Financial Valuation : Applications and Models

1322 Pages·2011·12.21 MB·English

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Financial
Valuation
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Financial
Valuation
Applications and Models
Third Edition
with Website
JAMES R. HITCHNER

John Wiley & Sons, Inc.
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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
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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
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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.
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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
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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
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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