Business Valuation

A guide that demystifies modern valuation theory and shows how to apply fundamental valuation concepts

The revised and updated third edition of Business Valuation: An Integrated Theory explores the core concepts of the integrated theory of business valuation and adapts the theory to reflect how the market for private business actually works.

In this third edition of their book, the authors—two experts on the topic of business valuation—help readers translate valuation theory into everyday valuation practice. This important updated book:

• Includes an extended review of the core concepts of the integrated theory of business valuation and applies the theory on a total capital basis
• Explains “typical” valuation discounts (marketability and minority interest) and premiums (control premiums) in the context of financial theory, institutional reality and the behavior of market participants
• Explores evolving valuation perspectives in the context of the integrated theory
• Written by two experts on valuation theory from Mercer Capital

The third edition of Business Valuation is the only book available regarding an integrated theory of business valuation—offering an essential, unprecedented resource for business professionals.

Introduction xiii

What’s New in the Third Edition? xiv

Who Should Read This Book? xvii

Part One Conceptual Overview of the Integrated Theory

Chapter 1 The World of Value 3

Introduction 3

Common Questions 3

The World of Value 4

The Organizing Principles 5

Summary 16

Chapter 2 The Integrated Theory (Equity Basis) 19

Introduction 19

Common Questions 20

The Fundamental Valuation Model 21

The Conceptual Levels of Value 23

Symbolic Notation for the Integrated Theory 27

The Marketable Minority Interest Level of Value 29

Introduction to the Control Levels of Value 35

Strategic Control Level of Value 51

Firmwide Levels versus the Shareholder Level of Value 58

The Nonmarketable Minority Level of Value 60

The Integrated Theory of Business Valuation on an Equity Basis 67

Summary 67

Chapter 3 The Integrated Theory (Enterprise Basis) 71

Introduction 71

Comparing the Levels of Value: Equity and Enterprise Bases 73

Final Comparisons of the Equity and Enterprise Bases 77

Summary 79

Part Two Valuing Enterprise Cash Flows

Chapter 4 Income Approach (Cash Flows) 83

Introduction 83

Reconciling Single-Period Capitalization and Discounted Cash Flow Methods 84

Defining Enterprise Cash Flows 90

Defining Equity Cash Flows 95

Reinvestment Rates and Interim Growth Rates 99

Terminal Growth Rates 104

Expected Cash Flows and the Integrated Theory 108

Marketable Minority Interest Level: Public Company Equivalent 115

Financial Control Level: Private Equity Cash Flows 124

Strategic Control Level: Strategic Acquirer Cash Flows 128

Assessing the Reasonableness of Projected

Enterprise Cash Flows 136

Conclusion 139

Chapter 5 Income Approach (Discount Rate) 141

Introduction 141

Return Basics: Realized versus Required Returns 142

Components of the Weighted Average Cost of Capital 148

Market Participants and the WACC 165

The Levels of Value and the WACC 169

Assessing Overall Reasonableness 175

Chapter 6 Market Approach (Guideline Public Companies) 177

Introduction 177

Relationship of the Income and Market Approaches 178

What Do Observed Public Company Valuation Multiples Mean? 180

Adjusting Valuation Multiples for Differences in Risk and Growth 199

Guideline Public Company Multiples and the Enterprise Levels of Value 214

Assessing Overall Reasonableness 219

Chapter 7 Market Approach (Guideline Transactions) 221

Introduction 221

Attributes of Guideline Transaction Data 222

Drawing Valuation Inferences from Guideline Transaction Data 225

Minority Interest Discounts Inferred from Observed Control Premiums 240

Guideline Transaction Multiples and the Levels of Value 242

Assessing Overall Reasonableness 244

Appendix 7-A: A Historical Perspective on the Control Premium and Minority Interest Discount 247

Part Three Valuing Shareholder Cash Flows

Chapter 8 Restricted Stock Discounts and Pre-IPO Studies 271

Introduction 271

An Overview of Restricted Stock Discounts 275

Review of the FMV/Stout Restricted Stock Database 306

Pre-IPO Discounts 317

Conclusion 325

Chapter 9 Introduction to the QMDM (Quantitative Marketability Discount Model) 327

Introduction 327

Potential Valuation Approaches at the Shareholder Level 328

A Shareholder Level Discounted Cash Flow Model in Outline 331

Economic Factors Giving Rise to the Marketability Discount 338

Conclusion 346

Appendix 9-A: Liquidity and Marketability 349

Chapter 10 The QMDM Assumptions in Detail 359

Introduction 359

Assumption 1: Expected Holding Period for the Investment (HP) 360

Assumption 2A: Expected Dividend Yield (D %) 368

Assumption 2B: Expected Growth of Dividends (GD) 377

Assumption 2C: Timing of Dividend Receipt 378

Assumption 3A: The Expected Growth Rate in Value (GV) 379

Assumption 3B: Adjustments to the Terminal Value 385

Assumption 4: Required Holding Period Return (Rhp) 385

Conclusion 399

Chapter 11 Applying the QMDM 401

Introduction 401

Comprehensive Example of the QMDM in Use 401

Condensed QMDM Examples 414

The Uniform Standards of Professional Appraisal Practice and the QMDM 427

Chapter 12 Applying the Integrated Theory to Tax Pass-Through Entities 435

Introduction 435

The Nature of the S Corporation Benefit 437

The Firmwide Level Value of S Corporations 440

Other Observations Regarding Relative Value at the Firmwide Levels 443

The Shareholder Level Value of S Corporations 446

S Corporations and the Tax Cuts and Jobs Act of 2017 458

Conclusion 467

About the Authors 469

Index 477

Z. Christopher Mercer, ASA, CFA, (Memphis, TN) is the founder and chief executive officer of Mercer Capital. He has prepared, overseen, or contributed to hundreds of valuations for purposes related to tax, ESOPs, buy-sell agreements, and litigation, among others. He has extensive experience in litigation engagements including statutory fair value cases, divorce, and numerous other matters where valuation issues are in question. He is also an expert in buy-sell agreement disputes. Mercer is a prolific author on valuation-related topics and a frequent speaker on business valuation issues for national professional associations and other business and professional groups.

TRAVIS W. HARMS, CFA, CPA/ABV, is the leader of Mercer Capital's Family Business Advisory Services Group. He focuses primarily on providing financial, strategic, and valuation consulting to multi-generational family businesses. Mr. Harms regularly speaks and writes on valuation and related topics for family business owners and their advisors.

Business Valuation: An Integrated Theory comprehensively and thoroughly describes the various approaches and methods valuation analysts use to measure the value of businesses and business ownership interests.

Written in three parts, Business Valuation first describes the organizing principles of business valuation. The authors discuss the financial, economic, logical, and psychological principles that provide the basis for effective business valuation. The first part develops an Integrated Theory of Business Valuation that allows valuation analysts to account for all the cash flows of a business, whether in the aggregate or in the portions attributable to specific ownership interests. The focus is on expected cash flows and their growth and the risks associated with achieving those cash flows.

In the second part, the authors apply the theory to practice, describing each of the methods valuation analysts might use to derive indications of value for the business as a whole. Like the first part, the discussion is rooted in the carefully defined concepts of expected cash flow, risk, and growth. This part examines calculating enterprise cash flows for use in the income approach, assigning and quantifying risk to calculate discount rates, using the guideline public company method under the market approach, and dealing with the challenges of using guideline transaction data.

Finally, Business Valuation closes with a section on the intersection of the Integrated Theory and the value of illiquid minority ownership interests in private companies at the nonmarketable minority level of value. In this section, the authors also provide a thoughtful and critical analysis of several traditional techniques for developing marketability discounts. Expected cash flow, risk, and growth remain the foundations. The Quantitative Marketability Discount Model (QMDM), as part of the Integrated Theory, is discussed at length and the book includes a detailed examination of its assumptions and applications. The twelfth and final chapter contains a discussion of the application of the Integrated Theory to tax pass-through entities.

Perfect for anyone with even a passing interest in business valuation or consulting, Business Valuation: An Integrated Theory belongs on the bookshelves of all valuation analysts, attorneys, accountants, and market participants who serve or interact with private and public companies. The book is also ideal for college and graduate level courses related to business valuation.

Praise for Business Valuation

"Mercer and Harms' Business Valuation: An Integrated Theory, Third Edition provides valuation professionals, attorneys, other users of valuations, and students of valuation a resource for better understanding how the pieces of the valuation puzzle fit together. This book is written in an easy to follow style and is worthy of being added to your valuation library."
—Roger J. Grabowski, FASA, Managing Director, Duff & Phelps

"It has been 13 years since the second edition of this book came out. It was certainly worth the wait. All the core chapters have been updated with easy-to-understand explanations of valuation concepts. Mercer and Harms have also added new chapters on the Income Approach (Cash Flows), the Income Approach (Discount Rate), the Market Approach (Guideline Public Companies), the Market Approach (Guideline Transactions), and Restricted Stock Discounts and Pre-IPO studies. This well-written book presents a thoughtful approach to business valuation. The bottom line is that this is a valuable resource that tackles controversial topics head on."
—James R. Hitchner, CPA/ABV/CFF, ASA, Managing Director, Financial Valuation Advisors

Master the approaches and methods of business valuation with this comprehensive resource from two industry leaders

In this book, distinguished authors and valuation analysts Z. Christopher Mercer and Travis W. Harms of Mercer Capital dive deeply into the intricacies of business valuation, providing readers with an Integrated Theory that acts as a practical and powerful tool to value businesses and business ownership interests. Using expected cash flow, growth, and risk as the foundations of the Integrated Theory, the authors discuss the major, organizing principles of business valuation, as well as the various methods used to value businesses and business ownership interests.

They provide a detailed discussion of the Quantitative Marketability Discount Model, which applies the Integrated Theory to the valuation of illiquid minority ownership interests in private companies.

The book is not just theoretical, but practical, eschewing unnecessary mathematical detail in favor of concrete examples and strategic advice designed to help valuation analysts put the Integrated Theory into practice. It contains actionable advice on how to deal with commonly encountered valuation dilemmas, like valuing tax pass-through entities and ownership interests in them.