Investment Value

The value to a particular investor based on individual investment application, requirements and expectations.

Liquidation Value

The net amount that would be realized if the business is terminated and the assets are sold piecemeal. Liquidation can be either "orderly" or "forced."

Intrinsic Value

The value that an investor considers, on the basis of an evaluation or available facts, to be the “true” or “real” value that will become the market value when other investors reach the same conclusion. When the term applies to options, it is the difference between the exercise price or strike price of an option and the market value of the underlying security.

Book value

With respect to a business enterprise, book value is the difference between total assets (net of accumulated depreciation, depletion, and amortization, if applicable) and total liabilities as they appear on the balance sheet (synonymous with Shareholder's Equity). With respect to a specific asset, this would be the historical (capitalized) cost less accumulated amortization or depreciation, if applicable, as it appears on the books of account of the business enterprise.  As a result, when a business has significant investment in land, buildings, and/or furniture, fixtures, and equipment, the book value only coincidentally will reflect fair market, fair, investment, liquidation or intrinsic values.

In addition to defining the applicable value standard and the valuation date, in a reasonably comprehensive valuation report, the appraiser should provide a discussion of the following:

1.           Current economic and market conditions to which the target business is subject;

2.           Specific industry conditions and outlook;

3.           Historical financial statement analysis of the target business, and history of any previous equity transactions;

4.           Adjustments necessary in order to reflect current expectations of cash flows and earnings;

5.           Valuation analyses which may incorporate capitalization of cash flows or earnings, comparable market transactions, and adjusted net assets (adjusted to current market values);

6.           Application of appropriate discounts such as minority interest discount, discount for lack of marketability, portfolio discount, blockage discount, etc: and,

7.            Overall opinion of value and the weight(s) given to each estimate of value provided in the analysis.

In a perfect world, the reader of these reports understands the relative impact of each assumption that the appraiser has made.  The report, if indeed it is as detailed as I have suggested above, should explain all valuation assumptions and their bases.  In reality, it probably takes a knowledgeable appraiser to ferret out many assumptions used and sensitivity analysis to determine the relative impact on the resulting opinion of value that changes in the assumptions generate.  Most often, you may have only summary reports presented, or you may be presented with an opinion of value only through testimony or some other form of verbal presentation.  Are you ready to ask instructive questions which illustrate the impact on value of what may appear to be minor changes?  What questions should you ask a jointly retained valuation expert, or your valuation expert, and/or the other side’s expert to insure that all pertinent issues are explored?

You cannot be an expert in all issues pertinent to your client, but you should have a reasonable understanding of the basic concepts in order to help insure that the expert has reasonably analyzed the situation and arrived at a justifiable conclusion.  Following are decisions made by the business appraiser which have the greatest impact on the valuation opinion.  They are presented in order of magnitude of impact, from the most significant to those of lesser significance.  Ask your valuation expert (or the other side’s expert) to explain the basis for the decisions he/she has made relative to these issues.  You should be able to determine if the responses are consistent and reasonable.

1.                  What standard of value is being used in this valuation?

The most prevalent standard of value used is “fair market” value.  This is generally defined as the price at which the interest being valued will exchange hands, assuming both parties have knowledge of all relevant facts and neither is under compulsion to act.  Fair market value incorporates the concepts of controlling versus minority interest and freely tradable (ready market as in stock exchange) versus no ready market (difficult and time consuming to find a buyer).

The concept of minority interest implies that a value of a non-controlling interest will be discounted below the pro-rata value of the total enterprise value, because the minority interest holder lacks control aspects which create value (e.g. ability to force cash distributions, force liquidation, establish debt structure, make hire and fire decisions).  For example, the fair market value of a 10% interest in an enterprise valued at $1 million, given its inherent lack of control, will be less than $100,000 (10% times $1 million).

Marketability also impacts value.  An ownership interest which is freely tradable (i.e. is easily converted to cash) is more highly treasured than an interest that does not have a ready market.  Liquidity is valued, illiquidity reduces value.

A second standard of value noted above is “fair” value.  Fair value opinions generally do not take into account the concept of minority/controlling interest, nor do they incorporate marketability.  Generally an opinion of value under this standard would be represented by the pro-rata value of the total enterprise value.  I use the word “generally” because this standard of value, as noted above, is generally defined by the court having jurisdiction.

A third standard of value is “investment” value.  The two previous standards of value require an analysis of the general acquisition market, i.e. the total population of potential buyers.  Investment value is the determination of the value of the subject interest to a specific investor.  This value will vary depending on specifics associated with the individual investor.  One investor may value a potential acquisition higher because of synergies they foresee given the acquisition.  Another investor may value an interest higher because of markets that may become available as a result of the acquisition.  A third investor may value the interest lower because of certain qualitative aspects associated with the subject interest (societal aspects or personal attitudes).  Investment value is specific to the entity for which the valuation is performed, and it does not necessarily reflect how the market, in total, would value the subject interest.

The standard of value should be determined by the attorney/arbiter based on the appropriate laws and precedents.  Be sure your valuation appraiser is developing an opinion of value based on the appropriate standard.  In some instances there may be no required standard of value.  Be sure to have your expert prepared to provide your client with an analysis which benefits their circumstances.  An error here can result in a material change of value.  Applying the “fair market” value standard to a minority interest instead of the “fair” value standard can result in the value estimate being more than 50% less than the “fair value” standard would report.

2.                  Is there adequate justification for the discount for lack of marketability?

As previously mentioned, liquidity is cherished.  It allows an investor to withdraw from an investment, for whatever reason, in a timely manner (generally defined as converting to cash in 3 days).  There have been numerous studies attempting to observe discounts associated with the lack of liquidity in investments.  All of the studies have been done by referencing the price of publicly traded stock versus the price of the exact (or similar) shares which are subject to certain restrictions on trading.  Suffice it to say that these studies have analyzed restricted stock prices (generally issued through options and restricted from public trading for a specified period of time) compared to the same freely tradable stock prices, and they have compared transaction prices of stock before an initial public offering (IPO) and after the offering.

In general, the median discounts observed have ranged from about 30% to 50%, depending on the particular study and the type of study.  Many business appraisers arbitrarily select a percentage discount, such as 40%, without analyzing the specifics associated with their particular engagement.

Valuations of minority interests, under the “fair market” value standard, would almost always be subject to some level of lack of marketability discount.  The question to ask is what is the appropriate magnitude of this discount?

Business appraisers may attempt to apply a marketability discount to a controlling interest.  This is a contentious topic among those of us in the business appraisal community.  This article is not an appropriate forum for this theoretical debate, but the point to be made is the empirical basis for the discount.  It is absolutely incorrect to reference the typical restricted stock studies, pre-IPO studies, or studies of option pricing in order to determine the magnitude of the lack of marketability discount applicable to a controlling or total enterprise value.  All of these studies relate to minority interests (i.e. per share values) not controlling interests or enterprise values.  If the business appraiser believes a lack of marketability discount is appropriate to the controlling interest being valued, there are no empirical studies on which to rely.  The analysis will rest on the subjective argument of the appraiser, not on any empirical observations, for there are none as of today.

Clearly the impact of the application of an inaccurate or unjustified marketability discount can be significant.  With medians of observed discounts ranging from 30% to 50%, and actual observations exceeding this range, the impact on the resulting opinion of value can be significant.

3.                  What level of minority interest discount (or the reciprocal control premium) is justifiable?

Minority interest discount reflects the loss in value due to an inability to influence business decisions which impact the cash flows to the minority interest holder.  A holder of a pure minority interest cannot:  1) force cash distributions; 2) require entity liquidation to access underlying asset values; 3) require the business entity to provide a job to the holder and receive fair compensation; 4) alter financial structure of the business;  5) adjust controlling owner compensation, perks; etc.  A controlling interest effectively can control all of these aspects of the business.  We consider the discount associated with the minority interest to be the reciprocal of the control premium associated with the controlling interest.

Minority interest discounts are studied by observing control premiums in the marketplace.  Generally, when a publicly traded company is acquired, the acquisition price of the stock is in excess of the current trading price of the stock.  When the acquisition price is announced the “control premium” can be developed.  If a stock is currently trading for $1 per share, and the announced acquisition price is $1.40 per share, the control premium is equal to the difference in price, $0.40 divided by the $1 traded price, or in this example a 40% control premium.  If we observe a price differential of $0.40, and we know the “control price” is $1.40, the observed minority interest discount is $0.40 divided by $1.40, or about 28.6%.  This is why we refer to them as reciprocals.

The application of a minority discount assumes that the value to which the discount is applied is based on controlling interest assumptions.  The application of a control premium assumes that the value to which the premium is applied has been developed by relying on minority interest assumptions.  For example, if a minority interest value is the goal, and it is developed by referencing a pro-rata value of the total enterprise value (enterprise value assumes control), then it is appropriate to apply a minority interest discount to the pro-rata value of the enterprise value.  If an enterprise value is the goal, and the value has relied on the values of public exchange traded stocks (minority interests since these are small lot stock prices), then it is appropriate to apply a control premium.

Studies report observed levels of control premiums, and their reciprocal minority interest discounts.  The business appraiser must have a logical, justifiable analysis to support the selection of the appropriate minority discount/control premium.  The studies report all publicly announced merger and acquisition activity.  Many of the announced transactions are not purely financial transactions, rather they are strategic or synergistic acquisitions.  When transactions are strategic or synergistic, the observed premia incorporate more than just that associated with control.  The business appraiser must not merely pick an observed median of premia/discounts.  The premium/discount applied should only reflect control/minority issues.  The discount applied should be developed without the taint of strategic acquisition premiums.

Has the business appraiser applied a minority interest discount or control premium based only on pure control aspects?  Has the business appraiser applied the appropriate discount or premium to an appropriate base, control or minority, respectively?

4.            Is the capitalization rate (the rate of return, required by the investor, adjusted for growth) appropriate?

The basic theoretical valuation model requires that the business appraiser project cash flows available, to the equity holder, for future periods over the business horizon.  Each of the periodic cash flows is then discounted back to the present (valuation date) based on the risk of realizing the projected cash flow.  This is generally considered to recognize the “time value” of money.  A projected cash flow of $110,000 to be received after one year of operations has a present value of $100,000 assuming the rate of return required is 10%.  An investor would pay $100,000 today for a cash flow of $110,000 one year off, assuming a 10% annual return rewarded the investor for the risk assumed.  The greater the risk (the greater the probability of not achieving that cash flow) is, the greater the rate of return that is required.  The same projection of $110,000, one year off, with a greater risk, such that an investor requires a rate of return of 25%, would have a present value of $88,000.  In this analysis of cash flow to equity, the term “required rate of return” is synonymous with “discount rate”.

When cash flows, available to the investor, grow (positively or negatively) unevenly, the appraiser projects each period’s cash flows.  When it is reasonable to assume that cash flows will grow at a constant rate, the present value calculation can be simplified to determine the sum of all cash flows once growth can be reasonably assumed to be constant.  When this is the case, “the discount rate” is adjusted for the anticipated constant growth rate, and the resulting rate is called the “capitalization rate”.

As a result of the method of development of the capitalization rate, there are two potential problem areas, the determination of a reasonable rate of return to the equity holder of the subject business, and the determination of a sustainable long term growth rate.  Both rates can and do have significant impact on the ultimate opinion of value.  As noted in the example above, a change in the required rate of return from 10% to 25% for the present value analysis one year’s cash flow resulted in a change in value of 12%.  Since businesses are assumed to generate cash flows over a period of years, the change in value can be very significant, even with reasonably small changes in the required rate of return.  For example, If cash flows to equity are projected to be $50,000 annually, and we assume no growth, the present value of these cash flows, assuming a required rate of return of 20% is reasonable given the risk, is $250,000.  If we assume the risk is greater, and it warrants a required rate of return of 25%, the present value is $200,000, a change in the value of 20%.  Using the same example, leaving the required rate of return unchanged, but changing a long term growth rate from 10% to 5% will have equally significant changes in value opinions.

The net impact of minor adjustments to the required rate of return in conjunction with apparent minor changes in long term growth rates can also significantly impact opinions of value.  For example, increasing a required rate of return by 2 percentage points, while simultaneously reducing growth by 3%, is the equivalent of a change in the required rate of return by 5% while holding growth constant.

What is a reasonable equity rate of return?  Appraisers look to observable returns of other investments to determine reasonable rates of return.  We call it alternative, but equally risky returns.  We incorporate current inflation assumptions in rates of return by using the current long term Treasury bond rate as a building block.  The largest of the New York Stock Exchange firms have averaged, over the last 75 years, an annual return to their investors of almost 8% in excess of the 20 year Treasury bond rate.  Given the current 20 year Treasury bond rate of approximately 5%, then investors in these very large companies would reasonably expect an average annual return approximating 13% today, when averaged over a long holding period.  If these extremely large businesses can provide that kind of return to their investors, why would an investor buy an equity position in a significantly riskier small local business that provides a return less than the 13%.  The appraiser developed must exceed this achievable 13% annual long term return.  The smallest of the New York Stock Exchange (NYSE) firms, over the same 75 years, have averaged a rate of return, in excess of the Treasury bond rate, of about 12% annually.  This means that those “little” NYSE firms (having $100 million or more of revenues annually) would be expected currently, over a long term, to provide an annual rate of return of about 17% (5% plus 12%).  If these types of firms with national or international markets, reasonable product diversification and a seasoned management team can provide this level of return to their investors, an investor in a smaller, riskier business would require a return in excess of 17% to account for the increased level of risk.  The business appraiser must be ready to explain their selection of an appropriate equity rate of return given rates of return available for alternative investments.

You may have observed that real estate appraisers often use a rate of return associated with their “income approach” approximating 10% annually.  Why is this reasonable relative to other investments?  That is a reasonable return because there is a “fall back” available to the investor in some types of real estate.  If the projected cash flow of the real estate investment does not materialize, the real estate may be sold.  You might say that the real estate serves as collateral to the investor.  If the cash flows from the subject operating business do not materialize as projected, there is no “fall back”.  The equity holding is not independent from the cash flow, therefore, it requires a greater rate of return to reward the investor for the assumption of greater risk.

In addition to recognizing a reasonable equity rate of return, the long term growth rate must be reasonable.  Over a short period of time, perhaps 5 years, it may be possible for a business to achieve cash flow growth of 10% or more.  Over the long term, growth rates at 8% to 10%, given current inflation, is almost impossible to achieve.  Achievable long term growth rates at that level are difficult because competition enters the market restricting achievable growth rates.  It takes a very unique product or service, protected from market encroachment (e.g. patent, copyright) to achieve such a sustained growth rate.  The business appraiser must be prepared to defend the selection of the long term cash flow growth rate used in the valuation.  If it is reasonable to achieve high near term growth rates, then generally cash flows are projected for the near term years over which this growth is expected to be achieved, until a reasonable long term growth rate is anticipated.  Most long term growth rates can be expected to be no more than 2 times inflation or less.

5.                  Are the market comparables really comparable?

We as business appraisers, like real estate appraisers, look to find comparable business transactions that are measures of business valuation.  We would like to find an identical business, or interest in a business, that just sold, allowing us to develop a value for our subject interest based on the recent transaction.  Unlike real estate, such transactions are not generally public.  We have several sources of data bases which report transactions of entire businesses which we may use.  Identifying information is not available, but some basic financial information is available.  From this information we develop value measures such as deal price to sales, deal price to equity book value, and deal price to various measures of cash flow.  We select transactions in businesses which we consider comparable to our subject business being valued.  The question which must be asked, and for which the appraiser must be prepared to defend, is, are the selected transactions comparable?  Is a business located in another area of the country comparable?  Is a business that does $200,000 a year in revenues, comparable to a business that does $2,000,000 per year?  Is a business that generates cash flow to the owner at a rate of 20% of annual sales comparable to a business that returns only 4% to the owner?  If the businesses that were sold/purchased are not comparable to the subject business, the merger and acquisition market multiple derived from the transaction will not be comparable.

While these concerns are prevalent in merger and acquisition multiples, they are more acute when the appraiser has selected a publicly traded guideline company or companies as comparable.  There are several concerns when developing values for a subject interest based on per share publicly traded prices of comparables.  There is the issue of developing a controlling interest value by referencing freely tradable minority interests (per share values).  The appraiser must be prepared to support an applied control premium, as discussed previously.  The appraiser must also be prepared to defend any adjustment, or lack of adjustment, based on the freely tradable nature of a publicly traded stock.

How comparable are the selected publicly traded companies to a subject company.  If the subject company is a distributor/wholesaler, it is generally not comparable to the company that manufactures the products subject to distribution.  Clearly size, market area, financial structure (high debt versus low or no debt), and product/service diversification are important factors in determining comparability.  A $1 billion revenue per year company is generally not comparable to a subject company that has $5 million in revenues, even when they operate in the same industry.  It may be possible to make adjustments to the publicly traded per share multiples to reflect difference in size, financial leverage, etc., but these will be subjective adjustments and the appraiser must be prepared to defend these adjustments.

A last thought on observed publicly traded multiples, and their use to develop the subject company valuation opinion.  When the publicly traded comparable company’s stock trades for low prices, generally around $1 or less, small movements in stock pricing can create significant movements in the observed price multiples.  A stock price that trades at $1 and moves 1/8^th has moved 12.5% in value.  A stock price that trades at $4 and moves 1/8^th has changed only 2.5% in value.  Appraisers should look for higher priced stocks to avoid these small movements in stock pricing around the valuation date, having a material impact on the resulting opinion of value.

6.            Has the appraiser applied all reasonable valuation methodologies in developing his/her opinion of value?

For almost all valuation engagements, at least two approaches to value are applicable.  Most interests in operating businesses can be valued using a market approach and an earnings/cash flow approach.  Generally, within these categories, there are multiple methods which can be used.  If the business appraiser provides only one methodology, the appraiser should be prepared to defend the lack of application of any other method.  Uniform Standards of Professional Appraisal Practice require appraisers to be prepared to explain why certain methods were used and why certain other methods were not used.  Failure to apply an available technique, without adequate justification, may reveal either an incomplete valuation analysis, or an attempt to purposely influence the results of the analysis.

7.            Can the business appraiser explain why the various valuation methodologies used arrive at significantly different value opinions for the same interest?

In a perfect appraisal world, each method used to estimate the value of a closely held business interest, should arrive at the exact opinion of value.  We do not necessarily expect an appraisal of an operating business (as versus a holding company) relying on liquidation values of the underlying tangible assets, to equal the value of the business estimated by use of a market or earnings/cash flow approach.  The liquidation value approach would generally not incorporate values associated with the business as a going concern, such as goodwill.  Goodwill or “blue sky” exists if the business generates a return in excess of what is reasonable from just the tangible assets.

While reality is different from pure theory, we still should expect, for operational entities, market approaches and capitalization of earnings/cash flow approaches similar valuation estimates.  When they do not, the appraiser should be prepared to explain why they are not similar.  It is inappropriate for the appraiser to merely select a method as appropriate, without fully explaining why the methods did not yield similar value estimates.  It may be appropriate for the appraiser to ultimately select a method, or give greater weight to one method over another, but that appraiser must be able to explain why the difference exists, and why they choose to select a single method, or give greater weight to one method over another.  From a very practical standpoint, analysis and reconciliation of value estimate differences by the appraiser can often expose errors, inappropriate assumptions, or inapplicable methods for particular circumstances.

Summary

As I stated at the beginning of this paper, business appraisers generally provide a detailed analysis of many factors influencing their opinion of value.  They may spend a significant amount of their report analyzing expense to sales relationships, aberrations in particular years’ results, and projecting an immediate year’s cash flow projections.  They may spend minimal time within their narrative report or testimony on the analysis of applicable discounts or premia, reconciling various value estimates, or explaining the rationale behind the required rate of return or expected growth rates used.  The appraiser must be prepared to defend all aspects of their valuation opinion.

It is not uncommon for an appraiser to spend considerable attention to detail in developing projected cash flows to immaterial levels, capitalizing this minutely detailed cash flow, and then haphazardly, and without adequate justification, applying a 40% discount to the total.

Do not be caught up in the appraiser’s detail.  Be aware of those variables which have the greatest impact on the valuation opinion, and require explanation for the assumptions made.