The Economics of Business Valuation

Towards a Value Functional Approach

Patrick Anderson

• Publisher: Stanford Economics and Finance
• Year: 2013
• ISBN:
  9780804783224
• Edition: 1
• Topic: Commerce
• Subtopic: Finance

For decades, the market, asset, and income approaches to business valuation have taken center stage in the assessment of the firm. This book brings to light an expanded valuation toolkit, consisting of nine well-defined valuation principles hailing from the fields of economics, finance, accounting, taxation, and management. It ultimately argues that the "value functional" approach to business valuation avoids most of the shortcomings of its competitors, and more correctly matches the actual motivations and information set held by stakeholders.

Much of what we know about corporate finance and mathematical finance derives from a narrow subset of firms: publicly traded corporations. The value functional approach can be readily applied to both large firms and companies that do not issue publicly traded stocks and bonds, cannot borrow without constraints, and often rely upon entrepreneurs to both finance and manage their operations. With historical side notes from an international set of sources and real-world exemplars that run throughout the text, this book is a future-facing resource for scholars in economics and finance, as well as the academically minded valuation practitioner.

I

THEORIES OF VALUE

1

MODERN VALUE QUANDARIES

THE FIRM IN ECONOMICS AND FINANCE

For at least two millennia, private businesses have been undertaken by farmers, traders, and artisans across the globe. Such businesses—including small farms, fishing and herding enterprises, textile and clothing producers, and larger ventures—have been the world’s primary employers and wealth producers for centuries. Furthermore, for at least the past two centuries society has benefited from the formal study of economics, accounting, and the precursors of finance. What we call a business, enterprise, undertaking, or “firm” figures prominently in all of these fields. Yet with all of this scholarship, we really know very little about the definition and value of the firm. Addressing this poverty is the prime motivation of this book.

For graduates and holders of professional credentials in the fields of accounting, finance, economics, and business, this bold assertion of our lack of knowledge may seem overwrought. However, in this chapter, we pose several quandaries that illustrate this poverty. If we really had a complete, coherent, and valid theory of the firm and its value, these quandaries would not exist. The fact that they do exist, and that similar serious self-contradictions exist in related fields of study, motivates this book.

TWO MILLENNIA OF BUSINESS: A BRIEF RECAP

Business from 500 BC to AD 1500

Two millennia ago, accounts of business activity and rules for business behavior appeared in ancient texts such as the books of the Old Testament of the Bible (including the books of the Torah), the books of the New Testament, the Vedas of Hindu literature, and ancient legal codes such as those of the Roman Empire and the Babylonian empire of Hammurabi.¹

During these twenty centuries, agriculture, hunting, fishing, and herding of game animals were the primary occupations. These farmers, hunters, fishermen, and herders were all engaged in business, and the prospect of hunger and famine made their business very important indeed.

For roughly the last thousand years, the emerging civilizations of the world benefited from mathematics, customs of trade, and other knowledge recorded in Greek and Roman literature, as well as lesser-known literature from other lands. Critical scientific advances that occurred in Egypt, China, India, and the Near East—including the creation of the number system we use today, as well as basic algebra—were transmitted to the West, sometimes with the actual origins forgotten. Much of this knowledge was directly used in business and trade, including weights and measures, arithmetic and numbering, geometry, timekeeping, navigation, water distribution, and cultivation.

Of course, such knowledge was not nicely recorded and widely distributed. Human and civil rights, such as the right to property and the fruits of one’s own labor, were denied to many. Life expectancy, literacy, and the need for subsistence were such that relatively few people received a formal education as we now understand it. However, businesses were organized, grew, and failed; trade flourished, was interrupted, and then resumed; people received wages for their work and paid for their purchases; wars and pestilence came and went; and somehow civilization survived—and with it, the institution of business survived and grew.

Business Since AD 1500

In the last five hundred years, business practices were further developed, as were a number of related fields of study, particularly the following:

1500s

• Traders and other businesspeople developed a formal system of accounting to record transactions within a firm. Such practices allowed commerce to grow and are still the bases for trade, contracts, and business investment.

1700s & 1800s

• Economists began writing about the economies of modern societies. Classical economists such as Adam Smith and David Ricardo proposed an explicit labor theory of value.

1900s

• Neoclassical economics emerged as a dominant influence in the whole of social science. It introduced the concepts of marginal cost, consumer utility, and profit maximization, which are now used in economics, law, government, sociology, and commerce. The pervasive idea that prices are set when supply meets demand in an open market took hold.

1940s

• A school of modern finance emerged as a separate discipline. Building on both neoclassical microeconomics and mathematics, modern finance developed notions of arbitrage, martingale pricing, portfolio choice, and mean-variance analysis.

1950s

• Formal credentials were developed for professionals engaged in selling securities of firms, providing advice for individuals investing in firms, accounting or auditing the accounts of firms, and appraising business property. The Modigliani-Miller proposition emerged as a pillar of modern finance. The basis for modern portfolio theory was established.

1970s–2010

• A specialized professional literature in the valuation of business developed. Alongside it grew a smaller literature for forensic economists, who estimate the change in value of firms for the purpose of estimating damages to businesses caused by breaches of contract and natural disasters. A formula for the valuation of certain financial options became widely available. Financial engineering and discounted cash flow analysis became ubiquitous.

We must acknowledge this tremendous progress in the fields of economics, finance, and accounting, and the ongoing efforts of scholars and professional societies dealing with businesses and business value. Indeed, we will devote several chapters to doing exactly that!

THE QUANDARIES

With all this knowledge, we should have a very well-developed theory of the firm and a very well-developed theory of the value of a firm. These theories should be amply tested by reality, comprehensive, and internally consistent.

Unfortunately, few theories provide a sound basis for determining the market value of a privately held firm. Moreover, we still have large gaps in our knowledge about the rationale of firms in the modern economy, and no workable universal definition of the firm. Notions of the firm used in microeconomics, accounting, corporate finance, and option pricing all differ. Finally, professionals who seek practical guidance on the definition and value of a firm routinely find it—at least in the United States—from an unlikely source for intellectual enlightenment: the federal taxation authorities.

This unsatisfactory state of affairs can be illustrated by the seven quandaries posed next. Each illustrates a significant gap in the orthodox theories of business drawn from economics, finance, and accounting.

Quandary 1: Mainstream Economics Ignores the Firm

The Neglect of the Firm in Economics

This quandary dates back to the creation of the mathematical models that form the basis of general equilibrium economics. Consider this statement by Léon Walras, the pioneer of welfare economics, writing in the nineteenth century:

Once the equilibrium has been established in principle, exchange can take place immediately. Production, however, requires a certain lapse of time. We shall resolve the second difficulty purely and simply by ignoring the time element at this point. (Walras, 1874, p. 242)

Walras developed the early model of exchange equilibrium, meaning that the buyers and sellers in a market reach agreements at market-clearing prices. However, in order to do this he had to ignore the fact that production took some time. It is the firm (or set of firms) that directly internalizes the time, cost, and uncertainty of production. Walras dealt with important issues in economics, and his thought is the basis for much of what we call microeconomics today. But he explicitly ignored the inner workings of the firm. In essence, the firm vanishes from the theoretical model of production, exchange, and consumption.

Next we quote an influential modern-era microeconomist:

The firm fits into general equilibrium theory as a balloon fits into an envelope: flattened out! Try with a blown-up balloon: the envelope may tear, or fly away: at best, it will be hard to seal and impossible to mail. . . . Instead, burst the balloon flat, and everything becomes easy. Similarly with the firm and general equilibrium—though the analogy requires a word of explanation.

Jacques H. Drèze, “Uncertainty and the Firm in General Equilibrium Theory,” Economic Journal, 1985, p. 1.²

These observations about the state of economic science are telling.³ In more than a hundred years, economics had moved quite far—but still typically viewed the firm as a “flattened balloon” abstraction. A few decades later, the standard presentation of the firm in both microeconomics and macroeconomics remains quite primitive.

In the standard microeconomics model, firms are typically assumed to sell homogenous goods using a simple production function. Workers adjust their consumption according to their wages and interest rates. To the extent that firms’ production plans are even considered, they are often presented as solutions to single-period profit maximization problems, or as the intersections of average cost curves, assuming static production technology and market structure. Entrepreneurial interests, uncertainty, institutional factors, and numerous financial, managerial, and practical considerations in the organization and operation of the firm are largely assumed away.⁴

To be sure, even this primitive specification of the firm leaves plenty of room for issues such as monetary policy, fiscal policy, trade policy, labor policy, regulation of markets with oligopoly structures, causes of business cycles, and so on. However, it also leaves a rather large void.

The Fulsome Importance of the Firm in the Real E...