bv integrated theory
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Presentation of an "integrated theory" of business valuation -- found in Business Valuation: An Integrated Theory Second Edition (John Wiley & Sons, 2008) by Mercer and HarmsTRANSCRIPT
The Integrated Theory of Business ValuationZ. Christopher Mercer, ASA, CFA July 16, 2008
Disclaimer» The Information contained in this presentation is only intended for general
purposes.
» It is neither intended nor should it be construed as either legal, accounting, and/or tax advice nor as an opinion provided by the Consultants’ Training Institute (CTI), the National Association of Certified Valuation Analysts (NACVA), the presenter or the presenter’s firm.
» The material may not be applicable or suitable for the reader’s specific needs or circumstances.
» Readers/viewers may not use this information as a substitute for consultation with qualified professionals in the subject matter presented here.
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Z. Christopher Mercer, ASA, CFA» Z. Christopher Mercer is founder and chief executive officer of Mercer
Capital, a business valuation and investment-banking firm serving national and international clientele. Mr. Mercer is a member of the Editorial Advisory Board of Valuation Strategies, and he is a regular contributor to the Business Valuation Review
» Chris began his valuation career in the late 1970s. He has prepared, overseen, or contributed to more than 1,000 valuations for purposes related to M&A, litigation, and tax, among others. He is a prolific author on valuation-related topics and a frequent speaker on business valuation issues for national professional associations and other business and professional groups.
» Chris is the author of six books including Buy-Sell Agreements: Ticking Time Bombs or Reasonable Resolutions? (Peabody Publishing, LP, 2007), and Business Valuation: An Integrated Theory, Second Edition, which he co-authored with Travis Harms (John Wiley & Sons, Inc., 2008). He has also published scores of articles and given many speeches on topics related to business valuation and investment banking.
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So Many Questions
» When asking the wrong questions
Difficult to get the right answers
True in life, and in valuation
» Not so complicated if you ask the right questions
» Wrong questions lead to confusion between valuation results and economic inputs (or valuation drivers)
MarketabilityDiscounts
GuidelineMethod
Net AssetValue
ControlPremiums
Adjustments
MinorityInterestDiscount
Levels of
ValueRestricted
StockDiscounts
CF CF
r - gr - g
CAPM
Income Method
The UNINTEGRATED Theory of Business Valuation
V V ==So Many
So Many
Questions
Questions
(BVIT pp. 61-63)
(BVIT pp. 61-63)So Many
So Many
Questions
Questions
(BVIT pp. 61-63)
(BVIT pp. 61-63)
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An Integrated Theory of Business Valuation
Business Valuation: An Integrated TheoryBy Z. Christopher Mercer, ASA, CFA
and Travis W. Harms, CFA, CPA/ABV
Published by John Wiley & Sons, Inc. (2008)
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Page References on Slides Refer to this Book (BVIT)
So Many Answers
Integrated Theory of
Business Valuation
Integrated Theory of
Business Valuation
© Mercer Capital, 2008
Shareholder Level
Enterprise Levels
Controlling Interest Level
Marketable Minority Level
Nonmarketable Minority Level(Illiquid Minority Interests)
MarketabilityDiscount
MinorityDiscount
ControlPremium
(“As-If-Freely Traded”)
Foundation: Levels of Value
Strategic Control Value
Financial Control Value
Marketable Minority Level
Nonmarketable Minority Level
StrategicPremiums
MarketabilityDiscount
Expanded, Modified
FCP MID
(BVIT, p. 83)
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Enterprise vs. Shareholder Levels of Value
The value of a business enterprise is the present value
of its expected cash flows (or benefits) discounted to the present at an appropriate discount rate.
“Ultimately, of course, the value of the nonmarketable minority interest is the present value of the benefits it
will produce for its owner.” Pratt/Reilly/Schweihs, Chapter 17
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The Integrated Theory of Business Valuation
Focus on the cash flows of the enterprise for enterprise values and on the derivative,
shareholder level cash flows for shareholder level (minority interest) values
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Definition of Value / DCF
No one disagrees with this
CF1 CF2 CFn
(1+r)1 (1+r)2 (1+r)n ++ + ...Value = V0
=
(BVIT, p. 2)
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Gordon Growth Model
CF1
r - gVo =
Taken for granted
(BVIT, p. 3)
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General Valuation Model
Value = Earnings x Multiple
(BVIT, p. 3)
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DCF = Gordon
CF0(1+g) CF0(1+g)2 CF0(1+g)n
CF1
(1+r)1 (1+r)2 (1+r)n r - g++ + ... =V0
=
g = constant
CF = 100% distributed
(BVIT, p. 4)
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Gordon Dividend Growth Model
D1
r - gd
Po =
D1 = DPO x CF1
(BVIT, p. 10)
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gv …a Function of Dividends
D1
P0
= Growth in Value + Dividend Yield
r = gv +
Two Sources of Returns
(BVIT, p. 11)
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Reinvestment Impact on Growth in Value
$0
$10
$20
$30
$40
$50
$60
$70
0 1 2 3 4 5 6 7 8 9 10Years
Value (Gv = r) Value (Gv = Ge) Poly. (Value (Gv = r)) Poly. (Value (Gv = Ge))
Growth at the core growth rate of earnings (10%) yields value of $16.1 million at the end of Year 5 (equivalent t DPO = 100%). Growth at the discount rate of 20% (DPO = 0%) yields Year 5 value of $24.9 million. The difference ($8.8 million) reflects the future value of reinvested cash flows. The relative importance of reinvestment decisions increases with time.
Exp
ecte
d F
utu
re V
alu
e ($
Mill
ion
s)
5 Years
(BVIT, p. 14)
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Does r relate to Net Income or to Net Cash
Flow?
The measure of net cash flow is determined by
distribution policy (DPO, or its result, the Earnings Retention
Rate)
Earnings D1 Earnings * DPO CF1
r - ge r - gd r - gd r - gcf
=V0 = = =
(BVIT, p. 20)
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» 4 key decisions
» Define Net Cash Flow
» What is ge?
» What is gCF?
» Net Income or Net Cash Flow
DCF
Single period income capitalization
Question: Net Income or Net Cash Flow?
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Business Owners Make One of Four Decisions Each Period
» Distribute all cash flows or earnings to the owners; or,
» Retain all cash flows or earnings in the business and reinvest them; or,
» Distribute a portion of cash flows and retain (reinvest) the rest; or,
» Repurchase shares (which, for our purposes, is analogous to a distribution)
Distribution Policy Determines Net Cash Flow
(BVIT, p. 21)
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What Is Net Cash Flow?
Net Income (after taxes)
+ Noncash Charges (depreciation and amortization and possibly, deferred taxes) - Net Capital Expenditures (new purchases of fixed assets less disposals)+/- Incremental Changes in Working Capital+/- Net Changes in Long-Term Debt (or, perhaps, total debt, depending on capital structure)
= Net (Free) Cash Flow
(BVIT, p. 22)
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What is ge?
» ge is the constant, long-term growth of net
earnings available to a business that
distributes all reported earnings each year
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Key Assumptions of ge?
» Capital expenditures are assumed equal to depreciation. To the extent that current capital expenditures are more productive than the machinery or equipment that they replace, some growth can occur.
» Inflationary price increases are achieved to the extent they are achievable over time.
» Productivity enhancements are also captured to the extent available over time.
» Incremental working capital requirements are assumed to be negligible, with incremental assets being financed by incremental liabilities.
(BVIT, p. 21)
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Expected Net Income vs. Expected Net Cash Flow
$0.00
$2.00
$4.00
$6.00
$8.00
$10.00
$12.00
$14.00
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Years
Exp
ecte
d N
I or
NC
F (
$ M
illio
ns)
Net Income Net Cash Flow
Investors expect to achieve a rate of return on reinvested earnings equal to the discount rate. Any lower return would call for current distribution. In the graph below, Earnings begin in Year 1 at $1.0 million. Continuing our example:
Net Income is forecasted based on (r = 20%) and (ge = 10%) and Stategy 1: (DPO = 100%) . With no earnings retentnion, investor achieves current return (10%) plus long-term, core growth in earnings (10%), or a return equal to the discount rate.
Net Cash Flow is forecasted based on the same discount rate, but Strategy 2: (DPO = 25%). Therefore (g* = gcf = 12.5%). The investor receives a current return of 7.5%, but is compensated with higher future growth (12.5%), thereby achieving a return equal to the discount rate.
Investors are assumed indifferent between the two strategies, since both yield a return of 20%. However, the second strategy generates lower current yield, but more robust capital apreciation as the compounding effects of reinvestments accumulate.
Net Income
Less CF Today
Net CF
More CF Tomorrow
(BVIT, p. 23)
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G Growth
R Risk & Reward
A Alternative Investments
P Present Value
E Expectations
S Sanity, Rationality, and Consistency
Organizing Principles of Business Valuation
(BVIT, Ch. 2)
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Polling Question One
Please rate your experience in the field of business valuation.
» A. None
» B. Nominal
» C. Modest
» D. Seasoned
» E. Well-Oiled
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The Enterprise Levels of Value
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The Enterprise Levels of Value
The value of a business enterprise is the:
» Present value of the
» Expected, and potentially
» Growing, future cash flows of the business.
These cash flows are discounted in a
» Sane, rational, and consistent manner, weighing the relevant
» Risks and rewards in the context of available
» Alternative investments.
CF1 CF2 CFn
(1+r)1 (1+r)2 (1+r)n++ +
...
Value = V0
=
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The Integrated Theory Enlightens» Valuation Premiums and Discounts
» Meaning and Interpretation of Ge
» Net income or net cash flow
Which to capitalize/discount when?
Does R relate to net income or net cash flow?
» Normalizing adjustments and the prerogatives of control
» Nature of control premiums
» Deriving Marketability Discounts
» Valuing S Corporations
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Focus of Questions: Value Trilogy
» Value/result is a function of expected Cash Flow Risk Growth
» Focus of questions should be on value drivers ofCash Flow, Risk and Growth
CF1
r- geV0
=
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Vmm
CFe(mm)
Rmm- Gmm
MarketableMinority
ConceptualConceptual Key Key Value Value MathMath Relationships Relationships ImplicationsImplications
GV = Rmm – Div Yld
Cash flow of the enterprise represents normalized cash flow, adjusting for non-recurring items and discretionary expenses
above market levels. Otherwise, the resulting valuation indication would not be marketable minority. Such
adjustments are not control adjustments in the context of the Integrated Theory.
Enterprise Levels: Marketable Minority (BVIT, p. 67)
The Enterprise Levels of Value
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Conceptual Math Relationships Value Implications
CFe(c,s) ≥ CFe(c,f)
Gs ≥ 0 Ve(c,s) ≥ Ve(c,f)
Rs ≤ Rmm
CFe(c,f) ≥ CFe(mm)
Gf ≥ 0 Ve(c,f) ≥ Vmm
Rf = Rmm (+/- a little)
Gv = Rmm - Div YldMarketable
Minority Value
CFe(mm)
Rmm - Gmm
Vmm is the
benchmark for the other levels
Strategic Control Value
CFe(c,s)
Rs - [Gmm + Gs]
Financial Control Value
CFe(c,f)
Rf - [Gmm + Gf]
(BVIT, p. 85)
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Prerogatives of Control» Right to declare dividends
» Right to select officers
» Right to choose business strategies
» Right to … (it is a long list)
» Where do these “prerogatives” come from? Corporate Charter
Articles of Incorporation
By-Laws
Other Agreements
» What are they?
Intangible assets of the enterprise
(BVIT, p. 78)
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Enterprise ValuationInsights into Key Questions» Value CF of private company in relationship to
public securities markets
What is cash flow?
Normalized cash flow using appropriate normalizing adjustments
» Determine r for private company in relationship to public securities markets
How and whether to adjust r?
Fundamental adjustments
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Normalizing Adjustments
» Two kinds of normalizing adjustments
Type 1Type 1Eliminate one-time gains or losses, other unusual items, non-recurring business elements, adjust for expenses of non-operating assets, and the like
Type 2Type 2Normalize officer/owner compensation to levels of comparable companies and adjust for other discretionary expenses that likely would not exist in a well-run publico
Must make, even in minority interest appraisals!
(BVIT, p. 110)
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Fundamental Adjustments
CFCFmmmm
RRmmmm - - GGmmmm
VmmVmm====
CFCFprivate, private,
normalizednormalized
RRprivateprivate - - GGprivateprivate
VVprivateprivateVVprivateprivate====
We look at We look at public public
companies .companies .....
… … to value to value private private
companiescompanies
(BVIT, Ch. 5)
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Fundamental Adjustments
RRprivate private RRmmmm==
» Often, private company is riskier than public guidelines
» Have concept of Small Company Stock Risk Premium (SSR) or, more broadly, the size premium, and the Specific Company Risk (SCR) in ACAPM
<<>>
(BVIT, Ch. 5)
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Fundamental Adjustments
GGprivate private GGmmmm==
» Often, the realistic expectations for growth of subject are less than expected growth rate imbedded in public company pricing
» Must be careful to compare expectations, which in public arena sometimes bear little resemblance to the recent past
<<>>
(BVIT, Ch. 5)
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Fundamental Adjustments - Example
FundamentalFundamental PublicPublic PrivatePrivateAdjustments Adjustments AA B B
RiskRisk 0%0% 2%2% Greater riskGreater risk
Expected Expected Growth Growth 10%10% 6%6% Slower growthSlower growth
Base RBase R 18%18% 18%18% Same base RSame base R
Adjusted RAdjusted R 20%20%(R - G)(R - G) 8%8% 14%14% Higher Cap FactorHigher Cap Factor
MultipleMultiple 12.5x12.5x 7.1x7.1x Lower multipleLower multiple
43% FundamentalDiscount
(BVIT, p. 136)
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Polling Question Two
Which Mercer Capital books are currently in your library
» A. Business Valuation: An Integrated Theory
» B. Quantifying Marketability Discounts
» C. Buy-Sell Agreements: Ticking Time Bombs or Reasonable Resolutions?
» D. More than one of the above
» E. None of the above
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The Shareholder Levels of Value
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The Shareholder Level of Value
The value of a shareholder interest in a business enterprise is the:
» Present value of the
» Expected, and potentially
» Growing, future cash flows attributable to the subject interest.
These cash flows are discounted in a
» Sane, rational, and consistent manner, weighing the relevant
» Risks and rewards in the context of available
» Alternative investments.
CFsh1 CFsh2 CFshn
(1+Rhp)1 (1+Rhp)2 (1+Rhp)n+ + +
...
Value = Vsh
=
(BVIT, p. 190)
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The Shareholder Level of Value
Conceptual Math Relationships Value Implications
Gv = Rmm - Div Yld
CFsh ≤ CFe(mm)
Gv ≤ Rmm - Div Yld Vsh ≤ Vmm
Rhp ≥ Rmm
MarketableMinority Value
CFe(mm)
Rmm - Gmm
Vmm is the
benchmark for the other levels
NonmarketableMinority Value
CFsh
Rhp - Gv
(BVIT, p. 92)
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The Theory & the Math
Enterprise LevelsValue is a function of the Expected Cash Flows to equity of the
Enterprise (as capitalized by the public markets or controlling buyers)
Shareholder LevelValue is a function of the Cash Flows expected by Shareholders from
their Interests in the Enterprise (which are derived from the cash flows of the Enterprise, but may not be the same)
Nonmarketable Minority Value
Strategic Control Value
Financial Control Value
Marketable Minority Value
(BVIT, p. 88)
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The Theory & the Math
Conceptual Math Relationships Value Implications
CFe(c,s) ≥ CFe(c,f)
Gs ≥ 0 Ve(c,s) ≥ Ve(c,f)
Rs ≤ Rmm
CFe(c,f) ≥ CFe(mm)
Gf ≥ 0 Ve(c,f) ≥ Vmm
Rf = Rmm (+/- a little)
Gv = Rmm - Div Yld
CFsh ≤ CFe(mm)
Gv ≤ Rmm - Div Yld Vsh ≤ Vmm
Rhp ≥ Rmm
Vmm is the
benchmark for the other levels
MarketableMinority Value
CFe(mm)
Rmm - Gmm
NonmarketableMinority Value
CFsh
Rhp - Gv
Strategic Control Value
CFe(c,s)
Rs - [Gmm + Gs]
Financial Control Value
CFe(c,f)
Rf - [Gmm + Gf]
(BVIT, p. 98)
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What is a Marketability Discount Applicable to a Controlling Interest?
Conceptual Math Relationships Value Implications
CFe(c,s) ≥ CFe(c,f)
Gs ≥ 0 Ve(c,s) ≥ Ve(c,f)
Rs ≤ Rmm
CFe(c,f) ≥ CFe(mm)
Gf ≥ 0 Ve(c,f) ≥ Vmm
Rf = Rmm (+/- a little)
Gv = Rmm - Div Yld
CFsh ≤ CFe(mm)
Gv ≤ Rmm - Div Yld Vsh ≤ Vmm
Rhp ≥ Rmm
Vmm is the
benchmark for the other levels
MarketableMinority Value
CFe(mm)
Rmm - Gmm
NonmarketableMinority Value
CFsh
Rhp - Gv
Strategic Control Value
CFe(c,s)
Rs - [Gmm + Gs]
Financial Control Value
CFe(c,f)
Rf - [Gmm + Gf]
(BVIT, p. 94-98)
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What is a Marketability Discount Applicable to a Controlling Interest?
» Common “Reasons”
Uncertain time horizon to complete the offering or sale
Cost to prepare for and execute the offering or sale
Risks concerning eventual sale price
Noncash and deferred transaction proceeds
Inability to hypothecate
(BVIT, p. 94-98)
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What is a Marketability Discount Applicable to a Controlling Interest?» What gives rise to the value of a business?
Present value of expected cash flows discounted to the present at an appropriate discount rate
» Who controls the cash flows during the period of marketing a business?
The controlling shareholder(s)
» What is the economic basis for a so-called “marketability discount for controlling interests”?
There is none
Consider the value drivers of expected cash flow, risk and growth
(BVIT, p. 94-98)
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The Integrated Theory Enlightens» Valuation Premiums and Discounts (another session)
» Meaning and Interpretation of Ge
» Net income or net cash flow
Which to capitalize/discount when?
Does R relate to net income or net cash flow?
» Normalizing adjustments and the prerogatives of control
» Nature of control premiums (another session)
» Deriving Marketability Discounts
» Valuing S Corporations
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Polling Question Three
Have you used the QMDM as a primary or secondary valuation method?
» A. Yes
» B. No
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1. Deriving Marketability Discounts
The Integrated Theory in Practice
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Theory in Practice» The Integrated Theory supports use of the income approach to directly
value the subject nonmarketable minority interest (in the context of the existing enterprise valuation)
» The asset approach seldom makes sense in valuing minority interests (except as a step along the way, e.g., to arrive at net asset value)
» Attempts at using the market approach will fail because of lack of sufficiently comparable and timely transactional data for minority interest transactions
“Benchmarking” is a very weak form of the market method
FMV Restricted Stock Study is a weak form of the market method
Pre-IPO studies are also a weak form of the market method
» The discounted cash flow model is the best tool to analyze the following question: What motivates hypothetical willing buyers and sellers of minority interests? In other words, what does available market evidence mean?
(BVIT, p. 170-172) (also, p. 185-188)
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Critical Insight
» In the Integrated Theory, the marketability discount is appropriately viewed as descriptive of the relationship between the marketable minority and nonmarketable minority values, not determinative of that relationship
» The marketability discount is a valuation result, not a valuation driver
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Understanding the QMDM» The QMDM is a shareholder-level discounted cash
flow model consistent with the Integrated Theory
It is inextricably linked to the enterprise valuation, since the shareholder cash flows are derived from (alternatively, are a subset of) the enterprise cash flows
The value of any business is a function of its expected cash flows, risks, and expected growth
The value of an interest in a business is a function of its expected cash flows (derived from the enterprise cash flows), risks (in addition to those of the enterprise), and expected growth (in the value of the enterprise)
(BVIT, p. 172)
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Challenges
» What are the three most important elements of an income approach
To value businesses
To value non-marketable minority interests in businesses
» Assumptions
» Assumptions
» Assumptions
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Polling Question Four
What is your opinion regarding the use of normalizing adjustments for owner compensation in minority interest appraisals
» A. They are appropriate/necessary
» B. They are inappropriate
» C. It depends on the facts and circumstances
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DCF vs. QMDM
QMDM DCF
1. Gv
2. D%
3. GD%
4. Holding Period Forecast Period
5. RHP R
The DCF Forecast
Interim CF + Growth
Selection of TV
(BVIT, p. 173-174)
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“Criticisms” of the QMDM
» Must make assumptions
» Sensitive to assumptions
» Must make assumptions re: expected holding period
» Appraiser must select a marketability discount within a range
» Must estimate holding period premium to develop discount rate
» Complicated
Legitimate?
No
No
No
No
No
No
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Expected Returns from Restricted Stock Discounts
1. What does RSD tell us? Nothing
2. What do lots of RSD’s tell us? Nothing
Pmm
Prs
$1.00
$0.70
RSD = 30%
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Expected Returns from Restricted Stock Discounts
Pmm
Prs
$1.00
$0.70
4. Implies RHP > R
5. $1.00 = $0.70 + $0.30 and $0.70 = $1.00 - $0.30
0 1 2 3 4
3. Transactions occurred at discounts
2. Rule 144 required 2 year minimum holding period
1. Value isExpected to grow
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Pmm
Prs
RSD = 30%
$1.00
$1.10
$1.21
$1.32
$1.46
gv = 10%
$0.70(PV) 31.5%
2 Years RHP(2)
20.2% 4 Years RHP(4)
23.5% 3 Years RHP(4)
Expected Future Values
Expected Returns from Restricted Stock Discounts
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Restricted Stock Discounts (and Marketability Discounts) are NOT Economic Drivers
» RSV = MMV * (1 - RSD)
» MMV = CFmm / r - ge
» RSV = CFsh / Rhp - gv
» CFsh = CFmm * 1 - RSD
Rhp - gv R - ge
Restricted Stock Discounts equate differing views of value, i.e., value from the perspective of the public markets and value to holders of illiquid interests
RSD’s reflect observed differences in economic thinking and not the economics behind that thinking
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Enterprise Assumptions
» Earnings = $0.10
» R = 16.0%
» Ge = 6.0%
» V = $0.10
= $1.00
» Use Gordon Model to summarize an enterprise DCF valuation
16.0% - 6.0%
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Shareholder Level DCF (QMDM) Inputs1. Expected Holding Period 10 years2a. Expected Distribution / Dividend Yield 10.0%2b. Expected Growth in Distributions / Dividends 6.0%2c. Timing (Mid-Year or End of Year) End3a. Growth in Value over Holding Period 6.0% $1.7913b. Premium/Discount to Projected Enterprise Value 0.0% $1.6894. Required Holding Period Return 16.0% $1.594
$1.504$1.419
$1.338$1.262
$1.191$1.124
Enterprise Value $1.060Normalized to $1.00 $1.000
(MM Value)
Interim Dividends / Distributions (Interim Cash Flows)$0.100 $0.106 $0.112 $0.119 $0.126 $0.134 $0.142 $0.150 $0.159 $0.169
0 1 2 3 4 5 6 7 8 9 10
Discount Periods (Interim Cash Flows) 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00 10.00PV Factors (Interim Cash Flows) 0.8621 0.7432 0.6407 0.5523 0.4761 0.4104 0.3538 0.3050 0.2630 0.2267PV Factor (Terminal Value) 0.2267 Nonmarketable Minority Value Present Value of Interim Cash Flows and Terminal Value
PVICF $0.594 59.4% $0.086 $0.079 $0.072 $0.066 $0.060 $0.055 $0.050 $0.046 $0.042 $0.038PVTV $0.406 40.6% $0.406
NMM Value $1.000 100.0%
Derivation of Marketability DiscountMarketable Minority Value (Enterprise Value) $1.000Less: Nonmarketable Value (Shareholder Value) $1.000Marketability Discount ($) $0.000Marketability Discount (%) 0.0%
Shareholder = Enterprise
Base Case
(BVIT, p. 179)
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Shareholder Level DCF (QMDM) Inputs1. Expected Holding Period 10 years2a. Expected Distribution / Dividend Yield 10.0%2b. Expected Growth in Distributions / Dividends 5.0%2c. Timing (Mid-Year or End of Year) End3a. Growth in Value over Holding Period 5.0% $1.6293b. Premium/Discount to Projected Enterprise Value 0.0% $1.5514. Required Holding Period Return 16.0% $1.477
$1.407$1.340
$1.276$1.216
$1.158$1.103
Enterprise Value $1.050Normalized to $1.00 $1.000
(MM Value)
Interim Dividends / Distributions (Interim Cash Flows)$0.100 $0.105 $0.110 $0.116 $0.122 $0.128 $0.134 $0.141 $0.148 $0.155
0 1 2 3 4 5 6 7 8 9 10
Discount Periods (Interim Cash Flows) 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00 10.00PV Factors (Interim Cash Flows) 0.8621 0.7432 0.6407 0.5523 0.4761 0.4104 0.3538 0.3050 0.2630 0.2267PV Factor (Terminal Value) 0.2267 Nonmarketable Minority Value Present Value of Interim Cash Flows and Terminal Value
PVICF $0.573 60.8% $0.086 $0.078 $0.071 $0.064 $0.058 $0.052 $0.047 $0.043 $0.039 $0.035PVTV $0.369 39.2% $0.369
NMM Value $0.943 100.0%
Derivation of Marketability DiscountMarketable Minority Value (Enterprise Value) $1.000Less: Nonmarketable Value (Shareholder Value) $0.943Marketability Discount ($) $0.057Marketability Discount (%) 5.7%
Suboptimal Reinvestment Only
(BVIT, p. 181)
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Shareholder Level DCF (QMDM) Inputs1. Expected Holding Period 10 years2a. Expected Distribution / Dividend Yield 10.0%2b. Expected Growth in Distributions / Dividends 5.0%2c. Timing (Mid-Year or End of Year) End3a. Growth in Value over Holding Period 5.0% $1.6293b. Premium/Discount to Projected Enterprise Value 0.0% $1.5514. Required Holding Period Return 16.0% $1.477
$1.407$1.340
$1.276$1.216
$1.158$1.103
Enterprise Value $1.050Normalized to $1.00 $1.000
(MM Value)
Interim Dividends / Distributions (Interim Cash Flows)$0.100 $0.105 $0.110 $0.116 $0.122 $0.128 $0.134 $0.141 $0.148 $0.155
0 1 2 3 4 5 6 7 8 9 10
Discount Periods (Interim Cash Flows) 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00 10.00PV Factors (Interim Cash Flows) 0.8621 0.7432 0.6407 0.5523 0.4761 0.4104 0.3538 0.3050 0.2630 0.2267PV Factor (Terminal Value) 0.2267 Nonmarketable Minority Value Present Value of Interim Cash Flows and Terminal Value
PVICF $0.573 60.8% $0.086 $0.078 $0.071 $0.064 $0.058 $0.052 $0.047 $0.043 $0.039 $0.035PVTV $0.369 39.2% $0.369
NMM Value $0.943 100.0%
Derivation of Marketability DiscountMarketable Minority Value (Enterprise Value) $1.000Less: Nonmarketable Value (Shareholder Value) $0.943Marketability Discount ($) $0.057Marketability Discount (%) 5.7%
Incremental Risk Only20.3%
6.0%
6.0%
20%
(BVIT, p. 183)
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Shareholder Level DCF (QMDM) Inputs1. Expected Holding Period 10 years2a. Expected Distribution / Dividend Yield 10.0%2b. Expected Growth in Distributions / Dividends 5.0%2c. Timing (Mid-Year or End of Year) End3a. Growth in Value over Holding Period 5.0% $1.6293b. Premium/Discount to Projected Enterprise Value 0.0% $1.5514. Required Holding Period Return 20.0% $1.477
$1.407$1.340
$1.276$1.216
$1.158$1.103
Enterprise Value $1.050Normalized to $1.00 $1.000
(MM Value)
Interim Dividends / Distributions (Interim Cash Flows)$0.100 $0.105 $0.110 $0.116 $0.122 $0.128 $0.134 $0.141 $0.148 $0.155
0 1 2 3 4 5 6 7 8 9 10
Discount Periods (Interim Cash Flows) 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00 10.00PV Factors (Interim Cash Flows) 0.8333 0.6944 0.5787 0.4823 0.4019 0.3349 0.2791 0.2326 0.1938 0.1615PV Factor (Terminal Value) 0.1615 Nonmarketable Minority Value Present Value of Interim Cash Flows and Terminal Value
PVICF $0.491 65.1% $0.083 $0.073 $0.064 $0.056 $0.049 $0.043 $0.037 $0.033 $0.029 $0.025PVTV $0.263 34.9% $0.263
NMM Value $0.754 100.0%
Derivation of Marketability DiscountMarketable Minority Value (Enterprise Value) $1.000Less: Nonmarketable Value (Shareholder Value) $0.754Marketability Discount ($) $0.246Marketability Discount (%) 24.6%
Suboptimal Reinvestment and Incremental Risk
(BVIT, p. 177)
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( 1 ) ( 2 ) ( 3 ) ( 4 )
Years 10 10 10 10
2a. Expected Distribution / Dividend Yield Yield 10.0% 10.0% 10.0% 10.0%
2b. Expected Growth in Distribution / Div. Yield Growth 6.0% 5.0% 6.0% 6.0%
2c. Timing (Mid-Year or End of Year) Timing E E E E
3a. Growth in Value over Holding Period Gv 6.0% 5.0% 6.0% 6.0%
3b. Premium or Discount to Marketable Value Prem/Disc. 0.0% 0.0% 0.0% 0.0%
Low 16.0% 16.0% 20.0% 20.0%
Marketability Discount 0.0% 5.7% 20.3% 24.6%
( 1 ) Enterprise Value (Figure 7-6)
( 2 ) Suboptimal Reinvestment Only (Figure 7-7)
( 3 ) Incremental Risk Only (Figure 7-8)
( 4 ) Suboptimal Reinvestment and Incremental Risk (Figure 7-5)
1. Expected Holding Period
4. Required Holding Period Returns
Components of Marketability Discount
5.0%
5.0%
Yield
(BVIT, p. 184)
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USPAP SR 9-4(d)
» d) An appraiser must, when necessary for credible assignment results, analyze the effect on value, if any, of the extent to which the interest appraised contains elements of ownership control and is marketable and/or liquid.
Comment: An appraiser must analyze factors such as holding period, interim benefits, and the difficulty and cost of marketing the subject interest. Equity interests in a business enterprise are not necessarily worth the pro rata share of the business enterprise interest value as a whole. Also, the value of the business enterprise is not necessarily a direct mathematical extension of the value of the fractional interests. The degree of control, marketability and/or liquidity or lack thereof depends on a broad variety of facts and circumstances that must be analyzed when applicable.
(BVIT, p. 247)
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USPAP Requirements
» Analyze the effect on value, if any, on subject interest of ownership control and liquidity/marketabilty, including consideration (analysis) of:
1. Holding period. The expected (or estimated) duration of the investment – at which time liquidity is achieved
2. Interim benefits. Dividends or distributions expected to be received during the expected holding period
3. Difficulty and cost of marketing. The risks of the expected holding period or costs of information acquisition and monitoring that would cause the next buyer to reduce price relative to marketable minority value
4. Other relevant facts and circumstances
(BVIT, p. 247)
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QMDM and USPAP
Shareholder Level DCF (QMDM) Inputs) Addresses Factors ofUSPAP SR 9-4(d)?
2a. Expected Distribution / Dividend Yield Interim Benefits? Yes2b. Expected Growth in Distribution / Div. Yield (including amount, 2c. Timing (Mid-Year or End of Year) growth and t)iming3a. Growth in Value over Holding Period Holding Period? Yes3b. Premium or Discount to Marketable Value (what happens to value
over Holding Period)Cost and Difficulty of
Marketing? Yes
Holding Period? Yes1. Range of Expected Holding Periods (Years)
4. Range of Required Holding Period Returns
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Polling Question Five
Based on your experience, do you believe that S corporations are worth more than C corporations at the level of enterprise?
» A. S Corps are worth more than C Corps
» B. S Corps are worth the same as C Corps
» C. S Corps are worth less than C Corps
» D. No opinion
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2. Valuing Tax Pass-Through Entities
The Integrated Theory in Practice
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S Corporation Synthesis
Strategic Control Value
Strategic Control Value
Financial Control Value
Financial Control Value
MarketableMinority Value
MarketableMinority Value
NonmarketableMinority Value
NonmarketableMinority Value
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Strategic Control Value
Strategic Control Value
Financial Control Value
Financial Control Value
MarketableMinority Value
MarketableMinority Value
NonmarketableMinority Value
NonmarketableMinority Value
(+) f (High distribution, Risk)
(-) f (Low distribution, Risk)
C Corporation S Corporation
=
=
< = >
Value Differentials Between a C Corporation and an Otherwise Identical S Corporation
Strategic Control Value
Strategic Control Value
Financial Control Value
Financial Control Value
MarketableMinority Value
MarketableMinority Value
NonmarketableMinority Value
NonmarketableMinority Value
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Strategic Control Value
Financial Control Value
Financial Control Value
MarketableMinority Value
MarketableMinority Value
NonmarketableMinority Value
NonmarketableMinority Value
(+) f (High distribution, Risk)
(-) f (Low distribution, Risk)
C Corporation S Corporation
=
=
< = >
Value Differentials Between a C Corporation and an Otherwise Identical S Corporation
(BVIT, p. 254)
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Who Gets the S Corp Benefit?
» The appropriate valuation treatment of S corporations hinges upon an appropriate understanding of where the indisputable benefit of the S election resides
» While the legal obligation to pay taxes on the corporate earnings falls to the individual shareholders, the economic obligation remains with the corporation
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Legal vs. Economic Obligation
0% Economic Payout 50% Economic Payout 100% Economic PayoutC Corp S Corp C Corp S Corp C Corp S Corp
Taxable Corporate Income $100 $100 $100 $100 $100 $100Corporate Tax on Corporate Earnings 40.0% (40) 0 (40) 0 (40) 0Shareholder Tax on Corporate Earnings 40.0% 0 (40) 0 (40) 0 (40)Net Income Available for Economic Distributions $60 $60 $60 $60 $60 $60
Economic Payout Ratio 0% 0% 50% 50% 100% 100%Economic Distribution to Shareholders (Pre-tax) $0.0 $0.0 $30.0 $30.0 $60.0 $60.0Shareholder Tax on Economic Distribution (%) 15% 0% 15% 0% 15% 0%Shareholder Tax on Economic Distribution ($) 0.0 0.0 4.5 0.0 9.0 0.0
Economic Distribution to Shareholders (After-tax) $0.0 $0.0 $25.5 $30.0 $51.0 $60.0 Shareholder Level Benefit of S Corporation Election 0.0 4.5 9.0
Retained Corporate Earnings $60.0 $60.0 $30.0 $30.0 $0.0 $0.0 Enterprise Level Benefit of S Corporation Election 0.0 0.0 0.0
(BVIT, p. 256)
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Who Gets the S Corp Benefit?
» Because the economic obligation for corporate income taxes remains with the S corporation, the S Corp benefit ought to be reflected at the shareholder level of value rather than the enterprise level of value
» Notably, the Delaware Chancery Court identified this distinction in Kessler
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What are the S Corp Benefits?
» At the enterprise level:
Increased Cash Flow? No
Reduced Risk? No
Increased Growth Prospects? No
» At the enterprise level, S corporations are worth no more or less than otherwise identical C corporations based on the functional drivers of value
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What are the S Corp Benefits?» At the shareholder level:
Reduction in expected holding period? Probably not
Increase in interim cash flows? Perhaps, depending on distribution policy
Increase in projected terminal value? No, although net proceeds from sale of interest may be higher due to build-up of tax basis from undistributed earnings
Reduction in discount rate? Probably not, depending on risk that
S election will be broken and/or distributions will be insufficient to pay taxes
» At the shareholder level, the value of an S corporation interest may be worth more or less than an otherwise identical C corporation interest, depending on the distribution policy and unique risks
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Enterprise = Shareholder
DCF Assumptions Corresponding QMDM Assumptions Model InputsLow 10
High 10
Expected Distribution / Dividend Yield Yield 10.0%
Expected Growth in Distribution / Dividend Growth 6.0%
Timing (Mid-Year or End of Year) Timing E
Growth in Value over Holding Period Gv 6.0%
Premium or Discount to Marketable Value Prem/Disc. 0.0%
Low 16.0%
High 16.0%
Base Value (Marketable Minority Interest) $1.00
Forecast Period Range of Expected Holding Periods (Years)
Range of Required Holding Period ReturnsDiscount Rate
Projected Interim Cash Flows (during forecast period)
Projected Terminal Value (at end of forecast period)
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Enterprise = Shareholder (MD=0)Assumed Holding Periods in Years
1 2 3 4 5 6 7 8 9 10 15 20 25 30 16.0% Implied Marketability Discounts13.0% - - - - - - - - - - - - - - 14.0% - - - - - - - - - - - - - - 15.0% - - - - - - - - - - - - - - 16.0% - - - - - - - - - - - - - - 16.0% - - - - - - - - - - - - - - 16.0% - - - - - - - - - - - - - - 17.0% 1% 2% 2% 3% 4% 4% 5% 5% 5% 6% 7% 8% 8% 9%18.0% 2% 3% 5% 6% 7% 8% 9% 10% 10% 11% 13% 15% 16% 16%19.0% 3% 5% 7% 9% 10% 12% 13% 14% 15% 16% 19% 21% 22% 22%
PV=100%
RETURNS EXPECTED TO BE REALIZED OVER VARIOUS HOLDING PERIODS GIVEN MARKETABILITY DISCOUNT SELECTED1.00% Selected Discount Increment
Subsequent Holding Period in Years
1 2 3 4 5 6 7 8 9 10 15 20 25 30
-4.0% 12% 14% 14% 15% 15% 15% 15% 15% 15% 15% 15% 16% 16% 16%-3.0% 13% 14% 15% 15% 15% 15% 15% 15% 15% 16% 16% 16% 16% 16%-2.0% 14% 15% 15% 15% 15% 16% 16% 16% 16% 16% 16% 16% 16% 16%-1.0% 15% 15% 16% 16% 16% 16% 16% 16% 16% 16% 16% 16% 16% 16%0.0% 16% 16% 16% 16% 16% 16% 16% 16% 16% 16.0% 16% 16% 16% 16%1.0% 17% 17% 16% 16% 16% 16% 16% 16% 16% 16% 16% 16% 16% 16%2.0% 18% 17% 17% 17% 17% 16% 16% 16% 16% 16% 16% 16% 16% 16%3.0% 20% 18% 17% 17% 17% 17% 17% 17% 17% 17% 16% 16% 16% 16%4.0% 21% 19% 18% 17% 17% 17% 17% 17% 17% 17% 17% 16% 16% 16%
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C Corporation Suboptimal Reinvestment and Extra Risk
DCF Assumptions Corresponding QMDM Assumptions Model InputsLow 5
High 10
Expected Distribution / Dividend Yield Yield 10.0%
Expected Growth in Distribution / Dividend Growth 5.0% < 6.0%Timing (Mid-Year or End of Year) Timing E
Growth in Value over Holding Period Gv 5.0%
Premium or Discount to Marketable Value Prem/Disc. 0.0%
Low 20.0% > 16%%High 20.0%
Base Value (Marketable Minority Interest) $1.00
Forecast Period Range of Expected Holding Periods (Years)
Range of Required Holding Period ReturnsDiscount Rate
Projected Interim Cash Flows (during forecast period)
Projected Terminal Value (at end of forecast period)
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C Corporation Suboptimal Reinvestment and Extra Risk
Assumed Holding Periods in Years
1 2 3 4 5 6 7 8 9 10 15 20 25 30 20.0% Implied Marketability Discounts17.0% 2% 3% 5% 6% 7% 8% 9% 10% 10% 11% 13% 15% 16% 16%18.0% 3% 5% 7% 9% 10% 12% 13% 14% 15% 16% 19% 21% 22% 22%19.0% 3% 6% 9% 11% 13% 15% 17% 18% 19% 20% 24% 26% 27% 28%20.0% 4% 8% 11% 14% 16% 18% 20% 22% 23% 24.6% 29% 31% 32% 33%20.0% 4% 8% 11% 14% 16% 18% 20% 22% 23% 24.6% 29% 31% 32% 33%20.0% 4% 8% 11% 14% 16% 18% 20% 22% 23% 24.6% 29% 31% 32% 33%21.0% 5% 9% 13% 16% 19% 21% 24% 25% 27% 28% 33% 35% 36% 37%22.0% 6% 11% 15% 19% 22% 24% 27% 29% 31% 32% 37% 39% 40% 41%23.0% 7% 12% 17% 21% 24% 27% 30% 32% 34% 35% 40% 43% 44% 44%
PV=100%
RETURNS EXPECTED TO BE REALIZED OVER VARIOUS HOLDING PERIODS GIVEN MARKETABILITY DISCOUNT SELECTED1.00% Selected Discount Increment
Subsequent Holding Period in Years
1 2 3 4 5 6 7 8 9 10 15 20 25 30
20.6% 45% 30% 25% 23% 22% 21% 20% 20% 19% 19% 18% 18% 18% 18%21.6% 47% 31% 26% 23% 22% 21% 20% 20% 20% 19% 18% 18% 18% 18%22.6% 49% 32% 26% 24% 22% 21% 21% 20% 20% 20% 19% 18% 18% 18%23.6% 51% 32% 27% 24% 23% 22% 21% 20% 20% 20% 19% 18% 18% 18%24.6% 53% 33% 28% 25% 23% 22% 21% 21% 20% 20.0% 19% 19% 18% 18%25.6% 55% 34% 28% 25% 24% 22% 22% 21% 21% 20% 19% 19% 19% 19%26.6% 57% 35% 29% 26% 24% 23% 22% 21% 21% 21% 20% 19% 19% 19%27.6% 59% 36% 29% 26% 24% 23% 22% 22% 21% 21% 20% 19% 19% 19%28.6% 61% 37% 30% 27% 25% 24% 23% 22% 21% 21% 20% 19% 19% 19%
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S Corporation Suboptimal Reinvestment and Extra Risk
S Corporation Suboptimal Reinvestment and Extra RiskDCF Assumptions Corresponding QMDM Assumptions Model Inputs
Low 5
High 10
Expected Distribution / Dividend Yield Yield 11.76% 10% / (1 - 15%)Expected Growth in Distribution / Dividend Growth 5.0% (Suboptimal by 1%)Timing (Mid-Year or End of Year) Timing E
Growth in Value over Holding Period Gv 5.0% (Suboptimal by 1%)Premium or Discount to Marketable Value Prem/Disc. 0.0%
Low 19.0% > 16%%High 21.0%
Base Value (Marketable Minority Interest) $1.00
Tax Pass-Thru Assumptions Distribute 100% of Earnings to ShareholdersPre-Tax Earnings Growth Rate 6.0% Personal Capital Gains Rate 15.0%
Assumed Corporate Federal Tax Rate 40.0%
Distribution Payout % of Earnings 100.0% Required Holding Period Return 20.0%
(normally the average of the range above)
Ongoing/Expd Net Income P/S $0.10 Marketable Minority Value Per Share (or Unit) $1.00
Forecast Period Range of Expected Holding Periods (Years)
Range of Required Holding Period ReturnsDiscount Rate
Projected Interim Cash Flows (during forecast period)
Projected Terminal Value (at end of forecast period)
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Distribute 100% of Earnings to Shareholders
Assumed Holding Periods in Years
1 2 3 4 5 6 7 8 9 10 15 20 25 30 20.0% Implied Marketability Discounts16.0% - - - - - - - - - - - - - - 17.0% 0% 0% 1% 1% 1% 1% 1% 1% 1% 1% 2% 2% 2% 2%18.0% 1% 2% 3% 4% 4% 5% 5% 6% 6% 7% 8% 9% 9% 9%19.0% 2% 4% 5% 6% 7% 8% 9% 10% 11% 11.4% 14% 15% 15% 16% Assuming Same20.0% 3% 5% 7% 9% 11% 12% 13% 14% 15% 15.9% 19% 20% 21% 21% Risk as C Corp21.0% 4% 7% 9% 11% 13% 15% 17% 18% 19% 20.1% 23% 25% 26% 26% Have Lower MD22.0% 4% 8% 11% 14% 16% 18% 20% 22% 23% 24% 28% 29% 30% 30% 15.9% vs. 24.6%23.0% 5% 9% 13% 16% 19% 21% 23% 25% 26% 28% 31% 33% 34% 34% If increase Rhp by 2.2%,24.0% 6% 11% 15% 19% 22% 24% 26% 28% 30% 31% 35% 37% 37% 38% MD is same as for C Corp
PV=100%
Potential Adjustment to the Marketability Discount Resulting from Basis Build-Up Over Expected Holding Periods
1 2 3 4 5 6 7 8 9 10 15 20 25 30
Pre-Tax Income $0.167 $0.177 $0.187 $0.199 $0.210 $0.223 $0.236 $0.251 $0.266 $0.282 $0.38 $0.50 $0.67 $0.90
Net Distribution (0.167) (0.177) (0.187) (0.199) (0.210) (0.223) (0.236) (0.251) (0.266) (0.282) (0.38) (0.50) (0.67) (0.90)
Retained Earnings $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.00 $0.00 $0.00 $0.00Cum. Basis Build-Up $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.00 $0.00 $0.00 $0.00
Cum. Tax Savings $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.00 $0.00 $0.00 $0.00
PV Factors 0.8333 0.6944 0.5787 0.4823 0.4019 0.3349 0.2791 0.2326 0.1938 0.1615 0.0649 0.0261 0.0105 0.0042
PV of Tax Shelter $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.00 $0.00 $0.00 $0.00Potential MD Adj. 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
No Basis Build-up
Average Shelter for the Expected Holding Period Relative to $1.00 of Marketable Minority ValueAverage Potential Adjustment to Marketability Discount To be considered in final determination of discount
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C Corporation – No Dividend
DCF Assumptions Corresponding QMDM Assumptions Model InputsLow 5
High 10
Expected Distribution / Dividend Yield Yield 0.00%
Expected Growth in Distribution / Dividend Growth 0.0% (Adj. for Payout %)Timing (Mid-Year or End of Year) Timing E
Growth in Value over Holding Period Gv 15.0% (Suboptimal by 1%)Premium or Discount to Marketable Value Prem/Disc. 0.0%
Low 19.0% > 16%High 21.0%
Base Value (Marketable Minority Interest) $1.00
Forecast Period Range of Expected Holding Periods (Years)
Range of Required Holding Period ReturnsDiscount Rate
Projected Interim Cash Flows (during forecast period)
Projected Terminal Value (at end of forecast period)
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C Corporation – No Dividend
Assumed Holding Periods in Years
1 2 3 4 5 6 7 8 9 10 15 20 25 30 20.0% Implied Marketability Discounts16.0% 1% 2% 3% 3% 4% 5% 6% 7% 7% 8% 12% 16% 19% 23%17.0% 2% 3% 5% 7% 8% 10% 11% 13% 14% 16% 23% 29% 35% 40%18.0% 3% 5% 7% 10% 12% 14% 16% 19% 21% 23% 32% 40% 47% 54%19.0% 3% 7% 10% 13% 16% 19% 21% 24% 26% 29.0% 40% 50% 57% 64%20.0% 4% 8% 12% 16% 19% 23% 26% 29% 32% 34.7% 47% 57% 65% 72%21.0% 5% 10% 14% 18% 22% 26% 30% 33% 37% 39.9% 53% 64% 72% 78%22.0% 6% 11% 16% 21% 26% 30% 34% 38% 41% 45% 59% 69% 77% 83%23.0% 7% 13% 18% 24% 29% 33% 38% 42% 45% 49% 64% 74% 81% 87%24.0% 7% 14% 20% 26% 31% 36% 41% 45% 49% 53% 68% 78% 85% 90%
PV=100%
1 2 3 4 5 6 7 8 9 10 15 20 25 30 Pre-Tax Income $0.167 $0.177 $0.187 $0.199 $0.210 $0.223 $0.236 $0.251 $0.266 $0.282 $0.38 $0.50 $0.67 $0.90Net Distribution 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00 0.00 0.00 0.00Retained Earnings $0.167 $0.177 $0.187 $0.199 $0.210 $0.223 $0.236 $0.251 $0.266 $0.282 $0.38 $0.50 $0.67 $0.90Cum. Basis Build-Up $0.167 $0.343 $0.531 $0.729 $0.940 $1.163 $1.399 $1.650 $1.915 $2.197 $3.88 $6.13 $9.14 $13.18Cum. Tax Savings $0.025 $0.052 $0.080 $0.109 $0.141 $0.174 $0.210 $0.247 $0.287 $0.330 $0.58 $0.92 $1.37 $1.98PV Factors 0.8333 0.6944 0.5787 0.4823 0.4019 0.3349 0.2791 0.2326 0.1938 0.1615 0.0649 0.0261 0.0105 0.0042PV of Tax Shelter $0.021 $0.036 $0.046 $0.053 $0.057 $0.058 $0.059 $0.058 $0.056 $0.053 $0.04 $0.02 $0.01 $0.01Potential MD Adj. -2.1% -3.6% -4.6% -5.3% -5.7% -5.8% -5.9% -5.8% -5.6% -5.3% -3.8% -2.4% -1.4% -0.8%
Average Shelter for the Expected Holding Period $0.057Average Potential Adjustment to Marketability Discount -5.7% Consider in final determination of discount
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QMDM CALCULATIONS
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S Corporation – No Economic Dividend
DCF Assumptions Corresponding QMDM Assumptions Model InputsLow 5
High 10
Expected Distribution / Dividend Yield Yield 0.00% 10% / (1 - 15%)Expected Growth in Distribution / Dividend Growth 0.0% (Adj. for Payout %)Timing (Mid-Year or End of Year) Timing E
Growth in Value over Holding Period Gv 15.0% (Suboptimal by 1%)Premium or Discount to Marketable Value Prem/Disc. 0.0%
Low 20.0% +1% Risk High 22.0%
Base Value (Marketable Minority Interest) $1.00
Tax Pass-Thru Assumptions
Pre-Tax Earnings Growth Rate 6.0% Personal Capital Gains Rate 15.0%
Assumed Corporate Federal Tax Rate 40.0%
Distribution % of Pre-Tax 40.0% Required Holding Period Return 21.0%
(normally the average of the range above)
Ongoing/Expd Net Income P/S $0.10 Marketable Minority Value Per Share (or Unit) $1.00
Forecast Period Range of Expected Holding Periods (Years)
Range of Required Holding Period ReturnsDiscount Rate
Projected Interim Cash Flows (during forecast period)
Projected Terminal Value (at end of forecast period)
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S Corporation – No Economic Dividend
Assumed Holding Periods in Years
1 2 3 4 5 6 7 8 9 10 15 20 25 30 21.0% Implied Marketability Discounts17.0% 2% 3% 5% 7% 8% 10% 11% 13% 14% 16% 23% 29% 35% 40%18.0% 3% 5% 7% 10% 12% 14% 16% 19% 21% 23% 32% 40% 47% 54%19.0% 3% 7% 10% 13% 16% 19% 21% 24% 26% 29% 40% 50% 57% 64% Versus 34.7%20.0% 4% 8% 12% 16% 19% 23% 26% 29% 32% 34.7% 47% 57% 65% 72% MD = 39.9%21.0% 5% 10% 14% 18% 22% 26% 30% 33% 37% 39.9% 53% 64% 72% 78% (Suboptimal by 1%)before considering
22.0% 6% 11% 16% 21% 26% 30% 34% 38% 41% 44.6% 59% 69% 77% 83% value impact of23.0% 7% 13% 18% 24% 29% 33% 38% 42% 45% 49% 64% 74% 81% 87% basis build-up24.0% 7% 14% 20% 26% 31% 36% 41% 45% 49% 53% 68% 78% 85% 90%25.0% 8% 15% 22% 28% 34% 39% 44% 49% 53% 57% 71% 81% 88% 92%
PV=100%
Potential Adjustment to the Marketability Discount Resulting from Basis Build-Up Over Expected Holding Periods
1 2 3 4 5 6 7 8 9 10 15 20 25 30 Pre-Tax Income $0.167 $0.177 $0.187 $0.199 $0.210 $0.223 $0.236 $0.251 $0.266 $0.282 $0.38 $0.50 $0.67 $0.90 Net Distribution (0.067) (0.071) (0.075) (0.079) (0.084) (0.089) (0.095) (0.100) (0.106) (0.113) (0.15) (0.20) (0.27) (0.36) S Corp 39.9%Retained Earnings $0.100 $0.106 $0.112 $0.119 $0.126 $0.134 $0.142 $0.150 $0.159 $0.169 $0.23 $0.30 $0.40 $0.54 C Corp -34.7%Cum. Basis Build-Up $0.100 $0.206 $0.318 $0.437 $0.564 $0.698 $0.839 $0.990 $1.149 $1.318 $2.33 $3.68 $5.49 $7.91 Delta for S 5.2%Cum. Tax Savings $0.015 $0.031 $0.048 $0.066 $0.085 $0.105 $0.126 $0.148 $0.172 $0.198 $0.35 $0.55 $0.82 $1.19 Basis Benefit -3.2%PV Factors 0.8264 0.6830 0.5645 0.4665 0.3855 0.3186 0.2633 0.2176 0.1799 0.1486 0.0573 0.0221 0.0085 0.0033 Adjusted Delta 2.0%PV of Tax Shelter $0.012 $0.021 $0.027 $0.031 $0.033 $0.033 $0.033 $0.032 $0.031 $0.029 $0.02 $0.01 $0.01 $0.00 Your CallPotential MD Adj. -1.2% -2.1% -2.7% -3.1% -3.3% -3.3% -3.3% -3.2% -3.1% -2.9% -2.0% -1.2% -0.7% -0.4%
Average Shelter for the Expected Holding Period $0.032 Relative to $1.00 of Marketable Minority ValueAverage Potential Adjustment to Marketability Discount -3.2% Consider in final determination of discount
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QMDM CALCULATIONS
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S Corporation vs. C Corporation
Value Trilogy C Corp S Corp1 C Corp S Corp1 Potential Differences for an S Corp Shareholder Relative to Otherwise Identical C Corp Shareholder
Cash Flow
1. Enterprise Earnings/ Distributions CF1 CF1 CFm,c CFm,s 1. To the extent that distributions are less than 100% of earnings, both will be less than CF1
2. To the extent that there are economic distributions, there is a premium yield applicable to S corp distributions
a. This premium is determined by the current level of income taxes on dividends/distributions (P = 1 / (1 - Dividend Tax%)) b. This premium lasts only as long as the expected holding period of the investment in an S corporation minority interest c. The "value" of this premium to an informed investor is the present value of the premium discounted to the present over the expected holding period at the appropriate required return (Rhp)
==> To the extent of any premium yield from economic distributions beyond taxes, the effective cash flow for S corporation shareholders will exceed that of C corporation shareholders and value will be biased upward
2. Basis Build-Up none CFm,s(b) 1. To extent that an S corporation retains earnings, its shareholders accrete incremental basis in their stock ownership positions
a. This basis can be used to offset capital gains upon sale at the end of expected holding period b. This basis accretion is an additional cash flow for S corporation shareholders not enjoyed by C corporation shareholders c. The"value" of this basis accretion to an informed investor is the present value of the sheltered capital gains tax savings realized at the terminal sale, discounted back to the present at the appropriate requried return (Rhp)
d. Note that if an S corporation retains all economic earnings (after personal taxes) there will be no value to basis build-up2. There are no other cash flow benefits experienced by S corp shareholders relative to otherwise identical C corp shareholders
==> To the extent of any basis build-up for S corporation shareholders, value will be biased upward (higher for low distributing S corporations, and lower for high distribution firms)
Expected Growth G G G G 1. Assuming equivalency between corporate and personal income taxes applicable to C and S corporations respectively, of Cash Flows there will be no differences between expected growth in earnings for the two
==> There is no differential in expected growth for an S or C, and therefore no impact on value Risk R R Rhp,c Rhp,s 1. The primary incremental risk associated with an S corporation holding is that the entity cannot or does not make distributions
for shareholders to pay their pass-through taxes. a. This risk is often mitigated by shareholder agreements, but cannot necessarily be eliminated completely==> To the extent that risks of owning an S corporation relative to an otherwise identical C corporation are greater, value will be biased downward. Otherwise, there will be no impact on value.
All identical at the ==> The net difference in value between an S corporation interest and an otherwise identical C corporation interest will result in enterprise level the interplay of the assumptions regarding differences in expected cash flow and risk, both considered over the expected
Assumes equivalency between corporate and personal income taxes holding period or investment horizon for the investments.
ShareholdersEnterprise
Enterprise
Earnings
Dividends/
Distributions
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S Corporation Synthesis
Strategic Control Value
Strategic Control Value
Financial Control Value
Financial Control Value
MarketableMinority Value
MarketableMinority Value
NonmarketableMinority Value
NonmarketableMinority Value
En
terp
rise
Le
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er
Le
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l
Strategic Control Value
Strategic Control Value
Financial Control Value
Financial Control Value
MarketableMinority Value
MarketableMinority Value
NonmarketableMinority Value
NonmarketableMinority Value
(+) f (High distribution, Risk)
(-) f (Low distribution, Risk)
C Corporation S Corporation
=
=
< = >
Value Differentials Between a C Corporation and an Otherwise Identical S Corporation
Strategic Control Value
Strategic Control Value
Financial Control Value
Financial Control Value
MarketableMinority Value
MarketableMinority Value
NonmarketableMinority Value
NonmarketableMinority Value
En
terp
rise
Le
ve
lS
ha
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er
Le
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l
Strategic Control Value
Strategic Control Value
Financial Control Value
Financial Control Value
MarketableMinority Value
MarketableMinority Value
NonmarketableMinority Value
NonmarketableMinority Value
(+) f (High distribution, Risk)
(-) f (Low distribution, Risk)
C Corporation S Corporation
=
=
< = >
Value Differentials Between a C Corporation and an Otherwise Identical S Corporation
(BVIT, p. 254)
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The Integrated Theory Enlightens» Valuation Premiums and Discounts
» Meaning and Interpretation of Ge
» Net income or net cash flow
Which to capitalize/discount when?
Does R relate to net income or net cash flow?
» Normalizing adjustments and the prerogatives of control
» Nature of control premiums
» Deriving Marketability Discounts
» Valuing S Corporations
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Ask the Right Questions and…
Integrated Theory of
Business Valuation
Integrated Theory of
Business Valuation
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Z. Christopher Mercer, ASA, [email protected]
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