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JWBT309_FM_pi-xxxiv.qxd 02/04/2011 7:09 PM Page i Aptara JWBT309_FM_pi-xxxiv.qxd 02/04/2011 7:09 PM Page i Aptara Financial Valuation JWBT309_FM_pi-xxxiv.qxd 02/04/2011 7:09 PM Page ii Aptara Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation, and financial instrument analysis, as well as much more For a list of available titles, please visit our Web site at www.WileyFinance.com JWBT309_FM_pi-xxxiv.qxd 02/04/2011 7:09 PM Page iii Aptara Financial Valuation Applications and Models Third Edition with Website JAMES R HITCHNER John Wiley & Sons, Inc JWBT309_FM_pi-xxxiv.qxd 02/04/2011 7:09 PM Page iv Aptara Copyright © 2011 by James R Hitchner All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002 Wiley also publishes its books in a variety of electronic formats Some content that appears in print may not be available in electronic books For more information about Wiley products, visit our web site at www.wiley.com Library of Congress Cataloging-in-Publication Data Hitchner, James R Financial valuation : applications and models / James R Hitchner – 3rd ed p cm – (Wiley finance series) Includes index ISBN 978-0-470-50687-5 (hardback); ISBN 978-0-470-91522-6; ISBN 978-0-470-91523-3; ISBN 978-0-470-91524-0 Corporations–Valuation I Title HG4028.V3H583 2011 658.15–dc22 2010048924 Printed in the United States of America 10 JWBT309_FM_pi-xxxiv.qxd 02/04/2011 7:09 PM Page v Aptara To my greatest champion, my dad, Earle R Hitchner, Jr Thank you for instilling in me a work ethic and tenacity that keeps me going I miss you To his sister and my godmother, Aunt Thelma You are simply the best and a true inspiration to all who know and love you To the authors: It has truly been one of the highlights of my career to work with such a wonderful group of professionals Thank you for your perseverance in helping to advance the business valuation profession To my mother, Virginia M Hitchner, who passed away during the final days of editing this book Thank you for sticking by me, always I miss you JWBT309_FM_pi-xxxiv.qxd 02/04/2011 7:09 PM Page vi Aptara Contents About the Editor xvi About the Authors xviii Acknowledgments xxx Preface xxxii CHAPTER Introduction to Financial Valuation Who Values Businesses? Purpose of a Valuation Professional Valuation Organizations Standards of Value Fair Market Value Investment Value Intrinsic Value Fair Value (State Rights) Fair Value (Financial Reporting) Premise of Value Principles of Appraisal Practice Dates Approaches to Value Valuation Procedures Summary Addendum 1—Valuation Checklist/Ready Reference (Revenue Ruling 59-60) Addendum 2—International Glossary of Business Valuation Terms 10 18 CHAPTER Standards of Value Introduction How Standard of Value Can Affect the Final “Number” Premises of Value Common Standards of Value Common Operational Premises Underlying the Standard of Value Application of Specific Standards of Value Fair Value in Shareholder Dissent and Oppression Control Premiums Immediately Before Unless Exclusion Would Be Inequitable Extraordinary Circumstances 27 27 29 30 31 36 38 42 43 44 44 45 vi 1 3 5 5 7 8 JWBT309_FM_pi-xxxiv.qxd 02/04/2011 7:09 PM Page vii Aptara Contents Current and Customary Techniques Standard of Value in Divorce Fair Value in Financial Accounting Measurement Conclusion CHAPTER Research and Its Presentation Obtaining Internal Information A Directive from the Internal Revenue Service Research Techniques and Planning the Search Information Sources: Business Financial Databases Economic Research Selected Sources of Economic Information Industry Research Selected Sources of Industry Information Guideline Company and Transaction Research Sources for Publicly Traded Company Data Guideline Transaction Databases Presenting Research in a Report Other Sources of Information Summary Addendum 1—Valuation Information Request (VIR) General Addendum 2—Management Interview–Operations Addendum 3—Management Interview–Financial Review Addendum 4—Industry Research Form CHAPTER Financial Statement and Company Risk Analysis Historical Financial Statement Analysis Length of Financial History to Be Used Spreading Financial Statements in Columnar Format Adjustments to Financial Statements Normalization of Historical Financial Statements Unusual, Nonrecurring, and Extraordinary Items Nonoperating Items Changes in Accounting Principle Nonconformance with GAAP Tax Affecting the Earnings of Subchapter S Corporations and Other Adjustments Degree of Ownership Interest Normalization Adjustments Common Sizing Normalized Financial Statements Ratio Analysis (Quantitative Analysis) Comparative Analysis Risk Analysis (Qualitative Analysis) Macroenvironmental Analysis Addendum 1—Commonly Used Financial Ratios: Application to Ale’s Distributing vii 45 46 52 52 54 55 55 55 57 61 62 63 64 65 66 66 67 68 68 69 70 76 80 83 85 85 86 86 86 89 89 90 90 91 91 92 92 96 103 104 107 114 115 JWBT309_FM_pi-xxxiv.qxd 02/04/2011 7:09 PM Page viii Aptara VIII CHAPTER Income Approach Fundamental Theory Basics of Income Approach—“A Fraction” Income Approach Methodologies Normalization Process Adjustments for Ownership Characteristics Adjustments for GAAP Departures and Extraordinary, Nonrecurring, and/or Unusual Items Adjustments for Nonoperating Assets and Liabilities and Related Income and Expenses Adjustments for Taxes Adjustments for Synergies from Mergers and Acquisitions Determination of Future Benefits Stream (Cash Flows) Defining the Benefit Stream Defining Net Cash Flow Use of Historical Information The Capitalized Cash Flow Method The Discounted Cash Flow Method Terminal Value Capitalized Cash Flow Method (Revisited) Excess Cash Flow Method Conclusion Addendum I—Application of the Direct Equity Method (DEM) and the Invested Capital Method (ICM) Addendum 2—Dealing With Debt CHAPTER Cost of Capital/Rates of Return Three Variables Characteristics of Cost of Capital Investor Expectations as Quantified by the Cost of Capital Cost of Capital Equals Discount Rate Cost-of-Capital Methods More on the Basic Concepts Discount Rate, Capitalization Rate, and Anticipated Growth Growth Relationship Between Risk and Cost of Capital Types of Risk—Another View Risks in a Small Business Methods for Developing Cost of Capital Size Premiums Methods to Articulate Unsystematic Risk Other Issues Capital Asset Pricing Model Method Development of the Weighted Average Cost of Capital Price/Earnings Method Adjustments to the Price/Earnings Ratio Arbitrage Pricing Theory Risk Rate Component Model FKA Build-Up Summation Model CONTENTS 121 121 122 123 124 124 127 128 129 130 131 131 132 134 139 143 149 156 157 167 168 175 181 181 182 182 183 183 183 184 184 190 193 194 194 202 209 219 221 228 230 232 235 236 ... Certified Valuation Analysts, Salt Lake City, Utah Mark Dietrich, Dietrich & Wilson, PC, Framingham, Massachusetts Christopher Mercer, Mercer Capital, Memphis, Tennessee Shannon Pratt, Shannon Pratt Valuations,... Board American Institute of Certified Public Accountants Internal Revenue Service Partnership Profiles, Inc Trugman Valuation Associates National Center for Employee Ownership Business Valuation