My co-author, Travis W. Harms, CFA, CPA/ABV, and I have been doggedly insisting that business valuation questions, issues, premiums, discounts, and more be viewed through the combined lens of expected cash flow, its expected growth, and the risks associated with achieving the expected cash flows. See our Business Valuation: An Integrated Theory, Third Edition (“the Integrated Theory”). This should not be surprising because the value of a business can be summarized using those three concepts:
Value = CF(1) / R – G
The equation is, of course, the familiar Gordon Model, which capitalizes next year’s expected cash flow, CF(1) by the difference between the equity discount rate, R, and the expected growth in cash flows, G. The assumptions for this equation, which we call the fundamental valuation equation, are straightforward. The equation summarizes the discounted cash flow model when CF(1) is expected to grow at the constant growth rate of G into the indefinite future, and all cash flows are reinvested in the business at the discount rate of R or paid out to investors (or some combination of reinvestment and payout). So the valuation triumvirate is expected cash flow, growth, and risk.
If business value is a function of expected cash flow, growth, and risk, it follows that differences in value between conceptual levels of value are a function of differences in expected cash flow, growth, and risk between conceptual levels of value. Until the latter 1990s, it was thought that buyers of companies paid premiums (over publicly-traded prices of targets) for elements of control. The current view is that buyers of companies pay for expected changes, post-acquisition, in combined cash flows and potentially reduced risk. Unfortunately, the valuation literature appears slow to recognize this change in thinking from paying for control (or lack thereof) to paying for relevant value based on the expected cash flows of a business or an interest in a business from the viewpoints of market participants at the respective levels.
Control Premiums Causation: Cash Flow and Risk Differences or Degrees of Control?
We look at the Sixth Edition of Valuing a Business (“VAB6”), which was published in 2022, for an example description of the cause of valuation premiums and discounts. Early in Chapter 3, we find a mention of the valuation triumvirate (page 54):
A given business or business ownership interest is likely to have more than one value at a given valuation date. This multiplicity of values is attributable to the different perspectives from which one may consider the value of a business or business ownership interest. Valuation analysts have traditionally referred to the available perspectives as levels of value. While a variety of charts have been offered by analysts and observers over the years, the Exhibit 3-2 includes the primary components that are common to all such charts.
Exhibit 3-2 identifies four distinct levels of value and four discounts or premiums that relate the levels to one another. The different levels of value , and the corresponding discounts or premiums, are rooted in differences in economic income and risk [i.e., expected cash flow, growth and risk] from each different perspective represented on the exhibit.” (emphasis added)
Exhibit 3-2 is a virtual duplicate of the figure on the right side of Exhibit 2.15 in the Integrated Theory (p. 52). In the Integrated Theory, Travis and I explain at length that the different conceptual levels of value mark different views of market participants at each level. For example, strategic buyers in Exhibit 3-2 view the expected cash flows of a business differently than financial buyers. Strategic buyers do not pay for elements of control, per se, but for what they can do with acquired business to, for example, increase overall cash flows and growth through synergies or strategic benefits, or to reduce overall risk by the combination of operations.
Chapter 17 of VAB6 is titled “Control versus Lack of Control: Premiums and Discounts.” After introducing the concept in Chapter 3 that valuation premiums and discounts are a function of differences in expected cash flow, growth, and risk between conceptual levels of value, VAB6 does not revisit the concept in Chapter 17. Instead, VAB6 appears to try to explain differences in levels based on varying degrees of control or lack thereof. For example, Exhibit 17-1 of VAB6 appears as follows.
This is a conceptual view of valuation premiums and discounts. However, it is not an operative view. There is no reference to valuation methods that enable valuation analysts to determine the value of degrees of control.
We know that a valuation premium has no meaning unless the base to which it is to be applied is defined. Further, we know that a valuation premium is warranted only when the characteristics affecting the value of the subject interest differ sufficiently from those inherent in the base value to which the discount or premium is applied. These thoughts reflect common sense, but they also reflect guidance from the ASA Business Valuation Standards at “BVS-VII Valuation Premiums and Discounts.” The same guidance applies to discounts taken from defined base values.
Focus on the $8.00 per share “publicly traded equivalent value” or “stock market value” as if freely traded in Exhibit 17-1. Presumably, that is a base value to which premiums might be applied. The figure then shows a “standalone control premium” of 25%, which leads to a “value of control shares standalone” of $10.00 per share. Presumably, per the chart and text, the $2.00 per share difference between the $8.00 per share “base value” and the $10.00 per share standalone control value is caused by a greater degree of control than at the as-if-freely-traded value. Three questions come to mind:
- Does a 25% premium in value exist just for standalone control? Probably not.
- If it does exist, how would it be possible to quantify the $2.00 per share “value of control”? It is not addressed.
- What market evidence might be available to help the appraiser quantify this difference? None, really.
The conceptual view in Exhibit 17-1 of VAB6 does not take the extra step of connecting “elements of control” with differences in expected cash flow, growth, and risk discussed.
Is Chapter 17 of VAB6 Behind the Times?
Eric Nath, ASA, wrote an article in 1990 that suggested that publicly-trading pricing for public companies reflected control values. That article began an evolution in thinking about the use of control premiums. Valuing a Business, Third Edition, published in 2000, contained a levels of value chart with four levels, rather than the three conceptual levels previously thought to exist. But that chart, like the figure above, focused only on differences in control to explain differences in value from the perspective of different market participants.
I have written and spoken since the latter 1990s that the relationship between financial control and marketable minority value levels is as shown in Exhibit 3-2 of VAB6, i.e., as overlapping or coincident. Indeed, what we write in the Integrated Theory aligns nicely with another credible source, Valuations in Financial Reporting Valuation Advisory 3: The Measurement and Application of Market Participant Acquisition Premiums published in 2017 by The Appraisal Foundation.
Two short sections are quoted below to place the discussion of this post into the perspective of expected cash flow, growth and risk (emphasis added).
Premiums for control have long been a focus in business valuation. Through the early 1990s, it was generally accepted that the publicly traded price of a company’s shares represented the value of a minority interest and that, if the goal was to value a control interest, a “premium for control” would be added to the value of equity indicated by that publicly traded price. That premium generally came from market evidence in which the price paid to acquire an entire company was compared to the publicly traded price of that same company’s shares prior to the acquisition. However, in the late 1990s, this concept came into question and views have since been changing. Various points have been made regarding why the [financial] control value of an entity might be no greater than that indicated by its publicly traded price.
In any case, it has become widely accepted that the market evidence supplied by comparing the acquisition price to the publicly traded price does not represent a premium for conceptual control but, rather, represents a premium linked to actual changes that can be made by exercising that control. Control, and whether one has it, is not really the focal point. What matters is that, after an acquisition, the acquired company is now under different management/stewardship. A price higher than the publicly traded price might be reasonable if the new management and/or combined entity expect(s) improved cash flow or growth or reduced risk. [i.e., expected Cash Flow, Risk and Growth]. If no improvements or risk reduction could reasonably be expected, there may be little ability for an acquirer to pay a price higher than the publicly traded price and still generate a reasonable return on its investment. In such cases, the control value may approximate the publicly traded price. (emphasis added)
Valuation Advisory #3 clearly indicates that market participants are not paying for “control” but rather for the positive enhancements in value that might be expected under new management through increasing expected cash flow, or growth, or reducing risk.
The view of the source of differences between strategic control pricing and freely traded pricing espoused in Valuation Advisory #3 is consistent with the Integrated Theory and with the levels of value chart labeled Exhibit 3-2 above. The view that, in some or most cases, control value may approximate the publicly traded pricing is also consistent with the Integrated Theory.
Interestingly, there is one footnote mention of Valuation Advisory #3 in Chapter 17 of VAB6, and it is not on point regarding differences in the levels of value. A further footnote reference to Valuation Advisory #3 in VAB6 is also not on point.
After years of advancement in valuation thinking, Chapter 17 could have made (but does not make) the connection between control premiums and differences in cash flow, growth, and risk.
Time for a Change in Valuation Thinking
Is it time for a realistic change in thinking about the levels of value? Yes. Control premiums between levels of value of whatever name are not caused by differing perceptions or degrees of control. They are caused by differences in expected cash flow, risk, and/or growth from the viewpoint of relevant market participants at the different levels of value.
I’ve been writing and speaking about the broader issue of valuation theory and how we should be looking at valuation and valuation premiums and discounts since the mid-1990s or pushing towards thirty years. It is past time for substantial changes in the way that many business appraisers approach valuation questions and issues.
We have not discussed valuation discounts in this post; however, the arguments for the cause of discounts relating to degrees of control or lack thereof, versus those relating to differences in expected cash flow, growth, and/or risk between conceptual levels are parallel. More on that later.
In the meantime, be well.