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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
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Business Valuation: Valuation Process
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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
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Business Valuation: Standards of Value
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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)
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Business Valuation: Income Approach
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Business Valuation: Income Approach
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Business Valuation: Income Approach
CF = Cash Flow
TCF = Terminal Cash Flow
R = Discount Rate (Weighted Average Cost of Capital) or (Cost of Equity)
G = Long-term Growth Rate
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Business Valuation: Weighted Average Cost of Capital
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Business Valuation: Weighted Average Cost of Capital
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Business Valuation: Weighted Cost of Capital
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Business Valuation: Weighted Cost of Capital
• The result will be a market-derived beta specifically adjusted for the degree of
financial leverage of the subject company
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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
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Business Valuation: Other Notes About Income Approach
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Business Valuation: Market Approach
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Business Valuation: Market Approach
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Business Valuation: Market Approach
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Business Valuation: Market Approach
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Business Valuation: Market Approach
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Business Valuation: Reconciling Items
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Discounts and Premiums
Control Premium
Lack of Control/Minority Discounts
Lack of Marketability/Illiquidity Discounts
Others Discounts
Business Valuation: Lack of Marketability Discounts
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Business Valuation: Lack of Marketability Discounts
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Business Valuation: Lack of Marketability Discounts
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Business Valuation: Lack of Marketability Discounts
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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.
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Business Valuation: Lack of Marketability Discounts
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Business Valuation: Lack of Marketability Discounts
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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
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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
agreement
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Business Valuation: Control Premium and Minority Discount
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Business Valuation: Control Premium and Minority Discount
1
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
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Business Valuation: Control Premium and Minority Discount
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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
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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%
(median)
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Business Valuation: Discounts and Premiums
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Business Valuation: Discounts and Premiums
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