Business Valuation: An Integrated Theory, Third Edition has been published by John Wiley & Sons, Inc. in the Wiley Finance Series. My co-author, Travis W. Harms, CFA, CPA/ABV and I are excited and relieved to have received this work in hand late last week. The book is available on Amazon.com and at wiley.com, where an E-book version is available. So now we begin to tell the story about the book and why you should own it and read it.
What do we mean by an integrated theory of business valuation?
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 interests, 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 a disciplined analysis of valuation questions. Too often, valuation analysts are tempted to view individual components of a 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.
What’s New in the Third Edition?
In the decade or so since the second edition of this book, valuation analysts have increasingly recognized the importance of evaluating private operating businesses from the perspective of the enterprise (equity plus net debt) rather than restricting the focus of analysis to the net equity of the business. The Integrated Theory is readily extended to the enterprise value perspective, and we demonstrate that extension in this edition.
Further, recognizing the need for more practical guidance regarding the application of the integrated theory to the valuation of enterprise value, we have added new chapters on estimating enterprise cash flows and developing enterprise discount rates. This third edition also includes new chapters relating the market and income approaches, using the Integrated Theory to expose the common conceptual underpinnings of the two approaches. Finally, we have added a new chapter dedicating to dissecting the often cited, but less often understood, restricted stock and pre-IPO studies using the Integrated Theory as our scalpel.
The twelve chapters in this edition are organized into three sections.
Section 1 :: The Integrated Theory
- Chapter 1 – The World of Value. We begin the book by laying out some fundamental principles that undergird the Integrated Theory. The principles of expectations, growth, risk and reward, present value, alternative investments, and rationality lay the necessary conceptual and theoretical foundation for the Integrated Theory.
- Chapter 2 – The Integrated Theory (Equity Basis). In Chapter 2, we describe the Integrated Theory on an equity basis, giving particular attention to the conceptual scaffolding the Integrated Theory provides to discussions of the levels of value and the associated valuation discounts and premiums.
- Chapter 3 – The Integrated Theory (Enterprise Basis). This chapter, new to the Third Edition, extends the conceptual basis for the Integrated Theory described in Chapter 2 to the enterprise value perspective.
Section 2 :: Using the Integrated Theory to Develop Firmwide Indications of Value
Each of the chapters in Section 2 is new to the Third Edition.
- Chapter 4 – Income Approach (Cash Flows). Our exposition of the Integrated Theory in Section 1 relies on the conventions of the single-period capitalization method. In Chapter 4, we demonstrate how valuation analysts can apply the Integrated Theory in forecasting cash flows whether using a single-period capitalization or multi-period discounted cash flow method. We also explore the relationship between reinvestment and growth, and the role of normalizing adjustments to derive cash flows applicable to the valuation of interests on a marketable minority interest basis. Finally, we discuss potential control adjustments to cash flows and provide a roadmap for assessing the overall reasonableness of cash flow projections.
- Chapter 5 – Income Approach (Discount Rate). We suspect that more is written about discount rates each year than any other valuation topic. In Chapter 5, we cast a somewhat skeptical eye over the discount rate terrain, concluding that valuation professionals devote far too much time and attention to competing techniques for sifting through the mountains of available historical return data, and too little time and attention on developing reasonable – although admittedly less precise – discount rates for valuation subjects. In addition, we consider the relationship between the discount rate and the level of value.
- Chapter 6 – Market Approach (Guideline Public Companies). Although we develop the Integrated Theory using the language of the income approach, it is equally applicable to the market approach. In Chapter 6, we reveal the conceptual components of common valuation multiples and demonstrate how to use the Integrated Theory to make supportable adjustments to observed valuation multiples.
- Chapter 7 – Market Approach (Guideline Transactions). In Chapter 7, we turn our attention to the unique challenges that arise when analyzing guideline transactions to develop firmwide indications of value. Chapter 7 is followed by an appendix providing a historical perspective on the control premium and minority interest discount, using the Integrated Theory to trace the evolution of these key concepts in practice.
Section 3 :: Using the Integrated Theory to Value Nonmarketable Minority Interests
- Chapter 8 – Restricted Stock Discounts and Pre-IPO Studies. In this new chapter, we analyze restricted stock discounts and pre-IPO studies through the lens of the Integrated Theory. While restricted stock discounts provide meaningful benchmarks for marketability discounts applicable to private companies only by chance, we demonstrate how the restricted stock data confirms the existence of a holding period premium applicable to illiquid interests in private companies. We also conclude that observed pre-IPO discounts actually capture two distinct phenomena: the marketability discount applicable prior to the IPO and the “pick-up” in value associated with the IPO itself.
- Chapter 9 – Introduction to the QMDM (Quantitative Marketability Discount Model). The Quantitative Marketability Discount Model is a shareholder level discounted cash flow model. In Chapter 9, we describe the QMDM, showing that the marketability discount is ultimately attributable to differences in cash flow risk and growth for minority shareholders in private companies. The Excel model of the QMDM is available here.
- Chapter 10 – The QMDM Assumptions in Detail. In Chapter 10, we present a more detailed review of the QMDM inputs: the expected holding period, dividend yield, growth in value, and required holding period return.
- Chapter 11 – Applying the QMDM. The QMDM is adaptable to the attributes of specific illiquid minority interests. In this chapter, we apply the QMDM to a variety of fact patterns, illustrating how to use the QMDM to identify the relevant cash flow, risk, and growth characteristics of the subject interest for a valuation.
- Chapter 12 – Applying the Integrated Theory to Tax Pass-Through Entities. We close by using the disciplined framework of the Integrated Theory to examine the valuation of shareholder interests in S corporations and other tax pass-through entities.
Who Should Read This Book?
A variety of business valuation, legal, and accounting professionals and students should read Business Valuation: An Integrated Theory Third Edition.
Valuation Analysts (Business Appraisers)
The Integrated Theory provides the foundation for a deeper understanding of business valuation concepts. These insights will be helpful for beginning and experienced appraisers alike. In this book, we use the term valuation analyst to be synonymous with the standard definition of a business appraiser.
In addition, the Integrated Theory raises (and answers) a number of questions about “standard” valuation practices employed by many appraisers, including the application of control premiums, minority interest discounts, and marketability discounts.
Auditors and Financial Statement Users Considering Fair Value Measurements
The prominent role of fair value measurements in generally accepted accounting principles means that auditors need to be fluent in fundamental valuation principles. While the Integrated Theory does not address specific fair value measurement applications, it does provide assistance to CPAs and appraisers as they both attempt to translate interpretations of the concept from the FASB, the SEC, or elsewhere into reliable valuation techniques.
Familiarity with basic valuation principles and techniques is also beneficial for financial analysts and others who regularly review financial statements. To be an informed reader of financial statements, it is critical that one be able to evaluate not just the “what” but also the “why” of fair value measurements. The Integrated Theory provides a unique introduction to these issues.
Users of Business Appraisal Reports
The Integrated Theory will also be helpful for users of appraisal reports, including accountants, financial planners, and attorneys. The basic concepts of the Integrated Theory are not difficult, and the limited use of symbolic math is fairly easy to follow. We have advised clients for many years: “If you don’t understand it, then don’t stand for it.” The Integrated Theory, particularly when consulted on a specific-topic basis when questions arise, can help readers develop a better understanding of business valuation reports.
Corporate Finance and Valuation Students
Finally, we believe that the Integrated Theory is an ideal teaching tool for students in accounting, finance, and economics. Valuation courses are increasingly common in business and economics programs at both the graduate and undergraduate levels. The Integrated Theory provides a concise, thorough, and logically consistent framework for introducing students to valuation theory and practice.
What Should a Reader Do Now?
We would like for you to do three things:
- Purchase the book. Here on Amazon.com. If you want an E-Book version go here to Wiley.com. This book will soon be a cornerstone work in every business appraiser’s library.
- Read the book. Section 1, which outlines the Integrated Theory, is a great place to start. Because of the new material in this third edition, significantly longer (about 500 pages) than the second edition (about 275 pages). We think the additional length was worth the effort to create and it is well worth your effort to read. If you did not read the second edition, having and reading the third edition is essential. If you did read the second edition, the third edition will further open your eyes to the Integrated Theory.
- Be the first (or second or one-thousandth!) to review the book on Amazon.com. We would, of course, appreciate favorable reviews☺. We think you will find the third edition of Business Valuation: An Integrated Theory deserving.
Until next time, be safe and be well!