With the conceptual framing of the control levels of value in Statutory Fair Value #15, we can now examine the two controlling interest levels of value.
It is important to have a clear understanding of the levels of value in order to begin to articulate statutory fair value concepts. Absent this understanding, courts are left to deal with important valuation questions on almost an ad hoc basis, relying on perhaps conflicting or inadequate or incorrect (or all three) valuation evidence that might be presented.
Financial Control Value
The following equation illustrates the conceptual math of the first control level of value – the financial control value. It introduces notation that we will use to discuss the levels of value in the context of the Integrated Theory. Each symbol is defined below the representation.
As with the marketable minority level of value, the terms found in the equation are defined as follows:
- Ve(c,f) is the value of the equity of an enterprise as a whole from the viewpoint of financial control buyers who do not expect to achieve improvements relative to the marketable minority value. Traditionally, appraisers have 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.
- CFe(c,f) is the expected cash flow of the enterprise from the viewpoint of the financial buyer. The first step in developing CFe(c,f) is to derive CFe(mm) by normalizing the earnings stream as described in this post. Note that the normalization of earnings is not a “control” process, but one of equating private company earnings to their as-if-public equivalent. 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 better. However, unless there are competing financial buyers, a single buyer would likely be unwilling to share the benefit of all expected cash flow improvement with the seller. In the real world, there would be a negotiation to determine the extent of such sharing. The issue of normalizing earnings has been discussed at length in three posts, Statutory Fair Value #9, Statutory Fair Value #10, and Statutory Fair Value #11. However, normalization is an integral part of public securities pricing. It is not uncommon to find companies with well above-peer group price/earnings multiples based on trailing 12-month earnings, yet with near average multiples of forward (next-year’s) earnings. Commonly, investigation reveals an unusual, non-recurring item in the most recent period that the market is “normalizing” and pricing based on the expectation of more normal earnings next year.
Note that the negotiations between buyers and sellers affects the purchase price and not the expected after-acquisition cash flows. This suggests that observed takeover premiums do not reflect the expected total change in cash flow, but only the portion negotiated and shared with sellers.
- Rf is the discount rate at the financial control level of value. In the real world, Rf may be identical to Rmm, as other writers, including Shannon Pratt, have observed. [Shannon P. Pratt, Cost of Capital (New York: John Wiley, 1998), pp. 111-112.] While market forces will tend to equate Rf and Rmm, Rf is distinctly specified to allow for potential differences. Financial control buyers may bid up prices in competition with other financial or strategic buyers, causing Rf to fall below Rmm. Certain buyers may consciously lower Rf to secure a deal, leading to potential overvaluation. Alternatively, specification of Rf in excess of Rmm recognizes that the value of an enterprise to financial control buyers may be less than the freely traded value. 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 specification of Rf helps explain the existence of occasional negative control premiums in acquisitions, or acquisition prices below the before-announcement trading prices of targets.
- (Gmm + Gf) is the expected growth rate of earnings for the financial control buyer. The first factor is the same Gmm found at the marketable minority level. The second factor (Gf) is the increment in the growth rate of earnings that a financial control buyer expects to generate. The second factor may not be relevant in determining the value of an enterprise for either of two reasons: 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. On the other hand, 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 Gf. Nevertheless, this component of expected growth needs to be specified in order to understand and describe 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 synergies, these internal opportunities for cash flow enhancement do not depend on a specific combination with another business.
Financial Control and Marketable Minority Compared
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 below.
The conceptual differences in value at the marketable minority and financial control levels of value can be discerned by examining the figure above. This analysis illustrates that control premiums (or other conceptual adjustments) are not automatic, but are based on expected differences in cash flows, risk, and/or growth. Recall our detailed discussion of the discounted cash flow model in Statutory Fair Value #2.
Based on the comparative figure, 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:
- CFe(c,f) is greater than CFe(mm). This would be true if the buyer of the enterprise could be expected to improve the operations of the enterprise (and would share that expected benefit with the seller). Note that CFe(c,f) will not exceed CFe(mm) because of above-market salaries paid to owners of a business. Such adjustments were required to derive CFe(mm). Some appraisers often assume that in valuing minority interests of private companies, no adjustment should be made for above-market owner salaries of perquisites “because the minority shareholder lacks the power to change the cash flows.” The preceding discussion of normalizing adjustments (again, see Statutory Fair Value #9-11), and the discussion of the minority interest discount in the next post should be the death knell of this common misconception.
- Gf is greater than zero. If the financial control buyer expects to augment the future growth of cash flows (and will share that benefit with the seller), then Ve(c,f) can exceed Vmm.
- Rf is less than Rmm. Conceptually, Rf could be less or greater than Rmm. 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 Rmm as the appropriate discount rate. The specification of Rf does provide an explanation for financial control premiums that might be paid for enterprises based on competition between private equity funds and hedge funds. Such funds have the capacity to bid up prices by accepting lower returns on individual deals. In fact, financial buyers have been shown to compete with strategic buyers. See “Control Premium Study Shows Decline in Market Multiples,” Shannon Pratt’s Business Valuation Update, October 2001, pp. 6-7 (now Business Valuation Resources (subscription)). Such capacity of private equity funds to bid up deals is likely correlated to the supply of investable funds at their disposal and continuing pressure to employ those funds.
Once again, the point of this analysis is that the financial control premium is not automatic. Sellers have a history of earnings (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 does not predict financial control value, but does provide a vocabulary to describe the economic behavior of rational market participants. The Integrated Theory also provides the conceptual and analytical framework within which appraisers can estimate financial (or strategic) control value in appropriate situations.
Financial Control Value and Statutory Fair Value
The conceptual discussion thus far suggests there could be a congruence of value between the marketable minority and financial control levels of value. This congruence conforms with the common sense observation that in any given year, most public companies are not sold or otherwise taken over. Could it be that for most companies most of the time their public pricing (marketable minority pricing) is reasonably reflective of their financial control values?
If it were not so (there I go again), then more companies would be taken over each year as other public companies, private equity funds and hedge funds, which collectively control many billions of available dollars, would engage in transactions in order to capture any available surplus between a financial control value and the public price. Eric Nath made this observation in an article published in Business Valuation Review in 1990 (subscription). The valuation profession has been slow to adapt.
I hope that this series, which, again, is based largely on Chapter 3 of Business Valuation: An Integrated Theory Second Edition, helps to bring clarity to what has been a confusing area of valuation for many years.