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 prod- ucts 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. 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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 1. Corporations–Valuation. I. Title. HG4028.V3H583 2011 658.15–dc22 2010048924 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1 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 help- ing 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 1 Introduction to Financial Valuation 1 Who Values Businesses? 1 Purpose of a Valuation 2 Professional Valuation Organizations 3 Standards of Value 3 Fair Market Value 3 Investment Value 5 Intrinsic Value 5 Fair Value (State Rights) 5 Fair Value (Financial Reporting) 5 Premise of Value 6 Principles of Appraisal Practice 7 Dates 7 Approaches to Value 8 Valuation Procedures 8 Summary 9 Addendum 1—Valuation Checklist/Ready Reference (Revenue Ruling 59-60) 10 Addendum 2—International Glossary of Business Valuation Terms 18 CHAPTER 2 Standards of Value 27 Introduction 27 How Standard of Value Can Affect the Final “Number” 29 Premises of Value 30 Common Standards of Value 31 Common Operational Premises Underlying the Standard of Value 36 Application of Specific Standards of Value 38 Fair Value in Shareholder Dissent and Oppression 42 Control Premiums 43 Immediately Before 44 Unless Exclusion Would Be Inequitable 44 Extraordinary Circumstances 45 vi JWBT309_FM_pi-xxxiv.qxd 02/04/2011 7:09 PM Page vii Aptara Contents vii Current and Customary Techniques 45 Standard of Value in Divorce 46 Fair Value in Financial Accounting 52 Measurement 52 Conclusion 54 CHAPTER 3 Research and Its Presentation 55 Obtaining Internal Information 55 A Directive from the Internal Revenue Service 55 Research Techniques and Planning the Search 57 Information Sources: Business Financial Databases 61 Economic Research 62 Selected Sources of Economic Information 63 Industry Research 64 Selected Sources of Industry Information 65 Guideline Company and Transaction Research 66 SourcesforPubliclyTradedCompanyData 66 Guideline Transaction Databases 67 Presenting Research in a Report 68 Other Sources of Information 68 Summary 69 Addendum 1—Valuation Information Request (VIR) General 70 Addendum 2—Management Interview–Operations 76 Addendum 3—Management Interview–Financial Review 80 Addendum 4—Industry Research Form 83 CHAPTER 4 Financial Statement and Company Risk Analysis 85 Historical Financial Statement Analysis 85 Length of Financial History to Be Used 86 Spreading Financial Statements in Columnar Format 86 Adjustments to Financial Statements 86 Normalization of Historical Financial Statements 89 Unusual, Nonrecurring, and Extraordinary Items 89 Nonoperating Items 90 Changes in Accounting Principle 90 Nonconformance with GAAP 91 Tax Affecting the Earnings of Subchapter S Corporations and Other Adjustments 91 Degree of Ownership Interest 92 Normalization Adjustments 92 Common Sizing Normalized Financial Statements 96 Ratio Analysis (Quantitative Analysis) 103 Comparative Analysis 104 Risk Analysis (Qualitative Analysis) 107 Macroenvironmental Analysis 114 Addendum 1—Commonly Used Financial Ratios: Application to Ale’s Distributing 115 JWBT309_FM_pi-xxxiv.qxd 02/04/2011 7:09 PM Page viii Aptara VIII CONTENTS CHAPTER 5 Income Approach 121 Fundamental Theory 121 Basics of Income Approach—“A Fraction” 122 Income Approach Methodologies 123 Normalization Process 124 Adjustments for Ownership Characteristics 124 Adjustments for GAAP Departures and Extraordinary, Nonrecurring, and/or Unusual Items 127 Adjustments for Nonoperating Assets and Liabilities and Related Income and Expenses 128 Adjustments for Taxes 129 Adjustments for Synergies from Mergers and Acquisitions 130 Determination of Future Benefits Stream (Cash Flows) 131 Defining the Benefit Stream 131 Defining Net Cash Flow 132 Use of Historical Information 134 The Capitalized Cash Flow Method 139 The Discounted Cash Flow Method 143 Terminal Value 149 Capitalized Cash Flow Method (Revisited) 156 Excess Cash Flow Method 157 Conclusion 167 Addendum I—Application of the Direct Equity Method (DEM) and the Invested Capital Method (ICM) 168 Addendum 2—Dealing With Debt 175 CHAPTER 6 Cost of Capital/Rates of Return 181 Three Variables 181 Characteristics of Cost of Capital 182 Investor Expectations as Quantified by the Cost of Capital 182 Cost of Capital Equals Discount Rate 183 Cost-of-Capital Methods 183 More on the Basic Concepts 183 Discount Rate, Capitalization Rate, and Anticipated Growth 184 Growth 184 Relationship Between Risk and Cost of Capital 190 Types of Risk—Another View 193 Risks in a Small Business 194 Methods for Developing Cost of Capital 194 Size Premiums 202 Methods to Articulate Unsystematic Risk 209 Other Issues 219 Capital Asset Pricing Model Method 221 Development of the Weighted Average Cost of Capital 228 Price/Earnings Method 230 Adjustments to the Price/Earnings Ratio 232 Arbitrage Pricing Theory 235 Risk Rate Component Model FKA Build-Up Summation Model 236