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Business Valuation

Valuation Methodologies
Discounts and Premiums
Business Valuation: Common Uses of Business Valuation

 Tax
– Estate/Gift – Employee Stock Ownership Plan (ESOP)
– Buy/Sell Agreements – Internal Revenue Codes (IRC) 743, IRC
409A, etc.
 Bankruptcy and Litigation
– Liquidation or Reorganization – Solvency and Fairness Opinions
– Patent Infringement – Damage Assessment
– Partner Disputes – Dissenting Shareholder Actions
– Economic Damages – Marital Dissolutions
 Financial Reporting
– Purchase Price Allocation, Impairment Testing and Stock Options and Grants, etc.
 Strategic Planning/Transaction
– Value Enhancement
– Business Plan/Capital Raising
– Strategic Direction, Spin-Offs, Carve Outs, etc.
– Acquisitions, Due Diligence

Business Valuation: Valuation Process

1.1 Proposal 1.2 Establish 1.3 Establish 1.4 Data

and Standard of Valuation Gathering
Engagement Value and Date
Letter Define Purpose
Signed Engagement
Letter with Retainer
Ongoing Internal Review and Discussion with Other
Professionals and Client
2.1 Company 2.2 Analyze 2.3 Adjustments 2.4 Financial
and Industry Historical and Recasts Statements
Analysis Financial (Control) Analysis
Statements (Ratios, etc.)

Ongoing Internal Review and Discussion with Other

Professionals and Client
3.1 Implement 3.2 Narrative 3.3 Final Internal 3.4 Finalize
Selected Write-up of the Review and QC
Valuation Report Process

Income, Market, Net

Asset Approaches

Business Valuation: Standard of Value

 Purpose
– Establish Purpose of the Engagement
» Estate/Gift, Buy/Sell Agreements, etc.
» Standards of Value (i.e. Fair Market Value, Fair Value, etc.)
» Interest Being Valued (i.e. Enterprise, Equity, Marketable, Non-
Marketable, Control, Minority, etc.)

 Valuation Date
– Agree on a Appropriate Valuation Date
» Utilize Data Subsequent to the Valuation Date
» Sometimes can Consider Data After the Valuation Date if it was
Foreseeable as of the Valuation Date

Business Valuation: Standards of Value

 Common Standards of Value

– Fair Market Value (Tax): Fair market value applies to virtually all federal
and state tax matters, including estate, gift, inheritance, income and ad
valorem taxes as well as many other valuation situations.
» “The fair market value is the price at which the property would change hands
between a willing buyer and a willing seller, neither being under any compulsion
to buy or to sell and both having reasonable knowledge of relevant facts.” – IRS
Revenue Ruling 59-60

– Liquidation Value: Orderly; forced.

– Fair Value (Financial Reporting): Can vary but it is generally similar to
Fair market value with some exceptions.
» The amount at which an asset (or liability) could be bought (or incurred) or sold
(or settled) in a current transaction between willing parties, that is, other than in
a forced or liquidation sale.” - FASB 157
– Fair Value (Litigation): Fair value may be the applicable standard of
value in a number of different situations, including shareholder dissent
and oppression matters, corporate dissolution and divorce.
Business Valuation: Gathering Data

 Gathering Company Data

– Articles of Incorporation; Operating Agreement
– History and Background
– Products and Services
– Shareholders and Key Personnel Compensations and Responsibilities
– Organization/Corporate Structure
– Operations
– Customers/Clients, Target Markets and Suppliers
– Legal, Tax and Other Considerations
– Five Year Historical and Latest Interim Financial Statements
– Other Financial Information (A/R, A/P, Fixed Asset Ledger, etc. - if needed)
– Adjustments
– Projections (If applicable)
Business Valuation: Analyzing Data

 Researching Economic and Industry Information

– U.S. Economy
– Local Economy
– Target Industry

 Financial Statements Analysis

– Adjustments and Recasts (Control Value)
» Extraordinary Items, Shareholders’ Perquisites (Personal
Expenses), Fair Market Value Compensation and Rent, etc.
– Ratio and Trend Analysis
» Growth Rates, Liquidity, Leverage, Profitability, Efficiency, etc.

Valuation Methodologies

Income Approach
Market Approach
Net Asset Approach
Business Valuation: Valuation Approaches

 Income Approach
–The Income Approach is a valuation technique that provides an
estimation of the value of an asset based on the present value of
expected cash flows.
–The various forms:
» Capitalization of Earnings/Cash Flow Analysis (Gordon Growth Model)
» Discounted Cash Flow Analysis (DCF)
» Dividend Discount Model (DDM)

Business Valuation: Income Approach

 Capitalization of Earnings Approach

– Single Period Discounted Cash Flow Analysis
– Simplest for Companies with Stable Growth
– Next Year Free Cash Flow to Firm (FCFF)
– Next Year Free Cash Flow to Equity (FCFE)
– Apply Appropriate Discount Rate
Value =

CF = Free Cash Flow

r = Discount Rate
Cost of Capital or
Cost of Equity
g = Expected Growth Rate

Business Valuation: Income Approach

 Common Levels of Value

– Enterprise Value: Free Cash Flow to Firm (FCFF)
» This is the total cash flow a 100% owner would receive assuming no
» NI + Depreciation +/- Non-Cash Items + Interest Expense*(1-Tax) +/-
Change in Working Capital – CAPEX
» Weighted Average Cost of Capital (WACC)
– Equity Value: Free Cash Flow to Equity (FCFE)
» This is the cash flow a shareholder would expect to receive after
interest and net borrowings
» Net Income + Depreciation +/- Non-Cash Items +/- Change in Working
Capital – CAPEX +/- Net Borrowings
» Cost of Equity (higher than WACC for the levered company)

Business Valuation: Income Approach

 Discounted Cash Flow Analysis

– More General and Flexible Than Capitalized Earnings Method

CF1 CF2 CFn TCF / (r-g)

Value = + +… +
1 2
(1+r) (1+r) (1+r)n (1+r)n

CF = Cash Flow
TCF = Terminal Cash Flow
R = Discount Rate (Weighted Average Cost of Capital) or (Cost of Equity)
G = Long-term Growth Rate

Business Valuation: Weighted Average Cost of Capital

 Weighted Average Cost of Capital (WACC)

– WACC = Weight of Equity (Cost of Equity) + Weight of Debt (Cost
of Debt * (1-Tax)) + Weight of Preferred Security (Cost of Preferred
– Provides Overall Cost of Capital to Whole Company
– Assumes Constant Debt to Capital Over Time

Business Valuation: Weighted Average Cost of Capital

 Cost of Equity: Capital Asset Pricing Model (CAPM)

– Simple CAPM
» For larger publicly-traded companies
» Re = Rf + B(Rm – Rf)
» Risk Free Rate (Rf)
• Risk free rate as of the valuation date (20-year U.S. Treasury)
» Equity risk premium (Source: Ibbotson/Morningstar)
» Size adjustments often are appropriate (Source: Ibbotson/Morningstar
and Duff & Phelps Risk Premium Reports)
» Beta is a systematic risk measure

Business Valuation: Weighted Cost of Capital

 Cost of Equity: Build-up

–For smaller closely-held companies
–Inputs are same as CAPM except for the application of industry risk
premium instead of Beta coefficient
–Industry risk premium based on Morningstar (Ibbotson) Yearbook
Build-up Cost of Equity Capital
Risk-free rate (Rf) 4.5%
Equity premium (RPm) 5.0%
Size premium (RPs) 6.0%
Industry risk premium -1.1%
Company-specific premium (RPu) 2.0%
Indicated Cost of Equity Capital 16.4%

–Generally similar to CAPM after adjustments for size and specific


Business Valuation: Weighted Cost of Capital

 Cost of Equity and Leverage

– Companies with More Debt Relative to Equity are Riskier and Have
Higher Costs of Equity
» Beta (B)
• Beta is a measure of the sensitivity of the movement in returns on a particular
stock to movements in returns on some measure of the market (i.e. S&P 500,
• Published and calculated betas typically reflect the capital structure of each
respective company at market values
• Unlevered beta is the beta a company would have if it had no debt
• Lever the beta for the subject company based on one more assumed capital
structure B L
Bu (Unlevered Beta) =
Wd = Weight of Debt
1 + ( 1 - t ) W d / We
We = Weight of Equity
BL (Relevered Beta) = Bu ( 1 + ( 1 - t ) Wd / Wc ) Wc = Weight of Capital

• The result will be a market-derived beta specifically adjusted for the degree of
financial leverage of the subject company

Business Valuation: Weighted Cost of Capital

 Cost of Debt
–Cost of Debt Based on Subject Company’s Credit Rating and
Borrowing Rate (i.e. Prime rate + 1%, BBB, BB, B-, Prime Rate,
etc.) at Valuation Date
– After Tax Cost of Debt
» Cost of Debt x (1 – Target Company’s Tax Rate)
– Debt to Capital Ratio
» Control Value: Target/Optimal or Industry Average Debt to
Capital Ratio
» Lack of Control/Minority Value: Company Specific Debt to
Capital Ratio

Business Valuation: Other Notes About Income Approach

 Other Notes on Income Approach

– Generally on a Control, Marketable Basis
– Levels of Value
» Synergy Level Cash Flow
» Control Level Cash Flow
» Minority Level Cash Flow
– Publicly-Traded Company Derived Discount Rate
» Minority and Marketable Level Discount Rate
» Many Consider it to be Appropriate for Control Level

Business Valuation: Market Approach

 Publicly-Traded (Guideline) Comparable Company

– The Guideline Publicly Traded Company Method indicates the value of
the subject company by comparing it to publicly-traded companies in
similar lines of business
– Valuation Multiples Vary Based on Industry and States of Growth
– Problem is that there are rarely perfect matches
– Equity Multiples
»Fair Market Value of Equity (Stock Price x Outstanding Number of
»Common Equity Level Multiples
• Price / Earnings (P/E)
• Price / Tangible Book Value (P/B)

Business Valuation: Market Approach

 Publicly-Traded (Guideline) Comparable Company

– Enterprise Multiples
» Enterprise Value = (Stock Price x Outstanding Number of
Shares) + Total Debt/Preferred Securities – Cash and Short-
Term Investments
» Common Enterprise Level Multiples
• EV / Revenue

Business Valuation: Market Approach

 Publicly-Traded (Guideline) Comparable Company

– Other Multiples
» EV / R&D Expenses; # of Phase I, Phase II and Phase III
products in pipeline – Early Stage Biotechnology
» EV / # of Licenses and Rights – Shell Company, etc
» Appropriate Multiple Depends on Company Characteristics

Business Valuation: Market Approach

 Market Transaction (M&A) Approach

– In the Guideline Merged and Acquired Company Method, the value of the
business is indicated based on multiples paid for entire companies or
controlling interests.
– Public Market Transaction Approach
» Public Buyer or Seller Transactions
» Control Value
– Private Market Transaction Approach
» Private to Private Transactions
» Control Value
– Common Transaction Database
» MergerStat, Pratts’ Stat, Biz Comps, Capital IQ

Business Valuation: Market Approach

 Market Approach Adjustments

– Most Companies Differ from the Subject Company
– Need to Adjust for Differences between Market Comparables and
Subject Company
– Common Adjustments are Based on:
» Size
» Growth Rate
» Profitability
» Leverage
» Other Company Specific Factors
» Discounts and Premiums

Business Valuation: Reconciling Items

 Reconciling Items and Adjustments

– Appropriate Weighting Value Conclusions from Different Approaches
– Non-Operating Assets/Liabilities and Excess Working Capital/Cash
– Pass-Through Entity Tax Adjustments
» Adjustment for Discounted Cash Flow Analysis and Publicly-Traded
Guideline Comparable Company Analysis
» Depends on Hypothetical Buyer (C-Corp.? S-Corp.?, etc.)
– Interest-Bearing Debt and Contingent Liabilities
– Discounts and Premiums
» Apply to Equity Level
» Lack of Marketability and Minority Discounts, Key Person Discount and Control
Premium, etc.

Discounts and Premiums

Control Premium
Lack of Control/Minority Discounts
Lack of Marketability/Illiquidity Discounts
Others Discounts
Business Valuation: Lack of Marketability Discounts

 Let the Fireworks Begin!!

– Often subject to wide disparity among practitioners
– Determination based on analogy
– Data sources problematic
– Reasonable range

Business Valuation: Lack of Marketability Discounts

 Lack of Marketability Discounts (LOM)

– Marketability (liquidity) is valuable. Other things equal, investors will pay
more for the more liquid (marketable) asset
– The discount for lack of marketability is the largest money issue in many,
if not most, disputed valuations of minority interests in closely-held,
private companies
– The U.S. Tax Court normally allows discounts for lack of marketability for
non-controlling interests in closely held companies, but the size of the
discounts varies greatly from one case to another
– Need to carefully study the recent case law in the relevant jurisdiction
– The quality of the expert evidence and testimony presented in the Tax
Court makes a big difference in the outcome
– The Tax Court expects good empirical evidence, relevant to the subject
at hand; simple averages are insufficient

Business Valuation: Lack of Marketability Discounts

 Lack of Marketability Discounts

– The highest discount that the Tax Court has allowed purely for
lack of marketability is 45%, and most discounts have been
considerably less
– The ESOP discounts for lack of marketability are generally low
because most ESOP stock has a “put” right to sell the stock back
to the sponsoring company, thus enhancing its liquidity and value.
– Dissenting shareholder and shareholder oppression cases are
quite mixed on the matter of discount for lack of marketability
– There is little case law on discount for lack of marketability in
divorce cases, and what exists is also quite mixed
– If the standard of value is clearly stated as fair market value, then
a discount for lack of marketability is appropriate

Business Valuation: Lack of Marketability Discounts

 Lack of Marketability/Illiquidity Discount for Minority

– Restricted Stock Studies
» Restricted stocks are, by definition, stocks of public companies that are
restricted from public trading under SEC Rule 144
» Although they cannot be sold on the open market, they can be bought
by qualified institutional investors. Thus, the “restricted stock studies”
compare the price of restricted shares of a public company with the
freely-traded public market price on the same date
» Price differences are attributed to liquidity
» Many feel the discounts are a reliable guide to discounts for LOM
» Empirical Studies: McConaughy, SEC Institutional Investor, Gelman,
Trout, Moroney, Maher, Standard Research Consultants, Siber, FMV
Opinion, Management Planning, Johnson, Columbia Financial Advisors
Business Valuation: Lack of Marketability Discounts

 Restricted Stock Studies

– General Findings
» Show that restricted shares are worth less than unrestricted shares – generally
ranging from 10 to 30%. Discounts as high as 55% have been observed
» Discounts are larger for smaller companies and companies with more volatile
stocks and more debt
» These data are most appropriate for valuing restricted stocks and are difficult to
apply to private companies
» The value of the studies is that the comparisons are apples to apples (i.e. liquid
stock value vs. illiquid stock value of the same company at the same time).
» Restrictions have been relaxed and discounts have dropped
» Statistical studies can explain at best 1/3 of the discount

Business Valuation: Lack of Marketability Discounts

 Pre-IPO Stock Studies

–A pre-IPO transaction is a transaction involving a private company
stock prior to an Initial Public Offering (IPO)
– The pre-IPO studies compare the price of the private stock
transaction with the public offering price. The percentage below
the public offering price at which the private transaction occurred is
a proxy for the discount for lack of marketability
–The application of pre-IPO studies heavily debated and criticized
because comparisons are apples to oranges
» The dates of the transaction differ at a time when the company is
changing rapidly (in the year before the IPO)
–Discounts are very large
–Discounts/premium should be based on specific to the subject case
and not past court cases
Business Valuation: Lack of Marketability Discounts

 Other Studies
–Modified put option model (i.e. Finnerty and Chaffee)
–Modified cost of capital – total beta (McConaughy and Covrig)
–“Private Company Discount” by Koeplin, Sarin & Shapiro, Journal
of Applied Corporate Finance Winter 2000.
» Find approximately a 30% discount. Perhaps the best study, but limited
sample size makes it difficult to apply to a specific case.

Business Valuation: Lack of Marketability Discounts

 Factors Affecting Discounts for Lack of Marketability

– Company’s Financial Performance and Growth
– Size of Distributions
– Prospects for Liquidity (Expected Liquidity Event)
– Restrictions on Transferability
– Company’s Redemption Policy
– Costs Associated with a Public Offering
– Pool of Potential Buyers
– Nature of the Company, Its History, Other Risk Factors
– Amount of Control in Transferred Shares
– Company’s Management

Business Valuation: Lack of Marketability Discounts

 Lack of Marketability/Illiquidity Discounts for Controlling

– Still a controversial concept
– A company with control can be marketable, but illiquid
– More marketable and liquid than the minority interest; Higher lack
of marketability discount for smaller blocks (for closely held
– Super majority requirement for certain States
– Typically, private companies sell in 6 months which is shorter than
the restriction period of restricted stocks

Business Valuation: Control Premium and Minority Discount

 Control Premium
– Other things equal, an interest with control is worth more than
one that lacks control
– An amount by which the pro rata value of a controlling interest
exceeds the pro rata value of a noncontrolling interest in a
business enterprise that reflects the power of control often
associated with takeovers of public companies
– Some suggest that valuations of controlling interests be
adjusted upward if they are based on publicly-traded stock
prices which are minority interests
– Hubris and synergy may explain premia
– Not needed if cash flows are estimated at the control level

Business Valuation: Control Premium and Minority Discount

 Control Premium
– Common Prerogatives of Control
» Elect directors and appoint management
» Determine management compensation and perquisites
» Set policy and change the course of business
» Acquire or liquidate assets
» Select people with whom to do business and award contracts
» Make acquisitions
» Liquidate, dissolve, sell, leverage or recapitalize the company
» Sell or acquire treasury shares
» Register the company’s stock for a public offering
» Declare and pay dividends
» Change the articles of incorporation or bylaws or operating
Business Valuation: Control Premium and Minority Discount

 Control Premium Database

– Control Premia Based on Market Transactions
» Identify one month to six months control premium prior to
announcement date for public and private transactions from
Mergerstat, Capital IQ, etc.
» Control premia should exclude potential synergies associated with
selected transactions, but this is extremely difficult
» Appropriately adjust for other qualitative factors based on control

Business Valuation: Control Premium and Minority Discount

 Lack of Control/Minority Discount

– Some feel that the control premium and the minority discounts should have
the relationship as shown below:

Minority Discount = 1
1 + Control Premium

– This is overly simplistic. Ignores hubris and synergy and other factors that
impact take-over premia
– Must deal with negative “premia” in databases

Business Valuation: Control Premium and Minority Discount

 Lack of Control/Minority Discount

– Supermajority Requirement – About a quarter of the states require
something more than 50% plus 1 share vote to approve certain major
corporate actions, such as selling out or merging. Thus, a discount for a
lack of supermajority may be appropriate
– Swing Vote Potential – Depending on distribution of the stock, a minority,
swing block could have the potential to gain a premium price over a pure
minority value
– Interest of 50% - Discount from lack of control value should be less for the
interest with some control prerogatives and a little greater for the interest
without the control prerogatives
– Many experts feel that publicly-traded stocks generally sell at a control

Business Valuation: Other Discounts

 Other Discounts
– Key Person Discount
» Measure potential negative impact to the projected cash flows in the
absence of Key Personnel
– Trapped-in Capital Gains
» A company holding an appreciated asset would have to pay a capital
gains tax on the sale of the asset. If ownership of the company were to
change, the liability for the tax on the sale of the appreciated asset
would not disappear
» Use with Caution, it depends on expected time of liquidity event (usually
applied when liquidity event is imminent
» Consult a tax expert to analyze the situations
– Block Discount
» A large interest may be less liquid than a smaller one
Business Valuation: Other Discounts

 Other Discounts
– Voting vs. Non-Voting
» If a company has both voting and nonvoting classes of stock, there
may be a price difference between the two, usually in favor of the
voting stock
» Based on level of influence by the voting shareholders, restrictive
agreements, state laws and policies and the total number of block of
shares between voting and non-voting
» Empirical studies indicates premium for voting shares
• Lease, McConnell and Mikkelson Study – 5.4%
• Robinson, Rumsey and White Study – 3.5% ~ 4.5%
• O’Shea and Siwicki Study – 3.5%
• Houlihan Lokey Howard & Zukin Study – 3.2% (average), 2.7%

Business Valuation: Discounts and Premiums

 Common Errors in Applying Discounts and Premiums

– Greed produces inconsistencies with economic reality
– Low value desired
» Conservative projections
» High discount rate
» Large DLOM, etc.
– Higher value desired
» Aggressive projections
» Low discount rate
» Small DLOM, etc.
– Conservative projections should be accompanied by a lower discount rate
– Aggressive projections should be accompanied by a higher discount rate

Business Valuation: Discounts and Premiums

 Common Errors in Applying Discounts and Premiums

– Using synergistic acquisition premia to quantify premiums for control
– Assuming that the discounted cash flow valuation method always produces a
minority value
– Assuming that the guideline public company method always produces a minority
– Valuing underlying assets instead of the stock or partnership interests
– Using minority interest marketability discount data to quantify marketability
discounts for controlling interests
– Using only pre-initial public offering studies and not restricted stock studies as
benchmark for discounts for lack of marketability
– Indiscriminate use of average discounts or premiums applying (or omitting) a
premium or discount inappropriately for the legal context
– Applying discounts or premiums to the entire capital structure
– Quantifying discounts or premiums based on past court cases
– Using a tangible (real property, fixed assets, etc.) appraiser to quantity discounts
and premiums