On November 4, 2016, I will be speaking at the AAML Annual Meeting at the Renaissance Chicago Downtown. For non-family lawyers, the AAML is the American Academy of Matrimonial Lawyers. I’m pleased to have been asked (by Carole Gailor and David Griffin) to address a topic that is near to my heart as a business appraiser: An Integrated Theory for the Major Valuation Issues of Today. I like this topic and have been addressing it for about two decades.
Each of the issues is worthy of hours of coverage. My purpose in what will be a fast-paced session will be to provide a thought-provoking overview of what have been since I entered the business appraisal profession and what remain the major valuation issues of today.
What is an “Integrated Theory” of Business Valuation?
The topic raises two questions right away.
The first questions is: What is an “integrated theory” regarding business valuation? Let’s begin with a definition. We know that the value of a business – today – is the value of all expected future benefits (or cash flows) to be derived from the business into perpetuity (that’s forever), discounted to the present at a discount rate that is reflective of the risks associated with the receipt of the expected cash flows.
The valuation triumvirate of expected cash flow, risk and growth flows directly from the definition of value.
If there is an integrated theory of business valuation, it should be able to address “the major valuation issues of today” in terms of these three critical drivers of business valuation.
I’ve written and spoken about an integrated theory of business valuation before.
- The Integrated Theory of Business Valuation, Peabody Publishing, LP, 2004. This book built upon an earlier book, Quantifying Marketability Discounts (Peabody Publishing, LP, 1997). The marketability discount was a major valuation issue in 1997 and remains as a major issue today. Both of these books are no longer in print; however, their major content can be found in the next book.
- Business Valuation: An Integrated Theory Second Edition (John Wiley & Sons, 2007).
- Speaking. Since 2002, I’ve spoken on the integrated theory and related topics like marketability discounts and “big problems” in valuation more than 30 times. Prior to 2002, I spoke more than 30 times on quantifying marketability discounts and related issues.
- Articles and blog posts. I didn’t count how many articles and blog posts I’ve written on these topics. They are legion.
So there is an integrated theory of business valuation. We just have to recognize it. So I’ll provide an brief overview of an integrated theory of business valuation in my session.
What Are the Major Valuation Issues of Today?
The second question is: What are the major valuation issues of today?
Whether in the context of divorce or not, the major valuation issues in business valuation are pretty much the same. In a one hour session, I won’t be able to go into detail for the issues, but I will provide an overview of each issue and discuss how, in the context of an integrated theory of business valuation, they might be addressed. My current outline for the coming AAML presentation is as follows (with a comment or two):
Issue 1: Discount Rates
Discount rates have been a major valuation issue since I came into the profession in the late 1970s. One of my early articles was titled “The Adjusted Capital Asset Pricing Model for Developing Capitalization Rates” and was published in the Business Valuation Review. Discount rate development is still a major issue. I’m afraid, though, that the debate has taken an unfortunate turn. I’ll talk about that.
Issue 2: Adjustments to Income Statements
Appraisers still debate on whether they should normalize owner compensation and adjust for other owner non-operating perquisites in minority interest valuations. The integrated theory is clear on this point. I’ll tell why appraisers should normalize for owner compensation – even if minority interest lacks the power to make the changes. And I’ll tell why and how we should account for the lower expected cash flow from non-normalized earnings in our appraisals.
Issue 3: Valuation Methods
Four broad valuation methods are used in many appraisals. I’ll not address any asset-based methods in the session and will stick to comments on income-based methods.
There are two broad methods under the income approach. While there are numerous sub-methods or techniques that we will not address, the two methods are:
- Single-period income capitalization method. We will see that many issues in the use of this method arise over misunderstandings with Issues 1 and 2 above.
- Discounted cash flow method. The DCF method is used in many, if not most, appraisals of larger companies. We’ll note that the DCF method also encounters misunderstandings regarding Issues 1 and 2 above. How realistic is the forecast? How calculate the terminal value? What is the terminal value growth rate? Can we use current market multiples to estimate terminal values?
Both the single-period income capitalization method and the DCF method share a common question when employed. Is the resulting value indication reasonable? How can we know?
There are two broad methods under the market approach to valuations, with numerous sub-methods we will not address. The issues are:
- Guideline public company method. With this method, we look at publicly traded companies to attempt to infer appropriate multiples to derive value indications for private companies. I’ll have a few comments here.
- Guideline transactions method. With this method, we attempt to look at actual transactions in other private companies to infer valuation multiples for subject private companies. I’ll have a few comments here, as well.
Issue 4: Major Valuation Premiums and Discounts
We will touch on one premium and four discounts in this portion of the session. Are they matters of “appraiser judgment?” If so, what is the basis for those judgments. Where do discounts or premiums come from? I’ll just list them here.
- Control premiums
- Minority interest discounts
- Marketability discounts(aka DLOM)
- Marketability discounts (DLOMs) for controlling interests
- Key-person discounts
We won’t have time to address these in depth, but attendees of the session will have little doubt where I stand on each issue – all in the context of the integrated theory of business valuation.
Issue 5: Active vs. Passive Appreciation in Divorce
Some states make a distinction between active versus passive appreciation in marital or non-marital assets. So is the appreciation “active” or is it “passive?” In the remaining portion of the session, we will unlock the mysteries of this question. Not! But I will share a brief overview where the integrated theory helped answer the question.
My two most recent books are available in an Ownership Transition Bundle. The bundle, priced at $35 plus s/h, has been attractive for many business owners, appraisers and attorneys.