Market Approach to Valuing Businesses

Shannon P. Pratt, CFA, FASA, MCBA, CM&AA, is the Chairman and CEO of Shannon Pratt Valuations, Inc. a premier business valuation firm located in Portland Oregon, and is the founder and Editor Emeritus of Business Valuation Resources, LLC. Over a distinguished career of close to four decades, he has performed valuation engagements for M&A, ESOPs, gift and estate taxation, marital dissolution, shareholder oppression and dissent, and numerous other purposes. He has conducted numerous fairness and solvency opinions, has testified in a wide variety of federal and state courts across the country, and frequently participates in arbitration and mediation proceedings. Dr. Pratt is one of the most successful and respected authors in his field. He is the author or coauthor of several industry standards, including Valuing a Business: The Analysis and Appraisal of Closely Held Companies, Valuing Small Businesses and Professional Practices, The Market Approach to Valuing Businesses, Standards of Value, Business Valuation and Taxes, The Lawyer's Business Valuation Handbook, and Cost of Capital.

• List of Exhibits xvForeword xixPreface xxiAcknowledgments xxvNotation System Used in This Book xxviiIntroduction xxxiPart I. Defining Market Multiples and Market Approach Methods 11. Defining Market Value Multiples 3Common Equity Only versus Total Invested Capital Multiples 5Computing Market Value of Equity Multiples 9Commonly Used Market Value of Equity Multiples 10Computing Market Value of Invested Capital (MVIC) Multiples 15Commonly Used MVIC Multiples 17Time Periods to Measure Financial Variables 22Relationship between Market Multiples and Capitalization Rates 23Summary 232. The Guideline Public Company Method 25Scope of Market 26Availability of Public Company Data 26Analytical Data for Public Companies 29The Guideline Public Company Basic Procedure 31Premiums and Discounts 33Summary 343. The Guideline Transaction (Merged and Acquired Company) 35MethodDifferences in Transaction Structure 36Scope of Market 38Availability of Merged and Acquired Company Transaction Data 38How Far Back in Time Are Transactions Relevant? 40The Guideline Merger and Acquisition Basic Procedure 41Premiums and Discounts 41Summary 42ix4. Other Market Methods 44Past Transactions 44Offers to Buy 46Rules of Thumb 46Buy-Sell Agreements 48Summary 49Part II. Finding and Analyzing Comparative Market Transaction Data 515. Finding Public Company Market Transaction Data 53Edgar 54Secondary Sources for SEC Reporting Companies 54Publicly Registered Limited Partnership Data 55Sources for Nonreporting Companies 55Summary 566. Finding Merger and Acquisition Market Data 57Large Transactions 58Middle Market and Small Transactions 63Very Small Transactions 69Summary 747. Adjusting Financial Statements 76Choosing the Time Periods for Comparative Statements 77Objectives of Financial Statement Adjustments 78Adjustments for Nonoperating or Excess Assets 79Nonrecurring Items 81Adjustments for Accounting Comparability 83Adjustments for “Insider” Anomalies 84Adjustments for Income Taxes in Pass-through Entities 85and S Corporations Summary 858. Comparative Financial Analysis 87Types of Comparative Financial Analysis 88Sources of Comparative Financial Analysis 89Types of Ratios 101Summary 117Part III. Compiling Market Value Tables and Reaching a Value Conclusion 1219. Compiling Useful Market Value Tables 123Two Distinct Alternatives in Market Multiples 124Examples of Market Value Tables 125Summary 13310. Selecting, Weighting, and Adjusting Market Value Multiples 137Size and Nature of Company 137Availability of Data 139Dispersion of Market Value Multiples 139The Harmonic Mean as a Measure of Central Tendency 139Adjusting from Observed Market Value Multiples 140Illustrative Estimate of Value Using Mathematical Weighting 141Summary 14211. Control Premiums and Minority Discounts 143Prerogatives of Control Ownership 144Quantifying Control Premiums and Minority Discounts 145How the Standard of Value Affects Control Premiums and/or Minority Discounts 148The Control versus Minority Issue Covers a Spectrum 150Summary 15112. Discounts for Lack of Marketability 153Defining Discount for Lack of Marketability 153Applying the Discount for Lack of Marketability 154Market Evidence Regarding the Discount for Lack of Marketability for Minority Interests 155Regulatory and Court Acceptance of Empirical Lack of Marketability Studies 158Factors Affecting Magnitudes of Marketability Discounts 162Discounts for Lack of Marketability for Controlling Interests 163Summary 163Part IV. Sample Market Approach Cases 16713. Small-size Service Company Sample Case: Sub Shop 169Business Description 169Valuation Assignment 170Economic Outlook 170Financial Statement Analysis 170Identification and Selection of Market Data 177Identification and Selection of Valuation Multiples 188Valuation of Wildcat Subs 190Reconciling Value Conclusions 194Addendum if Valuing for Other Purposes 19414. Medium-size Service Company Sample Case— Software Developer 195Valuation Assignment 196Economic Outlook 197Fundamental Position of the Company 198Selection of Market Data 200Financial Statement Analysis 203Identification and Application of Valuation Multiples 221Valuation of Colossal Software 232Part V. Important Aspects of Using the Market Approach 23915. Reconciling Market Approach Values with Income and Asset Approach Values 241Did We Appraise the Correct Property? 241Conformance to the Required Definition of Value 242Relative Adequacy and Reliability of Data 242Check for Errors 243Check Assumptions 243Relationship between Market Multiples and Discount or Capitalization Rates 243What to Do When Reconciliation Efforts Fail 247Explicit versus Implicit Weighting 249Summary 25016. Does Size Matter? Evidence from Empirical Data 252Evidence from Market Approach Data 252Evidence from Income Approach Data 255Summary 26217. Common Errors in Implementing the Market Approach 263Inadequate Selection of Guideline Companies 264Indiscriminate Use of Average (or Median) Multiples 265Failing to Consider Guideline Company Financial Statement Adjustments 265Failure to Conduct a Site Visit and Management Interviews 266Making Inappropriate or Unsupported Financial Statement Adjustments 267Applying Multiples to Inconsistently Defined Data 268Failure to Match Time Periods 268Reliance on Rules of Thumb 269Failure to Account for Excess or Deficient Cash 270Failure to Adjust for Differences in Deal Terms and Structure 271“Assets Plus .” Rules 272Failing to Apply Appropriate Discounts and Premiums 272Summary 27318. The Dismal Track Record of U.S. Market Acquisitions 274Acquirers Tend to Overpay 274Why Buyers Overpay: The Hubris Effect 276The Frog-kissing Princess 278Summary 27919. The Market Approach in the Courts 280U.S. Tax Court 280Marital Dissolutions 286Bankruptcy 287Condemnation 288Dissenting Stockholder, Minority Oppression, and Other Shareholder Disputes 288Summary 292Appendixes 297Appendix A Bibliography 299Appendix B Data Resources 309Appendix c International Glossary of Business Valuation Terms 331Appendix d The Quantitative Marketability Discount Model 339Appendix E Pratt’s Stats™ Data Contributors 351Index 377