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In the valuation area hehas coauthored ten courses, taught over 35 courses, published over thirty articles,and has made over eighty conference presentations including the American Instit

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Library of Congress Cataloging-in-Publication Data:

Hitchner, James R.

Financial valuation : applications and models / James R Hitchner

p cm.

Includes index.

ISBN 0-471- 06138-7 (cloth : alk paper)

1 Corporations —Valuation I Title.

To my three children, the shining lights of my life I love you more than I everdreamed possible Jason Earle Hitchner, Michael James Hitchner, Deborah MarieHitchner

To the families of all the authors Thank you for enduring our absences duringlong nights and weekends We appreciate your patience, tolerance and support inpreparing this book

To the authors Thank you for your strong opinions, that, when coupled withyour willingness to build a consensus, have helped to advance the profession ofbusiness valuation

To Shannon P Pratt and Raymond C Miles, two of the early pioneers in ness valuation books Thanks for getting this all started

busi-James R Hitchner, CPA/ABV, ASA Editor

iv INTRODUCTION TO FINANCIAL VALUATION

CHAPTER 1

iv

contents

Contents v

CHAPTER 3

Tax Effecting the Earnings of Subchapter S Corporations 55

Adjustments for GAAP Departures, Extraordinary, Nonrecurring,

Adjustments for Nonoperating Assets and Liabilities and

Adjustments for Synergies from Mergers and Acquisitions 93

CHAPTER 5

Investor Expectations as Quantified by the Cost of Capital 127

Discount Rate, Capitalization Rate, and Anticipated Growth 129

Development of the Weighted Average Cost of Capital 156

Cost-of-Capital Issues Related to Use of the Excess Cash Flow Method 166

CHAPTER 6

Advantages and Disadvantages of the Market Approach 186

Adjustments to the Guideline and Subject Companies 209

Effects of Adjustments on Value 213

Valuation of Individual Assets and Liabilities Example 237

Addendum 2 — Understanding Machinery and Equipment Appraisals 259

CHAPTER 8

Discounts for Lack of Control and Control Premiums 277

Addendum — Tax Court Cases (The Oldies but Goodies) 324CHAPTER 9

Types of Valuation Engagements and Related Reports 344

Sample Report 353Addendum — Sample Valuation Report, Valuation of the Common

Stock of Acme Measurement Devices Inc as of May 31, 2000 354CHAPTER 10

Other Business Valuation Standards and Credentials 431

Addendum — Internal Revenue Service Business Valuation Guidelines 435CHAPTER 11

Addendum — Valuation Checklists/Ready Reference

CHAPTER 12

Other Characteristics of Family Limited Partnerships 505State Law, Property Rights, and Their Importance to the

Improper Formation Can Create Problems for Partners 507

CHAPTER 16

Goodwill — The Battleground for Divorce Valuations 618

State Interpretations on Including Goodwill in the Marital Estate 618

Dividing Goodwill into Personal and Entity Components 620

Role of Noncompete Agreements in Determining Personal

Valuation Methodology and the Application of Discounts in

When an Interest Is Considered Control in a Divorce Setting 629

Family Aggregations in Divorce Settings 630Partnerships, LLCs, LLPs, and Family Entities in a Divorce Setting 630

CHAPTER 17

Appendix 1 — Management Interview Medical Practice 667

Appendix 3 — Management Interview Accounting Practice 674CHAPTER 19

Overview of Considerations for Valuing Healthcare Entities 691

Income Approach Discounted Cash Flow Method:

Valuation Issues for Specific Healthcare Industry Niches 702Publicly Traded Healthcare Services Companies by Niche 711

CHAPTER 20

Why Are Intangible Assets So Difficult to Measure? 752

Nature of Intangible Assets 753Identification and Classification of Intangible Assets 753

SFAS No 142, Goodwill and Other Intangible Assets 757

Goodwill, Indefinite-Lived Intangible Assets, and the Impairment Test 760

Financial Reporting Disclosures under SFAS Nos 141 and 142 764

Discount Rate Considerations for Intangible Assets 773Case Study: Determining Goodwill and Other Intangible Assets in a

CHAPTER 21

Marketing, Managing, and Making Money in a Valuation Services Group 821

CHAPTER 22

Measure of Damages: Diminution of Value or Lost Profits 837Differences Between Damage Computations and Business Valuations 839Can Business Damages Exceed the Fair Market Value of the Business? 848

CHAPTER 23

B: Valuations for Public Companies and/or Financial Reporting 861

CHAPTER 24

Valuation Views and Controversial Issues: An Illustration 955

Total Conclusion of Value on a Nonmarketable, Control Basis 998

H-1 Head xiii

James R Hitchner, CPA/ABV, ASA is the managing director of the Financial

Valuation Group (FVG) in Atlanta, GA FVG is a national financial advisory ices firm specializing in valuation and litigation services Mr Hitchner is a foundingmember of the Financial Consulting Group, L.C (FCG) FCG is a national associa-tion of professional services firms dedicated to excellence in valuation, financial andlitigation consulting

serv-Mr Hitchner has more than 24 years of professional experience, including 22years in valuation services and two years in real estate development He was withPhillips Hitchner Group, Inc for seven years and was also partner-in-charge ofvaluation services for the southern region of Coopers & Lybrand (currentlyPricewaterhouseCoopers), where he spent more than nine years He was alsoemployed as a senior appraiser with the national appraisal firm American AppraisalAssociates, in both the financial and industrial valuation groups

He has been recognized as a qualified expert witness, and has provided mony on valuations in numerous state and federal courts In the valuation area hehas coauthored ten courses, taught over 35 courses, published over thirty articles,and has made over eighty conference presentations including the American Institute

testi-of Certified Public Accountants, the American Society testi-of Appraisers, the NationalAssociation of Certified Valuation Analysts, and numerous state CPA societies Hehas also been a faculty member teaching valuation courses for judges for theNational Judicial College and the Flaschner Judicial Institute

Mr Hitchner is co-author of the book Valuation for Financial Reporting: Intangible Assets, Goodwill, and Impairment Analysis—SFAS 141 and 142, editor/ co-author of the book Financial Valuation: Applications and Models; and co-author

of the book Financial Valuation Workbook, all published by Wiley He is co-author

of the American Institute of Certified Public Accountants (AICPA) three-part study videocourse series on SFAS 141 and 142 on business combinations, intangi-ble assets and goodwill impairment

self-He is an inductee in the American Institute of Certified Public Accountants(AICPA) Business Valuation Hall of Fame and current member of the AICPA taskforce on Business Valuation Standards Mr Hitchner is past chairman of theBusiness Valuation Committee of the Georgia Society of CPAs, past member of theAICPA Business Valuation Subcommittee, past member of the AICPA ABV examcommittee, past chairman of the ABV exam review course committee, contributing

editor of AICPA CPA Expert newsletter, and a former member of The Appraisal

Foundation Industry Advisory Council He has a Bachelor of Science degree inEngineering from the University of Pittsburgh and a Masters of BusinessAdministration degree from Rider University He holds the AICPA Accreditation inBusiness Valuation (ABV) specialty designation, and also is an Accredited SeniorAppraiser (ASA) with the American Society of Appraisers

xiiiabout the editor

Mel H Abraham, CPA/ABV, ASA, CVA is the Co-Founder and Director of Kaplan,

Abraham, Burkert & Company, a national valuation and litigation consulting firmlocated in Wood Ranch, California He holds the AICPA specialty designation ofAccredited in Business Valuation (ABV), is an Accredited Senior Appraiser (ASA)with the American Society of Appraisers, and is a Certified Valuation Analyst (CVA)with the National Association of Certified Valuation Analysts Mr Abraham hasover 15 years of professional experience He has authored numerous articles as well

as his book entitled, Valuation Issues and Case Law Update—A Reference Guide,

and two new books He is a nationally recognized and award-winning lecturer onvaluation matters, and has addressed numerous conferences on a local, state, andnational level Mr Abraham is a member of the AICPA Consulting Division, and afaculty member of The National Judicial College He has a Bachelor of Science fromCalifornia State University, Northridge

R James Alerding, CPA/ABV, ASA, CVA is the Partner-in-charge of the Valuation and

Forensic Services Group for Clifton Gunderson, LLP’s Indianapolis Client ServiceCenter He holds the AICPA specialty designation of Accredited in Business Valuation(ABV), is an Accredited Senior Appraiser (ASA) with the American Society ofAppraisers, and is a Certified Valuation Analyst (CVA) with the National Association

of Certified Valuation Analysts Mr Alerding has over 34 years of ing/investment experience, including over 20 years of business valuation experience

financial/account-He has taught over 40 valuation courses, published over 45 articles, and made over

100 business valuation presentations He has been recognized as an expert witness inseveral states across the United States, and testified 500 times in depositions and trials

Mr Alerding is a charter Panelist on the Technical Advisory Panel for the AICPA

“ABV E-Valuation Alert,” a member of the Indiana CPA society, a member of theMaryland Institute of CPAs, past member of the AICPA Business Valuation Subcom-mittee, and an AICPA Business Valuation Hall of Fame Member Mr Alerding has aBachelor of Science in Business Administration from Xavier University

Terry Jacoby Allen, CPA/ABV, ASA is the Midwest Managing Director for The

Financial Valuation Group, a valuation and litigation services firm located in KansasCity, Missouri She holds the AICPA specialty designation of Accredited in BusinessValuation (ABV), and is an Accredited Senior Appraiser (ASA) with the AmericanSociety of Appraisers Ms Allen has over 20 years of professional experience,including 14 years of business valuation experience She is the editor of ASA’s BV E-Letter and has been a speaker on valuation matters at seminars and conferencessponsored by various national and state professional organizations She has taughtaccounting and finance at the college level and presently is a faculty member forASA and AICPA professional accreditation programs Ms Allen is a member of theAICPA Business Valuation Technical Issues Advisory Board, and the Iowa Society of

about the authors

About the Authors xv

CPAs Ms Allen has a Bachelor of Arts from the University of Missouri at KansasCity, and a Master of Business Administration in accounting from the University ofColorado

Larry R Cook, CPA/ABV, CBA is the owner of Larry R Cook & Associates, PC,

a financial services firm located in Houston, Texas, that focuses on business tion and succession planning, as well as a founding member of The FinancialConsulting Group, L.C He holds the AICPA specialty designation of Accredited inBusiness Valuation (ABV), and the designation of Certified Business Appraiser(CBA) from the Institute of Business Appraisers Mr Cook has over 26 years ofbusiness valuation experience He has testified as an expert witness numerous times

valua-in courts and depositions and participated as an valua-instructor for courses on a widerange of subjects for a number of audiences such as the AICPA, TSPA, IBA andFCG Mr Cook was past President of the Financial Consulting Group, chair of theABV Credential Committee for the AICPA, a Board of Director member of theTexas Society of CPAs, and on the Business Valuation Standards for ProfessionalPractice Committee of the Institute of Business Appraisers Mr Cook graduatedfrom Sam Houston State University, and was a member of the first graduating class

of Accounting majors from the university

Michael A Crain, CPA/ABV, ASA, CFE is a shareholder with Peed, Koross,

Finkelstein & Crain, P.A., a CPA and consulting firm in Ft Lauderdale, Florida Heholds the AICPA specialty designation of Accredited in Business Valuation (ABV), is

an Accredited Senior Appraiser (ASA) with the American Society of Appraisers, and

is a Certified Fraud Examiner (CFE) with the Association of Certified FraudExaminers Mr Crain has over 22 years of professional experience He has been rec-ognized as a qualified expert witness, and testified on valuations on numerous occa-sions He has published over 15 articles, and is a contributing author of the book

The Portable MBA in Finance and Accounting, 3 rd Edition Mr Crain is a member

of the AICPA ABV Examination Committee, the AICPA ABV E-Letter TechnicalAdvisory Committee, and a past member of the AICPA Litigation and DisputeResolution Services Committee Additionally, he is the Founding Chair of the FICPAValuation and Litigation Services Committee, and Vice President of the NationalLitigation Support Services Association Mr Crain has a Bachelor of Arts inAccounting and a Master of Business Administration from Bellarmine University

Robert E Duffy, CPA/ABV, ASA, CFA was a principal with Brueggeman and

Johnson, P.C., a Seattle, Washington–based firm specializing in the valuation of closelyheld business interests and related issues, and a founding member of The FinancialConsulting Group, L.C He is currently a partner with Grant Thornton He holds theAICPA specialty designation of Accredited in Business Valuation (ABV), is anAccredited Senior Appraiser (ASA) with the American Society of Appraisers, and is aChartered Financial Analyst (CFA) Mr Duffy has over 18 years experience in valua-tion services, and has been involved in over 1,200 matters He has appeared as anexpert witness over 50 times, and is a long-term instructor of the AICPA’s businessvaluation courses Mr Duffy is a Charter Panelist on the Technical Advisory Panel for

the AICPA’s ABV E-Valuation Alert and a contributing editor of the AICPA’s CPA Expert publication Mr Duffy has a Bachelor of Arts from Western Washington

University and a Master of Business Administration from Pacific Lutheran University

xvi ABOUT THE AUTHORS

Edward J Dupke, CPA/ABV is a Principal in the Rehmann Consulting Division of

The Rehmann Group, a 10 office Michigan firm of CPAs and consultants He isPractice Director for the firm’s Business Valuation, Litigation Services and Mergerand Acquisition practice He holds the AICPA specialty designation of Accredited inBusiness Valuation (ABV) Mr Dupke is a former chairman of the AICPA BusinessValuation Subcommittee and a past chairman of the Michigan Association of CPAs

He has over 30 years of professional experience in Public Accounting and BusinessValuation practice, has been qualified as an expert witness and is a regular instruc-tor in Business Valuation at both the state and national level Mr Dupke hasrecently completed a three-year term as a member of the AICPA Board of Directorsand Chair of its Strategic Planning Committee He chairs the AICPA Task Forcewriting Business Valuation Standards for CPAs In 1998, Mr Dupke was awardedthe Distinguished Service Award from the Michigan Association of CPAs and in

1999 was inducted into the AICPA Business Valuation Hall of Fame He holds aBachelor of Science in Business Administration degree from Wayne State University

Nancy J Fannon, CPA/ABV, BVAL, MCBA is a Principal in the Valuation

Consulting Division of Baker Newman & Noyes, an accounting and consulting firmlocated in Portland, Maine She holds the AICPA specialty designation of Accredited

in Business Valuation (ABV), is a Business Valuator Accredited in Litigation (BVAL),and a Master Certified Business Appraiser (MCBA) with the Institute of BusinessAppraisers Ms Fannon has over 10 years of professional experience She has beenqualified as an expert witness, instructed and presented over 15 courses and pre-

sentations on business valuation, was a contributing author for The Business Appraiser and Litigation Support textbook, and has authored over 15 articles Ms.

Fannon was a member of the AICPA Business Valuation Subcommittee, formerAICPA Business Valuation Conference Chairperson, and a member of the “CPAExpert” Editorial Advisory Board She has a Bachelor of Business Administration inAccounting from the University of Massachusetts

John R Gilbert, CPA/ABV, ASA, CVA is a managing director of the Rocky

Mountain region with The Financial Valuation Group, a business valuation sulting and litigation service firm in Great Falls, Montana He holds the AICPA spe-cialty designation of Accredited in Business Valuation (ABV), is an AccreditedSenior Appraiser (ASA) with the American Society of Appraisers, and is a CertifiedValuation Analyst (CVA) with the National Association of Certified ValuationAnalysts Mr Gilbert has over 29 years of professional experience, including 15years of valuation experience He has been recognized as a qualified expert witness

con-in Montana, and testified on valuations numerous times He has published over 75articles, including the Financial Consulting Group Estate & Gift Valuation E-Flash

Mr Gilbert is a member of the Montana Society of CPAs, and the NationalAssociation of Forensic Economists Mr Gilbert has a Bachelor of Arts in BusinessFinance from the University of Montana

Thomas E Hilton, CPA/ABV, CVA is a Partner with Anders, Minkler & Diehl LLP,

a CPA and financial consulting firm in St Louis, Missouri He holds the AICPA cialty designation of Accredited in Business Valuation (ABV), and is a CertifiedValuation Analyst (CVA) with the National Association of Certified ValuationAnalysts Mr Hilton has over 26 years of professional experience, including over 10

spe-About the Authors xvii

years of business valuation experience He has been recognized as a qualified expertwitness, and testified over 90 times in Missouri, Florida, Arkansas, and Illinois Hehas instructed and presented on various valuation and litigation topics at AICPAsponsored courses and conferences, and served as a reviewer of Shannon Pratt’s

Business Valuation Body of Knowledge Mr Hilton is the current Chair of the

AICPA Business Valuation Subcommittee, past Chair of the NACVA ExecutiveAdvisory Board, and past Chair of the Valuation Committee for CPA Associates He

is a member of the MSCPA, FICPA, and the IBA Mr Hilton has a Bachelor ofScience in Accounting from the University of Missouri, and a Master of Science inFinance from St Louis University

James R Hitchner, CPA/ABV, ASA is the managing director of the Financial

Valuation Group (FVG) in Atlanta, GA FVG is a national valuation and litigationservices firm Mr Hitchner is also a founding member of the Financial ConsultingGroup, L.C He holds the AICPA specialty designation of Accredited in BusinessValuation (ABV), and is an Accredited Senior Appraiser (ASA) with the AmericanSociety of Appraisers Mr Hitchner has over 22 years experience in valuation serv-ices He has often testified as a qualified expert witness, and has testified on valua-tions in eight states He has coauthored ten courses, taught over 35 courses,published over 30 articles, and has made over 80 conference presentations Mr

Hitchner is co-author of the book Valuation for Financial Reporting: Intangible Assets, Goodwill, and Impairment Analysis—SFAS 141 and 142, and co-author of Financial Valuation Workbook, both published by Wiley He is an

inductee in the AICPA Business Valuation Hall of Fame and current member of theAICPA task force on Business Valuation Standards Mr Hitchner is past chairman

of the Business Valuation Committee of the Georgia Society of CPAs, past member

of the AICPA Business Valuation Subcommittee, past member of the AICPA ABVexam committee, and past chairman of the ABV exam review course committee

Steven D Hyden, CPA, ASA is a managing director of The Financial Valuation

Group, LC, a valuation and litigation services firm located in Tampa, Florida He is

an Accredited Senior Appraiser (ASA) with the American Society of Appraisers Mr.Hyden has over 17 years of professional business valuation experience He has co-authored and taught 10 valuation courses, and was a guest expert for the AICPAContinuing Professional Education video course series, “Valuation of Intellectual

Property.” Additionally he was co-author of the book Valuation for Financial Reporting: Intangible Assets, Goodwill, and Impairment Analysis—SFAS 141 and

142 Mr Hyden is a past member of the ASA Exam Development Subcommittee.

He received a Bachelor of Science in Marketing from Syracuse University, and aMaster of Business Administration from Pace University

Gregory S Koonsman, CFA is a founder and principal of Value Management

Group, LLC in Dallas, Texas Value Management Group is a firm that specializes inproviding business valuation, transactions advisory services, and strategic consult-ing to healthcare services providers throughout the United States Mr Koonsman is

a Chartered Financial Analyst (CFA), and has over 14 years of business valuationexperience He has been recognized as a qualified expert witness in Texas andKansas, and testified on valuations many times He has published over 5 articles,and presented to numerous groups on the subject of equity valuation, merger and

xviii ABOUT THE AUTHORS

acquisitions, and joint venture strategy Mr Koonsman is a member of the AmericanSociety of Appraisers, the Association for Investment Management and Research,and the Healthcare Financial Management Association Mr Koonsman has aBachelor of Science in Aerospace Engineering, and a Master of BusinessAdministration from the University of Dallas

Eva M Lang, CPA, ASA is the Chief Operating Officer of the Financial Valuation

Group, L.C., a nationwide alliance of business valuation and consulting firms She

is an Accredited Senior Appraiser (ASA) with the American Society of Appraisers

Ms Lang has over 14 years of business valuation experience She is a nationally ognized expert on electronic research for business valuation and litigation services.She has published over 10 articles, is a frequent speaker to national groups on tech-

rec-nology issues, a contributing editor for The CPA Expert, published by the AICPA, and was a co-author or contributing author to six books, including The Best Websites for Financial Professionals, Business Appraisers, and Accountants Ms.

Lang has served as a member of the Business Valuations Subcommittee of theAICPA and on CPA committees at the state level in the areas of estate planning, lit-igation services, and management consulting Ms Lang has a Bachelor of Science inBusiness Administration from Northwestern State University

Michael J Mard, CPA/ABV, ASA is a Managing Director of The Financial

Valuation Group, a valuation and litigation services firm located in Tampa, Florida,and a founding member and founding President of the Financial Consulting Group,L.C He holds the AICPA specialty designation of Accredited in Business Valuation(ABV), and is an Accredited Senior Appraiser (ASA) with the American Society ofAppraisers Mr Mard has over 18 years of professional business valuation experi-ence He has been recognized as a qualified expert witness, and has testified on val-uations approximately 100 times He has published over 50 articles, and was

co-author of the book, Valuation for Financial Reporting: Intangible Assets, Goodwill, and Impairment Analysis—SFAS 141 and 142, and co-author of Financial Valuation Workbook, both published by Wiley Mr Mard has served on

numerous committees of the AICPA, FICPA, ASA; has been inducted into theAICPA Business Valuation Hall of Fame; and is very active at state and national lev-els with emphasis on business valuation standards and intellectual property valua-tions Mr Mard has a Bachelor of Science in Accounting and a M.Acc inAccounting from the University of South Florida

Harold G Martin, Jr., CPA/ABV, ASA, CFE is the Principal-in-Charge of the

Business Valuation and Litigation Services Group for Keiter, Stephens, Hurst, Gary

& Shreaves, P.C., a full-service CPA firm based in Richmond, Virginia He holds theAICPA specialty designation of Accredited in Business Valuation (ABV), is anAccredited Senior Appraiser (ASA) with the American Society of Appraisers, and is

a Certified Fraud Examiner (CFE) with the Association of Fraud Examiners Mr.Martin has over 20 years experience in financial consulting, public accounting, andfinancial services He is a frequent speaker and author on valuation topics, and is a

contributing author to Cost of Capital: Estimation and Applications, 2nd ed., lished by John Wiley & Sons, Inc Mr Martin is the editor of the AICPA ABV E-Valuation Alert, a national instructor for the AICPA’s business valuation educa-

pub-tion program, a former member of the AICPA Business Valuapub-tion Subcommittee,

About the Authors xix

and member of the Board of Directors of the Virginia Society of Certified PublicAccountants Mr Martin has an A.B degree from The College of William andMary, and has a Master of Business Administration from Virginia CommonwealthUniversity

Michael Mattson is the Managing Director of The Financial Valuation Group in

Chicago, Illinois, specializing in business and intellectual property valuations, gation, and consulting Mr Mattson has over 18 years of professional business val-uation experience He has authored over 10 articles, taught numerous businessvaluation courses, and written, edited, and taught courses for the American Institute

liti-of Certified Public Accountants Mr Mattson is a member liti-of the American Society

of Appraisers He has a Bachelor of Arts from Kenyon College, and a Master ofBusiness Administration in Finance and Accounting from the University of Chicago

Raymond E Moran, ASA serves as Senior Vice President of American Appraisal

Hongkong Limited Mr Moran has over 22 years of valuation experience He is anAccredited Senior Appraiser (ASA) with the American Society of Appraisers He hastestified as an expert witness numerous times in courts and depositions, such as U.S.Bankruptcy Court in Los Angeles, U.S Bankruptcy Court in Houston, and beforethe American Arbitration Association in New York Mr Moran is a member of theAmerican Association of Cost Engineers, and the American Chamber of CommerceHong Kong where he serves on the Real Estate and Energy Committees Mr Moranhas a Bachelor of Arts in Valuation Sciences from Hofstra University

Charles M Phillips CPA/ABV, CFE is a Shareholder with a valuation and litigation

consulting firm in Atlanta, Georgia He holds the AICPA specialty designation ofAccredited in Business Valuation (ABV), and is a Certified Fraud Examiner (CFE)

Mr Phillips has over 30 years experience including 25 years of business valuationexperience He has been recognized as a qualified expert witness numerous times,and has testified on valuations in eight states He has written articles for newsletters,

various local business publications, and The Licensing Journal Mr Phillips is the

current Chair of the Georgia Society of CPAs Business Valuation and LitigationServices Section; and a member of the AICPA, National Association of CertifiedFraud Examiners, and the American Bar Association He has a Bachelor of Science

in Business Administration from Auburn University, a Bachelor of Science inCommerce, Business Administration from the University of Alabama, and a Master

of Arts in Accounting from the University of Alabama

James S Rigby, Jr., CPA/ABV, ASA is a Managing Director of The Financial

Valuation Group, and president of the Financial Valuation Group of California, Inc.specializing in business and intellectual property valuations, litigation, and consult-ing, and a founding member of the Financial Consulting Group, L.C He holds theAICPA specialty designation of Accredited in Business Valuation (ABV), and is anAccredited Senior Appraiser (ASA) with the American Society of Appraisers Mr.Rigby has over 25 years of professional experience, including valuation related serv-ices and financial consulting He is co-author of multiple continuing educationcourses and articles published in varied professional journals Mr Rigby is a mem-ber of the AICPA, the American Society of Appraisers, and other state and localbusiness valuation societies and committees He has a Bachelor of Science in

xx ABOUT THE AUTHORS

Business Administration from Bryan College, and a Master of BusinessAdministration from Woodbury University

Ronald L Seigneur, CPA/ABV, CVA is owner of Seigneur & Company, P.C., a CPA

firm located in Lakewood, Colorado, specializing in valuation and litigation ices He holds the AICPA specialty designation of Accredited in Business Valuation(ABV), and is a Certified Valuation Analyst (CVA) with the National Association ofCertified Valuation Analysts Mr Seigneur has over 19 years experience workingwith complex valuation and litigation support matters, has published over 65 arti-cles on business valuation, and taught advanced business valuation courses for theAICPA and NACVA He presently assists the AICPA Business ValuationsSubcommittee where his primary focus is the technical review of the newFoundations of Business Valuations curriculum; additionally he develops technologyresources for ABV constituents Mr Seigneur is an adjunct professor at theUniversity of Denver College of Law where he teaches financial, management andleadership courses He has a Bachelor of Arts in Hotel, Restaurant and InstitutionalManagement from Michigan State University, and a Master of BusinessAdministration in Corporate Policy and Finance from the University of Michigan

serv-Robin E Taylor, CPA/ABV, CBA, CFE, CVA is a shareholder in the Birmingham,

Alabama, office of Dixon Odom PLLC, a regional accounting firm, and a foundingmember and current President of The Financial Consulting Group, L.C He holdsthe AICPA specialty designation of Accredited in Business Valuation (ABV), is aCertified Business Appraiser (CBA) from the Institute of Business Appraisers, aCertified Fraud Examiner (CFE) with the Association of Fraud Examiners, and aCertified Valuation Analyst (CVA) with the National Association of CertifiedValuation Analysts He has provided expert witness testimony in the area of busi-ness valuations, and testified in other areas including government contracts, anddamages quantification He has written and spoken to conferences on a number ofvaluation issues He is also an AICPA instructor for its valuation curriculum and theABV Examination Review Course and serves on several AICPA valuation taskforces He is an honors graduate from The University of Alabama and holds aMaster of Arts Degree in Accounting

Linda B Trugman, CPA/ABV, ASA, CBA is the Vice President of Trugman

Valuation Associates, a division of Rachlin Cohen & Holtz, and specializes in ness valuation and litigation services She holds the AICPA specialty designation ofAccredited in Business Valuation (ABV), is a Certified Business Appraiser (CBA)from the Institute of Business Appraisers, and is an Accredited Senior Appraiser(ASA) with the American Society of Appraisers Ms Trugman has over 15 years ofprofessional experience She has been qualified as an expert witness in State Courts

busi-in New Jersey, busi-instructed over 12 courses on busbusi-iness valuation, authored and authored two courses on valuation, and was awarded the Instructor of the YearAward from the Institute of Business Appraisers Ms Trugman was Chair of the

co-2002 AICPA Business Valuation conference, serves as editor of the professional

journal, Business Appraisal Practice, published by IBA and serves on the AICPA

Business Valuation Subcommittee She has a Bachelor of Science from theUniversity of North Carolina, and a Master of Business Administration fromFairleigh Dickinson University

Don Wisehart CPA/ABV, CVA is the owner of Wisehart & Associates, LTD., a

financial consulting firm located in Wakefield, Rhode Island, and a founding ber of The Financial Consulting Group L.C He holds the AICPA specialty desig-nation of Accredited in Business Valuation (ABV), and is a Certified ValuationAnalyst (CVA) with the National Association of Certified Valuation Analysts(NACVA) Mr Wisehart has over 30 years of professional experience, including 10years of business valuation experience He has given numerous business valuationpresentations, developed and taught many business valuation courses, two of whichare required courses for the NACVA certification program, and has testified as anexpert witness for valuations Mr Wisehart has served as the Chairman of theEducation Board for NACVA and served as the first president of the Rhode IslandBusiness Appraisal Group He received a Bachelor’s degree from Kent StateUniversity, and a Master of Taxation degree from Bryant College

mem-Mark L Zyla CPA/ABV, ASA, CFA is a shareholder with a business valuation and

litigation services firm located in Atlanta, Georgia He holds the AICPA specialtydesignation of Accredited in Business Valuation (ABV), is an Accredited SeniorAppraiser (ASA) with the American Society of Appraisers, and is a CharteredFinancial Analyst (CFA) Mr Zyla has over 16 years of professional business valu-ation experience He has taught 8 courses on business valuation practices, authorednumerous articles for various business publications, and presented to various com-

panies and organizations Mr Zyla is also co-author of the book Valuation for Financial Reporting: Intangible Assets, Goodwill, and Impairment Analysis—SFAS

141 and 142 Mr Zyla is a member of the AICPA, the Association for Investment

Management and Research, and the Atlanta Society of Financial Analysts Mr Zyla

is a former member of the Business Valuations Subcommittee of the AICPA Hereceived a Bachelor of Business Administration in Finance from the University ofTexas at Austin and Master of Business Administration with a concentration inFinance from Georgia State University

Contributing Authors: The following people provided valuable insight and

knowl-edge to the above authors, and assisted in the preparation of the text: Deborah Patryand Laura Kelley from Baker, Newman, & Noyes; Robert Kleeman from CliftonGunderson, LLP; Neil Beaton, Darren Cordier, and David Dufendach, previouslywith Brueggeman & Johnson and currently with Grant Thornton; Adrian Ciocoifrom Dixon Odom PLLC; Carl-Henry Geschwind, Derick O Champagne, andJeremy T Hess of Keiter, Stephens, Hurst, Gary & Shreaves, P.C.; Scott M LeMayfrom LeMay-Lang Consulting; Brenda M Clarke, CVA, CPA/ABV from Seigneur &Company, P.C.; Robert Grossman CVA, CPA/ABV, CBA, ASA from GrossmanYanak & Ford LLP

Iwould like to thank Terri Houston I appreciate all of her hard work and help inshaping this project with me from start to finish She was instrumental in keepingthings organized and on track over countless revisions Special thanks to BarbaraBrown, Sheri Krajewski-Bibins, Keith White, Maggie Van Ness, and Brian Skinnerfor helping with various parts of the manuscript In addition, I would like to thankall of my staff who were involved in preparing this book

I would also like to thank Sarah Nelson of Intellectual Capital Uplink Inc andEva Lang of the Financial Consulting Group for their assistance in the editingprocess

At Wiley I would like to thank John DeRemigis, Judy Howarth, and SujinHong for their encouragement, direction and tough love to keep me on track

I thank all of the following prominent valuation practitioners for reviewing thebook and for their insightful comments:

Parnell Black

National Association of Certified Valuation Analysts

Salt Lake City, UT

Mark Dietrich (Healthcare chapter)

Dietrich & Wilson, P.C

Business Valuation Resources

Willamette Management Associates

Portland, OR

Gary Trugman

Trugman Valuation Associates

Rachlin Cohen & Holtz

The Financial Valuation Group

The Appraisal Foundation

Risk Management Association

Beckmill Research

The Brookings Institution

The Financial Consulting Group

Financial Accounting Standards Board

American Institute of Certified Public Accountants

Internal Revenue Service

Partnership Profiles, Inc

Ibbotson Associates

Trugman Valuation Associates

The National Center for Employee Ownership

xxiv INTRODUCTION TO FINANCIAL VALUATION

xxiv

Financial Valuation: Applications and Models (FV) is an all-encompassing

valua-tion text that presents the applicavalua-tion of financial valuavalua-tion theory in an easilyunderstood manner Although valuation theory is thoroughly discussed, the focus is

on applications and methods FV contains numerous examples and methods thatwill assist the reader in navigating a valuation project, along with hundreds of short,easily understandable “ValTips.” These ValTips alert the reader to important andoften controversial issues

We have assembled 25 highly visible and well-respected valuation professionals

to discuss and agree on the proper methods of valuation and to collectively presentthe group’s views and positions on business valuation concepts and, most impor-tantly, applications Each author is the coauthor of the entire book The authorscome from all over the United States and are members of many professional valua-tion and financial associations including the American Institute of Certified PublicAccountants (AICPA), the American Society of Appraisers (ASA), the Associationfor Investment Management and Research (AIMR), the Institute of BusinessAppraisers (IBA) and the National Association of Certified Valuation Analysts(NACVA) Many hold multiple designations or certifications:

• Twenty-two are Certified Public Accountants (CPAs)

• Twenty are Accredited in Business Valuation (ABVs) with AICPA

• Fifteen are Accredited Senior Appraisers (ASAs) with ASA

• Seven are Certified Valuation Analysts (CVAs) with NACVA

• Four are Certified Business Appraisers (CBAs) with IBA

• Three are Chartered Financial Analysts (CFAs) with AIMR

Collectively they have several hundred years of valuation and related financial rience

expe-This is the first time such a large group of diverse valuation practitioners hasbeen assembled to agree on the application of valuation principles and methods.Given the generally subjective nature of valuation and the strong opinions that seem

to go with being a valuation analyst, this was no easy task We hope we haveadvanced the profession by providing our agreed upon views We invite other prac-titioners to comment on this edition and/or assist in future editions of this book Wewill never gain consensus in everything in the valuation profession; however, we dohope to narrow the long list of controversies and disagreements This text representsthe state of the art in the business valuation profession as it evolves

This book includes basic, intermediate and advanced topics, including:

• Shareholder disputes

• Mergers and acquisitions

preface

• Discounts and premiums

• Family limited partnerships

val-in a case study/report format that guides the reader through the preparation andreporting of a business valuation and conclusion of value Other chapters of inter-est are:

Chapter 3, Financial Statement and Company Risk Analysis, presents

qualita-tive and quantitaqualita-tive methods of analyzing a company including a detailedexample

Chapter 4, Income Approach, includes a detailed example on the proper

appli-cation of the excess cash flow (earnings) method

Chapter 5, Cost of Capital/Rates of Return, includes a comprehensive

presen-tation on the application of empirical data for determining risk premiums indiscount and capitalization rates

xxvi PREFACE

Chapter 6, Market Approach, presents a quantitative method for using and

adjusting guideline public company valuation multiples for size and growth ferences

dif-Chapter 9, Report Writing, presents a detailed valuation report with numerous

comments on why certain items were included or excluded

Chapter 12, Valuation of Family Limited Partnerships, presents a detailed case

study on the valuation of a Family Limited Partnership including the selection

of discounts for lack of control and lack of marketability

Chapter 13, Summary of Court Case Issues, includes synopses of over 40 tax

court cases organized by major valuation areas of dispute

Chapter 19, Valuation of Healthcare Service Businesses, includes two detailed

case studies: a surgery center and a hospital

Chapter 20, Valuation of Intangible Assets, includes a detailed case study on an

allocation of purchase price for a business combination under new SFAS 141

We also include brief examples of two emerging areas of valuation: EconomicValue Added (EVA) and real option theory

Financial valuations are very much affected by specific facts and circumstances

As such, the views expressed in these written materials do not necessarily reflect theprofessional opinions or positions that the authors would take in every business val-uation assignment, or in providing business valuation services in connection with anactual litigation matter Every situation is unique and differing facts and circum-stances may result in variations of the applied methodologies

Nothing contained in these written materials shall be construed as the ing of valuation advice; the rendering of a valuation opinion; the rendering of anopinion of a particular valuation position; or the rendering of any other professionalopinion or service

render-Business valuation services are necessarily fact-sensitive particularly in a tion context Therefore, the authors urge readers to apply their expertise to partic-ular valuation fact patterns that they encounter, or to seek competent professionalassistance as warranted in the circumstances

litiga-Mel Abraham, Jim Alerding, Terry Allen, Larry Cook, Mike Crain, Bob Duffy,

Ed Dupke, Nancy Fannon, John Gilbert, Tom Hilton, Jim Hitchner, Steve Hyden, Greg Koonsman, Eva Lang, Mike Mard, Harold Martin, Mike Mattson, Ray Moran, Charles Phillips, Jim Rigby, Ron Seigneur, Robin Taylor, Linda Trugman, Don Wisehart, Mark Zyla

* * * * * * *

Disclaimer Excluding Any Warranties: This book is designed to provide

guid-ance to analysts, auditors, and management but is not to be used as a substitute forprofessional judgment Procedures must be altered to fit each assignment Thereader takes sole responsibility for implementation of material from this book Theimplied warranties of merchantability and fitness of purpose and all other war-ranties, whether expressed or implied, are excluded from this transaction, and shallnot apply to this book None of the authors, editors, reviewers, nor publisher shall

be liable for any indirect, special, or consequential damages

Introduction to Financial Valuation

There is an ever-increasing need for financial valuation services pertaining to public companies and subsidiaries, divisions, or segments of public companies.Many textbooks discuss valuation issues pertaining to public companies and theirstock prices Much of that information also can be used to value nonpublic compa-nies However, over the past 20 years or so, specific techniques, methods, applica-tions, and models applicable to nonpublic companies have emerged This textaddresses this body of knowledge

non-Valuation has many subjective factors, which leads to many differences of ion This book presents the consensus view of 25 of the leading valuation analysts(analysts) in the country

opin-Much of the notation system used in this text is that used by Shannon Pratt inhis various publications,1 a system adopted by the American Institute of CertifiedPublic Accountants (AICPA), the National Association of Certified ValuationAnalysts (NACVA) and the American Society of Appraisers (ASA) in their businessvaluation courses

As a quick reference guide to important factors and concepts, numerous

“ValTips” are found throughout the volume These ValTips are intended to provideguidance and insight on handling key issues as well as to provide practice ideas

WHO VALUES BUSINESSES?

Many providers and/or users of business valuation services exist The AICPA ficially estimates that tens of thousands of Certified Public Accountants (CPAs) per-form business valuations on at least a part-time basis Many of these are alsofull-time valuation practitioners Several of the national accounting firms also havevaluation services groups There are also analysts and appraisers who practice out

unof-of various types unof-of organizations, including appraisal companies, valuation tiques, and consulting firms Valuations are also performed by investment bankers,usually as part of a transaction Owners and financial executives also participate invaluations of their companies or segments of their companies This book attempts

bou-to provide a sound understanding of financial valuation for all users and providers

of valuation services and to advance consensus views on some of the more some aspects of valuation science

trouble-1

CHAPTER 1

1Shannon P Pratt, Cost of Capital: Estimation and Applications (New York: John Wiley &

Sons, Inc., 1998), pp xxv – xxviii.

PURPOSE OF A VALUATION

Businesses or their assets are valued for a variety of reasons Some of the more mon purposes for valuation are:

com-• Mergers and acquisitions

• Litigation and ownership disputes

• Estate, gift, and income tax

• Marital dissolution

• Dissenters’ rights cases

• Shareholder oppression cases

• Employee Stock Ownership Plans (ESOPs)

• Financial reporting

• Allocation of purchase price

• Goodwill impairment

• Buy/sell agreements

• Family limited partnerships

• Reorganizations and bankruptcies

• Limited liability companies

• Limited liability partnerships

• 100 percent controlling interest

• Majority interests that possess control

• Majority interests that do not possess control

• 50 percent interest

• Dominant minority interest

• Nondominant minority interest

The individual ownership characteristics of any interest in a company beingvalued must also be evaluated As such, it is important for an analyst to reviewcorporate documents, including articles of incorporation, by-laws, buy/sell agree-ments, restrictive agreements, and the like A review of these documents along

with an understanding of state rights will indicate any particular rights that theinterest enjoys.

PROFESSIONAL VALUATION ORGANIZATIONS

Four U.S professional organizations, listed alphabetically below, provide tance to their members in valuing businesses, particularly closely held businessinterests:

assis-1 American Institute of Certified Public Accountants (AICPA)

2 American Society of Appraisers (ASA)

3 Institute of Business Appraisers (IBA)

4 National Association of Certified Valuation Analysts (NACVA)

Each of these organizations is briefly described in Chapter 10

ValTip

There are five standards of value:

1 Fair market value (FMV)

2 Investment value

3 Intrinsic value

4 Fair value (state rights)

5 Fair value (financial reporting)

FAIR MARKET VALUE

The U.S Treasury regulations define fair market value as “the price at which theproperty would change hands between a willing buyer and a willing seller, neitherbeing under any compulsion to buy or to sell and both having reasonable knowl-edge of relevant facts.”2

Fair market value for tax purposes also assumes a hypothetical willing buyerand a hypothetical willing seller This is in contrast to investment value, whichidentifies a particular buyer or seller and the attributes that buyer or seller brings

to a transaction Fair market value also assumes an arm’s-length deal and that thebuyer and seller are able and willing This is not the same as the definition of mar-ket value, an often-used real estate term For example, the Uniform Standards ofProfessional Appraisal Practice (USPAP) defines market value as “a type of value,stated as an opinion, that presumes the transfer of a property (i.e., a right of own-ership or a bundle of such rights), as of a certain date, under specific conditionsset forth in the definition of the term identified by the appraiser as applicable in

an appraisal.”

Internal Revenue Service Revenue Ruling 59-60 defines fair market value as

“the price at which the property would change hands between a willing buyer and

a willing seller when the former is not under any compulsion to buy and the ter is not under any compulsion to sell, both parties having reasonable knowledge

lat-of relevant facts Court decisions frequently state in addition that the cal buyer and seller are assumed to be able, as well as willing, to trade and to bewell informed about the property and concerning the market for such property.”3

3 Rev Rul 59-60,159-1 CB 237.

Although many states use the term “fair market value” in their maritaldissolution cases, the definition of fair market value may vary fromstate to state and will not necessarily be the same definition as in thetax area

ter for the complete International Glossary Its definition of fair market value reads:

“The price, expressed in terms of cash equivalents, at which property would changehands between a hypothetical willing and able buyer and a hypothetical willing andable seller, acting at arms-length in an open and unrestricted market, where neither

is under compulsion to buy or sell and when both have reasonable knowledge of therelevant facts.”

This is obviously very similar to the definition of fair market value in the taxarea Fair market value is used most often in tax situations It is also used in manybuy/sell agreements and marital dissolution situations Unless otherwise noted, thestandard of value discussed throughout this text is fair market value

INVESTMENT VALUE

The International Glossary defines investment value as “The value to a particular

investor based on individual investment requirements and expectations.”Investment value is the value to a particular investor, which reflects the particularand specific attributes of that investor The best example would be an auction set-ting for a company in which there are five different bidders attempting to purchasethe company More than likely each of the bidders will offer a different pricebecause the prices are based on the individual outlook and synergies that each bid-der brings to the transaction Investment value may also reflect more of the risk of

a particular investor than the market consensus of the risk of the investment.INTRINSIC VALUE

Intrinsic value is based on fundamental analyses of companies, particularly publiclytraded companies It is often what is taught in university financial courses and pre-

sented in finance textbooks Jeffrey C Hooke, in his text Security Analysis on Wall Street: A Comprehensive Guide to Today’s Valuation Methods, states that “Under

the intrinsic value method, future dividends are derived from earnings forecasts andthen discounted to the present, thereby establishing a present value for the stock Ifthe stock is trading at a price lower than this calculation, it is a ‘buy’; if the marketprice is higher than the intrinsic value, the stock is a ‘sell.’”4

The AICPA, in its course Fundamentals of Business Valuation — Part 1, definesintrinsic value as the “Amount an investor considers to be the ‘true’ or ‘real’ worth

of an item, based on an evaluation of available facts It is sometimes called mental value It is an analytical judgment of value based on perceived characteris- tics inherent in the investment (not characteristic peculiar to any one investor).”5

funda-Intrinsic value is not applied often in valuations of nonpublic companies

FAIR VALUE (STATE RIGHTS)

The common definition of fair value is that from the Uniform Business CorporationAct, which defines it as “the value of the shares immediately before the effectua-tion of the corporate action to which the dissenter objects, excluding any appreci-ation or depreciation in anticipation of the corporate action.”6 Fair value is thestandard of value for state actions, including dissenting rights cases and share-holder oppression cases Its definition and application can vary from state to state

As such, the definition of fair value in one state may be quite different from the inition of fair value in another state Analysts must understand both the definitionand the application of fair value in the particular state that the action is takingplace in

4 Jeffrey C Hooke, Security Analysis on Wall Street: A Comprehensive Guide to Today’s

Valuation Methods (New York: John Wiley & Sons, Inc., 1998), p 14.

5 David P Adams III, David M Bishop, Robert J Grossman, James R Hitchner, Eva M Lang, Shannon P Pratt, and Robert C Rosenthal, Fundamentals of Business Valuation— Part 1 (American Institute of Certified Public Accountants, 2000), pp 1–18.

6 Georgia Dissenters Right Statute.

FAIR VALUE (FINANCIAL REPORTING)

Fair value has been the standard of value for financial reporting for many years It isthe standard of value in many Statements of Financial Accounting Standards (SFAS)

as issued by the Financial Accounting Standards Board (FASB) The most recent inition of fair value is from SFAS 141 and 142: “The amount at which an asset (orliability) could be bought (or incurred) or sold (or settled) in a current transactionbetween willing parties, that is, other than in a forced or liquidation sale.”7

def-Fair value for financial reporting purposes often has been equated with fairmarket value However, in certain situations, fair value for a company or a segment

of a company would include synergies within a transaction As such, in those tions, fair value may have more aspects of investment value than fair market value

situa-In other situations, such as the value of certain individual assets, synergies may not

be included, and fair value would be more similar to fair market value It is tant for the analyst to look for guidance from FASB and the Securities and ExchangeCommission (SEC) in terms of their views on fair value and its applications.PREMISE OF VALUE

impor-There are two premises of value, going concern value and liquidation value The International Glossary defines premise of value as “An assumption regarding the most

likely set of transactional circumstances that may be applicable to the subject valuation,e.g., going concern, liquidation.” It defines going concern value as “The value of a busi-ness enterprise that is expected to continue to operate into the future The intangible ele-ments of going concern value result from factors such as having a trained work force, anoperational plant, and the necessary licenses, systems, and procedures in place.”There are two types of liquidation value, orderly liquidation and forced liquida-

tion The International Glossary defines orderly liquidation value as “Liquidation

value at which the asset or assets are sold over a reasonable period of time to maximizeproceeds received.” It defines forced liquidation value as “Liquidation value at whichthe asset or assets are sold as quickly as possible, such as at an auction.” It also definesliquidation value as “The net amount that can be realized if the business is terminatedand the assets are sold piecemeal Liquidation can be either ‘orderly’ or ‘forced.’”

7 Statements of Financial Accounting Standards No.142, “Goodwill and Other Intangible Assets,” Financial Accounting Standards Board of the Financial Accounting Foundation, June

2001, p 117.

Some companies are worth more dead than alive It is important for theanalyst, particularly when valuing an entire company, to determine ifthe going concern value exceeds the liquidation value For a minorityinterest, there are situations where the going concern value is less thanthe liquidation value However, the minority shareholder cannot force

a liquidation if the controlling shareholder desires to continue the ness as a going concern

busi-ValTip

PRINCIPLES OF APPRAISAL PRACTICE

The modern financial valuation body of knowledge is based to some extent on the

evolution of appraisal practices The ASA’s seminal text, Appraisal Principles and Procedures, discusses the general characteristic of value.

It is a characteristic of value, in the sense that the word is understood in

appraisal practice, that it is expressible in terms of a single lump sum ofmoney considered as payable or expended at a particular point in time

in exchange for property, i.e., the right to receive future benefits as at thatparticular time – point The amount of the lump sum of money, in anyparticular instance, is exactly equivalent to the right to receive the par-ticular future benefits encompassed in the property under consideration

In this, value differs from price or cost Price and cost refer to an amount

of money asked or actually paid for a property, and this may be more orless than its value.8

DATES

All valuations are done as of a single date It is important that the users of

valua-tions understand this fact The International Glossary defines the valuation date as,

“The specific point in time as of which the valuator’s opinion of value applies (alsoreferred to as ‘Effective Date’ or ‘Appraisal Date’).”

APPROACHES TO VALUE

There are only three approaches to value any asset, business or business interest:

1 The income approach

2 The market approach

3 The asset approach

There are no other approaches to value However, there are numerous methodswithin each one of the approaches that the analyst may consider in performing a

is the primary value driver Investors buy tomorrow’s cash flow, notyesterday’s or even today’s

ValTip

valuation For example, under the income approach, the analyst can use a counted cash flow method or a capitalized cash flow method Each of these meth-ods also can be prepared on a direct equity method or an invested capital method.

dis-In the market approach, the analyst can apply guideline public company multiples

or multiples derived from transactions both public and private In the assetapproach, the analyst often must choose between valuing just tangible assets, indi-vidual intangible assets or all intangible assets as a collective group Variousmethodologies exist for each one of these choices

All three approaches should be considered in each valuation However, it is notcommon to use all three approaches in each valuation For example, the asset ap-proach is used less often in valuing operating companies, since the time and costinvolved in performing valuations of intangible assets do not warrant the increasedlevel of accuracy, if any, provided by the cost approach Specific intangible asset val-ues are often excluded due to the fact that intangible asset values are captured in theproper application of the income and market approaches, which would provide, inmost circumstances, a ceiling on the aggregate intangible asset values

VALUATION PROCEDURES

Numerous procedures and factors must be considered in performing a businessvaluation However, they can generally be classified into the following areas:

• Understand the purpose of the engagement

• Understand who the client is

• Understand the client’s use of the valuation

• Determine the standard of value

• Determine the premise of value

• Determine the users of the value

• Determine the interest to be valued

• Ascertain whether discounts and/or premiums are to be considered

• Analyze the company’s financial information

• Gather information about the company

• Gather information about the industry and economy

• Consider all approaches of value and select the most appropriate

• Apply the approaches to value through the various methodologies

• Reconcile the values

• Apply discounts and premiums if applicable

• Write the report if applicable

All of these steps are discussed throughout the book

SUMMARY

Valuation, by its very nature, contains many controversial issues We address many

of these issues throughout this book, highlighting them through the ValTips These

issues are further addressed in Chapter 24, Controversial Issues, which presents

these issues as “Valuation Views” (VV) in the sequence of an actual report.The valuation of business enterprises and business assets is well-founded in aca-demic publications and empirical studies The use of public company information

has provided the foundation for the analysis of business valuation The biggest ference between valuing investments in public companies and nonpublic businesses

dif-is the lack of information The application of recognized valuation methodologyand rigorous analysis of the private company provides the foundation for businessvaluation This book presents state of the art methods for the valuation of closely-held businesses and other assets as it has evolved

International Glossary of Business Valuation Terms

To enhance and sustain the quality of business valuations for the benefit of the fession and its clientele, the below identified societies and organizations haveadopted the definitions for the terms included in this glossary

pro-The performance of business valuation services requires a high degree of skilland imposes upon the valuation professional a duty to communicate the valuationprocess and conclusion in a manner that is clear and not misleading This duty isadvanced through the use of terms whose meanings are clearly established and con-sistently applied throughout the profession

If, in the opinion of the business valuation professional, one or more of theseterms needs to be used in a manner that materially departs from the enclosed defi-nitions, it is recommended that the term be defined as used within that valuationengagement

This glossary has been developed to provide guidance to business valuationpractitioners by further memorializing the body of knowledge that constitutes thecompetent and careful determination of value and, more particularly, the commu-nication of how that value was determined

Departure from this glossary is not intended to provide a basis for civil ity and should not be presumed to create evidence that any duty has been breached

liabil-American Institute of Certified Public Accountants

American Society of Appraisers Canadian Institute of Chartered Business Valuators National Association of Certified Valuation Analysts

The Institute of Business Appraisers Adjusted Book Value Method—a method within the asset approach whereby all

assets and liabilities (including off-balance sheet, intangible, and contingent) areadjusted to their fair market values (NOTE: In Canada on a going concern basis)

Adjusted Net Asset Method—see Adjusted Book Value Method.

Appraisal—see Valuation.

Appraisal Approach—see Valuation Approach.

Appraisal Date—see Valuation Date.

Appraisal Method—see Valuation Method.

Appraisal Procedure—see Valuation Procedure.

Arbitrage Pricing Theory—a multivariate model for estimating the cost of equity

capital, which incorporates several systematic risk factors

Asset (Asset-Based) Approach—a general way of determining a value indication of

a business, business ownership interest, or security using one or more methodsbased on the value of the assets net of liabilities

Beta—a measure of systematic risk of a stock; the tendency of a stock’s price to

cor-relate with changes in a specific index

Blockage Discount—an amount or percentage deducted from the current market

price of a publicly traded stock to reflect the decrease in the per share value of ablock of stock that is of a size that could not be sold in a reasonable period of timegiven normal trading volume

Book Value—see Net Book Value.

Business—see Business Enterprise.

Business Enterprise—a commercial, industrial, service, or investment entity (or a

combination thereof) pursuing an economic activity

Business Risk—the degree of uncertainty of realizing expected future returns of the business resulting from factors other than financial leverage See Financial Risk Business Valuation—the act or process of determining the value of a business enter-

prise or ownership interest therein

Capital Asset Pricing Model (CAPM)—a model in which the cost of capital for any

stock or portfolio of stocks equals a risk-free rate plus a risk premium that is portionate to the systematic risk of the stock or portfolio

pro-Capitalization—a conversion of a single period of economic benefits into value Capitalization Factor—any multiple or divisor used to convert anticipated economic

benefits of a single period into value

Capitalization of Earnings Method—a method within the income approach

whereby economic benefits for a representative single period are converted to valuethrough division by a capitalization rate

Capitalization Rate—any divisor (usually expressed as a percentage) used to convert

anticipated economic benefits of a single period into value

Capital Structure—the composition of the invested capital of a business enterprise,

the mix of debt and equity financing

Cash Flow—cash that is generated over a period of time by an asset, group of assets,

or business enterprise It may be used in a general sense to encompass various els of specifically defined cash flows When the term is used, it should be supple-mented by a qualifier (for example, “discretionary” or “operating”) and a specificdefinition in the given valuation context

lev-Common Size Statements—financial statements in which each line is expressed as a

percentage of the total On the balance sheet, each line item is shown as a age of total assets, and on the income statement, each item is expressed as a per-centage of sales

percent-Control—the power to direct the management and policies of a business enterprise Control Premium—an amount or a percentage by which the pro rata value of a con-

trolling interest exceeds the pro rata value of a non-controlling interest in a businessenterprise, to reflect the power of control

Cost Approach—a general way of determining a value indication of an individual

asset by quantifying the amount of money required to replace the future servicecapability of that asset

Cost of Capital—the expected rate of return that the market requires in order to

attract funds to a particular investment

Debt-Free—we discourage the use of this term See Invested Capital.

Discount for Lack of Control—an amount or percentage deducted from the pro rata

share of value of 100 percent of an equity interest in a business to reflect the absence

of some or all of the powers of control

Discount for Lack of Marketability—an amount or percentage deducted from the

value of an ownership interest to reflect the relative absence of marketability

Discount for Lack of Voting Rights—an amount or percentage deducted from the

per share value of a minority interest voting share to reflect the absence of votingrights

Discount Rate—a rate of return used to convert a future monetary sum into present

value

Discounted Cash Flow Method—a method within the income approach whereby

the present value of future expected net cash flows is calculated using a discountrate

Discounted Future Earnings Method—a method within the income approach

whereby the present value of future expected economic benefits is calculated using

a discount rate

Economic Benefits—inflows such as revenues, net income, net cash flows, etc Economic Life—the period of time over which property may generate economic

benefits

Effective Date—see Valuation Date.

Enterprise—see Business Enterprise.

Equity—the owner’s interest in property after deduction of all liabilities.

Equity Net Cash Flows—those cash flows available to pay out to equity holders (in

the form of dividends) after funding operations of the business enterprise, makingnecessary capital investments, and increasing or decreasing debt financing

Equity Risk Premium—a rate of return added to a risk- free rate to reflect the

addi-tional risk of equity instruments over risk free instruments (a component of the cost

of equity capital or equity discount rate)

Excess Earnings—that amount of anticipated economic benefits that exceeds an

appropriate rate of return on the value of a selected asset base (often net tangibleassets) used to generate those anticipated economic benefits

Excess Earnings Method—a specific way of determining a value indication of a

busi-ness, business ownership interest, or security determined as the sum of a) the value

of the assets derived by capitalizing excess earnings and b) the value of the selected

asset base Also frequently used to value intangible assets See Excess Earnings Fair Market Value—the price, expressed in terms of cash equivalents, at which

property would change hands between a hypothetical willing and able buyer and a