The genesis of what we now call the Integrated Theory of Business Valuation  was my book, Quantifying Marketability Discounts (no longer in print), which was published in 1997. That book introduced the Quantitative Marketability Discount Model (QMDM) to the business appraisal profession and focused on shareholder level cash flows. The QMDM was, and is, a shareholder-level discounted cash flow model.
The book, The Integrated Theory of Business Valuation (no longer in print), was self-published in 2004 to focus the integrated theory on the valuation at both the enterprise and shareholder levels of value.
We published the second edition of the Integrated Theory with a major publisher in 2007 and titled it Business Valuation: An Integrated Theory Second Edition. Travis W. Harms, CFA, CPA/ABV became my co-author with that edition.
The third edition of the Integrated Theory was published in 2021 and was titled Business Valuation: An Integrated Theory, Third Edition. The integrated theory has been around now for many years. In this post, we begin to relate the integrated theory to the standard of value known as fair market value.
The Integrated Theory of Business Valuation
We repeat the levels of value chart from Appraisal Review #3 here for context for the discussion.
What is an integrated theory of business valuation? We explain in the Introduction to the third edition.
We use the term integrated theory to refer to our rather dogged insistence that the key to answering thorny valuation questions is devoting one’s attention to cash flow, risk, and growth. Simply put, we propose that any valuation question (or problem, or controversy, depending on your perspective) is ultimately answerable by analyzing expected cash flows, risk, or growth expectations.
In this book, we provide readers with both the conceptual basis for – and practical application of – the Integrated Theory, which we can summarize as follows:
The value of any business or business ownership interest is a function of the expected cash flows attributable to the that business or business ownership interest, the expected growth in those cash flows over the relevant holding period, and the risks associated with achieving those expected cash flows.
The Integrated Theory provides a conceptual framework for disciplined analysis of valuation questions. Too often, valuation analysts are tempted to view individual components of valuation assignment on a piecemeal basis. Adhering to the Integrated Theory helps valuation analysts develop base valuation conclusions, discounts, and premiums that are rooted in a shared perspective of the subject company and the subject ownership interest.
The most transparent application of the integrated theory is in developing the conceptual underpinnings of the so-called levels of value.
Developing the conceptual underpinnings of the levels of value is beyond the scope of this series of posts on appraisal review and fair market value. Nevertheless, each of the levels is developed based on the views of market participants, whether real or hypothetical of expected cash flows, the risks associated with their receipt, and the growth of those cash flows. These expectations determine the relevant levels of value and the conceptual basis for them.
For example, we define each of the levels of value in the chart above based on the expected cash flows and their growth, as well as the risks associated with achieving them. A summary of these definitions was provided in the discussion of the levels of value in an earlier post. We continue the discussion of the conceptual levels of value and the premiums and discounts that relate them to one another as we proceed. First, we develop symbolic notation relative to the various levels of value. This notation enables examining conceptual value at each level and facilitates examining differences in value between the various levels. These differences are the familiar valuation discounts and premiums shown in the levels of value chart.
In focusing on the marketable minority level above., VEq(mm) represents the value of the equity of a business at the marketable minority level of value. Similarly, CFEq(mm) represents the cash flow to equity for the business. Since we are looking at the marketable minority level, the appropriate cash flow is normalized, expected cash flow, since we know that the public markets are always in the process of valuing securities based on normalized, expected earnings. GCFEq(mm) and REq(mm) are the expected growth of cash flows and the risks associated with receiving them. We see these terms in the Gordon Model, which we refer to as the fundamental valuation equation.
Financial Control/Marketable Minority Level of Value
Appraisers use the fundamental valuation equation (above as Exhibit 2.2) to capitalize on businesses’ expected earnings or cash flows. The equation is written for the marketable minority level of value. When normalized, expected earnings are capitalized, the resulting value indications are at the marketable minority level of value. This fact should not be controversial. In the levels of value chart, the marketable minority and financial control levels of value sit atop each other, suggesting that the financial control premium, if any, is very small and similarly, the minority interest discount, if any, is also very small.
For public companies, we know that the markets “normalize” earnings and base pricing on expected, normalized earnings. For private companies, appraisers should normalize earnings similarly, regardless of whether the valuation objective is at the marketable minority/financial control level or the nonmarketable minority level. Public, marketable minority, pricing and financial control pricing are the same or close to each other. If there were a significant difference, strategic acquirers and private investors would engage in arbitrage to earn the difference. Given that relatively few public companies are acquired each year, we suggest that financial control and marketable minority values are synonymous. We see this more clearly when we compare the marketable minority and financial control levels of value.
Observe that the fundamental valuation equation is at the bottom left under “Conceptual Math.” The expected growth at the marketable minority level is the required return less the yield on any dividends paid (under “Relationships”). Under “Value Implications” we see that the resulting equity value is the benchmark to compare other equity levels and is an “as-if public” value. Ask the question, why would financial control value diverge from the marketable minority value? There are four possibilities:
- Expected cash flow. The expected cash flow at the financial control level exceeds the expected cash flow at the marketable minority level. This is unlikely since the normalized cash flows are capitalized at the marketable minority level. Financial buyers may think they can run a company better than it is being run, but if they can, they are unlikely to consider that expectation in their pricing.
- Growth. The basic business engine is the same whether looked at from the financial control or the marketable minority level. Expectations for growth are the same. Again, financial buyers may think they can grow the business faster. If so, they will likely keep that hoped-for benefit for themselves.
- Risk. Once again, the market’s discount rate for a business is the same or quite similar for current owners or future financial buyers who are looking for a market rate of return on their investment. Once again, there is little reason based on risk for there to be a differential in risk at the two levels.
- Combination of above.Presumably, some combination of differences from the viewpoint of financial buyers could create a net divergence in value from the marketable minority level of value. However, keep in mind that hypothetical or real financial buyers seek to maximize their expected returns. They are unlikely to pay sellers for small potential benefits unless many financial buyers would bid up price somewhat.
Fair Market Value Implications
The implication is that, as shown in the levels of value chart, the financial control and marketable minority levels are synonymous, or virtually so. This implication is important in fair market value determinations of operating companies. Suppose appraisers develop value indications of operating companies by capitalizing normalized. In that case, expected earnings, using the discounted cash flow models, or using the guideline public company method, the indications are at the marketable minority/financial control level of value. Given the close relationship between the two levels, it would be inappropriate to apply a minority interest discount in the process of developing indications at the nonmarketable minority level, or the lowest conceptual level above.
Differences in expected cash flow, risk and growth between the marketable minority and the nonmarketable minority levels account for any differences in value between the two levels.
Note that it would be inappropriate to consider available control premium studies as a basis to estimate minority interest discounts. See a more complete discussion of this issue in a post on the “disappearing minority interest discount.” I would suggest that this post is a must-read for appraisers who are still using control premium studies to develop minority interest discounts.
I will address the issue of the minority interest discount in the appraisal of asset holding entities in a future post.
Strategic Control Level of Value
The strategic (or synergistic) control level of value is the top level on the levels of value chart. This level of value is defined by how strategic investors view the expected cash flows of target businesses in combination with their own expected cash flows and expected synergistic benefits. The strategic level of value is based on the expectation of synergies or strategic benefits from combinations with target companies. The strategic level of value is also impacted by the application of lower discount rates often applicable to large, strategic purchasers relative to smaller public or private acquisition targets.
Looking at the conceptual math at the strategic control level of value, and compare it to the marketable minority (or financial control) level of value. A strategic buyer might pay a higher than marketable minority price for a company for any of four possible reasons. The same logic would apply to strategic buyers paying “control premiums” over the price of a public company unaffected by the announcement. Look at the conceptual math in the table below and see that the reasons include:
- Expected cash flow. The expected cash flow at the strategic control level exceeds the expected cash flow at the marketable minority level. Strategic buyers look at target cash flows differently than financial buyers and often have expectations for material cost or revenue synergies or other strategic benefits unavailable in the public markets or to financial buyers.
- Growth. Growth expectations for a strategic buyer may be enhanced relative to the marketable minority/financial control level (i.e., stand-alone) by selling a target’s products to the acquirer’s customers or the acquirer’s products to the target’s customers. This is a form of synergy but could enhance overall growth.
- Risk. Strategic buyers tend to have lower costs of capital than do smaller public companies and financial acquirers. To the extent that they employ their lower costs of capital in acquisitions, premium pricing relative to financial control can be the result.
- Combination of above. And then, a combination of the above factors could lead to higher than financial control pricing.
Fair Market Value Implications
Earlier in the series, we noted that most fair market value determinations are conducted under the going concern premise of value. Arguably, a strategic acquisition of a company in which the price is determined based on the expectation of merger-related synergies and strategic benefits not available to a target, is likely not reflective of the going concern premise of value. For this reason, strategic or synergistic control is not normally a value objective under the fair market value standard of value.
The possible exception might be for companies in consolidating industries where many acquirers are strategic in nature. However, the possible exception bears examining. Take the banking industry, for example. Most bank acquisitions are conducted by strategic acquirers. If that’s the case, one could argue that the fair market value of a bank (100%) should be determined at the strategic level of value. However, consider the following:
- The banking industry has been consolidating at the rate of about 3% to 5% of the industry per year for many years. Most of the acquisitions are by strategic acquirers, and “strategic” prices are generally paid. Should strategic values be accorded to the 95% to 97% of banks that are not acquired each year? That is a good question and the answer is likely no. What about a single bank being valued by an appraiser? Is fair market value represented by the strategic level of value? Likely not.
- Expectations for expense synergies are disclosed by acquiring banks as a justification for their pricing. Typically, those expectations call for expense saves, or synergies, in the range of 30% to 35% of the operating expense bases of acquired banks. Is an acquired bank that will be merged with another institution and have 30% to 35% of its operating expenses eliminated a going concern? Likely not.
- The acquisition multiples paid for banks reflects the portion of expected expense saves that the acquired banks could negotiate. Are those synergies available to a single bank that is being valued? Of course not. Is it appropriate to use multiples that reflect significant expenses saves to determine the fair market value of a bank, which cannot realize those savings? Likely not.
As the integrated theory matures, answers to questions such as whether strategic control is an appropriate level of value for fair market value determinations become clearer. Am I saying that it is impossible to identify a situation where it is appropriate to determine fair market value of a business at the strategic control level? No. But the prospects for a favorable answer to the question would appear to be significantly limited.
Appraisers may be asked or choose to develop fair market value indications for businesses at the strategic control level. If so, in light of the discussion in this post, it would incumbent on an appraiser attempting to determine fair market value for any particular business to show why the strategic control level is appropriate for that determination.
When reviewing a fair market value appraisal performed at the strategic control level, the reviewer should insure that, based on the information provided, whether that level of value is appropriate for a fair market value determination.
Wrap-Up and What’s Coming Next?
This series addresses a number of important valuation concepts under the general umbrella of appraisal review. We address critical definitions, implications, theories and more because absent clear understanding of valuation theory and practice, there is little hope for good valuation or good valuation review. Our discussion provides tools to address questions like this one, which will be discussed in a separate post later in the series.
In this post we discussed the integrated theory of business valuation. We have covered the marketable minority/financial control levels of value and the strategic or synergistic level and posed important implications for fair market value determinations. In the next post, we address the nonmarketable minority level of value in a similar fashion and then discuss the root causes of the valuation premiums and discounts shown on the levels of value chart.
As always, I encourage comments and feedback. If you are benefiting from this series, please recommend to your friends and colleagues that they sign up to receive posts from ChrisMercer.net regularly.
 Mercer, Z. Christopher, Quantifying Marketability Discounts (Memphis, TN, Peabody Publishing, L.P., 1997)
 Mercer, Z. Christopher, The Integrated Theory of Business Valuation, (Memphis, TN, Peabody Publishing, L.P., 2004).
 Mercer, Z. Christopher and Harms, Travis W., Business Valuation: An Integrated Theory Second Edition (Hoboken, NJ, John Wiley & Sons, Inc., 2007)
 Mercer, Z. Christopher and Harms, Travis W., Business Valuation: An Integrated Theory Third Edition (Hoboken, NJ, John Wiley & Sons, Inc., 2021)
 Ibid, p. xiii.
 I began to focus on the meaning of fair market value early in my valuation career and began writing and speaking about it in the latter 1990s. See Z. Christopher Mercer and Terry S. Brown, “Fair Market Value vs. The Real World,” Valuation Strategies, Vol. 2, No. 4 (1999), pp. 6-15; and “Fair Market Value vs. The Real World,” Business Valuation Review, Vol. 18, No. 1 (1999): pp. 16-25.