Business Valuation

An Integrated Theory

Z. Christopher Mercer, Travis W. Harms

• Publisher: Wiley
• Year: 2020
• ISBN:
  9781119583103
• Edition: 3
• Topic: Business
• Subtopic: Valuation
• Index: Business

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.

PART ONE
Conceptual Overview of the Integrated Theory

In this opening section, we describe the conceptual basis for the Integrated Theory. Before turning to practical application of the Integrated Theory in Parts Two and Three, we first provide the foundation of the Integrated Theory, which is rooted in the expected cash flows, risk, and growth attributes of businesses and business ownership interests.

• Chapter 1 sets the stage for our conceptual discussion by means of an overview of the organizing principles of the so‐called world of value. These organizing principles provide a consistent framework for interpreting the actions of market participants in the real world.
• In Chapter 2, we transpose the organizing principles into a conceptual key through analysis of the fundamental valuation model. Using the fundamental valuation model as our conceptual scaffolding, we build out the Integrated Theory, demonstrating the relationships among the various levels of value in terms of differences in expected cash flows, risk, and growth from the perspective of the equity owners of a business.
• The market for private businesses is typically denominated in terms of enterprise, rather than equity, value. In other words, buyers and sellers of private businesses generally measure the aggregate value of the equity and net debt, rather than focusing on the equity value. In Chapter 3 , we present the Integrated Theory on an enterprise value basis.

CHAPTER 1
The World of Value

INTRODUCTION

We have identified several underlying financial, economic, logical, and psychological principles that provide a solid basis for looking at what we can call the “World of Value.” We refer to these as the organizing principles of business valuation, because the integration of the principles provides a logical and consistent framework within which to examine business valuation questions and issues. These principles also provide the qualitative framework within which to discuss the Integrated Theory of Business Valuation.

COMMON QUESTIONS

The discussion of the world of value in this chapter will help readers answer the following questions:

1. What are organizing principles that can help valuation analysts and market participants form reasonable valuation conclusions?
2. What is the relevance of market behavior for valuation conclusions?
3. Is a forecast necessary to derive a valuation conclusion?
4. What determines the level of return expected by investors?
5. What is the significance of present value concepts in valuation analysis?

THE WORLD OF VALUE

The world of value consists of all the various markets in which valuation and investment decisions are made by real investors, whether individuals, companies, institutions, or governments. This world includes (but is certainly not limited to) the public stock and bond markets, the private placement markets for debt and equity securities, and the private equity markets.

The world of value is the real world. If valuation analysts develop a solid understanding of the world of value, they are more likely to be able to develop reasonable valuation conclusions under the standards of value appropriate for specific valuation assignments, including fair market value, fair value, investment value, and others. So we begin with a general discussion of the world of value.

The goal of the world of value is to understand value. For purposes of this book, we are talking about the value of businesses, business ownership interests, securities, and intangible assets. These organizing principles provide the foundation for the Integrated Theory.

The world of value begins with cash flow. The underlying foundation for business value lies in expectations for future cash flow in the context of several organizing principles, including:

• Principle of Expectations. Value is expectational (not historical) in nature.
• Principle of Growth. Value today is influenced by expectations for future growth.
• Principle of Risk and Reward. Value is impacted by the relationship between risk and reward.
• Present Value Principle. Business value is based on the present value of expected future cash flows, discounted to the present at a rate reflecting the risks of receiving those cash flows.
• Principle of Alternative Investments. Businesses and business investments are valued in relationship to reasonable alternative and competing investments.
• Principle of Rationality. The world of value is one of inherent rationality, sanity, and consistency.

The world of value is fascinating. The organizing principles lay the groundwork for the Integrated Theory and provide a basis for addressing nearly every business valuation issue. They describe the underlying behavior of public and private securities markets, which collectively form the (direct or indirect) reference point for valuing most businesses and business interests.

The principles also provide a framework for testing the reasonableness of valuation positions advanced by valuation analysts. We have used these principles actively for many years, both as an organizi...