax passthrough entities, the valuation analyst then converts the anticipated cash distribution to a C corporation equivalent yield. We take this step to promote comparability across all types of businesses. In some cases, the resulting C corporation equivalent yield may be negative, for example, when pass-through income tax liabilities exceed cash distributions.

Adjusting for the Tax Characteristics of the Subject Company Companies organized as C corporations pay federal and state income taxes on their earnings before returns are available to their shareholders. When C corporations pay dividends to their shareholders, the dividend income is taxable to the recipients at their respective personal dividend income tax rates. So dividend income received by shareholders of C corporations can be described as after corporate taxes but before personal taxes. C Corporations For C corporations, the calculation of expected dividend yield is straightforward. The expected dividend is divided into current value at the marketable minority level to obtain the yield. In the example shown in Exhibit 10.1, a C corporation has an expected dividend of $0.45 per share (annual basis), and a marketable minority value of $10.00 per share. The C corporation’s dividend yield is therefore 4.5%.

Dividend Yield =

Expected Dividends VEq(mm)

=

$0.45 = 4.5% $10.00

EXHIBIT 10.1 Calculation of Dividend Yield (C Corporation).

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S Corporations and Other Tax Pass-Through Entities3 Although many private companies are organized as S corporations, no public companies are. As a result, market evidence regarding publicly traded companies is derived from C corporations.4 Therefore, we recommend that distributions for S corporations and other tax pass-through entities be expressed on a C corporation equivalent basis. S corporation shareholder returns before personal taxes are then comparable to those of C corporation shareholder returns before personal taxes. Because the QMDM is an alternative returns model that compares the return potential of the subject interest to the expected returns available from the universe of alternative publicly traded and private investments, the appropriate benchmark for comparing yields is that of a C corporation equivalent dividend. The income of S corporations (and other tax pass-through entities) is attributed to the owners pro rata to their ownership 3 We apply the Integrated Theory to the valuation of S corporations in Chapter 12. Some might argue that if the interim cash distributions of pass-through entities are tax-affected, it necessarily follows that the QMDM analysis must also include consideration of the income tax status of the terminal value (or exit value). We disagree with this proposition. Interim cash distributions are restated to a fully taxable C corporation equivalent basis because the bulk of historical and current data on stock returns relates to returns (before personal taxes) on investments in C corporations, and dividends are generally fully taxable to the investor. Depending on a variety of factors, the proceeds from the sale of the stock of a C corporation or the proceeds from the liquidation of a C corporation may be less than fully taxable, or subject to an unusually high effective tax rate. Nevertheless, total return statistics are based on reported prices of securities, not on the net proceeds to individual investors. In most cases, any attempt to project special tax benefits or liabilities related to the exit value would involve speculation regarding potential buyers and sellers. In cases where special tax considerations have been identified, are readily quantifiable, and are appropriate for consideration, it may be necessary to incorporate these facts into the QMDM analysis. 4 Certain publicly traded entities, such as REITs and master limited partnerships, have unique tax attributes that more closely resemble tax passthrough entities. For the most part, however, public companies are C corporations.

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C Corp Equivalent Dividend =

Total Distribution − (Pretax Income × Income Tax RatePersonal ) (1 − Dividend Tax RatePersonal )

EXHIBIT 10.2 Calculation of C Corporation Equivalent Distributions from Tax Pass-Through Entities.

in the corporation (or other entity). Income “passes through” from S corporations to their shareholders, who then pay taxes on that income at their personal income tax rates. For purposes of this discussion, references to S corporations are also applicable to other tax pass-through entities, including partnerships, limited partnerships, and limited liability companies. Income distributed from S corporations to shareholders is sometimes characterized as being after corporate taxes (none) and before personal taxes. This characterization ignores the economic reality that S corporations virtually always distribute sufficient income to their shareholders to enable them to pay the “corporate” tax liability that flows through to them personally. Otherwise, unhappy shareholders would likely take measures to break the S election. Given the flow-through of “corporate” taxes to S corporation shareholders, there is no economic benefit to shareholders until distributions sufficient to pay the taxes are received. After that point, however, shareholder distributions are “tax-free.” As a result, S corporation distributions are not comparable to C corporation dividends, which are taxable to shareholders. As shown on Exhibit 10.2, S corporation distributions can be made equivalent to C corporation dividends by “grossing up” the after corporate/personal tax distributions by the arithmetic inverse of the personal income tax rate on dividends from C corporations. Applying the formula in Exhibit 10.3 to S corporation distributions yields a C corporation equivalent distribution. Exhibit 10.3

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Dividend Yield =

C Corp Equivalent Dividend VEq(mm)

EXHIBIT 10.3 Calculation of Dividend Yield (S Corporation).

illustrates the derivation of the C corporation equivalent dividend yield. Exhibit 10.4 illustrates the calculation of the C corporation equivalent dividend for an S corporation. ■

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As shown in Exhibit 10.4, we begin with total pre-tax earnings of the S corporation of $1.00 per share (Line 1). Pass-through taxes of $0.408 per share are estimated at the blended, marginal federal and state personal income tax rates (at Lines 2–5). The tax rates in Exhibit 10.4 are for illustration only; the valuation analyst will need to estimate the tax rates appropriate to the valuation assignment. The total distribution payout (80%) is then estimated at Line 6, to determine the expected total distribution per share (Line 7). The estimated pass-through taxes are subtracted from this total distribution, yielding the after pass-through tax S corporation dividend of $0.392 per share (Lines 8–9). The after pass-through tax distribution is then “grossed up” by dividing by (1 – Personal Tax Rate on Dividends) to obtain the C corporation equivalent dividend of $0.529 per share (Lines 10–12). Finally, the C corporation equivalent yield is divided by the valuation analyst’s estimate of marketable minority value per share to obtain the C corporation equivalent yield of 5.3% (Lines 13–15).

Note that the C corporation equivalent dividend for a tax passthrough entity is negatively related to the spread between tax rates on ordinary personal income and tax rates on corporate income tax. Since it is the personal dividend tax that is ultimately avoided

Inputs / Calculations 1 2 3 4 5

Expected Pre-Tax Earnings of Pass-Through Entity Personal Federal Ordinary Income Tax Rate Personal State Ordinary Income Tax Rate times: Blended Marginal Tax Rate Pass-Through Taxes

6 7 8 9

Expected Total Distribution Payout Percentage Expected Total Distributions less: Pass-Through Taxes on Pre-Tax Earnings = After-Tax Dividend

10 After Tax Dividend 11 Blended Tax Rate on C Corp Dividends (incl Medicare surcharge)

$1.00 37.0% 6.0% 40.8% $0.408 80.0% $0.800 ($0.408) $0.392

Per Share, appraiser's estimate Blended Federal/State Rate Federal Rate x (1 - State Rate) + State Rate Line 1 x Line 4 Appraiser's estimate of annual distribution payout Line 1 times Line 6 From Line 5 above

$0.392 74.2%

From Line 9 above Federal/State corporate marginal rate (1 - personal blended tax rate)

12 = C Corporation Equivalent Dividend

$0.529

After-Tax dividend ÷ Blended Tax Rate on Dividends

13 C Corporation Equivalent Dividend 14 divided by: Marketable Minority Interest Value

$0.529 $10.00

From Line 12 above Per Share, appraisers estimate (Exhibit x)

15 Implied Ongoing Dividend Yield - C Corporation Basis

5.30%

C Corporation Equivalent Basis, Rounded

25.8%

EXHIBIT 10.4 Calculation of C Corporation Equivalent Dividend Yield for Tax Pass-Through Entities.

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by the S corporation election, when personal tax rates on ordinary income exceed corporate tax rates, the incremental tax offsets the benefit from avoidance of personal dividend tax rates. As a result, the reduction of the corporate tax rate by the Tax Cut and Jobs Act of 2017 reduced the relative economic advantage of S corporation status. S Corporation Distribution Yields Can Be Negative Exhibit 10.5 illustrates the C corporation equivalent dividend yield calculation for an S corporation that fails to distribute any earnings to shareholders, despite the obligation to pay tax on corporate income passing through to shareholders. As a result, the S corporation shareholder must fund the required tax payment independently, resulting in a negative C corporation equivalent dividend yield.5 If expected to persist, this would have an adverse impact on the value of minority interests in the non-distributing S corporation. The QMDM enables valuation analysts to consider both the positive impact of S corporation (and pass-through) earnings as well as the negative impact in those unusual circumstances where no or inadequate distributions are made to pay taxes on corporate income passed through to shareholders. If the C corporation equivalent yield is negative, the present value of the expected cash outflows is subtracted from the present value of the terminal value at the end of the expected holding period. Conclusion Regarding Tax Equivalent Yields Valuation analysts should be very deliberate when developing the yields for S corporations and other tax pass-through entities, and must consider the prevailing tax laws affecting S corporations and C corporations in the same manner as a hypothetical investor. Hypothetical investors in tax pass-through entities with uncertain distribution policies must carefully weigh the implications of investing in nonmarketable securities, which could saddle them with a potential annual liability for taxes on corporate earnings 5

Given that the dividend yield for a C corporation cannot be negative, the analyst may choose not to “gross down” the resulting negative yield.

Inputs / Calculations 1 2 3 4 5

Expected Pre-Tax Earnings of Pass-Through Entity Personal Federal Ordinary Income Tax Rate Personal State Ordinary Income Tax Rate Blended Marginal Tax Rate Pass-Through Taxes

6 7 8 9

Expected Total Distribution Payout Percentage Expected Total Distributions - Pass-Through Taxes on Pre-Tax Earnings = After-Tax Dividend

10 After Tax Dividend 11 ÷ Blended Tax Rate on C Corp Dividends (incl Medicare surcharge)

$1.00 37.0% 6.0% 40.8% $0.408 0.0% $0.000 ($0.408) ($0.408)

Per Share, appraiser's estimate Blended Federal/State Rate Federal Rate x (1 - State Rate) + State Rate Line 1 x Line 4 Appraiser's estimate of annual distribution payout Line 1 times Line 6 From Line 5 above

($0.408) 74.2%

From Line 9 above Federal/State corporate marginal rate (1 - personal blended tax rate)

12 = C Corporation Equivalent Dividend

($0.550)

After-Tax dividend ÷ Blended Tax Rate on Dividends

13 C Corporation Equivalent Dividend 14 ÷ Marketable Minority Interest Value 15 Implied Ongoing Dividend Yield - C Corporation Basis

($0.550) $10.00 –5.50%

From Line 12 above Per Share, appraisers estimate (Exhibit x) C Corporation Equivalent Basis, Rounded

25.8%

EXHIBIT 10.5 Calculation of C Corporation Equivalent Dividend Yield for Tax Pass-Through Entities (No Distributions).

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with no accompanying distributions to pay those taxes. This has valuation implications and should be treated carefully in the context of valuing minority interests in tax pass-through entities. The risk of adverse tax consequences from investments in tax pass-through entities is virtually always greater than zero, if only through a mismatching of the timing of distributions in a manner that is inconvenient (and potentially costly) to the shareholder/taxpayer. The major point of this discussion of C corporation equivalent yields for tax pass-through entities, however, is that in using the QMDM, tax pass-through distributions should be converted to a C corporation equivalent basis for the dividend yield assumption of the QMDM. In so doing, valuation analysts will give appropriate consideration to the shareholder level tax benefits associated with the S election, and the pass-through status generally, for the duration of the expected holding period.

ASSUMPTION 2B: EXPECTED GROWTH OF DIVIDENDS (GD ) For many business entities that pay a regular dividend or distribution to their owners, there is a reasonable probability that the dividend will grow as the enterprise grows. For this reason, the QMDM requires the business valuation analyst to make a reasonable assumption about the expected growth rate of dividends. The expected growth rate of dividends actually specifies the expected interim cash flows of the shareholder level discounted cash flow models over expected holding periods. While this assumption does not often have a major impact on the calculations of the QMDM, it is necessary to fully specify the model. With respect to growth in dividends, valuation analysts make one of four potential assumptions, depending on the facts and circumstances pertaining to the subject interest: 1. Dividends will grow at the same rate as the expected growth in value (a constant dividend yield). In cases where earnings and value are expected to grow at approximately the same rate, it is

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appropriate to assume that dividends will grow at the same rate as the expected growth in value. 2. Dividends will grow at the same rate as earnings (a constant dividend payout ratio). In other cases, it may be appropriate to assume that dividend growth will mirror the expected growth of earnings of the subject enterprise. Many companies tie dividend growth to earnings growth. 3. Dividends will not grow (a constant dollar dividend). Some companies have a history of paying the same dollar or per share dividend every year. If the expectation is that this policy is unlikely to change over the expected holding period, a 0% growth assumption for dividends may be appropriate. Alternatively, if a company has paid dividends that have varied, and the valuation analyst has used some average of historical dividends as the best available estimate of future dividends, a 0% growth assumption may be appropriate. 4. Dividends will grow at some other rate. Other special circumstances may dictate the appropriate dividend growth assumption. For example, if a company is on the verge of paying off a significant debt and its cash flow will be freed to pay increased dividends, it may be appropriate to estimate a blended future growth rate for dividends. In the alternative, financing arrangements may suggest that dividends will grow at a slower rate than either earnings or value. As noted, the assumption regarding expected growth in dividends does not often have a major impact on QMDM marketability discount estimates. However, the analyst should make a specific estimate to develop a comprehensive shareholder level discounted cash flow model.

ASSUMPTION 2C: TIMING OF DIVIDEND RECEIPT As with any discounted cash flow model, the valuation analyst must also make a decision regarding the timing of receipt of interim cash flows in the QMDM. Valuation analysts familiar with the enterprise

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level discounted cash flow model understand the importance of this assumption. Dividends can be modeled for receipt at the end of each year, or at the middle of each year (simulating payments received throughout the year). Given the importance of dividends to the value of nonmarketable minority interests in high-yield entities, valuation analysts should be clear about this assumption and the reasons for the choice between end-of-year and mid-year receipt. Depending on the magnitude of the dividend yield, the timing assumption can noticeably affect the concluded marketability discount.

ASSUMPTION 3A: THE EXPECTED GROWTH RATE IN VALUE (GV ) The third assumption of the QMDM is the expected growth in value, or Gv . The expected growth in value defines the terminal value (TV) in the shareholder level discounted cash flow model. Prior to the application of the QMDM, the valuation analyst must develop an indication of value at the marketable minority level of value (Vmm ) consistent with the expected earnings, cash flows, and risk of the enterprise. Exhibit 10.6 summarizes the calculation of the terminal value. As discussed further below, the QMDM assumes that liquidity following the expected holding period is achieved at the marketable minority level of value although the model allows the valuation analyst to change this assumption if warranted.

Factors Influencing the Expected Growth Rate in Value Several reference points can assist valuation analysts in estimating the expected growth in value. In most appraisals using the income Terminal Value = VEq(mm) × (1 + Gv )HP

EXHIBIT 10.6 Calculation of Terminal Value.

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approach, valuation analysts develop specific estimates of earnings or cash flow growth. If the discounted future benefits method is used, specific growth assumptions are made for a finite forecast period. If the Gordon Model is used to estimate the terminal value, an assumption is made regarding the expected long-term growth beyond the finite forecast period. Public company investor returns consist of two components: current income (or dividend yield) and capital appreciation (or growth in value). For public companies, the expected growth in value is therefore equal to the excess of the required return over the expected dividend yield. For private companies, potential agency costs can disturb this relationship. We assign these agency costs to two categories, both of which increase the marketability discount applicable to the subject minority interest. ■

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Non–pro rata distribution of firmwide equity cash flows. Owner/managers of private companies occasionally divert a portion of the normalized firmwide equity cash flows to themselves on a non–pro rata basis through above-market compensation and perquisites or certain transactions with related parties. Such non–pro rata distributions of normalized firmwide equity cash flows reduce interim shareholder cash flows, thereby increasing the appropriate marketability discount. Suboptimal reinvestment of enterprise cash flows. The firmwide valuation methods assume that cash flows are either distributed pro rata to the shareholders or reinvested at the discount rate. When this condition is not met, management is engaging in suboptimal reinvestment. Managers of some private companies demonstrate a persistent inability or unwillingness to reinvest undistributed earnings at the required rate of return. This can be a result of undue risk aversion (accumulation of low-yielding excess assets) or empire building (chronic overpayment for acquisitions or new projects). Whatever the source, suboptimal reinvestment diminishes the prospective terminal value of the shareholder level discounted cash flow model, thereby increasing the appropriate marketability discount.

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Note that the burden of expected suboptimal reinvestment is borne by all shareholders, whether owning a control or minority interest. From a controlling shareholder’s viewpoint, the enterprise value is based on the normalized cash flows and efficient reinvestment of undistributed earnings, because the business could be sold for that value. However, the value of the business plan is reduced by the effect of the anticipated suboptimal reinvestment. The difference between the controlling shareholder and the minority shareholder of a private company is that the former has the power to eliminate the potential decrement in value by a change in reinvestment policy or through distributions. The latter does not, and the valuation analyst must consider this impact in determining the marketability discount applicable to illiquid minority interests.

Developing Gv Estimating the terminal value is a critical step in applying the shareholder level discounted cash flow model. With the QMDM, the expected growth in value establishes the projected terminal value. Valuation analysts encounter a number of potential situations in which different assumptions regarding the expected growth in value are appropriate. We discuss several such situations here, together with suggestions with respect to estimating Gv . ■

Dividend policies affect Gv. Some closely held companies pay out all or a substantial portion of earnings to their shareholders. All else equal, expected growth in value is inversely related to the level of expected dividends. Retained earnings, when reinvested in attractive capital projects, contribute to higher levels of growth in value. Since dividend yield and capital appreciation are the only two sources of return for shareholders, Gv is conceptually equal to the difference between the required return on equity and the expected dividend yield. In practice, however, this conceptual relationship can be disrupted in two different situations. ■ If normalizing adjustments have been made to reflect non– pro rata distributions to select shareholders or managers

382

■

BUSINESS VALUATION

(excess compensation would be a common example), the expected non–pro rata distributions reduce expected growth in value as if they were a component of dividend yield. The lower growth in value triggered by non–pro rata distributions results in higher marketability discounts, all else equal. While non–pro rata distributions do not influence the value of the business itself, they do negatively influence the value of a nonmarketable minority interest. ■ Some companies have a long history of reinvesting earnings in corporate assets that generate returns below the weighted average cost of capital or hurdle rate for the business. For some companies, this includes the acquisition of assets that do not pertain to operations (vacation properties and the like) while, for others, it may be the result of accumulating large cash balances or securities portfolios. In either case, the effect on the expected growth in value is not as pronounced, since the reinvested assets don’t actually leave the business, but the drag on future returns does reduce the expected growth in value. In these cases, historical or projected growth in reported shareholders’ equity can provide the valuation analyst with some guidance as to the magnitude of the downward adjustment required to Gv . In the end, a healthy dose of professional judgment is always required when assessing the effect of dividend yield on expected growth in value. As with other assumptions, the valuation analyst should strive to approximate the assumptions a market participant would make rather than seeking to achieve artificial precision. Underlying asset appraisals provide evidence of Gv. For an asset-holding entity, the expected growth rate in value may be implied by the underlying asset appraisals. Many times, discussion with the appraiser of the underlying asset (or reading available appraisal reports) will prove fruitful in developing a reasonable expectation for the growth in value of an asset holding entity.

The QMDM Assumptions in Detail ■

■

383

Changing leverage can affect Gv . For financially leveraged companies, equity can grow more rapidly than assets as debt is repaid. For an asset holding entity, for example, the real estate valuation analyst may have estimated that a particular property should grow in value at 5% to 6%. However, if the property is leveraged in a limited partnership, and the mortgage on the property is amortizing on the basis of a 15-year schedule, the pro rata value of a partnership interest will be expected to increase more rapidly than that of the underlying real estate as debt is repaid. The expected growth in value over a range of potential holding periods can be estimated by making discrete calculations of expected asset growth and debt amortization. Portfolio composition can affect Gv . The portfolio composition of asset holding entities can provide evidence as to the expected growth in value. Consider a limited partnership holding $100 million of shares in large capitalization public companies. A diversified portfolio of such stocks might have an expected total return on the order of 8%, with the expected growth in value dependent upon the dividend payout policy of the partnership. Alternatively, a portfolio of fixed income securities may not be expected to grow in value if all earnings are paid out; if interest income is retained, growth in value will be positive, but slower than for a corresponding equity portfolio. The expected growth rate in value for an entity holding multiple asset classes will be a value-weighted average expectation for the various classes. This observation suggests that the expected management philosophy of an entity can influence the expected growth in value. Valuation analysts should ask appropriate questions to develop reasonable expectations of management intent. Whether expressly stated or not, asset holding entities are managed with an investment policy (i.e., business plan), and valuation analysts do well to discuss the anticipated investment policy with the managers of the entity.

384

BUSINESS VALUATION

Sensitivity and Gv As with any discounted cash flow model, the value indicated by the QMDM is sensitive to the projected terminal value. To illustrate that sensitivity, Exhibit 10.7 compares the resulting marketability discount over various levels of expected growth in value and expected holding periods at a constant required holding period return of 20% for interests paying no dividends. Exhibit 10.7 presents the marketability discounts calculated under the indicated assumptions. While the change in discount from one assumption to the next may appear large, changes in expected growth in value from 4% to 8% or from 12% to 15% and so forth are not trivial. Likewise, the illustrated changes in the expected holding period are also not trivial. So while the model is “sensitive” to changes, it should be clear that significant changes in the expected growth rate of value will create significant changes in value. Further, significant changes in the expected holding period also create significant changes in value. Valuation analysts and many users of appraisal reports are wellaware of the sensitivity of value indications based on the enterprise level discounted cash flow method to changes in key assumptions such as revenue growth, projected margins, the discount rate, the capital structure assumption, and the expected growth in cash flow

Expected Holding Period (HP) in Years 3 Gv

5

7

10

15

Calculated Marketability Discounts (No Dividends)

4%

35%

51%

63%

76%

88%

8%

27%

41%

52%

65%

79%

10%

23%

35%

46%

58%

73%

12%

19%

29%

38%

50%

64%

15%

12%

19%

26%

35%

47%

Required Holding Period Return (Rhp) = 20% Note: Dividend yield equals 0% in all scenarios

EXHIBIT 10.7 Sensitivity of Marketability Discounts to Gv and HP.

The QMDM Assumptions in Detail

385

for the terminal value estimate. Sensitivity to assumptions in valuation is simply a fact of life. What is important is to make reasonable assumptions given the pertinent facts and circumstances. Because the QMDM is a shareholder level discounted cash flow model, sensitivity to significant changes in assumptions is no surprise. In the final analysis, the valuation analyst must make the same kind of judgments that willing buyers (whether hypothetical or real) make about the expected growth rate in value, based on a full understanding of the facts and circumstances of the subject investment.

ASSUMPTION 3B: ADJUSTMENTS TO THE TERMINAL VALUE The expected growth in value establishes the terminal value at the marketable minority level of value. A related assumption specifies any premium or discount for the terminal value estimate relative to the marketable minority base. Sometimes, the facts of a particular valuation suggest that marketability may be achieved at the end of the expected holding period at a different level of value. For example, the enterprise may be sold to a strategic buyer. Alternatively, a minority interest discount may be relieved if a partnership is expected to liquidate within the relevant expected holding period. In such cases, the valuation analyst may conclude that a premium would be expected. Finally, the facts could indicate that a discount to marketable minority value is expected when marketability is achieved. This could occur, for example, through the operation of a buy-sell agreement. In the absence of a contrary assumption, the QMDM specifies the terminal value at the marketable minority level of value.

ASSUMPTION 4: REQUIRED HOLDING PERIOD RETURN (Rhp ) After estimating the interim shareholder cash flows and terminal value at the end of the holding period, applying the discounted cash flow model requires the valuation analyst to specify a discount rate.

386

BUSINESS VALUATION

With respect to the QMDM, we refer to this discount rate as the required holding period return, or Rhp . Minority shareholders in private companies bear additional, unique risks associated with the illiquidity (or lack of marketability) of such investments in addition to the underlying risks of the company as a whole.6 The appropriate discount rate for the QMDM is therefore the sum of the required return on equity for the company as a whole, Rmm , and the holding period premium (HPP) to compensate for the unique risks of illiquidity. Rhp = Rmm + HPP In the following sections, we review the market evidence available to support not only the existence, but also the potential magnitude, of the holding period premium. Before examining the available market evidence, we briefly consider a few conceptual questions: ■

■

■

Can market participants assess risks if they have the facts? Yes. After all, the parties to any transaction face a given set of unique facts and circumstances that affect the transaction price. Do transactions occur in which nonmarketable minority interests actually change hands at arm’s length? Yes. The following discussion of available market evidence is derived from such transactions. In the context of financial, valuation, and economic theory, can business valuation analysts simulate the thinking of real-life sellers and buyers of minority interests in private companies? Yes. That is the essence of what valuation analysts do, regardless of the nature of the subject asset.

6 Some valuation analysts distinguish between liquidity and marketability. We find such efforts to be unpersuasive, and ultimately unnecessary. When comparing a minority interest in a private company to an otherwise identical minority interest in a public company, liquidity and marketability are the same concept. The comparison is the same for a minority interest in a private company and that same interest on a marketable minority interest (as-if-freely-traded) basis. See Appendix 9.A, “Liquidity and Marketability”.

The QMDM Assumptions in Detail

387

We have already described the cash flow attributes of investments in nonmarketable minority interests in private companies. We now turn our attention to the market evidence regarding the return expectations of investors in such interests.

Market Evidence Regarding Holding Period Premiums Restricted Stock Discounts The first potential source of market evidence regarding holding period premiums is data regarding transactions involving the restricted shares of publicly traded companies. We discussed the restricted stock studies at length in Chapter 8. Publicly Traded Partnership Returns Partnership Profiles, Inc. (PPI) of Dallas, Texas, publishes an annual study focusing on rates of return expected by secondary market buyers of limited partner interests.7 The information conveyed in the most recent survey is based on data for publicly traded limited partnerships from 1994 to 2018. The assumptions related to the survey’s derivation of expected rates of return include the following: ■

■

■

■

Expected future distributions are based on historical levels and are projected to increase 2.5% per year until the forecasted liquidation of the partnership; Debt amortization for leveraged partnerships was forecast through the expected liquidation date, upon which all residual debt is projected to be paid; The underlying value of the partnerships’ assets is projected to increase at an average annual rate of 2.5%; and, The liquidation horizon forecast by PPI is based on investor expectations as of the April/May time frame of each year. Many partnerships publicly announced their intent to liquidate beginning in 1995. Expected liquidation horizons have narrowed from 1994 (10 years) through recent years (approximately 4 years).

7 2019 Rate of Return Study: Publicly-Held Real Estate Limited Partnerships and Real Estate Investment Trusts. Published by Partnership Profiles, http://www.partnershipprofiles.com.

388

BUSINESS VALUATION

These assumptions are in fact the same assumptions used in the QMDM. With the QMDM, the valuation analyst makes assumptions about risk, expected cash flows, the expected holding period, and growth in value to solve for price, thereby determining the marketability discount. The Partnership Profiles study observes price in the market for limited partnership interests and uses assumptions about expected cash flows, growth in value, and the expected holding period to solve for the implied required return. Based on these assumptions, Partnership Profiles calculates expected rates of return for nonliquidating partnerships. The population is divided into two groups: those that make distributions and those that do not. Median annual expected returns for the distributing group are generally on the order of 17% to 21%, while those for the non-distributing group often approached 25% (albeit with a wider range of individual observations). This suggests that, from an investor perspective, regular distributions mitigate the risk of holding an illiquid investment. The Partnership Profiles data also confirms the positive relationship between financial leverage and expected return, with the more highly leveraged partnerships having expected returns significantly higher than those of their less leveraged peers. In summary, the data presented in the PPI study provides valuable market evidence to help support the overall reasonableness of a valuation analyst’s estimate of the range of expected required holding period returns applied in the QMDM. Venture Capital Returns Venture capital funds pool capital from limited partners to invest in early-stage enterprises at various stages of development. Funds often have 10-year lives, and fund investments tend to have expected holding periods on the order of 3 to 7 years. While there is a modest secondary market for limited partner interests in VC funds, partners’ capital commitments are essentially illiquid. As a result, observed returns from VC funds can provide market evidence regarding the return premium expected by investors in assets having only limited marketability.

389

The QMDM Assumptions in Detail 30% 25% 20% 15% 10% 5% 0% –5%

Difference

TRVCI

ec 19 D

ec 18 D

ec 16

ec 17 D

D

ec 14

ec 15 D

D

ec 13 D

ec 11

ec 12 D

D

ec 09

ec 08

ec 10 D

D

D

ec 06

ec 07 D

D

D

ec 05

–10%

NASDAQ

EXHIBIT 10.8 Trailing 10-year Annualized Returns. The Thomson Reuters Venture Capital Index (TRVCI) is designed to measure the value of the US-based venture capital private company universe in which venture capital funds invest. The index seeks to replicate the risk/return profile of individual US venture capital-backed private companies. Exhibit 10.8 compares the trailing 10-year returns for the TRVCI and the NASDAQ composite index. While the returns for both series are broadly correlated, the TRVCI has generated a premium return over all periods analyzed. In the wake of the Great Recession, the observed return premium has been on the order of 5% to 8%. It is possible that some portion of the return premium is attributable to greater investment risk, yet the data does confirm that investors in nonmarketable assets expect a premium return. Private Equity Returns Private equity funds have many similarities with venture capital funds, but invest in more established companies, often using financial leverage as a tool to provide incremental returns to limited partners.

390

BUSINESS VALUATION

Cambridge Associates publishes research on US private equity returns. In addition to the US Private Equity Index, which reports net-of-fee returns to limited partners from a universe of 1,486 US private equity funds, Cambridge calculates Modified Public Market Equivalent (mPME) returns for various public stock market indexes. The mPME series are described by Cambridge as follows:8 The mPME calculation is a private-to-public comparison that seeks to replicate private investment performance under public market conditions. The public index’s shares are purchased and sold according to the private fund cash flow schedule, with distributions calculated in the same proportion as the private fund, and the mPME NAV (the value of the shares held by the public equivalent) is a function of mPME cash flows and public index returns. The mPME attempts to evaluate what return would have been earned had the dollars been deployed in the public markets instead of in private investments while avoiding the “negative NAV” issue inherent in some PME methodologies. “Value-Add” shows (in basis points) the difference between the actual private investment return and the mPME calculated return.

As summarized in the Exhibit 10.9, the Value-Add relative to the S&P 500 has been on the order of 5% for the longest available investment horizons. 1-year

3-year

5-year

10-year

15-year

20-year

25-year

US Private Equity Index

10.7%

14.1%

11.8%

14.3%

13.4%

12.0%

13.2%

S&P500 mPME Return

–4.3%

9.5%

8.7%

13.9%

8.4%

7.1%

8.3%

Value-Add (Premium)

15.0%

4.5%

3.1%

0.5%

4.9%

4.9%

4.9%

Source: “US Private Equity: Index and Selected Benchmark Statistics,” published by Cambridge Associates, data through December 31, 2018, page 7.

EXHIBIT 10.9 Private Equity Return Premiums Over Different Holding Periods. 8

“US Private Equity: Index and Selected Benchmark Statistics,” published by Cambridge Associates. Data through December 31, 2018. Description of performance measurement methodology, p. 24.

The QMDM Assumptions in Detail

391

As with the venture capital return data discussed above, it is possible that the observed return premiums reflect factors in addition to the relative lack of marketability (such as greater use of financial leverage); nonetheless, the data does confirm that returns have historically been higher for investments with limited marketability.

Estimating the Required Holding Period Premium In this section, we review several of the specific shareholder level risks that contribute to the estimated holding period premium. Most of the risk factors are discussed in the various restricted stock studies. The specific shareholder level risks include: ■

9

Uncertainty of holding period. Investors demand additional compensation for bearing the risk of a long and indeterminate holding period. To the extent that the holding period can be fixed, or its uncertainty reduced, there is some mitigation of risk. Long expected holding periods without marketability leave investors exposed to adverse changes in either the subject company or their own circumstances. Rational investors desire a premium return relative to alternative investments that are readily marketable.9

In a 2001 paper, “Firm Value and Marketability Discounts,” Journal of Corporation Law 27 (1, Fall 2001): 89–115, Mukesh Bajaj (and his co-authors David J. Dennis, Stephen P. Ferris, and Atulya Sarin) suggest that there may be a “clientele effect” at work that minimizes the impact of the expected holding period on value. “Because buyers of the restricted shares tend to be institutional investors that do not value liquidity highly (e.g., life insurance companies and pension funds), it seems unlikely that such investors would require substantial marketability discounts for the commitments not to resell quickly.” The discussion in the Bajaj article was actually referencing another article. See Michael Hertzel and Richard L. Smith, “Market Discounts and Shareholder Gains for Placing Equity Privately” Journal of Finance 48 (1993): 459–469. In both of these papers, regression analyses were performed in an attempt to isolate the impact of registration among other factors (13.2% in the case of Hertzel & Smith and 7.2% in the case of Bajaj et al.). Readers should be aware that the average total restricted

392 ■

BUSINESS VALUATION

Likelihood of interim cash flows. The dividend yield can be a powerful influence on the size of the appropriate marketability discount. Although some companies have long track records of regular and predictable dividends, others do not. The absence of expected interim cash flows increases risk, and therefore the total return expected by the hypothetical willing investor. In other words, the total return is deferred until a liquidity event that will occur at an indeterminate time in the future. As a result, we believe it is appropriate to add an increment of required return if there are limited or no prospects for regular dividends from an investment. This insight is generally corroborated by the Partnership Profiles data discussed previously, which indicates that expected returns are higher for non-distributing partnerships than distributing partnerships. Two additional comments are necessary here: 1. There is commonly some incremental uncertainty regarding interim cash flows with tax pass-through entities (such as S corporations, limited partnerships, and limited liability corporations). The possibility that there are taxable earnings at the business level and cash distributions insufficient to enable the holders to fully cover their personal tax liabilities is real. Agreements requiring tax liability distributions can, of course, minimize the risks associated with mismatches between personal liability for entity taxes and actual distributions. 2. The valuation analyst should consider the actual historical record of shareholder dividends as well as the outlook for future dividends in assessing these risks, while acknowledging that minority shareholders do not have the authority to set dividend policy.

stock discounts in the studies were 20.1% and 22.2%, respectively. The articles suggested numerous factors to account for differences between the “liquidity” portion and the total observed discounts, including information costs, monitoring costs, and financial distress (i.e., creating additional risk over a period of illiquidity). These are precisely the kinds of risk factors captured with the QMDM when estimating the appropriate total marketability discounts from freely traded valuation indications.

The QMDM Assumptions in Detail ■

■

■

10

393

Prospects for marketability. Is the subject company a likely IPO candidate?10 Is it likely to be attractive as an acquisition candidate? And what industry trends could encourage a sale of the entire business? Does management have any plans to sell the company? Considering the history of the business, what is the likelihood it will be sold? If the prospects for marketability are limited, it may be necessary to apply an incremental risk premium to the required holding period return. Uncertainty regarding a favorable exit. If and when the subject interest becomes marketable, what is the likelihood of being “squeezed” out at a discounted value? If the past practices of the company suggest that minority shareholders have been disadvantaged, there is a greater likelihood that such behavior will occur in the future. It is important to consider the actual history of transactions at the minority level in assessing the probability of an unfavorable exit. Further, minority shareholders are seldom in a position to assure that optimal pricing is obtained when the company as a whole is sold. Restrictive agreements. Many private companies have shareholder agreements or charter provisions that restrict the transfer of their shares. This is an important source of risk for hypothetical and real buyers of those interests. Many restrictive agreements, even the fairly common “right of first refusal” clauses, which normally provide an option for shareholders or a company to acquire shares at an offered price before they are free for transfer, can have a chilling effect on the prospects for marketability. Why? Simply put, it takes a lot of work and analysis to understand a private company. The due diligence undertaken by sophisticated investors is time-consuming and costly. Why go to the effort to evaluate an investment when, if the proposed price is attractive to you, the shares will likely be acquired by insiders? If the price is not going to be attractive, one would not buy it

In recent years, the annual number of IPOs has fluctuated between 100 and 200 companies, suggesting that the number of private companies that are legitimate IPO candidates is small.

394

■

BUSINESS VALUATION

anyway. Such restrictions can have an impact on the required holding period return. Information and monitoring costs. As noted in the discussion of restrictive agreements, there are very real costs involved in preparing to invest in private businesses. In many cases, there is no future opportunity to recoup either the real costs of investigation for the investment or the expected ongoing costs of monitoring the investment. As result, investors require an element of premium return that is manifest in a larger discount to the enterprise value.

This list is not exhaustive. If other facts and circumstances indicate any other specific shareholder level risks, they should be considered by valuation analysts when developing the required holding period return.

The Framework for Estimating the Required Holding Period Returns The challenge facing valuation analysts using a shareholder level discounted cash flow model is translating the identified shareholder risks into a range of holding period premiums. In our experience, there are no simple shortcuts. ■

■

Valuation analyst experience and judgment. Experience in seeing a variety of valuation facts and circumstances and in seeing how conclusions of value relate to each other can be very helpful. However, the phrase “in my professional judgment” lacks significance unless it can be supported based on facts and circumstances and external evidence. Practice does not make perfect if the practice techniques are flawed. Comparisons with returns implied by the various restricted stock studies. While the average discounts in any restricted stock study are irrelevant for purposes of assessing marketability discounts (because of lack of comparability of businesses, time, expected holding periods, and other factors), we discussed how the implied required returns and expected holding periods

The QMDM Assumptions in Detail

■

■

■

395

can be inferred from the average discounts in the studies in Chapter 8. Comparisons with other market evidence. Current and historical market return data are available from Partnership Profiles for transactions in publicly traded real estate limited partnerships. In addition, as we described earlier in this chapter, market evidence is available regarding venture capital and private equity funds. The expected returns from these sources provide another reference point to test the validity of assumed shareholder-specific risk premiums and, therefore, required holding period returns. Common sense. Valuation analysts must employ basic common sense in the judgments that they make. For example, common sense will dictate that two investments, one growing in value at 6% with no dividends, and the other growing in value at 6% and with a 6% annual dividend yield, should have materially different marketability discounts over similar expected holding periods. Reasonableness. Common sense and reasonableness often go hand in hand. Revenue Ruling 59-60 admonishes valuation analysts to employ the “critical three” factors of common sense, informed judgment, and reasonableness. When marketability discounts are developed using the QMDM, the reasonableness of the concluded value can be assessed by calculating implied dividend yields, by calculating implied returns over a range of holding periods, or by making other relevant comparisons.

Ultimately, holding period premiums are analogous to the company-specific risk premiums used to derive enterprise discount rates. Most valuation analysts are comfortable estimating such company-specific risk premiums, despite the absence of direct market evidence for the magnitude of the premium in any particular valuation. Nevertheless, valuation analysts make reasonable assumptions in the context of their experience, judgment, common sense, reasonableness, and comparisons with alternative returns available in the marketplace.

396

BUSINESS VALUATION

Methodology for Developing the Required Holding Period Return Exhibit 10.10 lists more than 20 potential risk factors. The list can serve as a beginning checklist for valuation analysts as they consider the specific facts and circumstances of valuation situations. The beginning point for the development of the required holding period return is the expected return on equity from the WACC build-up on a marketable minority interest basis. An equity discount rate of 16.0% is developed on Exhibit 10.10 (Lines 1–8). To this base enterprise discount rate we add increments of risk (holding period premiums) based on specific risks associated with the subject nonmarketable minority investment. Exhibit 10.10 provides an example of the required holding period return build-up for the QMDM. In the example, five specific factors have been considered (Lines 9–13). These include uncertainties related to a holding period of unknown length, information and expected monitoring costs, the fact that the large (dollar) size of the investment limits the available buyers, and a premium because the right of first refusal applicable to the shares has a dampening impact on their marketability. In an appraisal report, the rows showing the factors not selected would likely not be displayed. Note that we have developed a range of holding period returns based upon the specific risk factors noted in Exhibit 10.10. This is intentional, reflecting the uncertainties facing our hypothetical buyer attributable to the lack of marketability for the subject interest. Note further that specific risk factors were selected for each of the five shareholder risks. There are no studies to provide guidance or market evidence for the shareholder-specific risk factors, so valuation analysts must estimate them exercising common sense informed, judgment, and reasonableness. We have previously considered the magnitude of returns suggested by the restricted stock studies, which is also helpful. But it is important to reiterate that these judgments are analogous to those made by valuation analysts every day in the development of discount rates.

397

The QMDM Assumptions in Detail

1 2 3 4 5 6 7 8

Components of the Required Holding Period Return Long-Term Government Bond Yield-to-Maturity Ibbotson Common Stock Premium times: Market Beta equals: Beta Adjusted Common Stock Premium plus: Small Cap Stock Premium plus: Specific Company Risk equals: Total Equity Premium Base Holding Period Required Return

Estimated Range Lower Higher 3.00% 3.00% 6.00% 1.00 6.00% 5.00% 2.00% 13.00% 16.00%

13.00% 16.00%

1.00% 1.00% 1.00% 0.50% 0.50% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 4.00%

2.00% 1.00% 1.00% 1.00% 1.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 6.00%

9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28

Investor-Specific Risk Premium(s) for This Investment: plus: Uncertainties of Expected Holding Period plus: Information Acquisition Cost Premium plus: Premium for Expected Holding Period Monitoring Costs plus: Adjustment for Large Size of the Interest plus: Rights of First Refusal Limiting Transferability (ROFR) plus: Uncertainties due to Potential for Unfavorable Exit plus: Potential for Adverse Cash Flow plus: More Onerous Restrictions on Transfer plus: Lack of Diversification of Assets plus: Unattractive Asset Mix plus: Uncertainties Due to Risks of Future Investment Strategies plus: Unlikely Candidate for Merger/Sale/Acquisition/IPO less: Likely Candidate for Merger/Sale/Acquisition plus: Uncertainties Related to Buy-Sell Agreement plus: Restrictions on Use as Loan Collateral plus: Small Shareholder Base plus: Lack of Expected Interim Cash Flows plus: General Illiquidity of the Investment plus: Other Total Investor-Specific Risk Premium for This Entity

29

Estimated Range of Required Holding Period Returns

20.00%

22.00%

30

Rounded Range

20.00%

22.00%

31

Mid-Point of Estimated Required Holding Period Return Range

EXHIBIT 10.10 Derivation of Required Holding Period Return.

21.0%

398

BUSINESS VALUATION

Exhibit 10.10 anticipates an example used in Chapter 11. The example corporation is a C corporation and the subject interest is a 20% minority interest. The company has been valued at $10 million. The investor-specific risk factors used in the example include the following: ■

■

■

■

■

Uncertainties of the expected holding period. This is a general risk factor that takes into account that the expected holding period is of uncertain length. Information acquisition cost premium. It takes a lot of work to develop an understanding of a closely held business and the facts and circumstances surrounding an investment in it. With nonmarketable investments there is normally no other source of recovery of information costs than through an increase in the required return. The valuation process illustrates the costs of obtaining adequate information about a private business for purposes of making an informed investment decision. Expected holding period monitoring costs. A related cost to that of information access is the cost of monitoring the investment on an ongoing basis. Again, the only opportunity to recover costs is through an increase in the required return. Large size of the interest. Fair market value presumes agreement between a willing buyer and a willing seller. It is necessary for the valuation analyst to consider the relevant pool of buyers and sellers in this context. This subject interest has a marketable minority value of $2.0 million (20% interest times $10 million enterprise value), which means that, after the application of a marketability discount, it is likely to have a value in excess of $1.0 million. This likely limits the available pool of buyers to individuals or institutions who can commit such amounts of their portfolio to nonmarketable investments for potentially long holding periods. Right of first refusal limits transferability. The subject company has a right of first refusal, which further limits the marketability of the subject interest. This component of return provides compensation for this fact.

The QMDM Assumptions in Detail

399

Note that specific judgments are reflected in the estimation of investor-specific risk premiums. In this example, we have developed a range of holding period premiums of 4.0% to 6.0%, yielding a range of required holding period returns of 20% to 22%, with a midpoint of 21%. Recall the formula discussed earlier: Rhp = Rmm + HPP. So where did the components of 4.0% to 6.0% come from? They are developed in the context of the facts and circumstances of the subject valuation and in the context of alternative rates of return that we have been discussing in this chapter. We discuss the role of professional judgment when evaluating enterprise discount rates in Chapter 5. The role of judgment is likewise inescapable when we turn our attention to the holding period premium. We reiterate our conviction that reasonable accuracy is possible for valuation analysts in such situations, even when absolute precision is not. In short, it is inconsistent to accept valuation analyst judgments in enterprise discount rate development but to judge them suspect in the context of shareholder-level discount rate development.

CONCLUSION The QMDM is a standardized shareholder level discounted cash flow model applicable to the valuation of minority interests in private companies.11 The required assumptions for using the model correspond to those required to develop an enterprise level discounted cash flow model. Moreover, the sensitivity of the conclusion of value developed using the QMDM is subject to the same sensitivities as the enterprise level discounted cash flow model. Exhibit 10.11 outlines the sensitivity of the QMDM to changes in the various assumptions. Note that the sensitivities are discussed relative to the nonmarketable minority interest value, not the marketability discount.

11

The QMDM model, as discussed in this book, is available in Excel format at www.mercercapital.com or www.chrismercer.net.

400

BUSINESS VALUATION

Shareholder Level DCF (QMDM) Inputs

Sensitivity

1 - Range of Expected Holding Periods

Longer holding periods without marketability lead to lower nonmarketable minority values

2a - Expected Dividend Yield

The value of the subject interest is positively related to the expected level of interim cash flows

2b - Expected Growth in Dividends

The value of the subject interest is positively related to the expected growth in interim cash flows

2c - Timing of Dividend Receipt

The value of the subject interest is higher under the mid-year convention

3a - Growth in Value over Holding Period

Higher growth in value leads to higher terminal values and a higher present value for the subject interest

3b - Premium/Discount upon Exit

Premiums increase the value of the subject interest; discounts decrease the value

4 - Range of Required Holding Period Returns

The value of the subject interest is inversely related to the discount rate

EXHIBIT 10.11 Sensitivity to QMDM Inputs. We recommend that users of the QMDM experiment with different combinations of assumptions to develop greater insight into the sensitivity of the concluded value of the subject interest.

CHAPTER

11

Applying the QMDM

INTRODUCTION The assumptions of the shareholder level discounted cash flow model are applicable to all valuation scenarios. Making the assumptions for a particular valuation forces the valuation analyst to address the underlying economic factors giving rise to the marketability discount. Differences of opinion are likely to exist with respect to the estimation of one or more of the parameters, but the QMDM framework pushes the parties to analyze the specific facts and circumstances of the subject interest and carefully support their assumptions. This chapter consists of three sections. The first is a comprehensive example of applying the QMDM to the valuation of a subject nonmarketable minority interest. The second section provides five condensed examples of the QMDM applied to nonmarketable minority shareholder interests with markedly different economic characteristics. The third section discusses the QMDM in the context of the Uniform Standards of Professional Appraisal Practice.

COMPREHENSIVE EXAMPLE OF THE QMDM IN USE In this section, we walk through using the QMDM to estimate the marketability discount for a hypothetical nonmarketable minority

401 Business Valuation, First Edition. Z. Christopher Mercer and Travis W. Harms. © 2021 Z. Christopher Mercer and Travis W. Harms. Published 2021 by John Wiley & Sons, Inc.

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interest. First, recall the seven inputs to the shareholder level discounted cash flow model, as shown in Exhibit 11.1. With these general inputs in mind, we can review an example appraisal situation and develop appropriate assumptions for the QMDM based on the specific facts and circumstances related to the subject company and to the particular subject interest. Assume the following background: ■

■

■

■

The valuation analyst has just completed an appraisal of a C corporation operating company at $10.0 million, or $1.00 per share, at the marketable minority level of value. The company expects net earnings of $1.0 million for the next year. It was valued based on an equity discount rate of 16% and expected growth in earnings of 6% ($1.0 million/(16% − 10%) = $10.0 million). Assume for purposes of this discussion that the valuation conclusion is reasonable. The company makes quarterly distribution to its shareholders equal to 40% of annual net earnings (Assumption 2a). This policy was established years ago and is expected to continue. The policy equates to a dividend yield of 4% ($0.04 dividend per share divided by $1.00 marketable minority value per share). Dividends are expected to grow with earnings at about 6% per year (Assumption 2b). The company has historically not been aggressive with its reinvestment for growth and has accumulated excess assets (which

Enterprise Level DCF Assumptions 1.

Forecast Period

2.

Projected Interim Cash Flows (during forecast period)

3.

4.

Projected Terminal Value (at end of the forecast period)

Discount Rate

Shareholder Level DCF (QMDM) Assumptions 1.

Range of Expected Holding Periods

2a.

Expected Distribution / Dividend Yield

2b. 2c.

Expected Growth in Distributions / Dividends Timing (Mid-Year or End of Year)

3a.

Growth in Value over Holding Period

3b.

Premium or Discount to Projected Enterprise Value

4.

Range of Required Holding Period Returns

EXHIBIT 11.1 Summary of QMDM Assumptions.

Applying the QMDM

■

■

403

were paid out in a special dividend in the year of the appraisal). No special dividends are anticipated for a number of years. Given the expectation that the company will be accumulating excess assets, the expected growth in value (Assumption 3a) has been estimated to be 10% (greater than the 6% expected growth in earnings but less than the 16% discount rate adjusted for the 4% dividend yield). The company provides annual financial statements to its minority shareholders, but that is the extent of financial disclosure. The audited financial statements are provided in April of each year following the company’s December 31 yearend. No explanations of results are provided, and there is no discussion of the outlook for the future. The interest being valued represents 20% of the ownership of the company. The pro rata share of total equity value is $2.0 million, so this is a large block of stock that may be difficult to market (Assumption 4). It is the company’s largest minority block of stock. The controlling shareholder owns 67% of the stock, and there are some forty other shareholders. There is a right of first refusal that provides opportunities for both the company and the other shareholders to purchase the block at the same price available from a bona fide offer from outside the shareholder base. These rights tie up the shares for a period of 120 days while the company and the other shareholders review their options (Assumption 4, impacting the required holding period return). The company is in a consolidating industry and it could be sold easily. The controlling shareholder is 55 years old and he has indicated that he will retire (and sell the company) by the time he is 65 or so. However, those who know him find it difficult to believe that he could ever let go of the company while he is still alive (Assumption 1).

The Specific QMDM Assumptions for the Example Based on these assumed facts and circumstances, we will develop a valuation at the nonmarketable minority level of value using the

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BUSINESS VALUATION

QMDM. The specific assumptions of the QMDM for this example are summarized in Exhibit 11.2. ■

■

■

■

■

Assumption 1: Range of Expected Holding Periods. Based on all the facts and circumstances, the valuation analyst estimated the expected holding period to be a broad range of five to ten years. This assumption was based on the fact that the controlling shareholder says he will retire in that time frame, but considers that no one in the management group believes that he will in fact do so. It further considers that the company’s industry is consolidating and that the company is an attractive acquisition candidate. Assumption 2a: Expected Distribution/Dividend Yield. Based on the current dividend policy of distributing 40% of earnings, net earnings of $1.0 million, and a dividend payout ratio of 40%, the expected dividend is $400 thousand. Dividing this by the marketable minority value of $10 million yields the expected dividend yield of 4.0%. Assumption 2b: Expected Growth in Distributions/Dividends. Based on history and discussions with management, the company is likely to maintain the current dividend payout ratio, suggesting that dividends are likely to grow at the same rate as earnings, or about 6.0% per year. Assumption 2c: Timing (Mid-Year or End of Year). Dividends are projected using the mid-year convention because the company declares and distributes dividends on a quarterly basis. Assumption 3a: Growth in Value over Holding Period. The expected growth rate in value is 10%, which was estimated to lie between the expected growth rate in earnings (from the appraisal of the company as a whole) and the enterprise discount rate, adjusted for dividends. Note that this is a situation where the value of the business plan will be less than the value of the business because the controlling shareholder expects to reinvest retained earnings at less than the hurdle rate. While the controlling shareholder could sell the company today, he chooses instead to operate it in a somewhat comfortable fashion and he, too, will experience the (future) value

Enterprise Level DCF Assumptions 1. Forecast Period

2. Projected Interim Cash Flows (during forecast period)

3. Projected Terminal Value (at end of forecast period)

4. Discount Rate

Shareholder Level DCF (QMDM) Inputs 1.

Range of Expected Holding Periods (Years)

2a. Expected Distribution / Dividend Yield

Model Inputs Low

5

High

10

Yield

4.0%

2b. Expected Growth in Distributions / Dividend Yield

Growth

6.0%

2c. Timing (Mid-Year or End of Year)

Timing

M

Gv

10.0%

3a. Growth in Value over Holding Period 3b. Premium or Discount to Marketable Value 4.

Range of Required Holding Period Returns

EXHIBIT 11.2 Base Assumptions: QMDM Example 1.

Prem/Disc

0.0%

Low

20.0%

High

22.0%

406

■

■

BUSINESS VALUATION

detriment of slower than optimal value growth until he sells the company or changes operating philosophy. In other words, the controlling shareholder will experience the same expected return as the minority shareholder (10% growth in value plus 4% yield, rather than the 16% discount rate). Assumption 3b: Premium or Discount to Marketable Minority Value. Because the valuation analyst made appropriate normalizing adjustments in assessing the company’s marketable minority value, she believes that there would be little room for a significant financial control premium above the marketable minority value. No premium or discount to the marketable minority value is projected in this case. Assumption 4: Range of Required Holding Period Returns. We developed this required return as the example in Exhibit 10.10. The base holding period required return was 16.0%, which was developed as the equity discount rate in the valuation of the enterprise at the marketable minority level of value. As detailed in Exhibit 10.10, the required holding period return is estimated to be 21%, which is the midpoint of a range of 20% to 22%. Specific shareholder level risk premiums were estimated based on the valuation analyst’s analysis of the situation. ■ Uncertainties of expected holding period. The assumed facts reflect considerable uncertainties regarding the duration of the expected holding period. A premium of 1% to 2% was added for this factor. ■ Information acquisition cost premium. It is difficult to learn about investment situations like the one in this example, and it can be costly to acquire the needed information. Hypothetical investors have no other means of recouping these costs other than through a premium return expectation. A premium of 1.0% is added for this factor. ■ Expected holding period monitoring costs. This company provides only its annual report each year. Nevertheless, investors would attempt to talk with management and to

Applying the QMDM

■

■

407

learn as much about the company’s ongoing performance as possible. There is no other means of recouping these costs other than through a premium return expectation. A premium of 1.0% is added for this factor. Adjustment for large size of the interest. The interest is relatively large in dollar terms. This fact will limit the pool of prospective hypothetical buyers to those of considerable capacity. These investors tend to recognize this fact and to charge a premium return component. A premium of 0.5% to 1.0% is added for this factor. Rights of first refusal limiting transferability (ROFR). This company has a right of first refusal that taints the marketability of the subject interest. The restrictions on transfer increase the difficulty of finding future buyers of the interest. A premium of 0.5% to 1.0% is added for this factor.

The combined investor-specific risk factors range from 4.0% to 6.0%, providing a range of required returns of 20% to 22%, and a midpoint of 21%. Recall from the discussion in Chapter 8 that this required return range and the estimated premiums lie comfortably within the range of available market evidence. We use the specified range and the midpoint in the QMDM analysis. Exhibit 11.3 summarizes the development of the required holding period return for this example.

The QMDM Results Exhibit 11.4 summarizes the results of the analysis. The valuation analyst’s assumptions are input at the top. Implied marketability discounts are calculated for alternative holding periods. The implied range of marketability discounts for the assumed range of discounts rates and expected holding periods is highlighted for reference. The valuation analyst’s concluded marketability discount of 35% is highlighted.

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BUSINESS VALUATION

QUANTITATIVE MARKETABILITY DISCOUNT MODEL (QMDM) QMDM ASSUMPTION #4

Required Holding Period Return (Shareholder-Level Discount Rate) (Using the Adjusted Capital Asset Pricing Model)

1 2 3 4 5 6 7 8

Components of the Required Holding Period Return Long-Term Government Bond Yield-to-Maturity Common Stock Premium times: Market Beta equals: Beta Adjusted Common Stock Premium plus: Small Cap Stock Premium plus: Specific Company Risk equals: Total Equity Premium Base Holding Period Required Return

Investor-Specific Risk Premium(s) for This Investment: plus: Uncertainties of Expected Holding Period 9 plus: Information Acquisition Cost Premium 10 plus: Premium for Expected Holding Period Monitoring Costs 11 plus: Adjustment for Large Size of the Interest 12 plus: Rights of First Refusal Limiting Transferability (ROFR) 13 14-27 plus: Potential Other Premiums 28 Total Investor-Specific Risk Premium for This Entity

Estimated Range Lower Higher 3.00% 3.00% 6.00% 1.00 6.00% 5.00% 2.00% 13.00% 16.00%

13.00% 16.00%

1.00% 1.00% 1.00% 0.50% 0.50% 0.00% 4.00%

2.00% 1.00% 1.00% 1.00% 1.00% 0.00% 6.00%

29

Estimated Range of Required Holding Period Returns

20.00%

22.00%

30

Rounded Range

20.00%

22.00%

31

Mid-Point of Estimated Required Holding Period Return Range

21.0%

EXHIBIT 11.3 Derivation of Required Holding Period Return. The valuation analyst applied the 35% marketability discount and reached a conclusion of $0.65 per share ($1.00 – 35%) on a nonmarketable minority interest basis. Applying this per-share value to the enterprise, the overall value is $6.5 million at the nonmarketable minority level of value. So the nonmarketable minority conclusion represents 4.9× pre-tax earnings and 6.5× net income. The 40% dividend payout provides a total dividend of $400 thousand ($1.0 million × 40%), which further implies a dividend yield for the nonmarketable minority investor of 6.2% ($400 thousand / $6.5 million). Based on these facts and other comparisons to relevant returns in her appraisal report, the valuation analyst concluded that her 35% marketability discount and the resulting $0.65 per share result were reasonable.

QUANTITATIVE MARKETABILITY DISCOUNT MODEL (QMDM) Conclusion of the Analysis Enterprise Level DCF Assumptions 1. Forecast Period

Shareholder Level DCF (QMDM) Inputs)

Model Inputs Low High

1. Range of Expected Holding Periods (Years) 2a. Expected Distribution / Dividend Yield

2. Projected Interim Cash Flows (during forecast period)

4.0%

2b. Expected Growth in Distribution / Div. Yield

Growth

6.0%

2c. Timing (Mid-Year or End of Year)

Timing

M

Gv

10.0%

Prem/Disc.

0.0%

3a. Growth in Value over Holding Period

3. Projected Terminal Value (at end of forecast period)

3b. Premium or Discount to Marketable Value

4. Discount Rate

4. Range of Required Holding Period Returns

Low

20.0%

High

22.0%

Base Value (Marketable Minority Interest)

Required Holding Period Return (Annual %)

Average Indicated Discounts for Selected Holding Periods (Mid-Point Return +/–1%) Average of 2–4 Year HP 15% Average of 5–10 Year HP Average of 5–7 Year HP 27% Average of 10–15 Year HP Average of 8–10 Year HP 37% Average of 15–20 Year HP Average of 10–20 Year HP 49% Concluded Marketability Discount

17.0% 18.0% 19.0% 20.0% 21.0% 22.0% 23.0% 24.0% 25.0%

1

2

3

4

5

2% 3% 4% 5% 5% 6% 7% 8% 8%

5% 6% 8% 9% 11% 12% 13% 15% 16%

7% 9% 11% 13% 15% 17% 19% 21% 23%

9% 12% 15% 17% 20% 22% 24% 27% 29%

11% 15% 18% 21% 24% 26% 29% 32% 34%

PV=100%

EXHIBIT 11.4 Results of QMDM Analysis.

5 10

Yield

Assumed Holding Periods in Years 6 7 8 9 Implied Marketability Discounts 13% 15% 17% 19% 17% 20% 22% 24% 21% 24% 26% 29% 24% 27% 30% 33% 27% 31% 34% 37% 31% 34% 38% 41% 33% 37% 41% 44% 36% 40% 44% 47% 39% 43% 47% 50%

$1.00

32% 45% 54% 35%

10

15

20

25

30

21% 27% 31% 36% 40% 44% 47% 50% 53%

30% 36% 42% 46% 51% 55% 58% 61% 64%

37% 43% 49% 54% 58% 61% 65% 67% 70%

43% 49% 54% 59% 63% 66% 68% 71% 73%

47% 53% 58% 62% 65% 68% 71% 73% 74%

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BUSINESS VALUATION

Application of the QMDM in this example resulted in the ever-popular 35% marketability discount. The differences between the QMDM example and benchmark analysis include: ■

■

■

Every assumption is developed from and supported by the particular facts and circumstances of the subject company. By employing the QMDM, the valuation analyst is able to model the expected economics of the investment from the viewpoint of the buyers and sellers, whether hypothetical or real. If the facts and circumstances change at a later time when a reappraisal is needed, the valuation analyst has the tools to reflect those changes in her conclusion of value at the nonmarketable minority level of value.

The advantage of using a shareholder level discounted cash flow model like the QMDM to develop marketability discounts can be easily illustrated by changing one assumption. In this modified case, the controlling shareholder is 62 years old and expects to sell the company or create liquidity opportunities around the age of 65. Assume now that every other aspect regarding this subject interest remains the same except that the expected holding period is reduced from five-to-ten years to two-to-four years. Examining Exhibit 11.4, the appropriate range of marketability discounts for consideration would be 9% to 22%. The average discount in that range is 15%, which might be a reasonable conclusion under these circumstances. Absent a tool like the QMDM, the valuation analyst would be unable to make the distinction between the first example and the second with any objectivity or confidence.

The Conclusion Is Selected from Within a Range Some valuation analysts are uncomfortable selecting the marketability discount from within a range determined by the required holding period return range and the expected holding period range. In the example, the highlighted range of marketability discounts is from 21% to 44%. Several comments are appropriate: ■

Valuation is a range concept. The concept of negotiation implies a relevant range of negotiation. Transactions do not occur when

Applying the QMDM

■

■

411

one party or the other makes offers outside the relevant price range for consideration (unless the buyer is irrational on the high side or the seller is irrational on the low side). The specified range is the relevant range for consideration. The discount range was developed based on the best available information and considers the expected cash flows to the shareholder for the relevant expected holding period and values those cash flows at an appropriate range of required returns. The range of 21% to 44% is narrower than the alternate range of 0% to 100% and is the appropriate range of discussion for hypothetical buyers and sellers. The conclusion is selected from within the relevant range. Within the specified range, a marketability discount of 35% is selected. The selection of 35% is based on the specific analysis of the facts and circumstances of the example valuation situation. There is little evidence to suggest early opportunities for marketability, so a conclusion weighted slightly above the midpoint of the five-to-ten-year range of discounts is appropriate.

At this point, we have selected a marketability discount of 35% for the initial set of assumptions. We have made this selection after carefully developing each of the seven assumptions of the QMDM. What more can we do to help assess the reasonableness of this conclusion? Recall that the discounted cash flow model is a rate of return model. We forecast expected cash flows and assess the risk of achieving those cash flows, whether at the enterprise or the shareholder levels. Discounting the expected cash flows to the present at an appropriate discount rate yields present value. If we turn the model around and begin with present value, while knowing the expected cash flows, we can derive the implied rate of return from those cash flows. This type of analysis is referred to as internal rate of return (“IRR”) analysis. We can perform IRR analysis to assess the reasonableness of the concluded discount. The concluded marketability discount specifies the price at the nonmarketable minority level of value. Given the price and the expected cash flows, we can examine the rates of return that would be achieved by investors purchasing an interest at the concluded price over a range of expected holding periods. In

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BUSINESS VALUATION

addition, we can observe prospective returns given different marketability discounts. Exhibit 11.5 summarizes the results of this analysis. The shaded area of Exhibit 11.5 reflects the rates of return that would be anticipated by an investor acquiring the subject interest at the concluded nonmarketable minority value over the expected holding period of five to ten years. Are these expected results reasonable in the context of fair market value? ■

■

■

■

■

The required return range of 20% to 22% would be achieved over a span of from seven to ten years. This seems reasonable given the fact that there is little evidence to suggest that marketability would be achieved earlier than that. An expected return of 24% to 25% would be achieved if the actual holding period were five to six years. This is higher than the required return, but there is little expectation of achieving marketability within the early portion of the expected holding period. If marketability were achieved in say, years two or three, very high rates of return would be achieved. However, there is little evidence suggesting that this would occur. If marketability were expected at this early stage, hypothetical willing sellers would demand a higher price (and a lower marketability discount) than 35%. What about longer holding periods? The pricing at the 35% marketability discount assures that investors would achieve 15% to 18% returns even if the expected holding period stretched to 20 or even 30 years. While this return range is shy of the required equity return on a marketable minority interest basis, it nevertheless provides downside risk protection for the hypothetical willing buyer. Finally, we note the sensitivity of expected returns to changes in the price (i.e., the marketability discount). ■ If we assume a lower marketability discount, say 25%, the expected returns over the five-to-ten-year expected holding period are only 18% to 21%. The only way that the hypothetical investor could achieve the required return range of

Discount Applied

RETURNS EXPECTED TO BE REALIZED OVER VARIOUS HOLDING PERIODS GIVEN MARKETABILITY DISCOUNT SELECTED 2.50% Selected Discount Increment Subsequent Holding Period in Years 25.0% 27.5% 30.0% 32.5% 35.0% 37.5% 40.0% 42.5% 45.0%

1 53% 59% 64% 71% 77% 85% 93% 101% 111%

2 33% 35% 38% 40% 43% 46% 49% 53% 56%

3 26% 28% 30% 31% 33% 35% 37% 39% 41%

4 23% 24% 26% 27% 28% 30% 31% 33% 34%

5 21% 22% 23% 24% 25% 27% 28% 29% 30%

6 20% 21% 22% 23% 24% 25% 25% 27% 28%

7 19% 20% 21% 21% 22% 23% 24% 25% 26%

8 19% 19% 20% 21% 21% 22% 23% 24% 24%

9 18% 19% 19% 20% 20% 21% 22% 22% 23%

10 18% 18% 19% 19% 20% 20% 21% 22% 22%

15 16% 17% 17% 17% 18% 18% 19% 19% 20%

20 15% 16% 16% 16% 17% 17% 17% 18% 18%

25 15% 15% 15% 16% 16% 16% 17% 17% 17%

30 15% 15% 15% 15% 15% 16% 16% 16% 17%

EXHIBIT 11.5 Rate of Return Analysis: Concluded Marketability Discount and Potential Holding Periods.

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BUSINESS VALUATION

■

20% to 22% would be to hope for a relatively short holding period, which the facts and circumstances do not support. Now assume a higher marketability discount of, say, 45%. The expected returns over the five-to-ten-year period are 22% to 30%. While this expectation would be fine for the hypothetical buyers of the interest, hypothetical sellers would likely balk at giving up that level of return.

The QMDM is a shareholder level discounted cash flow method. The calculated range of marketability discounts in Exhibit 11.4 is nothing more than a sensitivity table enabling the valuation analyst to understand the sensitivity of the conclusion to relevant changes in key assumptions. And the calculated range of implied returns in Exhibit 11.5 is another sensitivity table relating the concluded marketability discount (and implied price) with prospective returns across a range of expected holding periods. In the final analysis, the use of the QMDM enables valuation analysts to make important valuation judgments regarding nonmarketable minority investments based on facts and circumstances pertinent to each valuation situation. If the assumptions are reasonable and the tests of reasonableness are confirming, the conclusions reached should also be reasonable.

CONDENSED QMDM EXAMPLES Five condensed examples of the QMDM in use are provided for perspective and to illustrate the ability of valuation analysts using the model to consistently and logically address different fact patterns. We make no effort in these examples to develop the assumptions fully, but they are reasonable based on the facts and assumptions underlying each example. The examples include: 1. An unleveraged family limited partnership holding land 2. An unleveraged family limited partnership holding commercial real estate and providing high distributions 3. A leveraged family limited partnership holding commercial real estate

Applying the QMDM

415

4. A rapidly growing C corporation paying no dividends 5. A mature C corporation with potential for near-term sale

Example 1: An Unleveraged Family Limited Partnership Holding Land In our first example, a real estate limited partnership owns undeveloped land that is expected to grow in value at about 6% per year according to the real estate appraiser. The expected holding period is fairly lengthy, eight to ten years. Liquidity will likely come as adjacent land begins to be developed. The valuation analyst has determined that a required holding period return of 16% is appropriate, partially because of burdensome features of the limited partnership agreement. There are no dividends, with the property generating just enough cash flow to pay expected expenses. The results of the QMDM calculations for this example are shown in Exhibit 11.6. Under the indicated assumptions, the midpoint marketability discount for the eight-to-ten-year expected holding period is 56%. The valuation analyst concluded that the appropriate marketability discount was 55%. Such a discount would be appropriate for an investment with the described characteristics. This is a very large marketability discount in relationship to the means and medians of restricted stock studies (although well within the range of discounts found in the studies). The concluded marketability discount is 55% for very specific reasons, however. Prospective investors are faced with a quite long (eight to ten years) expected holding period with no interim cash flows, and a rather onerous partnership agreement. Relative to more attractive investments with interim cash flows, the discount should be larger. For perspective, we can consider an alternative set of assumptions. Examining Exhibit 11.6, the appropriate marketability discount for a two-to-four-year holding period would have been about 25%. As this simple illustration demonstrates, valuation analysts cannot ignore the outlook for the expected holding period or the

Enterprise Level DCF Assumptions 1. Forecast Period

Shareholder Level DCF (QMDM) Inputs)

Model Inputs Low

1. Range of Expected Holding Periods (Years)

10

Yield

0.0%

2b. Expected Growth in Distribution / Div. Yield

Growth

0.0%

2c. Timing (Mid-Year or End of Year)

Timing

E

G

6.0%

2a. Expected Distribution / Dividend Yield 2. Projected Interim Cash Flows (during forecast period) 3. Projected Terminal Value (at end of forecast period)

3a. Growth in Value over Holding Period

4. Discount Rate

4. Range of Required Holding Period Returns

3b. Premium or Discount to Marketable Value

Prem/Disc.

0.0%

Low

15.0%

High

17.0%

Base Value (Marketable Minority Interest)

Required Holding Period

Average Indicated Discounts for Selected Holding Periods (Mid-Point Return +/– 1%) Average of 2-4 Year HP 23% Average of 5-10 Year HP Average of 5-7 Year HP 42% Average of 10-15 Year HP Average of 8-10 Year HP 55% Average of 15-20 Year HP Average of 10-20 Year HP 72% Concluded Marketability Discount

1 16.0% 12.0% 5% 13.0% 6% 14.0% 7% 15.0% 8% 16.0% 9% 17.0% 9% 18.0% 10% 19.0% 11% 20.0% 12% PV=100%

2

3

4

5

10% 12% 14% 15% 16% 18% 19% 21% 22%

15% 17% 20% 22% 24% 26% 28% 29% 31%

20% 23% 25% 28% 30% 33% 35% 37% 39%

24% 27% 30% 33% 36% 39% 42% 44% 46%

Assumed Holding Periods in Years 6 7 8 9 Implied Marketability Discounts 28% 32% 36% 39% 32% 36% 40% 44% 35% 40% 44% 48% 39% 43% 48% 52% 42% 47% 51% 56% 45% 50% 55% 59% 47% 53% 58% 62% 50% 56% 60% 65% 52% 58% 63% 67%

$1.00

48% 67% 79% 55%

10

15

20

25

30

42% 47% 52% 56% 59% 63% 66% 69% 71%

56% 62% 66% 71% 74% 77% 80% 82% 84%

67% 72% 77% 80% 84% 86% 88% 90% 92%

75% 80% 84% 87% 89% 92% 93% 94% 96%

81% 85% 89% 91% 93% 95% 96% 97% 98%

EXHIBIT 11.6 QMDM Example 1: Unleveraged Family Limited Partnership Owning Undeveloped Real Estate.

8

High

Applying the QMDM

417

growth potential of the underlying assets when valuing nonmarketable minority interests in asset-holding entities.

Example 2: An Unleveraged Family Limited Partnership Holding Commercial Real Estate and Providing High Distributions In our second example, a family limited partnership holds an attractive, well-maintained, high-occupancy apartment building. The property value is expected to grow at about 3% to 4% per year per the real estate appraisers. The partners receive distributions equal to 10% of the marketable minority value per year, and rent increases suggest that distributions will grow at 3% to 4% per year. There is a long history of distributions, which are expected to continue. The expected holding period is 10 to 15 years based on current family ownership and long-term plans. The required holding period return of 17% is mitigated by the high level and predictability of distributions. The results of the QMDM calculations for this example are shown in Exhibit 11.7. Under the indicated assumptions, the highlighted range of marketability discounts reflects a required holding period return range of 16% to 18% and a 10-to-15-year expected holding period. The calculated range is 9% to 22%. Within that range, the valuation analyst selected the average, or 15% as the appropriate marketability discount. Relative to Example 1, the substantial impact of the interim cash flows on the value of the subject interest is evident.

Example 3: A Leveraged Family Limited Partnership Holding Commercial Real Estate The family limited partnership in this example owns the same attractive, well-maintained, high-occupancy apartment building as in the prior example. In this case, however, there is a ten-year mortgage against the property with a current principal balance equal to 50% of the property value. After debt service payments, the remaining cash flow available for distribution to the partners represents a 3.5% yield on the marketable minority value of the

Enterprise Level DCF Assumptions 1. Forecast Period

Shareholder Level DCF (QMDM) Inputs)

Model Inputs Low

1. Range of Expected Holding Periods (Years) 2a. Expected Distribution / Dividend Yield

2. Projected Interim Cash Flows (during forecast period)

2b. Expected Growth in Distribution / Div. Yield 2c. Timing (Mid-Year or End of Year)

3. Projected Terminal Value (at end of forecast period)

3a. Growth in Value over Holding Period

4. Discount Rate

4. Range of Required Holding Period Returns

3b. Premium or Discount to Marketable Value

15

Yield

10.0%

Growth

3.5%

Timing

M

G

3.5%

Prem/Disc.

0.0%

Low

16.0%

High

18.0%

Base Value (Marketable Minority Interest)

Required Holding Period Return (Annual %)

Average Indicated Discounts for Selected Holding Periods (Mid-Point Return +/– 1%) Average of 2-4 Year HP 6% Average of 5-10 Year HP Average of 5-7 Year HP 10% Average of 10-15 Year HP Average of 8-10 Year HP 13% Average of 15-20 Year HP Average of 10-20 Year HP 16% Concluded Marketability Discount

17.0% 13.0% 14.0% 15.0% 16.0% 17.0% 18.0% 19.0% 20.0% 21.0% PV=100%

1

2

3

4

5

1% 1% 2% 3% 4% 5% 5%

1% 3% 4% 6% 7% 9% 10%

2% 4% 6% 8% 10% 12% 14%

2% 5% 8% 10% 13% 15% 17%

3% 6% 9% 12% 15% 18% 20%

Assumed Holding Periods in Years 6 7 8 9 Implied Marketability Discounts 3% 4% 4% 4% 7% 8% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 17% 18% 20% 21% 20% 22% 23% 25% 23% 25% 26% 28%

10

High

$1.00

12% 15% 17% 15%

10

15

20

25

30

4% 9% 14% 18% 22% 26% 29%

5% 11% 17% 22% 26% 30% 34%

6% 12% 18% 23% 28% 32% 36%

6% 13% 19% 24% 29% 33% 36%

6% 13% 19% 25% 29% 33% 37%

EXHIBIT 11.7 QMDM Example 2: Unleveraged Family Limited Partnership Owning Commercial Real Estate.

Applying the QMDM

419

partnership. The anticipated growth in cash flows from the property, when compared to the fixed debt service payment, results in significant expected growth in the net cash flows available for distribution, on the order of 16.5%. The end result is rapid expected growth in distributions. The leverage also increases the expected growth in value to 10%, compared to the expected appreciation of the underlying property of 3.5%. Financial leverage increases risk, such that the required holding period return is assumed to range from 18.0% to 20.0%. The results of the QMDM calculations for this example are shown in Exhibit 11.8. With these assumptions, the appropriate marketability discount is on the order of 25% for the 10-to-15-year holding period. Compared to Example 2, the return to minority investors is realized primarily through capital appreciation rather than interim distributions, warranting a larger discount. This result is consistent with the market evidence from the Partnership Profiles data discussed in Chapter 10.

Example 4: A Rapidly Growing C Corporation Paying No Dividends In our next example, the subject enterprise is a rapidly growing C corporation with revenues of $50 million and a net income margin of 10%. The company is well-run, operating in an expanding service industry. Management expects to be able to maintain margins as revenue grows. All earnings are being reinvested into the company to finance its growth, and there are realistic expectations for 15% compound growth in value for the next ten years or more. Management intends to continue to build the company, but a sale or even an IPO could be possible over the next decade should the controlling shareholders desire liquidity. There are no expectations, however, for any near-term sale. The required holding period return of 20% represents a premium to the required equity return on a marketable minority interest basis to reflect the numerous uncertainties and risks of illiquid minority ownership over and above the risks of the company. The valuation analyst estimated the holding period to

Enterprise Level DCF Assumptions 1. Forecast Period

Shareholder Level DCF (QMDM) Inputs)

Model Inputs Low

1. Range of Expected Holding Periods (Years)

15

Yield

3.5%

2b. Expected Growth in Distribution / Div. Yield

Growth

16.5%

2c. Timing (Mid-Year or End of Year)

Timing

M

G

10.0%

Prem/Disc.

0.0%

2a. Expected Distribution / Dividend Yield 2. Projected Interim Cash Flows (during forecast period)

3a. Growth in Value over Holding Period

3. Projected Terminal Value (at end of forecast period)

3b. Premium or Discount to Marketable Value

4. Discount Rate

4. Range of Required Holding Period Returns

Low

18.0%

High

20.0%

Base Value (Marketable Minority Interest)

Required Holding Period Return (Annual %)

Average Indicated Discounts for Selected Holding Periods (Mid-Point Return +/– 1%) Average of 2-4 Year HP 11% Average of 5-10 Year HP Average of 5-7 Year HP 19% Average of 10-15 Year HP Average of 8-10 Year HP 24% Average of 15-20 Year HP Average of 10-20 Year HP 26% Concluded Marketability Discount

19.0% 15.0% 16.0% 17.0% 18.0% 19.0% 20.0% 21.0% 22.0% 23.0% PV=100%

1

2

3

4

5

1% 2% 3% 4% 4% 5% 6% 7% 7%

2% 4% 5% 7% 8% 10% 11% 13% 14%

3% 5% 7% 9% 12% 14% 16% 18% 19%

3% 6% 9% 12% 15% 17% 20% 22% 24%

3% 7% 11% 14% 17% 20% 23% 26% 29%

10

High

Assumed Holding Periods in Years 6 7 8 9 Implied Marketability Discounts 3% 3% 3% 2% 8% 8% 8% 8% 12% 13% 13% 14% 16% 17% 18% 19% 19% 21% 23% 24% 23% 25% 27% 29% 26% 29% 31% 33% 29% 32% 35% 37% 32% 35% 38% 40%

$1.00

22% 26% 27% 25%

10

15

20

25

30

1% 8% 14% 20% 25% 30% 34% 39% 42%

5% 13% 21% 28% 34% 39% 44% 48%

9% 18% 26% 34% 40% 45% 50%

2% 13% 23% 31% 38% 44% 50%

7% 19% 28% 36% 43% 48%

EXHIBIT 11.8 QMDM Example 3: Leveraged Family Limited Partnership Owning Commercial Real Estate.

Applying the QMDM

421

be within the range of five to ten years. The results of the QMDM calculations are shown in Exhibit 11.9. Under the indicated assumptions for Example 4, the valuation analyst determined the appropriate marketability discount to be 27%, which is the midpoint of the calculated discounts for the five-to-ten-year expected holding period. While the subject company is not expected to pay dividends, the minority shareholder can expect significant capital appreciation and reasonable prospects for eventual marketability. The highlighted range of discounts is broad, but it is the relevant range. Within that range, the valuation analyst must assess the appropriate discount, just as a real-life investor would assess the price he would pay based on the overall facts and circumstances.

Example 5: Mature C Corporation with Potential for Near-Term Sale Our final example features a mature C corporation operating in a cyclical industry. This example is summarized in Exhibit 11.10. The company pays a dividend equal to 5.0% of its marketable minority value and has an expected growth in value of 7.5%. Dividends are expected to grow at the same rate. Industry fundamentals are likely to peak in the next two years or so, and the majority shareholder has committed to a sale of the company during that time if the right buyer comes forward with sufficiently attractive pricing and terms. If such a scenario does not materialize during the next two to four years, the window for such transactions in the industry will likely be closed until the next industry peak. The required holding period return is increased to 21% to account for this unusual uncertainty regarding the expected holding period. Based on this particular situation, the valuation analyst elects to consider two distinct holding periods. The first, two to four years from the valuation date, assumes a near-term sale of the business. The second, of eight to ten years, is the likely outcome if the opportunity for a near-term sale during the current industry peak is missed and the controlling shareholder decides to wait until the next cycle.

Enterprise Level DCF Assumptions 1. Forecast Period

Shareholder Level DCF (QMDM) Inputs)

Model Inputs Low

1. Range of Expected Holding Periods (Years) 2a. Expected Distribution / Dividend Yield

2. Projected Interim Cash Flows (during forecast period)

10

Yield

0.0%

2b. Expected Growth in Distribution / Div. Yield

Growth

2c. Timing (Mid-Year or End of Year)

Timing

E

G

15.0%

Prem/Disc.

0.0%

3a. Growth in Value over Holding Period

3. Projected Terminal Value (at end of forecast period)

3b. Premium or Discount to Marketable Value

4. Discount Rate

4. Range of Required Holding Period Returns

0.0%

Low

19.0%

High

21.0%

Base Value (Marketable Minority Interest)

Required Holding Period Return (Annual %)

Average Indicated Discounts for Selected Holding Periods (Mid-Point Return +/– 1%) Average of 2-4 Year HP 12% Average of 5-10 Year HP Average of 5-7 Year HP 22% Average of 10-15 Year HP Average of 8-10 Year HP 32% Average of 15-20 Year HP Average of 10-20 Year HP 46% Concluded Marketability Discount

20.0% 16.0% 17.0% 18.0% 19.0% 20.0% 21.0% 22.0% 23.0% 24.0% PV=100%

5

High

1

2

3

4

5

Assumed Holding Periods in Years 6 7 8 9

1% 2% 3% 3% 4% 5% 6% 7% 7%

2% 3% 5% 7% 8% 10% 11% 13% 14%

3% 5% 7% 10% 12% 14% 16% 18% 20%

3% 7% 10% 13% 16% 18% 21% 24% 26%

4% 8% 12% 16% 19% 22% 26% 29% 31%

Implied Marketability Discounts 5% 6% 7% 7% 10% 11% 13% 14% 14% 16% 19% 21% 19% 21% 24% 26% 23% 26% 29% 32% 26% 30% 33% 37% 30% 34% 38% 41% 33% 38% 42% 45% 36% 41% 45% 49%

$1.00

27% 41% 52% 27%

10

15

20

25

30

8% 16% 23% 29% 35% 40% 45% 49% 53%

12% 23% 32% 40% 47% 53% 59% 64% 68%

16% 29% 40% 50% 57% 64% 69% 74% 78%

19% 35% 47% 57% 65% 72% 77% 81% 85%

23% 40% 54% 64% 72% 78% 83% 87% 90%

EXHIBIT 11.9 QMDM Example 4: Growing C Corporation with No Dividends.

Enterprise Level DCF Assumptions 1. Forecast Period

Shareholder Level DCF (QMDM) Inputs)

Model Inputs Low

1. Range of Expected Holding Periods (Years)

10

Yield

5.0%

2b. Expected Growth in Distribution / Div. Yield

Growth

7.5%

2c. Timing (Mid-Year or End of Year)

Timing

E

(at 3a. Growth in Value over Holding Period

G

7.5%

2a. Expected Distribution / Dividend Yield 2. Projected Interim Cash Flows (during forecast period) 3. Projected Terminal Value end of forecast period)

3b. Premium or Discount to Marketable Value

4. Discount Rate

Prem/Disc.

0.0%

Low

20.0%

High

22.0%

4. Range of Required Holding Period Returns

Base Value (Marketable Minority Interest)

Required Holding Period Return (Annual %)

Average Indicated Discounts for Selected Holding Periods (Mid-Point Return +/– 1%) Average of 2-4 Year HP 19% Average of 5-10 Year HP Average of 5-7 Year HP 32% Average of 10-15 Year HP Average of 8-10 Year HP 41% Average of 15-20 Year HP Average of 10-20 Year HP 51% Concluded Marketability Discount

1 21.0% 17.0% 4% 18.0% 5% 19.0% 5% 20.0% 6% 21.0% 7% 22.0% 8% 23.0% 9% 24.0% 9% 25.0% 10% PV=100%

2

3

4

5

7% 9% 10% 12% 13% 15% 16% 17% 19%

11% 13% 15% 17% 19% 21% 23% 24% 26%

14% 16% 19% 21% 24% 26% 28% 30% 32%

16% 20% 23% 25% 28% 31% 33% 36% 38%

8

High

Assumed Holding Periods in Years 6 7 8 9 Implied Marketability Discounts 19% 21% 23% 25% 22% 25% 28% 30% 26% 29% 31% 34% 29% 32% 35% 38% 32% 35% 39% 41% 35% 38% 42% 45% 38% 41% 45% 48% 40% 44% 47% 50% 43% 47% 50% 53%

$1.00

36% 48% 55% 25%

10

15

20

25

30

27% 32% 36% 40% 44% 47% 50% 53% 56%

34% 39% 44% 48% 52% 56% 59% 62% 64%

39% 44% 49% 53% 57% 60% 63% 66% 68%

42% 47% 52% 56% 60% 63% 65% 68% 70%

44% 49% 54% 58% 61% 64% 67% 69% 71%

EXHIBIT 11.10 QMDM Example 5: Mature C Corporation with Potential for Near-Term Sale.

424

BUSINESS VALUATION

The valuation analyst recognizes that either one or the other of the two scenarios will likely occur, but there is a reasonable probability of either. The shorter holding period yields a range of marketability discounts of 12% to 26%. Within that range, the valuation analyst concluded that 15% was the appropriate marketability discount, thinking that if a sale occurs, it might occur during the initial portion of the holding period. The longer holding period yields a range of marketability discounts of 35% to 47%. Within that range, the valuation analyst concluded that the appropriate discount was 40%. The question is, of course, how to reconcile these two disparate conclusions. The valuation analyst in this situation must perform the same assessment investors do when considering investments that will result in one of two radically different outcomes. Balancing the majority shareholder’s stated commitment to a near-term sale against the challenge of consummating such a sale on reasonably favorable terms, the valuation analyst deems the shorter holding period to be somewhat more likely than the longer holding period, concluding that a 25% marketability discount is appropriate. In this case, the valuation analyst attempted to simulate the (hypothetical) negotiations of hypothetical willing buyers and sellers. The seller obviously desires a lower discount and a higher price while the buyer wants a higher discount and lower price. The reconciling element in the discussion would have to be a probability assessment of expected returns under both specified scenarios. The best tool for evaluating this hypothetical discussion is the pro forma return analysis shown as Exhibit 11.11. The hypothetical seller argues for a 15% discount (higher price), consistent with the shorter holding period. The hypothetical buyer, on the other hand, says that this is too much to pay. There is no premium return relative to the required return range of 20% to 22% for taking on the potential for a much longer holding period than two to four years (as seen by the highlighted but unshaded area in Exhibit 11.10 at an assumed 15% marketability discount).

Discount Applied

RETURNS EXPECTED TO BE REALIZED OVER VARIOUS HOLDING PERIODS GIVEN MARKETABILITY DISCOUNT SELECTED 2.50% Selected Discount Increment Subsequent Holding Period in Years 15.0% 17.5% 20.0% 22.5% 25.0% 27.5% 30.0% 32.5% 35.0%

1 32% 36% 41% 45% 50% 55% 61% 67% 73%

2 22% 24% 26% 28% 30% 33% 35% 38% 40%

3 19% 20% 22% 23% 24% 26% 27% 29% 31%

4 18% 18% 19% 20% 22% 23% 24% 25% 26%

5 17% 17% 18% 19% 20% 21% 22% 23% 24%

6 16% 17% 17% 18% 19% 20% 20% 21% 22%

7 16% 16% 17% 17% 18% 19% 19% 20% 21%

8 15% 16% 16% 17% 17% 18% 19% 19% 20%

9 15% 15% 16% 16% 17% 17% 18% 19% 19%

10 15% 15% 16% 16% 17% 17% 18% 18% 19%

15 14% 15% 15% 15% 16% 16% 16% 17% 17%

20 14% 14% 14% 15% 15% 15% 16% 16% 16%

25 14% 14% 14% 14% 15% 15% 15% 16% 16%

EXHIBIT 11.11 QMDM Example 5: Rate of Return Analysis under Different Holding Period Scenarios.

30 14% 14% 14% 14% 15% 15% 15% 15% 16%

426

BUSINESS VALUATION

The hypothetical buyer then argues for a 35% to 40% marketability discount because of the risk of the longer holding period. The hypothetical seller counters by saying that there would be too great a premium return in the event of a near-term sale, and very little penalty to return for the longer holding period. See the highlighted but unshaded portion with an assumed marketability discount of 35%, which would yield returns of 26% to 40% if a sale occurred in two or three years. The valuation analyst concluded that hypothetical willing buyers and sellers would consummate a transaction at a marketability discount of 25%. Absent use of a shareholder level discounted cash flow model, it would be difficult to consistently or credibly address a fact pattern such as this while developing a marketability discount.

Summary of the Examples The five examples illustrate markedly different investments in minority interests of private businesses. The concluded discounts are summarized in Exhibit 11.12.

Example Description

Concluded Discount

1.

An unleveraged family limited partnership holding land

55%

2.

An unleveraged family limited partnership holding commercial real estate, providing high distributions

15%

3.

A leveraged family limited partnership holding commercial real estate

25%

4.

A rapidly growing C corporation paying no dividends

27%

5.

A mature C corporation with potential for near-term sale

25%

Average Concluded Discount

29%

EXHIBIT 11.12 Summary of QMDM Results from Examples.

Applying the QMDM

427

While the average discount for the five examples of 29% is close to the commonly cited benchmark range, application of that benchmark to any of the particular examples could lead to a discount that is too high or too low by a material amount. It should be clear from the wide range of potential investment situations illustrated by the five examples that a shareholder level discounted cash flow method within the income approach is an appropriate valuation method. The QMDM provides a consistent framework for application of this method.

THE UNIFORM STANDARDS OF PROFESSIONAL APPRAISAL PRACTICE AND THE QMDM The Uniform Standards of Professional Appraisal Practice (USPAP) are updated every two years by the Appraisal Standards Board of The Appraisal Foundation.1 Because of the widespread recognition and acceptance of USPAP, business valuation analysts should be familiar with the standards generally, the business appraisal standards specifically, and how changes in USPAP can influence valuation practice. Since the mid-2000s, USPAP has included two provisions that relate specifically to the valuation of illiquid minority interests of businesses. Standards Rule 9-4(c) states: An appraiser must, when necessary for credible assignment results, analyze the effect on value, if any, of buy-sell and option agreements, investment letter stock restrictions, restrictive corporate charter or partnership agreement clauses, and similar features or factors that may influence value.

1

Uniform Standards of Professional Appraisal Practice 2020–2021 Edition (Washington, D.C.: Appraisal Standards Board, The Appraisal Foundation, 2020).

428

BUSINESS VALUATION

Standards Rule 9-4(d) states: An appraiser must, when necessary for credible assignment results, analyze the effect on value, if any, of the extent to which the interest appraised contains elements of ownership control and is marketable and/or liquid. An appraiser must analyze factors such as holding period, interim benefits, and the difficulty of marketing the subject interest. These provisions underscore the value of techniques like the QMDM for business appraisers in meeting their professional obligations to assess how contractual provisions or other features of the subject interest influence marketability and the appropriate conclusion of value. The first portion of each clause is the same: “An appraiser must, when necessary for credible assignment results, analyze the effect on value, if any.” To the extent that the listed conditions exist, they have the potential of affecting the value of the interest being appraised. We doubt that appraisers can adequately fulfill these requirements by simply stating, “In my judgment, there is no effect on value.” The standards call for analyzing the effect on value. The question is, how can valuation analysts analyze the effect on value of buy–sell agreements, restrictive agreements, and marketability or control? USPAP includes a relevant comment, which is a binding portion of the standard, immediately following SR 9-4(d): Comment: Equity interests in a business enterprise are not necessarily worth the pro rata share of the business enterprise interest value as a whole. Also, the value of the business enterprise is not necessarily a direct mathematical extension of the value of the fractional interests. The degree of control, marketability and/or liquidity or lack thereof depends on a broad variety of facts and circumstances that must be analyzed when applicable. We now examine the USPAP requirements in light of the Quantitative Marketability Discount Model. We should be clear at

Applying the QMDM

429

the outset. The Appraisal Foundation is not endorsing the QMDM or any other quantitative rate of return model for developing marketability discounts through these provisions of USPAP. However, the appeal of these provisions to commonsense factors affecting the value of nonmarketable business interests is entirely consistent with use of the QMDM. SR 9-4(d) identifies three factors that must be analyzed, including holding period, interim benefits, and the difficulty and cost of marketing the subject interest. In addition, SR 9-4(c) requires analysis of buy–sell and option agreements, investment letter stock restrictions, restrictive corporate charter or partnership agreement clauses, and similar features or factors (or generally, restrictions on transfer). We now look at each of these elements in the context of the QMDM: ■

■

Holding period. The holding period corresponds to the expected holding period assumption of the QMDM. Investors in nonmarketable investments are keenly interested in when they will be able to sell their investments and realize their returns. Investors accept the fact that they cannot know the precise duration of the prospective holding period with any certainty, but their investment decisions are based on a range of reasonable holding periods in the context of their informed judgment. A portion of Exhibit 11.4 is reproduced as Exhibit 11.13 to illustrate “the effect on value, if any,” of the expected holding period. The effect on value of changes in the expected holding period is clear. For a 21% required holding period return, the indicated discount increases from 11% for a two-year holding period to 40% for a 10-year holding period. Qualitative comparisons do not accommodate this type of analysis. Interim benefits. Interim benefits are the expected dividends of the QMDM. In the exhibit, dividends equal to a 4.0% C corporation equivalent yield are forecast to grow at a rate of 6.0% per year. This forecasted stream of benefits comprises the “interim benefits” discussed in USPAP. Can we “analyze the impact on value, if any,” of the interim benefits? Under the

Required Holding Period Return (Annual %)

17.0% 18.0% 19.0% 20.0% 21.0% 22.0% 23.0% 24.0% 25.0%

1

2

3

4

5

2% 3% 4% 5% 5% 6% 7% 8% 8%

5% 6% 8% 9% 11% 12% 13% 15% 16%

7% 9% 11% 13% 15% 17% 19% 21% 23%

9% 12% 15% 17% 20% 22% 24% 27% 29%

11% 15% 18% 21% 24% 26% 29% 32% 34%

Assumed Holding Periods in Years 6 7 8 9 Implied Marketability Discounts 13% 15% 17% 19% 17% 20% 22% 24% 21% 24% 26% 29% 24% 27% 30% 33% 27% 31% 34% 37% 31% 34% 38% 41% 33% 37% 41% 44% 36% 40% 44% 47% 39% 43% 47% 50%

PV=100%

EXHIBIT 11.13 Analysis of Holding Period on Marketability Discount.

10

15

20

25

30

21% 27% 31% 36% 40% 44% 47% 50% 53%

30% 36% 42% 46% 51% 55% 58% 61% 64%

37% 43% 49% 54% 58% 61% 65% 67% 70%

43% 49% 54% 59% 63% 66% 68% 71% 73%

47% 53% 58% 62% 65% 68% 71% 73% 74%

Applying the QMDM

■

431

preceding assumptions, the calculated marketability discount for an eight-year expected holding period and a 21.0% required holding period return is 34%, which correlates closely with the concluded 35% marketability discount in the exhibit. If all assumptions remain the same except that the expected dividend yield is reduced to zero, the calculated marketability discount for eight years and a 21.0% expected holding period rises to 53%. This would be equivalent to assuming that agency costs consume all potential dividends to the illiquid interest. On the other hand, if there are no agency costs, the dividend yield could be increased to 6.0%, and the corresponding marketability discount would be 25%. This type of analysis cannot be performed with any confidence on the basis of qualitative comparisons alone. Difficulty and cost of marketing the subject interest. There is greater risk associated with owning an illiquid investment than an otherwise comparable liquid one. Higher expected return is the investment reward for accepting incremental risk. The required holding period return of the QMDM is developed with explicit consideration for the difficulty and cost of marketing subject interests. Exhibit 11.3 is reproduced here as Exhibit 11.14 to illustrate the consideration of the difficulty and cost of marketing on the required holding period return.

The investor-specific premiums listed on Lines 9–12 clearly address the “difficulty and cost of marketing the subject interest.” These include uncertainties of the expected holding period, an information acquisition cost premium, holding period monitoring costs, and an adjustment for the large size of the interest (which limits marketability). Together, these elements add 3.5% to 5.0% of incremental holding period risk to the required return. Absent these risk premiums, the required return range would be 16.5% to 17.0%. The increase in the required return resulting from the investor-specific premiums has a material and measurable impact on value. Qualitative comparisons do not allow for this type of analysis.

432

1 2 3 4 5 6 7 8

BUSINESS VALUATION

Components of the Required Holding Period Return Long-Term Government Bond Yield-to-Maturity Common Stock Premium times: Market Beta equals: Beta Adjusted Common Stock Premium plus: Small Cap Stock Premium plus: Specific Company Risk equals: Total Equity Premium Base Holding Period Required Return

Investor-Specific Risk Premium(s) for This Investment: plus: Uncertainties of Expected Holding Period 9 plus: Information Acquisition Cost Premium 10 plus: Premium for Expected Holding Period Monitoring Costs 11 plus: Adjustment for Large Size of the Interest 12 plus: Rights of First Refusal Limiting Transferability (ROFR) 13 14-27 plus: Potential Other Premiums 28 Total Investor-Specific Risk Premium for This Entity

Estimated Range Lower Higher 3.00% 3.00% 6.00% 1.00 6.00% 5.00% 2.00% 13.00% 16.00%

13.00% 16.00%

1.00% 1.00% 1.00% 0.50% 0.50% 0.00% 4.00%

2.00% 1.00% 1.00% 1.00% 1.00% 0.00% 6.00%

29

Estimated Range of Required Holding Period Returns

20.00%

22.00%

30

Rounded Range

20.00%

22.00%

31

Mid-Point of Estimated Required Holding Period Return Range

21.0%

EXHIBIT 11.14 Derivation of Required Holding Period Return.

■

Restrictions on transfer (SR 9-4(c)). A variety of elements that we place into the general category of restrictions on transfer are discussed in SR 9-4(c). Restrictions on transfer tend to increase the risk of investing in illiquid investments relative to illiquid investments without such restrictions. At Line 13 in the exhibit, we added a premium of 0.5% to 1.0% because a right of first refusal agreement limits the transferability of the subject interest. The increase in required return resulting from consideration of the right of first refusal has a material and measurable impact on value. Qualitative comparisons do not provide a framework for this type of analysis.

Applying the QMDM

433

The QMDM is an ideal tool to assist valuation analysts in meeting the analytical requirements found in USPAP. Once again, neither the Appraisal Standards Board nor The Appraisal Foundation have endorsed the QMDM or any other model for conducting the analysis required by Standards Rules 9-4(c) and 9-4(d). However, we believe the QMDM (or a similar tool) provides a concise and reliable means of satisfying these provisions of USPAP.

CHAPTER

12

Applying the Integrated Theory to Tax Pass-Through Entities

INTRODUCTION The appropriate valuation treatment of S corporations and other tax pass-through entities is one of the most durable valuation controversies facing valuation analysts. The input of the tax court has not been helpful in reaching an economically sensible consensus on the issue. In this chapter, we apply the disciplined approach of the Integrated Theory to the valuation of S corporations and other tax pass-through entities at both the firmwide and shareholder levels of value. Exhibit 12.1 summarizes the results of applying the Integrated Theory to the valuation of S corporations at each level of value. Application of the Integrated Theory suggests that the appropriate valuation treatment at the firmwide levels differs from that at the shareholder level. ■

Firmwide Levels. At the firmwide levels, an S corporation has the same value as an otherwise identical C corporation. In other words, the S corporation election confers no particular benefit

435 Business Valuation, First Edition. Z. Christopher Mercer and Travis W. Harms. © 2021 Z. Christopher Mercer and Travis W. Harms. Published 2021 by John Wiley & Sons, Inc.

436

BUSINESS VALUATION Value Differentials Between a C Corporation and an Otherwise Identical S Corporation

C Corporation

=

Strategic Control Value

Firmwide Level

Strategic Control Value

S Corporation

Shareholder Level

Financial Control Value Marketable Minority Value

=

Financial Control Value Marketable Minority Value

(+) f (Distribution, Risk, Basis Build-up)

Nonmarketable Minority Value

Nonmarketable Minority Value (-) f (Distribution, Risk, Basis Build-up)

EXHIBIT 12.1 Value Differences between a C Corporation and an Otherwise Identical S Corporation.

■

to the value of the company as a whole. The operating cash flows are identical, so there is no compelling economic rationale to suggest that the value of the two businesses should not also be identical. Shareholder Level. At the shareholder level, a particular minority interest may have a different value than that same interest in an otherwise identical C corporation. As we will demonstrate, the S corporation election ultimately confers a tax benefit on the shareholders rather than the enterprise. The tax benefit is manifest in different shareholder cash flows. It is these shareholder cash flow differences, appropriately considered in the context of their risk, timing, and duration, which generate potential differences in value.

Applying the Integrated Theory to Tax Pass-Through Entities

437

THE NATURE OF THE S CORPORATION BENEFIT The benefit of S corporation status is easily summarized: the election eliminates the dreaded double taxation of C corporation earnings that are distributed to shareholders. Earnings are taxed one time at the level of the C corporation and again upon distribution to shareholders. The valuation controversy stems from confusion regarding whether the tax benefit derived from the elimination of the second level of taxation for an S corporation accrues to the company itself or the shareholders. Unfortunately, the mechanics of the tax pass-through contribute to this confusion. The S corporation election replaces the corporate income tax with a personal shareholder tax burden on S corporation income passed through to the individual shareholders. The elimination of the corporate income tax leads some observers to the erroneous conclusion that the benefit of the election by necessity accrues to the company. The S corporation’s income continues to be fully taxable; the legal obligation simply transfers from the S corporation to the individual shareholders. The economic obligation, however, remains with the enterprise. The real benefit of the S corporation election is the elimination of personal tax on economic distributions to shareholders. Thus, the S corporation benefit accrues to the shareholders rather than the enterprise. A brief example will clarify. In the example, we assume that the effective corporate and personal income tax rates are identical. Prior to passage of the Tax Cuts and Jobs Act of 2017 (TCJA), top marginal personal and corporate rates were broadly comparable, at 39.6% and 35%, respectively. With the passage of the Tax Cuts and Jobs Act of 2017, the federal corporate tax rate is materially lower than the federal personal tax rate. We explore the implications of this rate differential in a subsequent section of this chapter. In Exhibit 12.2 we consider otherwise identical C and S corporations under three different distribution scenarios. To simplify the analysis, we have assumed that effective corporate and personal tax rates are both 37%.

438

BUSINESS VALUATION

We make the following observations with respect to Exhibit 12.2: ■

■

■

■

■

Taxes are paid on the taxable corporate income in each scenario, regardless of distribution policy. While the legal obligation to pay the tax falls to the S corporation shareholders individually, the economic obligation remains with the company, as distributions sufficient to pay the personal tax obligation are practically assured. The rare instances in which insufficient distributions are made are best viewed as additional reinvestment of the undistributed corporate tax obligation into the enterprise. Corporate earnings are fully taxed in each scenario, but economic distributions to shareholders are not. We use the term “economic distributions” to refer to all shareholder distributions beyond the level needed to fund the personal taxes due on corporate earnings. Economic distributions to C corporation shareholders are taxed at the maximum federal dividend income rate of 23.8%, while the same distributions to S corporation shareholders are not taxed. The fact that taxes paid on the taxable corporate income are equal for both companies in this example suggests that, for any given level of economic distribution, the retained earnings available to the C and S corporations for reinvestment are identical. Therefore, the S corporation election does not confer any benefit on the company itself. The tax-free nature of economic distributions to S corporation shareholders gives rise to a potential S corporation tax benefit at the shareholder level. The magnitude of the cash flow benefit increases with the portion of available earnings distributed to shareholders. In the case of no economic distributions, there is no cash flow benefit related to the S corporation election. The valuation impact of the tax benefit is contingent upon the accompanying shareholder risks and the expected duration of the shareholder benefits. Finally, the magnitude of the shareholder level cash flow benefit is directly related to the prevailing dividend income tax rate

0% Economic Payout

50% Economic Payout

100% Economic Payout

C Corp

S Corp

C Corp

S Corp

C Corp

S Corp

$100.00 ($37.00) $0.00 $63.00

$100.00 $0.00 ($37.00) $63.00

$100.00 ($37.00) $0.00 $63.00

$100.00 $0.00 ($37.00) $63.00

$100.00 ($37.00) $0.00 $63.00

$100.00 $0.00 ($37.00) $63.00

Economic Payout Ratio Economic Distribution to Shareholders (Pre-tax) Shareholder Tax on Economic Distribution (%) Shareholder Tax on Economic Distribution ($)

0.0% $0.00 15.0% $0.00

0.0% $0.00 0.0% $0.00

50.0% $31.50 15.0% $4.73

50.0% $31.50 0.0% $0.00

100.0% $63.00 15.0% $9.45

100.0% $63.00 0.0% $0.00

Economic Distribution to Shareholders (After-tax) Shareholder Level Benefit of S Corporation Election

$0.00

$0.00 $0.00

$26.78

$31.50 $4.73

$53.55

$63.00 $9.45

$63.00

$63.00 $0.00

$31.50

$31.50 $0.00

$0.00

$0.00 $0.00

Taxable Corporate Income Corporate Tax on Corporate Earnings Shareholder Tax on Corporate Earnings Net Income Available for Economic Distributions

Retained Corporate Earnings Enterprise Level Benefit of S Corporation Election

37.0% 37.0%

EXHIBIT 12.2 Effect of Payout Ratios on S Corporation Benefit.

440

BUSINESS VALUATION

avoided by the S corporation election. The shareholder level tax benefit is positively related to the tax rate on dividend income.

THE FIRMWIDE LEVEL VALUE OF S CORPORATIONS In this section, we apply the conceptual framework of the Integrated Theory to analysis of the S corporation tax benefit presented in Exhibit 12.2 to demonstrate that, at the firmwide levels, the value of an S corporation is equal to that of an otherwise identical C corporation. Exhibit 12.3 reproduces Exhibit 2.17. For the value of an S corporation to be different at the firmwide level from an otherwise identical C corporation, there must be a difference in at least one of the three inputs to the Gordon Model: cash flow, growth in cash flows, or risk. 1. Cash Flow. The transfer of the legal obligation to pay taxes on the corporate earnings of the S corporation from the corporation itself to the individual shareholders has led some valuation analysts (and currently, the Internal Revenue Service) to the improper conclusion that the enterprise cash flows of an S corporation are substantially greater than those of an otherwise identical C corporation. However, as we demonstrated in Exhibit 12.2, the economic obligation to pay taxes on the corporate earnings of the S corporation does not transfer to the individual shareholders. In other words, the enterprise cash flows are unchanged, and there is no S corporation tax benefit at the firmwide levels. 2. Growth. It is sometimes suggested that the transfer of the legal obligation for taxes on corporate earnings away from the S corporation permits the S corporation to retain more earnings for reinvestment, thereby fueling greater growth in cash flows. This misconception is also corrected by a proper understanding of the economic obligation for taxes on corporate earnings. As illustrated in Exhibit 12.2, after considering the economic obligation for taxes on corporate earnings, the S corporation has the

Conceptual Math

Strategic Control (Equity Basis)

Financial Control (Equity Basis)

Marketable Minority Value (Equity Basis)

CFEq(sc) REq(sc) – GCF Eq(sc)

CFEq(fc) REq(fc) – GCF Eq(fc)

CFEq(mm) REq(mm) – GCF Eq(mm)

Relationships

Value Implications

CFEq(sc) ≥ CFEq(mm) GCF Eq(sc) ≥ GCF Eq(mm)

VEq(sc) ≥ VEq(mm)

REq(sc) ≤ REq(mm)

CFEq(fc) ≥ CFEq(mm) GCF Eq(fc) ≥ GCF Eq(mm)

VEq(fc) ≥ VEq(mm)

REq(fc) ≈ REq(mm)

GCF Eq(mm) = REq(mm) –

EXHIBIT 12.3 The Three Firmwide Levels of Value Summarized.

CFEq(mm) VEq(mm)

VEq(mm) is the benchmark for the other equity levels of value ("as-if-freely-traded")

442

BUSINESS VALUATION

same amount of retained earnings available for reinvestment as its C corporation counterpart. As a result, there is no reason for assuming a growth differential between S and C corporations at the firmwide levels. 3. Risk. The relevant risk at the firmwide levels relates to the business risk of the enterprise. These risks generally encompass areas such as revenue volatility and the prospects for margin compression, susceptibility to competition, the effects of regulation, dependence on suppliers or key managers, and sensitivity to economic and market conditions, among others. The S corporation election has no effect on these or any of the other myriad business risks typically considered in the firmwide discount rate. Appraisers and courts are occasionally distracted in the development of firmwide discount rates for S corporations by a desire to match the tax characteristics of the discount rate to those of the cash flow stream. In other words, some advocate converting S corporation enterprise discount rates to a pre-tax basis to discount the pre-tax corporate earnings. While this is an admirable goal, it is ultimately misguided, given an understanding that the economic obligation for the tax on corporate earnings remains with the S corporation. Rather than embarking on the potentially perilous path of converting discount rates to a pre-tax basis, it is preferable to simply apply appropriate discount rates developed using traditional methods to the earnings of the S corporation after deduction of the corporate tax obligation. Disciplined application of the Integrated Theory allows us to demonstrate that, at the firmwide levels of value, there are no differences in cash flow, risk, or growth between otherwise identical S and C corporations. We conclude, therefore, that there is no economic basis for asserting that, by virtue of having made the S election, the electing company is more (or less) valuable than it was on a pre-election basis.

Applying the Integrated Theory to Tax Pass-Through Entities

443

OTHER OBSERVATIONS REGARDING RELATIVE VALUE AT THE FIRMWIDE LEVELS The conceptual framework of the Integrated Theory is necessarily quantitative. In this section we summarize other qualitative observations that reinforce our conclusion that the firmwide value of an S corporation is no different than that of an otherwise comparable C corporation. First, we observe that, with the exception of very small corporations owned primarily by individuals, the most likely acquirers of many S corporations are C corporations that are ineligible to own shares of an S corporation. In other words, the S corporation tax benefit – even if perceived to reside with the company – cannot be transferred to many of the most likely acquirers of the enterprise. If the S election increased firmwide value, one would expect S corporation acquirers to have a comparative advantage relative to C corporation buyers. Such advantage is not apparent in the marketplace. The consistent experience of investment bankers at Mercer Capital and elsewhere suggests that buyers pay no more for S corporations than for otherwise equivalent C corporations.1 Second, treating the S corporation as a “tax-free” enterprise assumes that the tax benefits conferred upon S corporation shareholders will persist indefinitely. We have demonstrated that the magnitude of the shareholder tax benefit is a function of the level of economic shareholder distributions and the tax rate on dividend income avoided by the S corporation election. The duration of the S corporation benefit is correlated with the expected holding period of the investor, and is therefore finite. Third, if the S corporation election materially increased the value of the enterprise, valuation analysts must then recognize

1 C corporations with significant embedded gains may have lower values, but that differential is attributable to the embedded tax liability itself, not an inherent difference in cash flow, risk, or growth expectations.

444

BUSINESS VALUATION

that most C corporations have the option to make the S election. Further, the option to make the S election is essentially costless. In other words, if the firmwide level S corporation value premium were as substantial as sometimes suggested, one would expect to see a great deal of financial engineering to allow large (even, perhaps, publicly traded) C corporations to convert to S corporation status in order to unlock the S corporation value premium. This simply has not happened. Finally, some observe that the net proceeds to S corporation shareholders from a sale of the company may be greater than the net proceeds to the sellers of an otherwise comparable C corporation. For one, the S corporation election can facilitate asset sales by eliminating embedded gains issues, and many acquirers prefer to consummate asset, rather than stock purchases. In addition, to the extent S corporation earnings are retained, the basis of the S corporation shareholders in the stock increases, minimizing capital gains realized upon eventual sale of the underlying stock. However, we caution appraisers and courts not to confuse value (based on the capitalization of expected enterprise cash flows) with proceeds (the negotiated value of the enterprise, adjusted for the corporate and personal liabilities and expenses arising from the transaction). We have demonstrated that the capitalizable firmwide cash flows for an S corporation are the same as those of a comparable C corporation. The transactional expenses and liabilities that create the wedge between value and proceeds may, however, differ for S and C corporations. ■

As previously mentioned, the S corporation shareholder’s basis increases as corporate earnings are retained, leading to a smaller capital gain tax burden upon eventual sale of the stock. Alternatively, an S corporation may be able to extract a higher price from an acquirer seeking an asset transaction, and endure fewer tax disadvantages than the typical C corporation asset sale. Furthermore, the 338 (h)(10) election allows the parties to a qualifying sale of S corporation shares to teat the transaction as an asset sale for tax purposes. In any event, the net proceeds to the selling shareholders of the S corporation may be greater

Applying the Integrated Theory to Tax Pass-Through Entities

■

445

than they would be for an otherwise comparable C corporation, where comparability is assessed with respect to expected cash flows, risk, and growth. No lunch is free, however, particularly with respect to the sale of S corporation assets. When an S corporation engages in an asset sale, its shareholders retain the corporation and the accompanying residual or “tail” liability. The tail liability encompasses the unknown liabilities accruing from business operations prior to the transaction. Buyers naturally desire to avoid inheriting this liability while sellers naturally desire to pass it along to the buyer. As a result, S corporation shareholders who negotiate a higher price by acquiescing to an asset sale see their effective proceeds reduced by the expected present value of the unknown tail liability. The possibility of making the 338(h)(10) election does not eliminate the economic reality of the tail liability. In a stock purchase with a 338(h)(10) election, the buyer inherits the tail liability and adjusts pricing accordingly.

Accordingly, the net proceeds from sale of an S corporation may be less than, equal to, or greater than those received from sale of an otherwise identical C corporation. Differences in net proceeds do not, however, affect the value of the company itself. Further, an S corporation that yields greater proceeds from an asset sale than a similar C corporation’s stock sale is not otherwise identical. The asset sale occurs only because the S corporation has fewer liabilities (embedded capital gains) than does the C corporation. And we reiterate that the sellers of S corporation assets (rather than the stock itself) retain the tail liability, which, while unknown at closing, can be substantial. A qualifying share purchase with a 338(h)(10) election allows for the acquirer to receive stepped-up basis in the acquired assets (as in an asset purchase), but the buyer inherits the unknown tail liability that is avoided in an asset sale. In short, the 338(h)(10) election provides additional structuring flexibility in the sale of an S corporation and raises the possibility of greater sale proceeds to the S corporation shareholders in a change of control transaction. Whether this possibility should be reflected in the conclusion of value will depend on the subject interest, definition of value, and purpose of the valuation.

446

BUSINESS VALUATION

THE SHAREHOLDER LEVEL VALUE OF S CORPORATIONS Earlier in this chapter, we demonstrated that the potential tax benefit associated with the S corporation election actually accrues to the shareholders, rather than the company itself. As a result, the value of the business is unaffected by the S corporation election. In this section, we illustrate how to determine the effect on value, if any, of the potential S corporation tax benefits at the shareholder level of value. We are occasionally credited with developing a model to value the S corporation benefit. While we appreciate the credit, we have not done so. Rather, we advocate valuing nonmarketable minority interests in S corporations using the very same shareholder level discounted cash flow approach we apply to similar interests in C corporations. We find that the relevant shareholder tax benefits of the S corporation election can be reliably incorporated into the value of the subject interest using the Quantitative Marketability Discount Model (QMDM, as discussed in Chapter 9). Consulting the conceptual framework of the Integrated Theory (Exhibit 12.4), we observe that any difference in value between a subject minority interest in an S corporation and a similar interest in an otherwise comparable C corporation must be attributable to a difference in interim shareholder cash flows (CFsh ), risks over the expected holding period (manifest in Rhp ), or growth in value over the expected holding period (Gv ).

S Corporation Considerations for the QMDM Inputs There are four broad classes of QMDM inputs. In the following sections, we describe the specific considerations required when applying the QMDM to a subject interest in an S corporation. In order to facilitate comparability and understanding, we mirror this example of developing a marketability discount for an S corporation after the detailed example developed for a C corporation in Chapter 11 (reproduced as Exhibit 12.5 below). The C corporation

Conceptual Math

Marketable Minority Value (Equity Basis)

Nonmarketable Minority Value (Equity Basis)

CFEq(mm) REq(mm) – GCF Eq(mm)

CFsh Rhp – Gv

Relationships

GCF Eq(mm) = REq(mm) –

Value Implications

CFEq(mm)

VEq(mm) is the benchmark for the other equity levels of value

VEq(mm)

("as-if-freely-traded")

CFsh ≤ CFEq(mm) Gv ≤ (REq(mm) – Dividend Yield)

Vsh ≤ VEq(mm)

Rhp ≥ REq(mm)

EXHIBIT 12.4 Comparison between the Benchmark Marketable Minority and Nonmarketable Minority Levels of Value: Equity Basis.

448

BUSINESS VALUATION

had a marketable minority value of $10 million based on net earnings of $1.0 million, a discount rate of 16%, and expected growth of 6.0% ($1.0 million/(16% − 10%) = $10 million). The corporation paid a dividend equal to 40% of its earnings, providing a 4.0% expected yield for investors, providing a first-year dividend of $400 thousand. The expected holding period was five to ten years, and the required holding period return was 21.0% (with a range of 20% to 22%). The concluded marketability discount was 35%. Forecast Period The first input to a shareholder level discounted cash flow model is the expected holding period over which the investor’s return objectives will be achieved. With respect to differences between S and C corporation interests, we expect situations in which there is a difference in the expected holding periods to be rare. For this example we have assumed an expected holding period of five to ten years. This is identical to the expected holding period used in Exhibit 12.5. The holding period assumption materially impacts the effect of the S corporation tax benefit on the value of the subject interest. Properly conceived as a shareholder benefit, the potential tax savings to the shareholder arising from the S election are relevant only during the expected holding period, rather than into perpetuity. Perpetuity calculations of the shareholder tax benefit for investments with limited expected holding periods are, for this reason, inappropriate. The QMDM captures this distinction. Projected Interim Cash Flows The second input to the shareholder level discounted cash flow model is a projection of interim shareholder distributions. As illustrated in Exhibit 12.2, the economic distributions to S corporation shareholders are not taxable, in contrast to identical distributions to C corporation shareholders. As a result, the S election has a direct and quantifiable effect on the interim cash flows (reflected in the distribution yield and distribution growth inputs to the QMDM).

QUANTITATIVE MARKETABILITY DISCOUNT MODEL (QMDM) Conclusion of the Analysis Enterprise Level DCF Assumptions 1. Forecast Period

Shareholder Level DCF (QMDM) Inputs)

Model Inputs Low

1. Range of Expected Holding Periods (Years) 2a. Expected Distribution / Dividend Yield

2. Projected Interim Cash Flows (during forecast period)

10

Yield

4.0%

2b. Expected Growth in Distribution / Div. Yield

Growth

2c. Timing (Mid-Year or End of Year)

Timing

M

Gv

10.0%

Prem/Disc.

0.0%

3. Projected Terminal Value (at end of forecast period)

3a. Growth in Value over Holding Period

4. Discount Rate

4. Range of Required Holding Period Returns

3b. Premium or Discount to Marketable Value

6.0%

Low

20.0%

High

22.0%

Base Value (Marketable Minority Interest)

Required Holding Period Return (Annual %)

Average Indicated Discounts for Selected Holding Periods (Mid-Point Return +/–1%) Average of 2–4 Year HP 15% Average of 5–10 Year HP Average of 5–7 Year HP 27% Average of 10–15 Year HP Average of 8–0 Year HP 37% Average of 15–20 Year HP Average of 10–20 Year HP 49% Concluded Marketability Discount

21.0% 17.0% 18.0% 19.0% 20.0% 21.0% 22.0% 23.0% 24.0% 25.0%

1

2

3

4

5

2% 3% 4% 5% 5% 6% 7% 8% 8%

5% 6% 8% 9% 11% 12% 13% 15% 16%

7% 9% 11% 13% 15% 17% 19% 21% 23%

9% 12% 15% 17% 20% 22% 24% 27% 29%

11% 15% 18% 21% 24% 26% 29% 32% 34%

5

High

Assumed Holding Periods in Years 6 7 8 9 Implied Marketability Discounts 13% 15% 17% 19% 17% 20% 22% 24% 21% 24% 26% 29% 24% 27% 30% 33% 27% 31% 34% 37% 31% 34% 38% 41% 33% 37% 41% 44% 36% 40% 44% 47% 39% 43% 47% 50%

PV=100%

EXHIBIT 12.5 Results of QMDM Analysis.

$1.00

32% 45% 54% 35%

10

15

20

25

30

21% 27% 31% 36% 40% 44% 47% 50% 53%

30% 36% 42% 46% 51% 55% 58% 61% 64%

37% 43% 49% 54% 58% 61% 65% 67% 70%

43% 49% 54% 59% 63% 66% 68% 71% 73%

47% 53% 58% 62% 65% 68% 71% 73% 74%

450

BUSINESS VALUATION

In applying the QMDM, we account for the favorable tax attributes of S corporation economic distributions by expressing the distribution yield on a C corporation equivalent basis. In other words, the net economic distribution after all taxes have been paid is grossed up to reflect the pro forma dividend from a C corporation that would yield the same after-tax distribution. Based on the preceding discussion in this chapter, we are assuming that an S corporation otherwise identical to this C corporation would have a marketable minority value of $10 million. The S corporation would distribute 40% of after-tax earnings to its shareholders, and would retain $0.6 million after having done so. In order to maintain equivalency between the C corporation and the S corporation to the extent possible, we assume that the S corporation will distribute 37% of its pre-tax earnings to fund the corporate tax liability passed through to the shareholders (see Lines 1–5 in Exhibit 12.6). Please note that, in this example, we continue to assume commensurability between the effective corporate and personal tax rates; we will modify this assumption when we discuss the impact of the Tax Cuts and Jobs Act of 2017 in a subsequent section of this chapter. We assume a 62.2% aggregate distribution payout ratio, inclusive of shareholder-level taxes, to provide for a $0.40 dividend to shareholders after those taxes (Lines 5–9). This leaves the S corporation with $0.60 of retained earnings ($1.587 − $0.987 = $0.60), just like the C corporation after paying a dividend of 40% of net earnings. We now “gross-up” the after-tax S corporation to its C corporation equivalent (Lines 10–12). Assuming a personal tax rate on dividends of 23.8%, the $0.40 dividend translates into a $0.525 C corporation equivalent dividend. Given the marketable minority value of $10.00, the C corporation equivalent yield is 5.25%. This compares to the 4.0% yield for the otherwise identical C corporation in Chapter 11. A $0.40 economic distribution from an S corporation is superior to a $0.40 dividend from a C corporation. All else equal, the

451

Applying the Integrated Theory to Tax Pass-Through Entities

1 2 3 4 5

Expected Pre-Tax Earnings of Pass-Through Entity Personal Federal Ordinary Income Tax Rate Personal State Ordinary Income Tax Rate times: Blended Marginal Tax Rate Pass-Through Taxes

6 Expected Total Distribution Payout Percentage 7 Expected Total Distributions less: Pass-Through Taxes on Pre-Tax Earnings 8 9 = After-Tax Dividend 10 After Tax Dividend 11 Blended Tax Rate on C Corp Dividends (incl Medicare surcharge) 12 = C Corporation Equivalent Dividend 13 C Corporation Equivalent Dividend divided by: Marketable Minority Interest Value 14 15 Implied Ongoing Dividend Yield - C Corporation Basis

Inputs / Calculations $1.587 37.0% 0.0% 37.0% $0.587 62.2% $0.987 ($0.587) $0.400

23.8%

$0.400 76.2% $0.525 $0.525 $10.00 5.25%

EXHIBIT 12.6 Calculation of C Corporation Equivalent Dividend Yield for Tax Pass-Through Entities.

tax-free nature of S corporation economic distributions would lead to a higher value for a given subject minority interest, relative to a similar interest in a comparable C corporation. Projected Terminal Value (Growth in Value) Within the QMDM, the projected terminal value of the subject interest at the end of the expected holding period is determined by applying the expected growth in value to the marketable minority value of the subject interest at the valuation date. We have previously shown that the growth prospects of the enterprise are unaffected by the S corporation election. Accordingly, we do not expect any difference in the expected growth in value assumption to contribute to a difference in the value of minority interests in S and C corporations. In a previous section of this chapter, we ascribed the potentially lower capital gain obligation upon the eventual sale of the interest to

452

1 2 3 4 5 6 7 8

Components of the Required Holding Period Return Long-Term Government Bond Yield-to-Maturity Ibbotson Common Stock Premium times: Market Beta equals: Beta-Adjusted Common Stock Premium plus: Small-Cap Stock Premium plus: Specific Company Risk equals: Total Equity Premium Base Holding Period Required Return

BUSINESS VALUATION Estimated Range Lower Higher 3.00% 3.00% 6.00% 1.00 6.00% 5.00% 2.00% 13.00% 16.00%

13.00% 16.00%

1.00% 1.00% 1.00% 0.50% 0.50% 0.50% 4.50%

2.00% 1.00% 1.00% 1.00% 1.00% 0.50% 6.50%

9 10 11 12 13 14 15

Investor-Specific Risk Premium(s) for This Investment: plus: Uncertainties of Expected Holding Period plus: Information Acquisition Cost Premium plus: Premium for Expected Holding Period Monitoring Costs plus: Adjustment for Large Size of the Interest plus: Rights of First Refusal Limiting Transferability (ROFR) plus: Potential for Adverse Cash Flow Total Investor-Specific Risk Premium for This Entity

16

Estimated Range of Required Holding Period Returns

20.50%

22.50%

17

Rounded Range

20.50%

22.50%

18

Mid-Point of Estimated Required Holding Period Return Range

21.5%

EXHIBIT 12.7 Derivation of Required Holding Period Return.

the net proceeds from sale of the enterprise, rather than the value of the enterprise. The same logic can be applied when considering the value of a specific minority interest. However, appraisers wishing to incorporate the benefit of increasing basis from undistributed earnings may do so by estimating the benefit specifically and reducing the concluded marketability discount as a result (as demonstrated in the following example). Because our example S corporation retains precisely the same amount as the example C corporation, the expected growth in value of 6.0% assumed in Chapter 11 is also assumed for the S corporation.

Applying the Integrated Theory to Tax Pass-Through Entities

453

Discount Rate The final element of the shareholder level discounted cash flow model is an appropriate discount rate to determine the present value of the projected interim cash flows and terminal value. In the QMDM, we call this discount rate the required holding period return (Rhp ). The required holding period return is the sum of the enterprise discount rate and incremental holding period premiums (HPP) accounting for shareholder risks borne during the expected holding period. The salient question in the valuation of minority interests in S corporations, then, is whether the risks of the holding period are different for S corporation shareholders than their C corporation counterparts. We suggest that, in many cases, minority shareholders in S corporations face greater risks than those in C corporations, and therefore would assume larger holding period premiums. For example, S corporation shareholders face the risk that the tax benefits from the S corporation election, which are assumed to persist throughout the expected holding period, may be lost, either through revocation of the S corporation election or through a legislative change in the dividend income tax rate. In addition, because of the arithmetic required to restate S corporation distributions to a C corporation equivalent basis, the anticipated S corporation interim cash flows are more sensitive to changes in the level of enterprise earnings and economic distribution payout ratios. Finally, while shareholders are unlikely to allow such practices to persist, the legal obligation to pay taxes on corporate earnings regardless of whether sufficient distributions to fund the tax payments are received is real. The prospect of such an outcome occurring even once likely supports some additional return premium. Exhibit 12.6 derives the required holding period return for the example S corporation. The build-up of the required holding period return is identical to that found in Exhibit 11.3 for the C corporation with one exception. At Line 14, we add an increment of return (0.50%) to account

454

BUSINESS VALUATION

for the potential for adverse cash flow that exists in nearly every tax pass-through entity, even if such an outcome is unlikely. Compared to the 21.0% required holding period return midpoint for the C corporation, the corresponding return for the S corporation is 21.5%. As with any other discounted cash flow model, the QMDM is sensitive to the selected discount rate. To the extent the discount rate applicable to an S corporation shareholder interest exceeds that applicable to an otherwise comparable C corporation shareholder interest, the value of the S corporation interest will be lower.

Synthesis The value differential at the shareholder level between a subject S corporation interest and a corresponding interest in a C corporation is a function of the level of economic distributions (CFsh ) and shareholder risks during the expected holding period (as manifest in Rhp ). The potential for higher economic distributions suggests that S corporation interests will be worth more, all else equal, than their C corporation counterparts. In contrast, the incremental holding period risks suggest, all else equal, that the S corporation interest will be worth less than the corresponding C corporation interest. The balance of these two competing considerations determines the value differential in each particular circumstance. Exhibit 12.8 summarizes the effect of these competing considerations on the value of a minority interest in an S corporation (Vsh(S) ), relative to a minority interest in a C corporation (Vsh(C) ).

Vsh(S) =

CFsh(s) Rhp+SP − Gv(s)

≤≥

CFsh(C) Rhp − Gv(C)

= Vsh(C)

EXHIBIT 12.8 Shareholder Values for S and C Corporations.

Applying the Integrated Theory to Tax Pass-Through Entities

455

At this point, we need to determine the value of the S corporation interest relative to the corresponding C corporation interest. Exhibit 12.9 summarizes the basic QMDM analysis for the S corporation. In Exhibit 11.4, the appraiser concluded that the appropriate marketability discount for the C corporation was 35%. The calculated discounts for a 21.0% required return were 31%, 34%, and 37% for holding periods of seven, eight, and nine years. The corresponding discounts for a 21.5% required return are 27%, 30%, and 33% for the S corporation in Exhibit 12.9. The differences in the implied marketability discount are generally modest (about 4%). The higher expected cash flows from S corporation ownership have been mitigated by the higher expected risks. In this example, the incremental risk increased the indicated marketability discounts on the order of 2%, other things be equal. This risk borne by S corporation shareholders cannot be quantified without using a shareholder level discounted cash flow analysis. However, we have not yet considered all of the expected cash flows from S corporation ownership. Given that this S corporation is retaining significant earnings, the tax bases of its shareholders will be increasing pro rata over the expected holding period. The benefit of the basis build-up is quantifiable, as shown in Exhibit 12.10. The table summarizes the annual retained earnings and the cumulative basis build-up. At the end of each period, the portion of the implied capital gain sheltered from taxes is calculated based on an assumed capital gains rate of 23.8% from the preceding example. The present value factors using the required holding period return of 21.5% are then calculated, and the present values of the cumulative basis shelter are then calculated for each potential holding period. In this case, the present value of the basis shelter is $0.030 relative to $1.00 of marketable minority value, suggesting a reduction of the marketability discount of about 3%. Some analysts would consider a lower discount rate applicable to the tax shield. Reducing the discount rate increases the calculated value of the tax shield. For

Enterprise Level DCF Assumptions 1. Forecast Period

Shareholder Level DCF (QMDM) Inputs)

Model Inputs Low

1. Range of Expected Holding Periods (Years) 2a. Expected Distribution / Dividend Yield

2. Projected Interim Cash Flows (during forecast period)

10

Yield

5.3%

2b. Expected Growth in Distribution / Div. Yield

Growth

2c. Timing (Mid-Year or End of Year)

Timing

M

G

10.0%

3a. Growth in Value over Holding Period

3. Projected Terminal Value (at end of forecast period)

3b. Premium or Discount to Marketable Value

4. Discount Rate

4. Range of Required Holding Period Returns

6.0%

Prem/Disc.

0.0%

Low

20.5%

High

22.5%

Base Value (Marketable Minority Interest)

Required Holding Period

Average Indicated Discounts for Selected Holding Periods (Mid-Point Return +/– 1%) Average of 2-4 Year HP 13% Average of 5-10 Year HP Average of 5-7 Year HP 24% Average of 10-15 Year HP Average of 8-10 Year HP 33% Average of 15-20 Year HP Average of 10-20 Year HP 44% Concluded Marketability Discount

21.5% 17.5% 18.5% 19.5% 20.5% 21.5% 22.5% 23.5% 24.5% 25.5% PV=100%

1

2

3

4

5

2% 2% 3% 4% 5% 5% 6% 7% 8%

3% 5% 6% 8% 9% 11% 12% 13% 15%

5% 7% 9% 11% 13% 15% 17% 19% 21%

6% 9% 12% 15% 17% 20% 22% 24% 26%

8% 12% 15% 18% 21% 23% 26% 29% 31%

5

High

Assumed Holding Periods in Years 6 7 8 9 Implied Marketability Discounts 10% 12% 13% 15% 14% 16% 18% 20% 17% 20% 22% 24% 21% 24% 26% 29% 24% 27% 30% 33% 27% 30% 34% 36% 30% 34% 37% 40% 33% 37% 40% 43% 35% 39% 43% 46%

EXHIBIT 12.9 QMDM Results for S Corporation Example.

$1.00

28% 40% 48% 30%

10

15

20

25

30

16% 22% 27% 31% 35% 39% 42% 46% 49%

24% 30% 36% 41% 45% 49% 52% 56% 58%

30% 37% 42% 47% 51% 55% 58% 61% 64%

35% 42% 47% 52% 56% 59% 62% 64% 67%

39% 45% 50% 55% 58% 61% 64% 66% 68%

Trim Size: 6in x 9in

Expected Holding Period Range Years of Forecast

1

2

3

4

5

6

7

8

9

10

Pre-Tax Earnings Growing @

6.0%

$0.159

$0.168

$0.178

$0.189

$0.200

$0.212

$0.225

$0.239

$0.253

$0.268

Distribution Payout %

62.2%

($0.10)

($0.10)

($0.11)

($0.12)

($0.12)

($0.13)

($0.14)

($0.15)

($0.16)

($0.17)

Retained Earnings

$0.06

$0.06

$0.07

$0.07

$0.08

$0.08

$0.09

$0.09

$0.10

$0.10

Cumulative Retained Earnings (Basis Build-Up)

$0.06

$0.12

$0.19

$0.26

$0.34

$0.42

$0.50

$0.59

$0.69

$0.79

Capital Gains Tax Savings at

23.8%

$0.01

$0.03

$0.05

$0.06

$0.08

$0.10

$0.12

$0.14

$0.16

$0.19

Present Value Factors

21.5%

0.823

0.677

0.558

0.459

0.378

0.311

0.256

0.211

0.173

0.143

Cumulative PV of Basis Shelter at Each Year

$0.01

$0.02

$0.03

$0.03

$0.03

$0.03

$0.03

$0.03

$0.03

$0.03

Potential Adjustment to Marketability Discount

–1.2%

–2.0%

–2.5%

–2.9%

–3.0%

–3.1%

–3.1%

–3.0%

–2.8%

–2.7%

$0.030 –3.0%

EXHIBIT 12.10 S Corporation Tax Basis Build-up Analysis.

Relative to $1.00 of Marketable Minority Value Relative to otherwise concluded Marketability Discount

Mercer583097 c12.tex V1 - 08/29/2020 1:03pm Page 457

Average Shelter for Expected Holding Period Average Potential Adjustment to Marketability Discount

458

BUSINESS VALUATION

example, if we assume a discount rate of 8%, the indicated value of the tax shield increases to between $0.055 and $0.087. The value of the basis build-up is inversely related to the expected level of distributions. When distributions are expected to be significant, the increase in basis is limited, but the benefit of the S election is manifest in the current yield. The Integrated Theory suggests that the value of an illiquid interest is the present value of its expected cash flows discounted to the present at an appropriate discount rate. By considering the benefit of the tax shield from basis build-up, we have considered all of the cash flows potentially attributable to the interest. In this case, the analyst took the benefit of the tax shield into consideration, together with all the other elements of his analysis, and concluded that the appropriate marketability discount for the S corporation interest was 27% (the base discount of 30% less 3% for basis build-up). Recall that the concluded marketability discount for the otherwise identical C corporation was 35%. In this case, the S corporation interest was worth more than the C corporation interest. As the preceding discussion makes clear, that result was not a foregone conclusion, but was dependent on the facts and circumstances of the example. We have presented this example in a fashion to be able to see the impact of the S election on the value of a minority interest relative to an otherwise identical C corporation interest. In practice, analysts value interests of tax pass-through entities based on the facts and circumstances surrounding each engagement. The QMDM provides an excellent tool for capturing the benefits and risks of the S election from the viewpoint of minority shareholders and incorporating those factors directly into the development of valuation conclusions.

S CORPORATIONS AND THE TAX CUTS AND JOBS ACT OF 2017 Our analysis of the valuation benefit of the potential value of the S election at the nonmarketable minority level of value suggests the following sensitivities:

Applying the Integrated Theory to Tax Pass-Through Entities

459

1. The S election eliminates personal taxes on distributions from the corporation in excess of the amount required to fund pass-through tax liabilities. The economic benefit of the S election is therefore inversely related to the personal dividend tax rate that is avoided. While the effective dividend tax rate to the S corp shareholder is 0% in either case, the benefit relative to an otherwise comparable C corp shareholder is greater if the personal tax rate on dividend income is 20% than if the dividend tax rate is 10% because more tax is avoided. 2. Following the S election, taxes are payable on corporate earnings at the applicable personal tax rate on ordinary income rather than the applicable corporate tax rate. If the personal tax rate is less than the corporate tax rate, the economic benefit of component 1 above is augmented. If, on the other hand, the personal tax rate is greater than the corporate tax rate, the economic benefit of component 1 above is mitigated. In the preceding examples in this chapter, we have assumed that corporate and personal tax rates are identical, which neutralizes the impact of this factor on the value of the S election. 3. The S election reduces future capital gains on the sale of stock through the build-up of basis in the form of retained earnings. The higher the capital gains tax rate, the greater the economic benefit of basis build-up; the lower the capital gains tax rate the lower the economic benefit of basis build-up. We summarize these sensitivities in Exhibit 12.11. The Tax Cuts and Jobs Act of 2017 reduced the corporate tax rate and personal tax rate on ordinary income while leaving the personal tax rate on dividend income and capital gains unchanged. As shown in Exhibit 12.12, the net effect of the TCJA was to reduce the value benefit of the S election at the shareholder level. In the following section, we illustrate the negative effect of the TCJA on the value of a shareholder interest in an S corporation relative to an interest in a comparable C corporation. Note that this conclusion does not address whether the value of a given shareholder interest in an S corporation increased or decreased on an absolute basis following the passage of TCJA. Rather, it means that

C Corporation Tax on Corporate Earnings

S Corporation

All else equal, higher corporate tax rates increase the shareholder value of an S corp interest.

Corporate Rate Personal Rate Ordinary Income

Tax on Distributions

Personal Rate Dividend Income

Tax on Future Capital Gain

Personal Rate Dividend Income

Sensitivity of S Corp Shareholder Value

All else equal, higher personal ordinary income tax rates increase the shareholder value of an S corp interest. All else equal, higher personal dividend income tax rates increase the shareholder value of an S corp interest.

None

Personal Rate Dividend Income

Both C corp and S corp shareholders pay the same tax rate on capital gains. However, by virtue of the basis build-up, the capital gain subject to tax is lower for S corp shareholders. As a result, the relative shareholder value of an S corp interest is positively related to the capital gain tax rate.

EXHIBIT 12.11 Sensitivity of S Corporation Shareholder Values to Personal and Corporate Tax Rates.

C Corporation Tax on Corporate Earnings

S Corporation

35% to 21% 39.6% to 37.0% (29.6% with QBI)

Tax on Distributions

Sensitivity of S Corp Shareholder Value The TCJA increased the negative spread in tax rates applicable on corporate earnings from 4.6% to 16.0%. The Qualified Business Income (QBI) deduction mitigates the negative impact for many S corp shareholders. In either case, however, the changes reduce the value of a shareholder interest in an S corp relative to a C corp. Since the personal tax rate on dividend income was unaffected by TCJA, there is no impact on the value of a shareholder interest in an S corp relative to a C corp.

Unchanged at 23.8% None

Tax on Future Capital Gain

Since the personal tax rate on capital gains was unaffected by TCJA, there is no impact on the value of a shareholder interest in an S corp relative to a C corp.

Unchanged at 23.8% Unchanged at 23.8%

EXHIBIT 12.12 Sensitivity of S Corporation Shareholder Values to Personal and Corporate Tax Rate Changes in TCJA.

462

BUSINESS VALUATION

the potential incremental value of a shareholder interest in an S corporation over that of an interest in an otherwise comparable C corporation was diminished (and in some cases, likely eliminated) by the passage of TCJA.

Post-TCJA S Corporation Valuation Example In this section, we follow the same example as developed in Exhibit 12.6 through Exhibit 12.10. However, rather than assuming that the corporate and personal ordinary income tax rates are equal, we use the actual tax rates implemented by TCJA. For purposes of this example, we assume that the shareholders of the subject S corporation are eligible for the Qualified Business Income (QBI) deduction; as a result, the effective personal tax rate on ordinary income passed through to shareholders is 29.6% (37.0% × (1–20% deduction)). For shareholders not eligible for the QBI deduction, the negative impact of TCJA is more pronounced than shown in our example. Forecast Period We assume the same forecast period as the prior example. The change to tax rates under TCJA would presumably have no effect on the expected holding period for a nonmarketable minority interest. Projected Interim Cash Flows The calculation to measure the C corporation equivalent dividend yield is unchanged by the TCJA, but the required inputs result in a lower yield, as illustrated in Exhibit 12.13. Giving effect to the revised tax rates under TCJA, the C corporation equivalent yield for our subject S corporation interest is 3.82%, compared to 5.25% in the prior iteration of this example (see Exhibit 12.6). This is a significant change, and we analyze the factors contributing to this change in Exhibit 12.14.

463

Applying the Integrated Theory to Tax Pass-Through Entities

1 2 3 4 5

Expected Pre-Tax Earnings of Pass-Through Entity Personal Federal Ordinary Income Tax Rate Personal State Ordinary Income Tax Rate times: Blended Marginal Tax Rate Pass-Through Taxes

6 7 8 9

Expected Total Distribution Payout Percentage Expected Total Distributions less: Pass-Through Taxes on Pre-Tax Earnings = After-Tax Dividend

10 11 12

After Tax Dividend Blended Tax Rate on C Corp Dividends (incl Medicare surcharge) = C Corporation Equivalent Dividend

13 14

C Corporation Equivalent Dividend divided by: Marketable Minority Interest Value

15

Implied Ongoing Dividend Yield - C Corporation Basis

16

Memo: Retained Earnings

Inputs / Calculations $1.266 29.6% 0.0% 29.6% $0.375 52.6% $0.666 ($0.375) $0.291

23.8%

$0.291 76.2% $0.382 $0.382 $10.00 3.82%

$0.600

EXHIBIT 12.13 Calculation of C Corporation Equivalent Dividend Yield for Tax Pass-Through Entities.

A few comments regarding the comparison of Exhibits 12.5 and 12.12 are in order: ■

■

The base level of pre-tax earnings is lower in the post-TCJA example because the reduction in corporate tax rates means that generating $1.00 of after-tax C corporation earnings requires less pre-tax income (see lines 16 through 18). The expected total distribution payout percentage (line 6) is lower in the post-TCJA example in order to preserve equivalence in the amount of retained earnings available for reinvestment to support future growth. As shown on lines 20 and 24, the annual retained earnings is $0.60 for both the C corporation and S corporation in both the base and post-TCJA examples.

464

BUSINESS VALUATION Base Case Exhibit 12.5

1 2 3 4 5

Expected Pre-Tax Earnings of Pass-Through Entity Personal Federal Ordinary Income Tax Rate Personal State Ordinary Income Tax Rate times: Blended Marginal Tax Rate Pass-Through Taxes

6 7 8 9

Expected Total Distribution Payout Percentage Expected Total Distributions less: Pass-Through Taxes on Pre-Tax Earnings = After-Tax Dividend

10 11 12

After-Tax Dividend Blended Tax Rate on C Corp Dividends (incl Medicare surcharge) = C Corporation Equivalent Dividend

13 14

C Corporation Equivalent Dividend divided by: Marketable Minority Interest Value

15

Implied Ongoing Dividend Yield - C Corporation Basis

16 17 18 19 20 21 22 23 24

Post-TCJA Case Exhibit 12.13

Inputs / Calculations $1.587 37.0% 0.0%

Inputs / Calculations $1.266 29.6% 0.0%

37.0% $0.587 62.2%

23.8%

29.6% $0.375 52.6%

$0.987 ($0.587) $0.400

$0.666 ($0.375) $0.291

$0.400

$0.291

76.2% $0.525

23.8%

76.2% $0.382

$0.525 $10.00

$0.382 $10.00

5.25%

3.82%

Expected Pre-tax Earnings of Comparable C Corporation less: Corporate Tax Rate Expected Net Earnings of Comparable C Corporation less: C Corporation Dividend Expected Retained Earnings of Comparable C Corporation Dividend Yield for Comparable C Corporation

$1.587 37.0% $1.000 (0.400) $0.600 4.0%

$1.266 21.0% $1.000 (0.400) $0.600 4.0%

Expected Pre-tax Earnings of Pass-Through Entity less: Total Distribution from Pass-Through Entity Expected Retained Earnings of Pass-Through Entity

$1.587 (0.987) $0.600

$1.266 (0.666) $0.600

EXHIBIT 12.14 Comparison of Yield Inputs before and after TCJA.

■

In the base example, the C corporation equivalent dividend yield is 5.25%, compared to a 4.0% dividend yield for the corresponding C corporation. The value of a nonmarketable minority interest is positively related to dividend yield, so all else equal, the higher dividend yield for the S corporation will contribute to a higher nonmarketable minority interest value (i.e., to a lower marketability discount). In contrast, the C corporation equivalent dividend yield in the post-TCJA example is 3.82%, which is actually less than the unchanged 4.0% dividend yield for the corresponding C corporation. This is attributable to the fact that the tax rate

Applying the Integrated Theory to Tax Pass-Through Entities

465

paid on pass-through earnings by the S corporation shareholder (29.6%) exceeds the tax rate payable by the corresponding C corporation. In order to retain an equal amount of earnings, the post-TCJA S corporation will receive a net distribution (after payment of pass-through taxes) of just $0.291. Even after grossing this amount up for the forgone personal tax on dividend income, the C corporation equivalent dividend still falls short of the 4.0% C corporation benchmark. If the S corporation were not eligible for the QBI deduction, the negative impact on dividend yield would be even more pronounced, with the expected yield (on a C corporation equivalent basis) falling to 2.59%. Projected Terminal Value (Growth in Value) Because we have preserved the equivalence of annual retained earnings between the subject S corporation and the otherwise comparable C corporation in our post-TCJA example, the expected growth in value of 10% is unaffected. Discount Rate The passage of TCJA has no discernable effect on the discount rate applicable to the subject nonmarketable minority interest. Indicated Discount The indicated range of marketability discount for the subject interest under the post-TCJA inputs is depicted in Exhibit 12.15. The indicated range of marketability discounts extends from 23% to 46%, compared to a range of 18% to 39% in our base example (Exhibit 12.9). The only assumption affected by TCJA was the dividend yield. The decrease in dividend yield resulted in an increase in the indicated marketability discount of 5% to 7%. As with our base example, however, the valuation analyst may desire to give explicit consideration to the potential benefit of basis build-up in the S corporation. Since the amount of retained earnings each year is unaffected and TCJA did not change personal tax rates on capital gains, the analysis in Exhibit 12.9 indicated a

QUANTITATIVE MARKETABILITY DISCOUNT MODEL (QMDM) Conclusion of the Analysis S Corporation Minority Interest

Enterprise Level DCF Assumptions 1. Forecast Period

Shareholder Level DCF (QMDM) Inputs)

Model Inputs Low

1. Range of Expected Holding Periods (Years ) 2a. Expected Distribution / Dividend Yield

2. Projected Interim Cash Flows (during forecast period)

10

Yield

3.8%

2b. Expected Growth in Distribution / Div. Yield

Growth

2c. Timing (Mid-Year or End of Year)

Timing

M

Gv

10.0%

3a. Growth in Value over Holding Period

3. Projected Terminal Value (at end of forecast period)

3b. Premium or Discount to Marketable Value

4. Discount Rate

4. Range of Required Holding Period Returns

6.0%

Prem/Disc.

Required Holding Period

21.5% 17.5% 18.5% 19.5% 20.5% 21.5% 22.5% 23.5% 24.5% 25.5% PV=100%

2

3

4

5

3% 4% 4% 5% 6% 7% 7% 8% 9%

6% 7% 9% 10% 12% 13% 14% 16% 17%

8% 11% 13% 15% 17% 19% 20% 22% 24%

11% 14% 16% 19% 21% 24% 26% 28% 30%

14% 17% 20% 23% 26% 28% 31% 33% 36%

Assumed Holding Periods in Years 6 7 8 9 Implied Marketability Discounts 16% 18% 21% 23% 20% 23% 25% 28% 23% 26% 29% 32% 27% 30% 33% 36% 30% 33% 37% 40% 33% 37% 40% 43% 36% 40% 43% 47% 38% 42% 46% 50% 41% 45% 49% 52%

0.0%

Low

20.5%

High

22.5%

Base Value (Marketable Minority Interest) Average Indicated Discounts for Selected Holding Periods (Mid-Point Return +/– 1%) Average of 2–4 Year HP 17% Average of 5–10 Year HP Average of 5–7 Year HP 30% Average of 10–15 Year HP Average of 8–10 Year HP 40% Average of 15–20 Year HP Average of 10–20 Year HP 52% Concluded Marketability Discount

1

5

High

$1.00

35% 48% 57% 30%

10

15

20

25

30

25% 30% 35% 39% 43% 46% 50% 53% 55%

34% 40% 45% 50% 54% 57% 61% 63% 66%

42% 48% 53% 57% 61% 64% 67% 69% 72%

48% 53% 58% 62% 65% 68% 71% 73% 75%

52% 57% 62% 65% 68% 71% 73% 75% 76%

EXHIBIT 12.15 QMDM Results for S Corporation Example (Post-TCJA).

Applying the Integrated Theory to Tax Pass-Through Entities

467

3.0% benefit from basis build-up is the same under the post-TCJA assumptions. On the basis of the preceding analysis, the valuation analyst concludes a marketability discount of 30% is applicable to the subject interest in the post-TCJA S corporation. Recall that this compares to a marketability discount of 35% for the otherwise comparable C corporation. So, as predicted, the benefit of the S election from the perspective of a minority shareholder has been diminished by the TCJA, but in our example was not fully extinguished. The point of this discussion and example is not to offer any specific conclusions regarding the appropriate magnitude of marketability discounts for S corporations following the passage of TCJA, but rather to demonstrate the robustness and continuing validity of the economic analysis presented in this chapter, regardless of what current tax rates happen to be. The net benefit of the S election for the value of nonmarketable minority interests – if any – is always dependent on the relevant facts and circumstances, and those facts and circumstances always include the prevailing tax rates.

CONCLUSION Are S corporations worth more than otherwise identical C corporations? Using the conceptual framework of the Integrated Theory, this question need not be so vexing for appraisers. We point to Exhibit 12.1 to summarize our conclusions regarding the valuation of S corporations at the enterprise and shareholder levels of value. At the enterprise levels of value, there is no basis for a difference in value between S corporations and C corporations, as the potential tax benefit of the S corporation election inures to the individual shareholders rather than the business. Because there is no difference in company cash flows, risk, or growth prospects, there is no difference in enterprise value.

468

BUSINESS VALUATION

At the shareholder level of value, three factors interact to determine whether the subject minority interest in an S corporation is worth more or less than the corresponding interest in a C corporation. 1. The potential for higher economic distributions to the S corporation shareholders suggests that the S corporation interest could be worth more. 2. In contrast, the incremental risks borne by S corporation shareholders suggest that the C corporation interest could be worth more. 3. Finally, the potential for basis build-up in the event of undistributed earnings may be considered in concluding that an S corporation interest could be worth more. We also demonstrated that, following passage of the TCJA, C corporation equivalent dividend yields for S corporations may actually be impaired, which may in some cases erase the benefit of the S election to shareholders, or potentially even cause the S election to be an economic burden. Regardless of the applicable facts and circumstances, the resolution of the S corporation value conundrum is simpler than many assume – a focus on expected cash flow, growth, and risk. A shareholder level discount cash flow analysis is the most direct way to reliably measure the valuation impact of the S election on a subject interest. Regardless of what changes the next tax bill may bring, the Integrated Theory is a reliable guide for thinking clearly about the value of interests in S corporations relative to interests in otherwise comparable C corporations.

About the Authors

Z. CHRISTOPHER MERCER Z. Christopher Mercer, FASA, CFA, ABAR, is founder and chairman of Mercer Capital, a national business valuation and financial advisory firm with offices in Memphis and Nashville, Tennessee and Houston and Dallas, Texas. Mercer Capital has 45 employees and conducts business in forty or more states every year.

Education, Experience and Valuation Credentials Mr. Mercer was born in Daytona Beach, Florida. He attended Stetson University in DeLand, Florida, where he graduated cum laude with a B.A. degree in economics in 1968. He was a Distinguished Military Graduate in ROTC and was commissioned as a Second Lieutenant in the U. S. Army. He then went to Vanderbilt University in Nashville, Tennessee, where he earned an M.A. degree in economics in 1971. From Vanderbilt, Mr. Mercer went directly into the U.S. Army. After initial training in the United States, he served for more than three years in the First Armored Division, and was stationed just outside Nurnberg, Germany. He was discharged with the rank of Captain in late 1974. After some travel, he returned to the United States in early 1975. Mr. Mercer’s first job after the military was with First Tennessee National Corporation (now First Horizon Corporation), a regional bank holding company headquartered in Memphis. Within a year, he was the Manager for Investor Relations, and was then promoted to Assistant Treasurer. The experience at First Tennessee provided the beginnings of his life as a financial analyst.

469 Business Valuation, First Edition. Z. Christopher Mercer and Travis W. Harms. © 2021 Z. Christopher Mercer and Travis W. Harms. Published 2021 by John Wiley & Sons, Inc.

470

ABOUT THE AUTHORS

After a “flickering moment” as a bank consultant with Peat Marwick Mitchell & Co. (now KPMG) in Houston, Mr. Mercer returned to Memphis as a bank stock analyst. He followed regional bank stocks for a Memphis-based New York Stock Exchange firm, Morgan Keegan & Co., Inc. (now part of Raymond James) beginning in late 1978. At Morgan Keegan, Mr. Mercer was introduced to business valuation almost immediately, and “sold” his first valuation engagement within a month of arriving. He then had to perform that valuation assignment, only to discover that there were no books on the subject. (Shannon Pratt’s first edition of Valuing a Business was not published until 1982). Nevertheless, he prepared his first business appraisal in early 1979. He obtained varied experience with bank and business valuation and corporate finance, and served for the last part of his tenure at Morgan Keegan as Director of Fixed Income Research. Mr. Mercer founded Mercer Capital in June 1982 in a two-room office with an Osborne One luggable computer (with word processing and spreadsheet programs on floppy disks), a Smith Corona TP-1 printer that printed one letter quality page in five minutes, a thermal copier, and a telephone. His objective was to build a business valuation firm. In early 1984, however, Mercer Capital acquired a few contracts to deliver bank consulting services and began delivering consulting services in the region while continuing to perform valuation work. In mid-1985, Mr. Mercer made the decision to gradually exit the bank consulting business and to engage in business valuation services exclusively. By 1987, while maintaining the firm’s revenue size, the exit from bank consulting was completed. Mercer Capital has been a business valuation and financial advisory company since that time. Mr. Mercer has served on the boards of directors of several private and one public company. He is currently chair of the executive committee of a privately-owned nurse staffing company. Mr. Mercer earned the right to use the Chartered Financial Analyst designation (CFA) in 1984 and was awarded Charter Number 7714 by the CFA Institute. In 1987, after completing five years of full-time valuation experience at Mercer Capital, he earned the

About the Authors

471

Accredited Senior Appraiser designation (ASA). And in 2008, he was awarded the Accredited in Business Appraisal Review designation (ABAR) by the Institute of Business Appraisers (now NACVA). Mr. Mercer was elected to the College of Fellows of the American Society of Appraisers in 2016 and now holds the designation, Fellow – FASA.

Writing and Speaking Mr. Mercer co-authored a chapter in The Banker’s Handbook, a Dow-Jones Irwin (now McGraw Hill) publication in 1978. The title of the chapter was “Capital Planning and Capital Adequacy.” He has been writing books, chapters in books, articles and blog posts ever since. By the late 1980s, Mr. Mercer recognized that there was significant confusion regarding the use of the Capital Asset Pricing Model to develop discount rates and valuation multiples. There was no published methodology to explain how business appraisers and market participants could develop valuation multiples. His article, “The Adjusted Capital Asset Pricing Model for Developing Capitalization Rates: An Extension of Previous ‘Build-Up’ Methodologies Based Upon the Capital Asset Pricing Model,” was published in Business Valuation Review (of the American Society of Appraisers) in December 1989. What was new at that time has become standard fare for valuation analysts and market participants. Mercer Capital developed an early specialization in the valuation of financial institutions because of Mr. Mercer’s early work history. In 1992, he published Valuing Financial Institutions (a Dow-Jones Irwin book). While focused on financial institutions, this book was one of only four valuation books published by the mid-1990s. A great deal has changed since then. Mr. Mercer saw that valuation analysts were attempting to develop marketability discounts based on comparisons with averages of restricted stock studies and pre-IPO studies. He began to develop a model to value illiquid minority interests in private businesses based on expected cash flow, risk and growth. That work culminated in the Quantitative Marketability Discount Model (QMDM), which was introduced in Mercer’s Quantifying

472

ABOUT THE AUTHORS

Marketability Discounts in 1997, along with an Excel-based version of the QMDM. Developing the QMDM was the first step in the development of the Integrated Theory of Business Valuation, which was published in 2004. The next edition, Business Valuation: An Integrated Theory (a John Wiley & Sons, Inc. book) was published in 2007. And now we have the third edition. Mr. Mercer has bridged the gap between theory and practical valuation issues in his writing. He has written three books on buy-sell agreements from business and valuation perspectives. Companies and industries differ widely, but the underlying issues causing the need for buy-sell agreements are similar across companies and industries. He published: ■

■

■

Buy-Sell Agreements: Ticking Time Bombs or Reasonable Resolutions (Peabody Publishing, LLC, Memphis, 2007) Buy-Sell Agreements for Closely Held and Family Business Owners (Peabody Publishing, LLC, Memphis, 2010) Buy-Sell Agreements for Baby Boomer Business Owners (an Amazon book, 2013)

Another of his practical books relates basic corporate finance principles to private company wealth management. Unlocking Private Company Wealth: Proven Strategies for Managing Wealth in Your Private Business (Peabody Publishing, LLC, 2014) discusses numerous shareholder wealth enhancing strategies used by public companies for direct application to private companies. In addition to his books, Mr. Mercer has written many articles for business valuation, accounting, legal, financial planning, and industry publications addressing both theoretical and practical valuation and business issues. He has been a blogger for many years and has published hundreds of posts on his various blogs, many of which formed the basis for later articles and books. Mr. Mercer has been speaking at conferences of business appraisers, accountants, attorneys, financial planners, business industry associations, and to business owners since the late 1980s. He has spoken at events across the nation and in Canada, Japan,

About the Authors

473

Hong Kong, Australia, Germany, Italy, Russia, and Brazil. He has been a member of the National Speakers Association for more than twenty years.

Professional Involvement Mr. Mercer joined the Business Valuation Standards Subcommittee of the American Society of Appraisers in 1990 and served on that committee until 2005. In 2007, he was asked to rejoin the standards subcommittee as its chair. The current ASA Business Valuation Standards were completely revised and updated under his leadership and republished in 2009 (the current version as of this writing). He served as Vice Chairman of the International Board of Examiners (Business Valuation) of the American Society of Appraisers from 1991 to 1994. He also served as an elected member of the Business Valuation Committee of the American Society of Appraisers for two terms. Mr. Mercer served as liaison between the American Society of Appraisers and the International Valuation Standards Council for several years and served on the Professional Board of the IVSC from 2011 to 2014.

Expert Witness Experience Mr. Mercer first testified in court regarding a business valuation matter in 1981. Since then, he has become well-known as an expert in the business valuation field. He has testified in deposition and/or trial in state courts in more than twenty-five states over the years. He has also testified in several U.S. District Courts, U.S. Bankruptcy Court, and the U.S. Tax Court. He has testified in numerous arbitrations and before regulatory bodies in several jurisdictions. Mr. Mercer has testified regarding a variety of business valuation, economic damages, and appraisal review issues. He has testified in a number of matters involving buy-sell agreements or buy-sell agreement valuation processes. And he has testified in deposition and/or trial regarding statutory fair value in dissenting minority shareholder and oppression matters in some fifteen states.

474

ABOUT THE AUTHORS

TRAVIS W. HARMS Travis W. Harms, CFA, CPA/ABV is a senior vice president at Mercer Capital, a national business valuation and financial advisory firm with offices in Memphis, Nashville, Dallas, and Houston. Since its founding in 1982, Mercer Capital grown to approximately 45 employee shareholders and performs engagements in more than forty states annually. Travis holds an undergraduate degree in finance and accounting from Quincy University in Quincy, IL and received an MBA from Saint Louis University. He is a Certified Public Accountant and has earned the Accredited in Business Valuation designation from the American Institute of Certified Public Accountants. Mr. Harms has been a CFA Charterholder since 2001. Travis began his valuation career at Mercer Capital in 1999. During his tenure there, he has led many complex valuation assignments for gift & estate planning engagements, financial reporting, litigation consulting, and transaction advisory engagements. Mr. Harms has also provided expert witness testimony in several matters since 2008. Mr. Harms contributed to the first edition of Business Valuation: An Integrated Theory, which was published in 2004. He was coauthor of the second edition of the book. Since 2016, Mr. Harms’ practice has been primarily focused on providing valuation and financial consulting services to multi-generation family businesses. The Family Business Advisory Services group at Mercer Capital provides shareholder education and training, benchmarking services, and strategic consulting regarding dividend policy, capital structure decisions and capital budgeting policy. Mr. Harms’ most recent book is The 12 Questions That Keep Family Business Directors Awake at Night. He also provides weekly commentary on valuation and financial topics of interest on the Family Business Director blog at mercercapital.com. Mr. Harms has been a frequent speaker at business valuation conferences and other venues for the past fifteen years. In addition to this book, he has been a contributing author of several other books and has written articles that have appeared in numerous

About the Authors

475

publications, including Business Valuation Review, Family Business Magazine and others. Throughout his career, Mr. Harms has served on various AICPA volunteer committees, and was a member of The Appraisal Foundation’s working group on control premiums in financial reporting. That working group published its whitepaper The Measurement and Application of Market Participant Acquisition Premiums in 2017. Travis and his wife Maggie are proud parents to Sophie, Kenneth, Nate and Bella.

Index

Acquirer cash flow, stand-alone basis, 172e Activity-based multiples, application, 194–96 Activity multiples, 192–93 Adjustments, 200–09 factors, 258 historical/prospective adjustments, applicability, 126e, 127e, 135e normalizing adjustments, 117–23 qualitative factors, 200–04 strategic adjustments, 131e strategic control adjustments, 115, 128–33 After-tax cost of debt, 162 Agency costs, 338–46, 341e, 346e American Institute of Certified Public Accountants (AICPA), 349 American Society of Appraisers (ASA), 349–53 Amortization, estimation, 92–93, 93–94 Anticipated future inflows, 99 As-if freely tradable level, 296 As-if freely traded level, 29 As-if freely traded price, strategic price (contrast), 133 Asset appraisals, 382 Asset value, realized returns (relationship), 144 Assumed ERP, beta (impact), 155e

Available cash flow, perspective, 109–11, 109e Benchmark marketable minority financial control value level, comparison, 42e levels, nonmarketable minority levels (contrast), 63, 64e nonmarketable minority value level, comparison (equity basis), 297e, 447e value level, 32e Benchmarks, 26, 410 Beta, 155–57, 155e, 201–02 Bidding process, 57 Blockage discount, 361 Board of directors, members (appointment/change), 247 Business bad/good fortune, occurrence (assumptions), 116 course, change, 248 discretionary policies (change), shareholder incentive (absence), 118 enterprises, 359, 428 equity, value, 51, 53e owners, financial condition, 365 plans, 364 valuation, 3, 67 Buy-sell agreements, 362, 363–64, 385 BVR Cost of Capital Professional, 153

477 Business Valuation, First Edition. Z. Christopher Mercer and Travis W. Harms. © 2021 Z. Christopher Mercer and Travis W. Harms. Published 2021 by John Wiley & Sons, Inc.

478 Canadian Institute of Chartered Business Valuators, 350 Capital, 201–03 components, WACC (relationship), 169e costs/structure, dynamic relationship, 166–69 gains, reduction, S election (impact), 459 investments, return (earning example), 102 venture capital returns, 388–89 Capital Asset Pricing Model (CAPM), 155–57 Capital expenditures, 94, 132, 138 Capitalization rate, 21 Capital structure, 163–64 assumptions, development (methods), 163 capital costs, dynamic relationship, 166–69 comparison, 167e impact, 168e, 181–83 iterative method, 163 performance measures, 183 target capital structure method, 163–64 Cash flow (CF), 42e, 43 adjustments, 84, 112–15, 113e, 134 available cash flow, perspective, 109–11 differences, 356 expected cash flow to equity, 39–40, 39e expected growth rate (GCF ), 53e, 54 firmwide equity cash flows, non-pro rata distribution, 380 forecasts, 84, 90e, 100–04 future growth, augmentation, 55 Gordon Model input, 440

INDEX income approach, 83 increase, 44 incremental value, post-combination, 173e interim cash flows, likelihood, 391 normalized cash flows, usage, 45 numerator position, 37 projection, 100e–02e target/acquirer cash flows, stand-alone basis, 172e unusual/nonrecurring events, adjustments, 113–14 valuation input, 353 value/return, relationship, 145e values, contrast, 63 C corporations, 370 calculation, 372e dividend payment, absence, 415, 419–21, 422e equivalent dividend yield, calculation, 376e, 451e, 463e equivalent yield, 373, 374e forecast period, 448 minority interest, 468 near-term sale potential, 415, 421–26, 423e shareholder value, 454e transactional expenses/liabilities, differences, 444–45 value differences, 436e Change-of-control transaction data, usage, 36 Companies (subject company) analogy, creation, 178 attractiveness, increase, 125, 170 characteristics, 369 company-specific risk premium, 158–60 debt, absence, 161 EBITDA margin, generation (example), 229 equity value, 29, 29e

Index growth reinvestment, 402–403 industry conditions, 366 liquidation/sale/recapitalization, 248 money, loss, 311 offers, 362 pre-announcement price, 235 prior transactions, 329 private company transaction structure, 165–66 sale, 361, 403 subject company WACC/growth rate, 205 tax characteristics, adjustment, 370–77 transaction price, 235 Conceptual premiums, 36 Controlling interest value levels, 353–56 Controlling owner, exit strategies, 364 Controlling shareholder characteristics, 369–70 Control premium (CP), 36 adjustment, 258–59 application, 238e, 267 calculation, bases (usage), 233e data, 38, 233–34, 236–39 discounts, 318 existence, 20 expression, 233–34, 235e, 236 historical perspective, 247 measurement, 234 Mergerstat Review definition, 251e observed control premiums, 234–36, 240–42 studies (Mergerstat Review), 250–52 traditional measurement, 50 valuation analyst reliance, 50 Corporate earnings, taxation, 438, 459

479 Corporate finance/operational decisions, normalization, 114 Corporate taxes, 372, 460e, 461e Cost of debt capital, 161–62 Cost of equity capital, 148–61 Debt, 161–62 Debt, repayment, 97 Depreciation, 92–93, 93–94, 138 Direct multiple selection approach, 211e Discounted cash flow (DCF) equation, solution, 13 expectations, 332e inputs, specification, 330–31 model, 85e, 88e shareholder level, 331–38 ten-year increments, 87e two-stage enterprise DCF model, 332e two-stage shareholder DCF model, 333e Discounted cash flow (DCF) method analyst migration, 87–88 application, 13, 20 fundamental equivalence, 85–87 single-period capitalization method, 83–90 Discounted value, 393 Discount for lack of marketability (DLOM), 65–66 Discount rate, 39e, 40, 42e, 43, 141, 315 Discounts, 34, 352e Distribution determination, 281 expected growth, assumption, 404 growth, expectation, 334, 336 making, 368 negative yield, 375 non-pro rata distributions, 339

480 Distribution (Continued) personal taxes (elimination), S election (impact), 459 timing, 334, 336 total distribution payout, 373 yield, expectation, 333, 336 Distribution expenses, 131 Dividends expectations, absence, 298 expected growth, assumption, 377–78, 404 growth, 377–78 history, 369 median yield, 311 payment, 368 policies, impact, 381–82 preferential dividend claims, 369 receipt, timing (assumption), 378–79 timing, 404 yield, 370e, 373e, 402 Due diligence, 393–94 Duff & Phelps Cost of Capital Navigator, 153 Earnings, 21–22, 216 reinvestment, company history, 382 single-period capitalizations, 13 Earnings before interest and taxes (EBIT), 93, 187 Earnings before interest, taxes, depreciation, and amortization (EBITDA), 91–92, 184–92, 189e capitalization, indicated value, 194, 197e depreciation factors, 191e EBITDA to EBIT ratio, 212 formula, 190 margins, 194, 212, 229 Economic factors, impact, 20 Emory, John, 319

INDEX Emory Studies (pre-IPO study), 319 Enterprise basis, 28, 72–73, 74e, 75–77, 109e Enterprise cash flows, 83, 90–94 derivation, 91e expected growth, increase, 44 projected enterprise cash flows, reasonableness (assessment), 136–39 strategic cash flow adjustments, meaning, 133–34 strategic control adjustments, 115, 128–33 suboptimal reinvestment, 380 valuation, 81 Enterprise DCF expectations, 332e Enterprise discount rate, incremental HPP (sum), 453 Enterprise, strategy, 125, 170 Enterprise valuation multiples, conceptual math, 186e, 226e Equity cost, strategic buyer consideration, 55 discount rate, 29e, 30, 298 holders, expected cash flow, 29e, 30 interests, 428 investments, value (growth), 12 offering/acquisition, likelihood (increase), 364 total equity value, 39, 39e, 334 Equity basis, 27, 73–76 business valuation, Integrated Theory, 67 Integrated Theory, 67, 68e value, conceptual levels (comparison), 74e Equity cash flows (CF), 95–99 components, 84 derivation, 97e expected growth rates (GCF ), 29e, 30–31, 39e, 40–41, 42e, 43

Index strategic control buyer viewpoint, 53, 53e Equity risk premium (ERP), 150–55, 154e, 155e Existing/pro forma capital structures, comparison, 167e Expected benefits, sharing (willingness), 44 Expected cash flow, 37, 108–15 Expected distribution, assumption, 404 Expected dividend yield (D %), 368–77, 404 Expected growth rate (GV ), 61–62 assumption, 379–85 development, 381–83 dividend policies, impact, 381–82 evidence (provision), asset appraisals (usage), 382 factors, 379–81 leverage, change (impact), 383 marketability discounts, sensitivity, 384e portfolio composition, impact, 383 sensitivity, relationship, 384–85 value, contrast, 63 Expected holding period, 336, 360–68 assumption, holding period (correspondence), 429 estimation, factors, 363–65 marketability, relationship, 361–63 monitoring costs, 398, 406 ranges, 367–68, 404 uncertainties, 398, 406 Expected return, 412, 414 Fair market value, determination, 20 Family, relationships, 366 Financial buyers, 128e, 227e, 265 Financial Control, 27, 35, 76–77, 114, 124–25, 135

481 Financial Control Premium (FCP), 36, 44–46, 44e, 73, 76, 263 Financial control value levels, 42e, 357e Financial engineering, usage, 124–25, 170 Financially motivated guideline transactions, 225–29 Financial returns, generation (focus), 124–25 Firmwide equity cash flows, non-pro rata distribution, 380 Firmwide levels, 435–36, 440–45, 441e FMV/Stout opinions database, implied required returns/HPPs, 313–17 FMV/Stout restricted stock database, 306–17, 307e, 308e, 310e, 312e Forward multiples, 183–84 Freely traded shares, 284–87, 284e, 285e, 293e Fundamental adjustment applicability, 216, 228–29 direct quantification, 204–09 impact, 208e implied fundamental adjustment, 209–14 qualitative factors, 200–04 quantification, 205e, 206 scenarios, 207e Fundamental valuation model, 293e components, usage, 26 enterprise basis, 23e equations, 13e, 72e equity basis, 21–23, 21e, 22e Future returns, impact, 122 Future values, expectation, 315–16 General/administrative expenses, 132 Gordon Model, 292–93, 293e, 295, 320, 440, 442

482 Gross margin, 200 Gross profit multiple, 191–92, 194 Growth, 199–214, 356 company reinvestment, 402–03 expectations, 203–04 Gordon Model input, 440, 442 growth in value, 451–52, 465 historical growth, 203 prospects, differences, 228 subject company growth rate, 205 valuation input, 353, 355 Guideline growth rate, 205 Guideline public companies, 222–23, 224e enterprise value multiples, example, 193–96 market approach, 177 performance metrics, comparison, 195e reasonableness, assessment, 244–45 Guideline public company multiples, 45 usage, 218e value enterprise levels, relationship, 214–19 Guideline public/private company WACC, 208 Guideline transactions, 221–33, 224e method, 244, 272–75 multiples, 242, 243e Guideline WACC, 204–05 Historical adjustments, applicability, 126e, 127e, 135e Historical cash flows, transition, 84 Historical ERP, calculation, 154e Historical growth, 203 Historical ownership policies, 363 Historical reinvestment patterns, 203 Historical results, adjustment, 116–17 Historical returns, 204

INDEX Hitchner and Morris Studies (pre-IPO study), 319 Hitchner, James, 319 Holding period (HP), 333, 336–38 analysis, 430e areas, investigation, 365–66 assumption, 360–68 expected holding period assumption, correspondence, 429 importance, 281 incremental holding period risk, 339, 344 length, impact, 412 marketability discounts, sensitivity, 384e uncertainty, 391 value, growth, 334, 336 Holding Period Premium (HPP), 61, 65, 287, 292–94 expected HPP, calculation, 301e FMV/Stout opinions database, 313–17 implied holding period premium analysis, 314e market evidence, 387–91 measurement, 296–301 required return on equity, sum, 386 Holding period (HP) return, 61, 62e, 338 expectations, range, 334 median implied holding period return, 316 range, development, 396 Illiquid assets, owner risk, 63, 65 Illiquidity, incremental risks (association), 66 Implied annual return, 317 Implied expected annual return, 316 Implied holding period premium, 314e, 316 Implied holding periods, 315

Index Implied minority interest discount, traditional definition (usage), 50 Implied required returns (FMV/Stout opinions database), 313–17 Inbound/outbound license/sharing agreements, entry, 248 Income approach, 96e, 141 market approach, relationship, 178–80, 179e shareholder level, 330–31 Income taxes, deduction, 97 Incremental borrowings, 98 Incremental holding period premium, enterprise discount rate (sum), 453 Incremental holding period risk, 339–46 Incremental return, determination, 299–300 Incremental risks, 66, 341e, 345e, 346e Incremental value, cash flows (post-combination), 173e Inflation, expectation, 106 Inflows, impact, 99 Information, 394, 398, 406 Initial public offerings (IPOs), 271, 321, 322e, 362 benchmark IPO pricing, differences, 325 candidate, likelihood, 393 Integrated Theory, 54, 435 enterprise basis, 28e, 71 enterprise level, 78e equity basis, 19, 28e expected cash flow, relationship, 108–15 Nath approach, consistency, 260–61 pre-IPO discount, 320–25, 321e symbolic notation, 27–28 value, conceptual levels, 27

483 Integrated valuation model, reconciliation, 27 Interest, 407, 431 Interest expense, 96–97 Interim benefits (USPAP discussion), 429, 431 Interim cash flows, 391, 448–50, 462, 465 Interim growth rates, 99–104 Internal rate of return (IRR), 99, 101e–02e, 103–04, 411–12 International Glossary of Business Valuation Terms (IGBVT), 349–50 Invested capital, 103–04, 103e, 204 Investments, 142 cash flow characteristics, 12 duration, 12 holding period, assumption, 360–68 risk characteristics, 12 Investors, 362, 431, 432e Issuer, information (adequacy), 280 Iterative method, 163 Joint venture/partnership agreements, entry, 248 Leverage, 124, 170 change, impact, 383 relative negotiating leverage, factors, 130e Leveraged family limited partnership, commercial real estate holding, 420e Liquidation horizon, PPI forecast, 387 Liquidity, 349–53 absence, discount, 352–56 ASA business valuation definition/standards, 350–53, 351e discounts, definitions, 352e

484 Liquidity (Continued) IGBVT definition, 349–50, 350e marketability, relationship, 349 Long-term management (LTM) multiples, 183 Long-term Treasury yields, 151e Management compensation/perquisites, determination, 247 Management/ownership succession, 364 Manufacturing overhead, 131 Marginal tax rate, 162 Market, 103–04, 103e capitalization, decline, 311 market return data, availability, 395 multiples, usage, 107 participants, WACC (relationship), 165–69 prices, analysis, 152 Marketability, 349–53 absence, discount, 352–53 achievement, 412 ASA business valuation definition, 351e ASA business valuation standards, 350–53 expected holding period, relationship, 361–63 IGBVT definition, 349–50, 350e liquidity, relationship, 349 prospects, 393 Marketability discount (MD) (DLOM), 38, 65–67, 73, 335, 352e absence, base case, 340 agency costs/incremental risks, impact, 346e development, 359 difference, 259 economic factors, impact, 20

INDEX equation, 65, 66e, 335e holding period, analysis, 430e impact, combination, 344 midpoint, 415 restricted stock, conceptual equivalency, 295e restricted stock discount, relationship, 295–96 rise, economic factors (impact), 338–46 sensitivity, 384e Marketable Minority, 27, 75, 76, 406 interest level, public company equivalence, 115–23 levels, 54–55, 76–77, 120e, 135, 258 Marketable minority value level, 20, 35, 353–55, 354e Market approach, 177, 221 income approach, relationship, 178–80, 179e shareholder level, 329–30 Market Participant Acquisition Premium (MPAP), 252–58 Median implied holding period return, 316 Median restricted stock discounts, 315 Mergers and acquisitions (M&As), negotiation/completion, 248 Mergerstat Review (control premium study), 250–52, 251e Minority interest discount (MID), 46–50, 74 calculation, 241e, 259–67, 260e conception, 259 conceptual discount, contrast, 37 disappearance, 258–67 equation, 48e, 49, 49e existence, question, 267–68 historical perspective, 247 inference, observed control premiums (usage), 240–42

Index Minority interests, 266, 364–65 Minority investors, 109–11, 118, 267 Minority shareholders, annual financial statements (company provision), 403 Modified Public Market Equivalent (mPME), calculation, 390 Monitoring costs, 394, 398 Morris, Katherine E., 319 Multiples, 187–93 capital structure, impact, 181–83 forward multiples, 183–84 long-term management (LTM) multiples, 183 measurement period, impact, 183–85 valuation multiples, adjustment, 199–214 NASDAQ composite index, comparison, 389, 389e Nath, Eric, 260 National Association of Certified Valuation Analysts, 350 Negotiation, concept (implication), 410–11 Net operating profit after taxes (NOPAT), 23, 93, 185–87, 186e Net reinvestment, absence, 100e Nominal growth rate, expectation, 106 Nonmarketable Minority, 27, 63, 64e, 120e, 359, 386, 447e Nonmarketable minority value, 60, 61, 75, 297e Non-pro rata distributions, 339, 380 Nonrecurring events, adjustments, 113–14, 117–23, 121e Nonrecurring events, historical results (adjustment), 116–17 Normalized cash flows, usage, 45

485 Normalizing adjustments, 117–23, 381–82 Operating cash flow, 91, 98e, 122 Operating efficiency, 200–01 Operating margin, projections (comparison), 137–38 Operational efficiency, enhancement, 125–26, 170 Operational management, appointment/change, 247 Operational policy, setting, 248 Opportunity costs, concept (suggestion), 15 Outflows, impact, 99 Owner compensation, excess (operational decision), 123 Partnership Profiles, Inc. (PPI), return rate study, 387 Pass-through tax distribution, 373 Payout ratios, impact, 439e Performance, 116, 204 measures, valuation multiples (application), 213e metrics, comparison, 195e Periodic returns, calculation, 143e Personal taxes elimination, S election (impact), 459 rates, 460e, 461e Portfolio composition, impact, 383 Positive-NPV projects, identification/execution (ability), 103–04 Post-combination cash flows/incremental value, 173e Post-TCJA S corporation valuation discount, indication, 465, 467 discount rate, 465 example, 462–67 forecast period, 462

486 Post-TCJA S corporation valuation (Continued) interim cash flows, projection, 462, 464 pre-tax earnings, base level, 463 Pre-IPO discounts, 317–25 calculation, 318e components, 323e, 324e defining, 318–19 Integrated Theory calculation, 321e relationship, 320–25 Pre-IPO studies, 271, 319–20, 331 Pre-IPO subjects, studies (differences), 325 Pre-IPO transactions, 317, 320, 324, 329–30 Pre-IPO valuations, 322e, 323 Premiums, 20, 34 Present Value of Interim Cash Flow, 61e, 332–33 Present Value of Terminal Value (PVTV), 61e, 332–33 Present value principle, 4–5, 12–14 Pre-tax cost of debt, 161–62 Pre-tax earnings, base level, 463 Pre-tax income, 97 Principal, loss, 351 Principle of alternative investments, 5, 14–15 Principle of expectations, 4, 5–8 Principle of growth, 4, 9–10 Principle of rationality, 5, 15–16 Principle of risk and reward, 4, 10–11 Private companies, 165–66, 223–25 Private equity cash flows, financial control level, 124–27 Private equity funds, financial return generation (focus), 124–25 Private equity returns, 389–90, 390e Production inputs, cost, 131

INDEX Pro forma capital structures, comparison, 167e Pro forma income taxes, 93 Projected enterprise cash flows, reasonableness (assessment), 136–39 Prospective adjustments, applicability, 126e, 127e, 135e Public companies acquisitions, 223 investors, pro rata dividends, 266 marketable minority interest level, equivalence, 115–23 restricted stock, definition, 276–77 stocks, investor minority interest sale, 266–67 trading prices/restricted shares, 24 valuation multiples, meaning, 180–99 Publicly traded partnership returns, 387–88 Public market price, restricted stock transaction price (reconciliation), 300e Public minority investors, control, 266 Public multiples, 45, 206 Qualified Business Income (QBI), 461e deduction, 462, 465 Quantitative Marketability Discount Model (QMDM), 26, 61, 270, 317, 327 agency costs, 341e, 343e analysis, 346, 409e, 410, 449e application, 401 assumptions, 359, 402e, 403–07, 405e, 411 background, assumption, 402–03 condensed examples, 414–27 incremental risks, 341e, 345e

Index inputs, 400e, 446–54 mechanics, example, 335–38 representation, 337e results, 407–10, 426e S corporation results, 456e, 466e shareholder level DCF model, 331 structure, 332–35 Uniform Standards of Professional Appraisal Practice, relationship, 427–33 usage, example, 401–14 Real estate investment trusts (REITs), 371 Realized equity risk premiums, calculations, 153–55 Realized returns (historical returns) analysis, 152 asset value, relationship, 144 changes, required returns (impact), 146e measurement, 142–43 observability, 144 outcomes, 144 required returns, 142–48, 143e Reasonableness, assessment guideline public company method, 244–45 income/market approaches, 219–20 weighted average cost of capital, 175–76 Reasonableness, common sense (relationship), 395 Reinvestment company history, 382 effects, 101e–02e historical reinvestment patterns, 203 impact, 100–04 management decisions, 84 net reinvestment, absence, 100e rates, 99–104

487 suboptimal reinvestment, 339, 380 Relative negotiating leverage, factors, 130e Relative sharing, importance, 132–33 Relative value, firmwide levels, 443–45 Repurchase activities, 362 Required holding period return (Rhp ), 61, 62e assumption, 385–99 derivation, 397e, 408e, 432e, 452e development, methodology, 396–99 estimation, 391–95 range, assumption, 406–07 Required returns calculation, 301e impact, 146e implied required returns (FMV/Stout opinions database), 313–17 percentage range, 412 Required returns, realized returns contrast, 142–48 directional relationship, 145–47 relationship, 143–47, 143e Restricted securities publicly traded issuer affiliate sale, 282 sales, restrictions (termination), 283 Restricted shares freely traded shares, contrast, 284–87, 285e fundamental valuation model, 293e, 294e holders, expected holding period, 287 holding, riskiness (investor assessment), 292 investment inducement, 301 Restricted stock

488 Restricted stock (Continued) FMV/Stout restricted stock database, review, 306–17 historical studies, 302–06, 303e–04e marketability discounts, conceptual equivalency, 295e performance, investor expectations (importance), 287 studies, 301–02, 394–95 transactions, 298, 300e, 329–30 Restricted stock discount (RSD), 271, 275, 387 analysis, Silber Study, 288–92, 288e, 290e, 291e conceptual source, 293e data points, usage, 278 defining, 277–79 definition/calculation, 277e equation, 293e inferences, 277–78 issuances, dollar size (average), 289 issuers, size variation, 289 marketability discount, relationship, 295–96 meaning, understanding, 279 negotiation, 294–95 reasons, 292–94 revenues/market capitalization, average, 290 SEC Rule 144, applicability, 279–84 variation, causes, 289 Restrictive agreements, 393–94 Return (R), 142–48 acceptance, 44 comparisons, restricted stock study implications, 394–95 expected return, risk (relationship), 11e future returns, impact, 122 implied expected annual return, 316

INDEX periodic returns, calculation, 143e premium returns, generation (private equity investor techniques), 124–25 rate, analysis, 413e, 425e realized returns, required returns, 142–48 trailing 10-year annualized returns, 389e value/cash flow, relationship, 145e Revenue multiple, 192 projections, comparison, 137 synergies, impact, 130 Revenue Ruling 59-60, impact, 14, 16, 395 Right of first refusal, 393, 398 Rights of first refusal limiting transferability (ROFR), 407 Risk differences, 199–214, 356 expected return, relationship, 11e factors, 202 Gordon Model input, 442 premium, 158–60 profile, 201–03, 228 valuation input, 353 Risk-free rate, 149–50 Rule 144 (SEC), 276–84 applicability, 279–84 Preliminary Note, 280 restriction period reduction, 302 S corporations, 371–75 asset sale, 445 benefits, 437–40, 439e distribution, negative yield, 375 dividend yield, calculation, 373e economic distributions, tax-free nature, 438 election, 437 firmwide level value, 440–42 forecast period, 448

Index minority interest, 468 net proceeds, 444 QMDM input considerations, 446–54 QMDM results, 456e, 466e shareholder basis, 444–45 shareholder level value, 446–58 shareholder value, 454e, 460e, 461e tax basis build-up analysis, 457e Tax Cuts and Jobs Act of 2017 (TCJA), 458–67 transactional expenses/liabilities, differences, 444–45 value differences, 436e Securities Act of 1933, 280 Securities and Exchange Act of 1934, 279 Securities and Exchange Commission (SEC) Rule 142, 276–84, 302 Securities Exchange Act of 1934, 276 Selling/marketing expenses, reduction, 132 Sensitivity, expected growth rate (relationship), 384–85 Shareholder cash flow, 66, 269 Shareholder level, 436 asset-based approach, 328–29 cash flow benefit, 438, 440 DCF model, 331–38 discount rate, 453–54 forecast period, 448 income approach, 330–31 market approach, 329–30 valuation approaches, 328–31 value, 446–58 value differential, 454 Shareholder level discounted cash flow model, 60, 61e Shareholders agreements, 363 basis, 444–45

489 CF expectations, 332e controlling shareholder characteristics, 369–70 dividends, historical record (valuation consideration), 392 offers, 362 relationships, 366 Shares, price, 315 Silber Study, 302 samples, 291e summary statistics, 288e, 290e usage, 288–92 Single-period capitalization method application, 87–88 change, meaning, 88 DCF method, 83–90 fundamental equivalence, 85–87 unreliability, 88 usage, 45 Single-period capitalization model, 86e, 90e Single-period income capitalization, valuation method, 12–13 Size premium, 157–58, 159e, 202 Standard & Poor’s 500 Index (S&P500), 10e Standard & Poor’s 1000 Index , EBITDA depreciation factors, 191e Statements on ASA Business Valuation Standards (SBVS), 180, 274 Stout Restricted Stock Study, 274 Strategic acquirer cash flows, 128–35 Strategic adjustments, 131e Strategically motivated guideline transactions, 229–33 Strategic buyers attributes, 128e equity cost (R), consideration, 55 equity discount rate (R), 53–54, 53e

490 Strategic buyers (Continued) return, lower level (acceptance), 57 seller synergistic/strategic benefits, 57 Strategic cash flow adjustments, meaning, 133–34 Strategic Control, 27, 35 adjustments, 114, 128–33 level, 51–55, 128–35, 171–74 value, 75 Strategic Control Premium (SCP), 36, 55–58, 74–75, 263 Strategic policy, setting, 248 Strategic transactions, conceptual dynamics, 129 Strategic values, range, 173e Suboptimal reinvestment, 339, 380 Systematic risk (beta), 201–02 Target capital structure method, 163–64 Target cash flow, stand-alone basis, 172e Taxable corporate income, tax payments, 438 Tax Cuts and Jobs Act of 2017 (TCJA), 437 post-TCJA S corporation valuation, example, 462–67 S corporations, relationship, 462–67 yield inputs, comparison, 464e–65e Tax equivalent yields, 375 Tax pass-through entities, 371–75 C corporate equivalent dividend yield, calculation, 451e, 463e distributions, 372e Integrated Theory, application, 435 interim cash flows, uncertainty, 392 Terminal growth rates, 104–08 conceptual meaning, 106e

INDEX market participant evaluation process, 84 meaning, 105–07 Terminal value adjustments, assumption, 385 calculation, 379e extra-normal growth, incorporation, 107 inclusion, 88e projection, 451–52, 465 Thomson Reuters Venture Capital Index (TRVCI), 389 Three-level chart, refinement, 51, 52e TIC Foundation, usage, 255, 257 Total debt, equivalence, 75 Total distribution payout, 373 percentage, expectations, 463 Total equity value, 39, 39e, 334, 336 Total value creation, relative sharing, 172, 173e Trailing 10-year annualized returns, 389e Transaction multiples components (financial buyers), 227e guideline transaction multiples, 242, 243e impact, 217e Transferability (limitation), right of first refusal (impact), 398 Two-stage enterprise DCF model, 332e Two-stage shareholder DCF model, 333e Uniform Standards of Professional Appraisal Practice (USPAP) QMDM, relationship, 427–33 requirements, 428–31 Rule 9-4(c), 427 Rule 9-4(d), 428, 429 SR 9-4(d), 428–29

Index SR 9-4(c), transfer restrictions, 432, 433 Unit pricing, 200 Unleveraged family limited partnership commercial real estate holding, 414, 417–19, 418e land holdings, 414, 415–17 undeveloped real estate holding, 416e Unrealistic expectations (usage), expectations role (impact), 8–9 Unusual events, adjustments, 113–14, 117–23, 121e Unusual events, historical results (adjustment), 116–17 US Private Equity Index, 390 Valuation analyst experience/judgment, 394 assessment, 424 components, comparison, 73e guidance, 359 inputs, 353–55 questions, 20 range concept, 410–11 ratios, 272, 274 realized returns, impact, 145 treatment, firmwide levels, 435–36 Valuation Advisors Studies and Database (pre-IPO study), 319–20 Valuation multiples adjustment, 199–214 application, 213e example, 182e implied fundamental adjustment, 209–14 market expectations, relationship, 185–93 meaning, 180–99 structure, 180e

491 Valuations in Financial Reporting Valuation Advisory 3 (Appraisal Foundation), 252 Value base level, 267–68 cash flow/return, relationship, 145e charts, traditional/modified levels, 37e, 52e conceptual levels, 23–27, 74e control levels, 35 derivation, 45 enterprise basis, 73–77 equity basis, 32e, 73–77 equity levels, 25e expected growth, 66 expected growth rate (GV ), 61–62, 379–81 financial control level, 39, 39e, 40, 84, 170–71, 214–15 firmwide levels, 54, 56e, 441e firmwide levels, shareholder value level, contrast, 58–60, 59e fundamental adjustment, impact, 208e future values, expectation, 315–16 growth, 334, 404 implications, levels, 51 implied adjustments, 198e indications, 85, 178 marketable minority interest level, 29–35, 117–21 marketable minority level, 29e, 30, 170, 214, 323 nonmarketable minority level, 60, 61e principles, 5 questions, 3–4 source, 20 strategic control level, 51–55, 53e, 135, 171–74, 215–17 three-level chart, refinement, 51, 52e understanding, world of value (impact), 4–5

492 Value enterprise levels, guideline public company multiples (relationship), 214–20 Value levels, 169–74 charts, traditional/modified levels, 262e, 264e comparison, 73–77 conceptual descriptions, 26 guideline transaction multiples, relationship, 242 relationships, 249e, 258 Valuing Shareholder Cash Flows (Mercer), 306 Venture capital returns, 388–89 Weighted average cost of capital (WACC), 99 assumptions, cumulative effect, 165e capital components, relationship, 169e

INDEX capital structure, impact, 168e components, 148–64, 149e equation, 148 guideline WACC, 204–05 IRR, relationship, 101e–02e, 103–04 levels, 169–74 market participants, relationship, 165–69 reasonableness, assessment, 175–76 subject company WACC, 205 usage, 189e Willamette Studies (pre-IPO study), 319 Working capital, 94, 132, 139 World of value, goal, 4–5 Yield inputs, comparison, 464e