We used the Gordon Model to develop a “basic valuation equation” in an earlier post in this series on statutory fair value. Everyone who is familiar with business value in an way understands this equation:
Value = Earnings x Multiple
This generalized valuation model and the integrated theory of business valuation that I have written about (Business Valuation: An Integrated Theory, 2nd Edition with Travis W. Harms) suggest that value indications should be developed by estimating appropriate indications of earning power and a reasonable valuation multiple.
It follows that appraisers may need to consider potential adjustments to both earnings and the multiple in order to develop appropriate indications of value.
- Normalizing Adjustments. The next couple of posts will explore normalizing adjustments to develop private company earnings that correspond with the valuation multiples of guideline companies to yield marketable minority indications of value.
- Control Adjustments. We will also consider earnings adjustments that relate to the other enterprise levels of value, namely, the financial control and strategic control levels of value. A fundamental insight arising from the integrated theory of business valuation is that the discount rate applicable to individual private companies should remain (approximately) the same for the various enterprise levels of value. Control adjustments yield a measure of enterprise earnings appropriate to the control levels of value.
- Fundamental Adjustments. Fundamental adjustments relate appropriate private company valuation multiples to the median or average multiples of guideline company groups. Fundamental adjustments account for differences in risk and expected growth for private companies relative to selected guideline companies. We postpone treatment of fundamental adjustments for possible treatment later.
This post and the next one (or two) lay the theoretical foundation for these adjustments commonly applied in valuation practice.
The Marketable Minority Level of Value
In our previous post, we developed mathematical expressions for the marketable minority level of value. In future posts, we will develop the other levels of value in similar fashion. For now, however, we need to discuss normalizing adjustments to facilitate understanding of the other levels of value.
This cash flow is assumed to be normalized to approximate that of comparable well-run public companies. Otherwise, if there were, for example, excessive compensation or other discretionary expenditures of an ongoing, egregious nature, there would be pressure from shareholders (or potential acquirers) for the earnings stream to be normalized.
To foreshadow the nonmarketable minority level, which is discussed below, the marketable minority level of value is determined, in part, by capitalizing the cash flow of the enterprise (CFe(mm)).
The Nonmarketable Minority Level of Value
The nonmarketable minority level of value is determined by capitalizing (or discounting) a different set of cash flows – only those cash flows directly available to minority shareholders. We know that the Gordon Model assumes full distribution of earnings (or alternatively, the reinvestment of earnings in the enterprise at the discount rate). In a sense, distribution policy does not matter for public companies. Regardless of whether earnings are distributed or retained (or a combination), shareholders of public companies have access to the capitalized value of all future cash flows through the mechanism of the public securities markets.
Owners of illiquid interests have no ready market for their shares, and obtain only those cash flows that are distributed if and when they are, together with a terminal cash flow upon exit.
Cash flow to minority shareholders can be equal to, but not greater than, the cash flows of the enterprise at the marketable minority level. Cash flows can be less for two reasons. In the extreme case, assume there are no distributions. The cash flow available to owners of an illiquid interest is comprised of a future terminal cash flow. The absence of cash flow and the risk of holding the interest over a likely uncertain holding period warrant a diminution in value.
Another reason for a potential diminution in value pertains to the potential for agency costs, or non pro rata distributions to selected shareholders. Agency costs also include excess perquisites and other discretionary expenditures. Some appraisers seem to think that these expenses should not be normalized in valuations of minority interests. This treatment is inconsistent with the theory that to value an illiquid interest we must first value the enterprise. That is precisely the theory summarized in the levels of value charts themselves.
It should be clear that agency would be normalized, so that the resulting enterprise cash flows approximate the expected enterprise cash flows (assuming any nonrecurring items in historical earnings have been eliminated). We classify adjustments for both agency costs and nonrecurring items as normalizing adjustments.
As we move up the levels of value chart from the marketable minority level to the levels of financial control and strategic control, we see that it is possible that a controlling shareholder may make adjustments to expected cash flows based on the expected ability to run the existing enterprise better (financial control), or to modify or manage the enterprise differently (strategic control). Such adjustments are control adjustments, and increase value if such adjustments would normally be negotiated between buyers and sellers. In other words control adjustments are those that, if appropriate, increase enterprise cash flow above that of the (normalized) marketable minority level.
In the next post(s), we will discuss two types of normalizing adjustments as well as two types of control adjustments. Then, with this understanding, we will proceed to develop the other levels of value in a fashion as in the figure above.
To remind readers, this series of posts on statutory fair value relies heavily on my book (with Travis W. Harms) Business Valuation: An Integrated Theory, 2nd Edition.