Standards of Value: Theory and Applications (Wiley Finance)
A measure of common sense and a good grasp of mathematics is helpful.
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The income approach relies upon the economic principle of expectation: the value of business is based on the expected economic benefit and level of risk associated with the investment. Income based valuation methods determine fair market value by dividing the benefit stream generated by the subject or target company times a discount or capitalization rate. The discount or capitalization rate converts the stream of benefits into present value. There are several different income methods, including capitalization of earnings or cash flows , discounted future cash flows " DCF " , and the excess earnings method which is a hybrid of asset and income approaches.
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The result of a value calculation under the income approach is generally the fair market value of a controlling, marketable interest in the subject company, since the entire benefit stream of the subject company is most often valued, and the capitalization and discount rates are derived from statistics concerning public companies. IRS Revenue Ruling states that earnings are preeminent for the valuation of closely held operating companies.
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However, income valuation methods can also be used to establish the value of a severable business asset as long as an income stream can be attributed to it. An example is licensable intellectual property whose value needs to be established to arrive at a supportable royalty structure. A discount rate or capitalization rate is used to determine the present value of the expected returns of a business.
The discount rate and capitalization rate are closely related to each other, but distinguishable. Generally speaking, the discount rate or capitalization rate may be defined as the yield necessary to attract investors to a particular investment, given the risks associated with that investment. There are several different methods of determining the appropriate discount rates. The discount rate is composed of two elements: 1 the risk-free rate , which is the return that an investor would expect from a secure, practically risk-free investment, such as a high quality government bond; plus 2 a risk premium that compensates an investor for the relative level of risk associated with a particular investment in excess of the risk-free rate.
Most importantly, the selected discount or capitalization rate must be consistent with stream of benefits to which it is to be applied. Capitalization and discounting valuation calculations become mathematically equivalent under the assumption that the business income grows at a constant rate. The capital asset pricing model CAPM provides one method of determining a discount rate in business valuation.
The method derives the discount rate by adding risk premium to the risk-free rate. The risk premium is derived by multiplying the equity risk premium with "beta", a measure of stock price volatility. Beta is compiled by various researchers for particular industries and companies, and measures systematic risks of investment.
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One of the criticisms of the CAPM is that beta is derived from volatility of prices of publicly traded companies, which differ from non-publicly companies in liquidity, marketability, capital structures and control. Other aspects such as access to credit markets, size, and management depth are generally different, too. The rate build-up method also requires an assessment of the subject company's risk, which provides valuation of itself.
Where a privately held company can be shown to be sufficiently similar to a public company, the CAPM may be suitable. However, it requires the knowledge of market stock prices for calculation. For private companies that do not sell stock on the public capital markets, this information is not readily available. Therefore, calculation of beta for private firms is problematic.
The build-up cost of capital model is the typical choice in such cases. With regard to capital market-oriented valuation approaches there are numerous valuation approaches besides the traditional CAPM model. Furthermore, alternative capital market models were developed, having in common that expected return hinge on multiple risk sources and thus being less restrictive:. Nevertheless, even these models are not wholly consistent, as they also show market anomalies. However, the method of incomplete replication and risk covering come along without the need of capital market data and thus being more solid.
Among them the approximative decomposition valuation approach can be found. The weighted average cost of capital is an approach to determining a discount rate. The WACC method determines the subject company's actual cost of capital by calculating the weighted average of the company's cost of debt and cost of equity.
The WACC must be applied to the subject company's net cash flow to total invested capital. One of the problems with this method is that the valuator may elect to calculate WACC according to the subject company's existing capital structure , the average industry capital structure , or the optimal capital structure.
Such discretion detracts from the objectivity of this approach, in the minds of some critics. Indeed, since the WACC captures the risk of the subject business itself, the existing or contemplated capital structures, rather than industry averages, are the appropriate choices for business valuation. Once the capitalization rate or discount rate is determined, it must be applied to an appropriate economic income stream: pretax cash flow , aftertax cash flow , pretax net income , after tax net income , excess earnings, projected cash flow , etc.
The result of this formula is the indicated value before discounts. Before moving on to calculate discounts, however, the valuation professional must consider the indicated value under the asset and market approaches. Careful matching of the discount rate to the appropriate measure of economic income is critical to the accuracy of the business valuation results.
Net cash flow is a frequent choice in professionally conducted business appraisals. The rationale behind this choice is that this earnings basis corresponds to the equity discount rate derived from the Build-Up or CAPM models: the returns obtained from investments in publicly traded companies can easily be represented in terms of net cash flows. At the same time, the discount rates are generally also derived from the public capital markets data.
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The Build-Up Method is a widely recognized method of determining the after-tax net cash flow discount rate, which in turn yields the capitalization rate. The figures used in the Build-Up Method are derived from various sources. This method is called a "build-up" method because it is the sum of risks associated with various classes of assets. It is based on the principle that investors would require a greater return on classes of assets that are more risky. The first element of a Build-Up capitalization rate is the risk-free rate, which is the rate of return for long-term government bonds.
Investors who buy large-cap equity stocks, which are inherently more risky than long-term government bonds, require a greater return, so the next element of the Build-Up method is the equity risk premium. In determining a company's value, the long-horizon equity risk premium is used because the Company's life is assumed to be infinite. The sum of the risk-free rate and the equity risk premium yields the long-term average market rate of return on large public company stocks. Similarly, investors who invest in small cap stocks, which are riskier than blue-chip stocks, require a greater return, called the "size premium.
By adding the first three elements of a Build-Up discount rate, we can determine the rate of return that investors would require on their investments in small public company stocks. These three elements of the Build-Up discount rate are known collectively as the "systematic risks. It arises from external factors and affect every type of investment in the economy.
As a result, investors taking systematic risk are rewarded by an additional premium. In addition to systematic risks, the discount rate must include "unsystematic risk" representing that portion of total investment risk that can be avoided through diversification. Public capital markets do not provide evidence of unsystematic risk since investors that fail to diversify cannot expect additional returns. Unsystematic risk falls into two categories. One of those categories is the "industry risk premium". It is also known as idiosyncratic risk and can be observed by studying the returns of a group of companies operating in the same industry sector.
Morningstar's yearbooks contain empirical data to quantify the risks associated with various industries, grouped by SIC industry code. The other category of unsystematic risk is referred to as "company specific risk. However, as of late , new research has been able to quantify, or isolate, this risk for publicly traded stocks through the use of Total Beta calculations.
Butler and K. Pinkerton have outlined a procedure which sets the following two equations together:. It is similar to using the market approach in the income approach instead of adding separate and potentially redundant measures of risk in the build-up approach.
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The use of total beta developed by Aswath Damodaran is a relatively new concept. It is, however, gaining acceptance in the business valuation Consultancy community since it is based on modern portfolio theory. Total beta can help appraisers develop a cost of capital who were content to use their intuition alone when previously adding a purely subjective company-specific risk premium in the build-up approach.
It is important to understand why this capitalization rate for small, privately held companies is significantly higher than the return that an investor might expect to receive from other common types of investments, such as money market accounts, mutual funds, or even real estate. Those investments involve substantially lower levels of risk than an investment in a closely held company. Depository accounts are insured by the federal government up to certain limits ; mutual funds are composed of publicly traded stocks, for which risk can be substantially minimized through portfolio diversification.
Closely held companies , on the other hand, frequently fail for a variety of reasons too numerous to name. Examples of the risk can be witnessed in the storefronts on every Main Street in America. There are no federal guarantees. The risk of investing in a private company cannot be reduced through diversification, and most businesses do not own the type of hard assets that can ensure capital appreciation over time. This is why investors demand a much higher return on their investment in closely held businesses; such investments are inherently much more risky.
This paragraph is biased, presuming that by the mere fact that a company is closely held, it is prone towards failure. In asset-based analysis the value of a business is equal to the sum of its parts. That is the theory underlying the asset-based approaches to business valuation. The asset approach to business valuation reported on the books of the subject company at their acquisition value, net of depreciation where applicable. These values must be adjusted to fair market value wherever possible. The value of a company's intangible assets, such as goodwill, is generally impossible to determine apart from the company's overall enterprise value.
Standards of Value : Theory and Applications. Jay E. Expert direction on interpretation and application of standards of value Written by Jay Fishman, Shannon Pratt, and William Morrison—three renowned valuation practitioners— Standards of Value, Second Edition discusses the interaction between valuation theory and its judicial and regulatory application. Features new case law in topics including personal good will and estate and gift tax, and updated to cover the new standards issued since the first edition Includes an updated compendium discussing the standards of value by state, new case law covering divorce, personal goodwill, and estate and gift tax, and coverage of newly issues financial standards Shows how the Standard of Value sets the appraisal process in motion and includes the combination of a review of court cases with the valuator's perspective Addresses the codification of GAAP and updates SOV in individual states Get Standards of Value, Second Edition and discover the underlying intricacies involved in determining "value.
Chapter 1 Common Standards and Premises of Value. Chapter 2 Fair Market Value in estate and Gift tax.
Pratt , William J. A must-read for appraisers, accountants, judges, attorneys, and appraisal users, this insightful book addresses standards of value as applied in four distinct contexts: estate and gift taxation; shareholder dissent and oppression; divorce; and financial reporting. Here, practitioners will discover some of the intricacies of performing services in these venues, and appraisers will find this book helpful in understanding why the practitioners are asking such questions.
Theory and Applications Index.