Business appraisers, do you remember the “good old days?”
In terms of business valuation, the good old days weren’t so long ago. I think we can trace the birth of our young profession to two publications from the year 1959. Some readers may remember 1959 fondly. For others, 1959 is ancient history. Nevertheless, in 1959:
- Revenue Ruling 59-60 which defined the standard of value known as fair market valuewas published by a group of Internal Revenue Service employees who were allegedly assisted by some early business valuation practitioners – although no one I know has claimed to have been part of the group.
- In 1959, Professor Myron Gordon published the seminal article which introduced what we now refer to as the Gordon Dividend Discount Model, the Gordon Growth Model, or the Gordon Model.
It’s impossible to think of business valuation as we approach 2013 without referring to both of these still highly relevant publications from 1959.
Some aspects of the “good old days” are still with us. And so are some “good old issues.”
Several months ago, Jim Hitchner asked me to present a session at the AICPA Business Valuation and Forensic Accounting Conference held November in Orlando. He asked me to talk about five “big” valuation issues. And so I did. He must have liked the session, because he asked me to prepare it again for a VPS webinar (given on December 12, 2012).
We did address five valuation issues that many consider “big”, but let’s be clear:
- The issues business appraisers tackle today are not new issues. Most have been with us since the 1970s, 1980s and 1990s.
- The fact that these “big issues” are issues today reflects, I believe, a lingering reluctance on the part of many business appraisers to grapple with the basics of financial and valuation theory in an integrated way.
- The integration I am referring to relates to the way that rational investors make investment decisions. They do so inevitably based on the expected cash flows to be received from the investments over the relevant time horizons for the investment (and this would include the expected growth in those cash flows), and their perceptions of the riskiness of their receipt of the expected future cash flows.
- Investor “valuations” are expectational in nature. Investors make their investment decisions by comparing each investment with relevant alternative investments.
- Investors translate their perceptions of the riskiness of an investment’s expected cash flows into present value terms, taking into account the myriad factors that might influence their perceptions of in investments value to them. Other things being equal, riskier investments are valued lower than similar investments with less perceived risk.
- While in the real world, there may be temporary conditions of seeming insanity, the markets tend to be sane or rational over time.
Growth, Risk (and reward), Alternative Investments, Present Value, Expectations, and Sanity (or reason) are the guiding principles undergirding the decision-making processes of individual investors and of markets. These are the “Grapes of Value” I have been talking about for years.
These principles are interrelated with what we appraisers call the standard of value known as fair market value – or even fair value for the financial reporting types – which itself is a standard based on the behavior of market participants. We cannot realistically address the “big” issues without maintaining focus on the markets for the investments we are called upon to value as business appraisers.
With this background, let’s introduce the “big” issues. I’ll do so by stating the name of the issue and then asking a question or two that will be rhetorical, but I hope also revealing:
- ACAPM and Discount Rates
- Have you ever seen a corporate investor develop a discount rate and then adjust it based on different looks at the same earnings stream?
- Control Premiums and Minority Interest Discounts
- Have you ever seen a corporate investor negotiate a price for a business and then, gratuitously, add a 30% premium to the price for the benefit of the seller?
- On the other hand, have you ever heard of a private equity investor who grabbed a control premium from somewhere and did a little bit of math to develop a minority interest discount that was, in turn, used to reduce the price they would pay?
- Adjustments to the Income Statement
- Have you ever heard of a seller of a business not demand that the buyer consider appropriate normalizing adjustments?
- Alternatively, would you or any rational investor make a minority investment in a business or asset holding entity without knowing what the underlying business or asset base were worth?
- Guideline Public Company Method and the Guideline Transactions Method and Fundamental Adjustments
- Have you ever wondered what the real factors are that necessitate fundamental adjustments to public company or transaction multiples derived from the public or transaction markets, and how to develop appropriate adjustments that have a chance of being perceived as credible?
- Marketability Discounts
- Do you think that most real world investors in minority business interests go read restricted stock studies or pre-IPO studies to make their investment decisions? If not, how do they make their decisions?
- Have you ever seen or know of a business owner who, after negotiating a price for his business with a potential buyer, offered a 25% (or some other) discount to the buyer out of the kindness of his heart?
The primary text for both my AICPA presentation and the VPS webinar was drawn largely from the book, Business Valuation: An Integrated Theory Second Edition (Mercer/Harms; John Wiley & Sons, 2008).