Financial Valuation Applications and Models

Financial_Valuation-Applications__26_Models.pdf

CHAPTER 1

Introduction to Financial Valuation 1
Who Values Businesses? 1
Purpose of a Valuation 2
Professional Valuation Organizations 3
Standards of Value 3
Fair Market Value 3
Investment Value 5
Intrinsic Value 5
Fair Value (State Rights) 5
Fair Value (Financial Reporting) 6
Premise of Value 6
Principles of Appraisal Practice 7
Dates 7
Approaches to Value 7
Valuation Procedures 8
Summary 8
Addendum 10

CHAPTER 2

Research and Its Presentation 18
Obtaining Internal Information 18
A Directive from the Internal Revenue Service 18
Research Techniques and Planning the Search 20
Information Sources: Business Financial Databases 24
Economic Research 25
Selected Sources of Economic Information 25
Industry Research 27
Selected Sources of Industry Information 27
Guideline Company and Transaction Research 28
Presenting Research in a Report 30
Other Sources of Information 31
Summary 31
Addendum 1—Valuation Information Request List 33

CHAPTER 3

Financial Statement and Company Risk Analysis 49
Historical Financial Statement Analysis 49
Length of Financial History to Be Used 50
Spreading Financial Statements in Columnar Format 50
Adjustments to Financial Statements 50
Normalization of Historical Financial Statements 53
Unusual, Nonrecurring, and Extraordinary Items 53
Nonoperating Items 54
Changes in Accounting Principle 54
Nonconformance with GAAP 55
Tax Effecting the Earnings of Subchapter S Corporations 55
Degree of Ownership Interest 57
Normalization Adjustments 58
Common Sizing Normalized Financial Statements 58
Ratio Analysis (Quantitative Analysis) 62
Comparative Analysis 69
Risk Analysis (Qualitative Analysis) 72
Macroenvironmental Analysis 76
Appendix—Commonly Used Financial Ratios Application to
Ale’s Distributing 78

CHAPTER 4

Income Approach 85
Fundamental Theory 85
Income Approach Involves a Numerator 86
Income Approach Involves a Denominator 86
Income Approach Methodologies 87
Normalization Process 87
Adjustments for Ownership Characteristics 88
Adjustments for GAAP Departures, Extraordinary, Nonrecurring,
and/or Unusual Items 90
Adjustments for Nonoperating Assets and Liabilities and
Related Income and Expenses 91
Adjustments for Taxes 92
Adjustments for Synergies from Mergers and Acquisitions 93
Determination of Future Benefit Stream (Cash Flows) 94
Defining the Benefit Stream 94
Defining Net Cash Flow 95
Use of Historical Information 96
Discounted Cash Flow Method 101
Terminal Value 109
Capitalized Cash Flow Method 114
Excess Cash Flow Method 116
Conclusion 125

CHAPTER 5
Cost of Capital/Rates of Return 126
Three Variables 126
Characteristics of Cost of Capital 127
Investor Expectations as Quantified by the Cost of Capital 127
Cost of Capital Equals Discount Rate 128
Cost-of-Capital Methods 128
More on the Basic Concepts 128
Discount Rate, Capitalization Rate, and Anticipated Growth 129
Growth 129
Relationship Between Risk and Cost of Capital 134
Types of Risk—Another View 137
Risks in a Small Business 138
Methods for Developing Cost of Capital 139
Size Premiums 141
Methods of Articulate Unsystematic Risk 145
Other Issues 150
Capital Asset Pricing Model Method 151
Development of the Weighted Average Cost of Capital 156
Price/Earnings Method 159
Adjustments to the Price/Earnings Ratio 161
Arbitrage Pricing Theory 163
Build-Up Summation Model 165
Cost-of-Capital Issues Related to Use of the Excess Cash Flow Method 166
Addendum 168

CHAPTER 6

Market Approach 184
Overview 184
Type of Value Obtained 185
Advantages and Disadvantages of the Market Approach 186
Basic Implementation 187
Sources and Characteristics of Guideline Company Data 188
Information Sources 188
Advantages and Disadvantages of the Guideline Company
Transaction Method 189
Publicly Traded Companies 190
Information Sources for Industry “COMPS” 192
Stock Prices and Number of Shares Outstanding 192
Advantages/Disadvantages of Public Company Data 193
Characteristics of Publicly Traded Companies 193
Choosing Guideline Companies 197
Financial and Other Indicators 200
Sample Size Matters 203
Comparable Companies Information Dates 203
Basic Financial Indicators 203
Displaying the Information 204
Adjustments to the Guideline and Subject Companies 209
Income Adjustments 209
Balance Sheet Adjustments 211
Effects of Adjustments on Value 213
Concluding Remarks on Choosing Comparables 213
Calculating Standard Pricing Multiples 214
Equity versus Invested Capital 214
Financial Statement Measures 216
Computation of Multiples 218
Matching Price to Parameter 219
Dispersion of Pricing Multiples 219
Applying the Valuation Multiples 221
Concluding Thoughts on Value 223
Using the Pricing Multiples for Growth 223
Adjusting the Guideline Multiples for Size 227
Summary 230

CHAPTER 7

Asset Approach 232
Fundamental Theory 232
Applicability 233
Premise of Value 235
Control versus Minority 235
Built-In Gains 236
General Steps in the Asset Approach 236
Valuation of Individual Assets and Liabilities Example 237
Liabilities 243
Unrecorded Assets and Liabilities 244
Built-In Gain 244
Conclusion 247
Addendum 1—Understanding Real Estate Appraisals 248
Addendum 2—Understanding Machinery and Equipment Appraisals 259
Addendum 3—Revenue Procedure 77-12 270

CHAPTER 8

Valuation Discounts and Premiums 272
Levels of Value 272
Classifying Discounts 275
Discounts for Lack of Control and Control Premiums 277
Discounts for Lack of Marketability 285
Empirical Evidence of Marketability Discounts 287
Quantitative Tools 311
Other Discounts 316
Discounts and Premiums Summary 323
Addendum—Tax Court Cases (The Oldies but Goodies) 324
CHAPTER 9
Report Writing 342
USPAP Engagements 342
Types of Valuation Engagements and Related Reports 344
Complete Valuation Report 344
Other Business Valuation Reports 352