In the second post in this series on statutory fair value, we provided background information on the Gordon Model. This model is a single-period income capitalization model that summarizes the way securities are valued in the public markets. The Gordon Model is shown again as a beginning point for discussing of the Integrated Theory of Business Valuation.

The basic formulation of the Gordon Model defines the value of a business or interest as the next period’s expected cash flow divided by an appropriate discount rate less the expected growth rate of the specified cash flow. As we have previously shown, this formula is a summary of the discounted cash flow method of valuation under the following conditions:

- The 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 the Integrated Theory of Business Valuation. As a reminder, this series of posts is based on my book (With Travis Harms), *Business Valuation: An Integrated Theory, Second Edition.*

**EARLY VIEWS OF THE LEVELS OF VALUE**

The so-called levels of value chart first appeared in the valuation literature in 1990. However, the general concepts embodied in the chart were known by appraisers (and courts) prior to that time. Even today, most discussions regarding levels of value in the valuation literature are very general, and 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, as indicated below. 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 past and future posts) in virtually every valuation report since about 1992.

We, like most appraisers in the 1990s, assumed the existence of the conceptual adjustments referred to as the control premium, the minority interest discount, and the marketability discount. We relied on market evidence from control premium studies to help ascertain the magnitude of control premiums (and minority interest discounts). And we relied on certain benchmark studies, the so-called Pre-IPO Studies and the Restricted Stock Studies, as the basis for estimating the magnitude of marketability discounts.

Such reliance contributed then, and unfortunately, continues to do so today, to a failure to understand the basis for the valuation premiums and discounts being estimated.

One purpose of this series of posts is to integrate the Gordon Model (and how the markets value companies) and the conceptual framework of the levels of value. In so doing, we will discuss an integrated theory of business valuation, which will help as we continue our discussion of statutory fair value. We will proceed to:

- Provide a conceptual description of each level of value in the context of the Gordon Model.
- 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).
- Begin a discussion of this conceptual framework in the context of statutory fair value generally.
- Discuss specific statutory fair value cases and issues in the context of an integrated theory of business valuation.

With this background, we will develop the marketable minority interest level of value, or the middle level in the three-level chart, as the benchmark level of value from which other levels of value are developed and can be understood.

**THE MARKETABLE MINORITY INTEREST LEVEL OF VALUE**

The Gordon Model provides a shorthand representation of the value of public securities at the marketable minority interest level of value. For privately owned enterprises, it indicates the same level of value (the “as-if-freely-traded” level). In developing the Integrated Theory, we use the Gordon Model to analyze how the levels of value relate to each other. To do so, we introduce a symbolic notation to designate which elements of the model relate to each level of value.

The following equation introduces conceptual math for the benchmark level of value – the marketable minority value.

We just described the marketable minority level of value as the “benchmark” level of value. The marketable minority level of value is the benchmark to which control premiums are added to derive controlling interest indications of value, and from which marketability discounts are subtracted to reach the nonmarketable minority level of value.

The components of the equation above are defined as follows:

**V**represents the market value of the equity a company at the marketable minority level of value, whether public or private. This is the benchmark, observable value for public securities. The as-if-freely-traded value for private enterprises is a_{mm}*hypothetical*value. By definition, it is not observable for nonmarketable interests of private enterprises since there are no active, public markets for the shares. Appraisers develop indications of value at the marketable minority level as a first step in determining other levels of value. Such indications of value are developed either by direct reference to the public securities markets (using the guideline public company method), or indirectly, using the Adjusted Capital Asset Pricing Model or other build-up methods.**CF**is the expected cash flow of the enterprise at the marketable minority level (for the next period). The marketable minority level of cash flow reflects enterprise earnings, “normalized” for unusual or non-recurring events and having an expense structure that is market-based, at least in terms of owner/key shareholder compensation. Public companies attempt to keep investors focused on their “normalized” earnings. Many public companies, for example, disclose_{e(mm)}*pro forma earnings*, or earnings after adjusting for unusual or nonrecurring (and sometimes not so non-recurring) items. The concept of normalizing adjustments is so important and so misunderstood that the next post will be devoted to it. At this point, I ask readers to accept this assumption and then consider the more detailed treatment when we get to it.**R**is the discount rate at the marketable minority level of value. While it is not directly observable, it can be inferred from public pricing or estimated using the Capital Asset Pricing Model or other models. For private companies, R_{mm}_{mm}is most often estimated using one of several build-up approaches.**G**is the expected growth rate of core earnings for the enterprise under the assumption that all earnings are distributed to shareholders. However, earnings are often reinvested in businesses. It is the compounding effect of reinvested earnings that enables a company to grow its_{mm}*reported earnings (and value)*at rates (g*) in excess of its*underlying core earnings growth rate*. So, G_{mm}is not equal to the expected growth rate of earnings published by stock analysts for public companies. The*analysts’**g*(g*) includes the compounding effect of the reinvestment of cash flows on the expected growth of earnings.

At this point, we can begin to connect the mathematics of valuation theory with the conceptual levels of value chart. The marketable minority level of value is the conceptual value from which other levels of value are derived. The following figure presents the conceptual math of the marketable minority level of value.

We refer to the marketable minority level of value as an *enterprise level* of value. We do so because CF_{e(mm)} is defined as the cash flow of the enterprise. All the shareholders of a publicly traded enterprise, controlling or minority, share the benefit of all of its cash flows (as they are capitalized in the public stock markets every day). The importance of this definition will become clear as the remaining mathematical relationships of the conceptual levels of value are built.

The conceptual math of the marketable minority level indicates that, as we have discussed previously, value is a function of expected cash flows (next period and expected growth) and risk.

The figure shows an important relationship regarding the expected growth in value in the middle column. The Gordon Model is a dividend discount model. CF_{e(mm)} is the expected cash flow available for distribution.

- Expected returns to shareholders come in two forms, distributions, or dividend yield, and capital gains. Dividends provide current income, and reinvested earnings provide the potential for future growth in value and for capital gains.
- If there are no dividends, then CF
_{e(mm)}is equal to the net income of an enterprise. Intuitively, that is why the long-term growth rate used in the Gordon Model is typically fairly low, quite often in the lowto-mid single digits. If all earnings are distributed, growth is limited to inflation and productivity increases. Owners get substantial current returns and limited expected capital gains. If all earnings are paid out to shareholders, then the expected growth in value is the long-term growth of core earnings. - If some earnings are retained to finance growth, then two things occur. First, owners get a current return in the form of current dividends and a portion of expected returns relates to the more rapid growth (than long term core growth) because of the compounding effect (at the discount rate) of reinvested earnings.
- The point is that expectations for growth in value of an enterprise are related to a company’s distribution policy (or, alternatively, its earnings retention policy). If all earnings are retained in the enterprise, the expected growth in value is the discount rate. If all earnings are distributed, the expected growth in value is the long-term core (slow) growth in earnings. For distribution policies in between 0% and 100%, the expected growth in value is discount rate (R
_{mm}) minus the dividend yield. This is true because shareholders expect to get their expected return either in the form of dividends or capital gains (and are assumed to be indifferent between the two forms of return).

Finally, the right side of the figure above indicates that the Gordon Model provides value at the marketable minority level.

We will continue to build the Integrated Theory from the base found in the figure above.

The marketable minority level of value is that level to which appraisers have almost automatically applied control premiums to develop controlling interest indications of value. It is also the level from which appraisers have subtracted marketability discounts to derive indications of value at the nonmarketable minority level of value.

Refer again to the levels of value chart above. The control premium and the marketability discount are conceptual adjustments enabling appraisers to relate the marketable minority level of value with the controlling interest level (control premium) and the nonmarketable minority level (marketability discount). The minority interest discount also relates the controlling interest and marketable minority levels.

As pointed out clearly by numerous writers, including me, no valuation premium or discount has meaning unless we understand the base to which it is applied. The *ASA Business Valuation Standards* (BVS VII Valuation Discounts and Premiums) states:

II. The concepts of discounts and premiumsA. A discount has no meaning until the conceptual basis underlying the base value to which it is applied is defined.B. A premium has no meaning until the conceptual basis underlying the base value to which it is applied is defined.C. A discount or premium is warranted when characteristics affecting the value of the subject interest differ sufficiently from those inherent in the base value to which the discount or premium is applied.D. A discount or premium quantifies an adjustment to account for differences in characteristics affecting the value of the subject interest relative to the base value to which it is compared.

The marketable minority value is the benchmark level of value for the enterprise in the Integrated Theory of Business Valuation. It is the “conceptual base” to which marketability discounts and control premiums are applied. We need to understand what this conceptual base is, and importantly, what it is not.

A review of the valuation literature prior to the latter part of the 1990s yields little insight into the theoretical basis for applying the well-known conceptual premiums and discounts. Practically, appraisers applied control premiums because they were frequently observed when public companies changed control. And marketability discounts were applied because it was observed that restricted stocks of public companies traded at prices lower than their freely traded counterparts.

Only in recent years have appraisers begun to understand and to articulate *why* control premiums and restricted stock discounts exist, and consequently, to understand the theoretical basis for their existence. The Integrated Theory explains the *why* behind the generally accepted valuation premiums and discounts.

Statutory fair value for interests in businesses is judicially determined in the various states, usually with assistance from business appraisers. However, courts cannot render clear judicial guidance in the absence of clear valuation evidence.

In the next post, we will talk about normalizing adjustments before proceeding with our investigation of the control level(s) of value.