In the second post in this statutory fair value series, we provided background information on the Discounted Cash Flow Method of Valuation and the Gordon Model.
THE GORDON MODEL
The Gordon Model is a single-period income capitalization model that provides a summary interpretation of how securities are valued in the public markets.
The basic formulation of the Gordon Model defines the value of a business or interest as next period’s expected cash flow divided by an appropriate discount rate less the expected growth rate of the specified cash flow. As we discussed earlier in this series, this formula is a summary of the discounted cash flow method of valuation under the following conditions:
- The cash flows are expected to grow at the constant rate of g, and
- All cash flows are distributed to shareholders or are reinvested in the firm at the discount rate, r.
The discounted cash flow model as summarized by the Gordon Model provides an ideal basis for discussing what we call an integrated theory of business valuation, which is fully developed in my book (with Travis W. Harms), Business Valuation: An Integrated Theory (2nd Edition).
EARLY VIEWS OF THE LEVELS OF VALUE
The so-called levels of value chart first appeared in the valuation literature some time around 1990 (for more information, see Business Valuation: An Integrated Theory (2nd Edition)). However, the general concepts embodied in the chart were known by appraisers (and courts) prior to that time. Even today, virtually all discussions regarding levels of value in the valuation literature are very general, lacking any compelling logic or rationale regarding the factors giving rise to value differences at each level.
The early levels of value chart showed three conceptual levels.
The chart is so important to an understanding of valuation concepts that analysts at Mercer Capital have included it or an evolving version with four levels (see future posts) in virtually every valuation report since about 1992.
STATUTORY FAIR VALUE AND AN INTEGRATED THEORY OF BUSINESS VALUATION
Guided by the discussion in Business Valuation: An Integrated Theory (2nd Edition), we will begin a process of integrating the Gordon Model with a discussion of how the markets value companies as we continue in the statutory fair value series. And, we will frame this discussion within the conceptual framework of the levels of value.
The end game is to create a theoretical framework and vocabulary with which we can talk about the valuation concepts that arise in statutory fair value determinations. As we proceed with developing an integrated theory of business valuation, we will:
- Provide a conceptual description of each three level, levels of value on the levels of value chart above in the context of the Gordon Model.
- Develop the four level, levels of value chart previously shown in earlier posts in this series.
- Use the components of the Gordon Model to define the conceptual adjustments between the levels of value, the control premium (and its inverse, the minority interest discount) and the marketability discount.
- 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 level(s) of value), and the market for illiquid, minority interests in private enterprises (the nonmarketable minority level of value).
- Use the integrated theory of business valuation to discuss statutory fair value concepts such as the implicit minority discount, the use of a marketability discount in statutory fair value determinations in New York, and other concepts of value that appear in historical and emerging cases relating to statutory fair value.
WE WILL BEGIN WITH THE MARKETABLE MINORITY LEVEL OF VALUE
Remember, no valuation premium has any meaning unless the base to which it is applied is specified. And no valuation discount has any meaning unless the base from which it is taken is specified.
The marketable minority interest level of value is the middle level in the three level, levels of value chart above. It is the base from which marketability discounts are applied and to which control premiums are added. As such, an understanding of what this level of value is becomes pivotal to our developing understanding of valuation concepts.
With these objectives in mind, we proceed with the development of the integrated theory of business valuation and with our discussion of statutory fair value.
The next post in this series will discuss the benchmark level of value known as the marketable minority interest.