618 Making Key Strategic Decisions
as of De
cember 31, 2000, on an as-if-freely-traded basis. Since this amount is
based on rates of return of freely traded marketable securities, Victoria will
take a valuation discount for lack of liquidity at the end of her analysis.
Because Victoria made adjustments to the 2000 pro forma income state-
ment (see the pro forma column in Exhibit 18.5) for discretionary items (offi-
cers’ compensation and rent expense) and income tax expense, the 2000 pro
forma earnings and resulting value of $31.7 million represents a value for a
control (rather than a minority) equity interest.
In summary, the discounted cash flow methodology determines ACME’s
value today, which represents an owner’s perceived future benefits discounted
to the present value. The DCF method forecasts ACME’s cash flows into the
future and discounts them to their present value. In addition, this method as-
sumes that the owner will sell the company at some point in the future and re-
ceive the sale price. The estimated future sale price is also discounted back to
present value. The present values of future earnings and future sale price are
added together to determine the value of ACME.
MARKET APPROACH: PUBLICLY TRADED
GUIDELINE—COMPANIES METHOD
Bob asks Victoria to explain the market approach to determining value. She
says the market approach is a general way of determining a value by comparing
the asset to similar assets that have been sold. In business valuation, this can be
done by looking for any prior arm’s-length sales of the company’s stock, sales of
other companies, or prices of shares in publicly traded companies. In the latter
two instances, careful analysis of the other companies must be done to deter-
mine if they would properly serve as guidelines under this approach. The
American Society of Appraisers describes guideline companies as those “com-
panies that provide a reasonable basis for comparison to the investment char-
acteristics of the company being valued. Ideal guideline companies are in the
same industry as the company being valued; but if there is insufficient transac-

tion evidence available in the same industry it may be necessary to select com-
panies with an underlying similarity of relevant investment characteristics
(risks) such as markets, products, growth, cyclical variability and other salient
factors.”
2
In ACME’s case, there have never been any prior sales of corporate stock.
In addition, Victoria is unable to find any sales of guideline companies in which
adequate information is available. However, she is able to identify five publicly
traded companies that could potentially serve as guidelines under the market
approach.
Having identified the list of potential public companies through database
searches, Victoria performs a qualitative and quantitative analyses on the com-
panies to determine whether they should serve as guideline companies. This
analysis results in the selection of five companies.
Business Valuation 619
Victoria’s analysis looks at the public companies’ balance sheets and in-
come statements over several years, growth rates, margins, returns on assets
and equity, and financial ratios. She also analyzes various share price multiples
of the public companies such as:
• Market value of invested capital to sales.
• Market value of invested capital to earnings before interest, taxes, depre-
ciation, and amortization (EBITDA).
• Market value of invested capital to earnings before interest and taxes
(EBIT).
• Market value of equity to pretax income.
• Market value of equity to net income.
• Market value of equity to cash flow.
• Market value of equity to book value.
Based on her detailed analyses of the guideline companies and comparing
them to ACME, Victoria determines that the following price multiples of the

public companies appear to be most correlated and relevant for application to
ACME: market value of invested capital to sales, market value of invested cap-
ital to EBITDA, market value of invested capital to EBIT, and market value of
equity to pretax income.
The median price multiples for the five public companies are:
Then Victoria applies the median price multiples to ACME. See Ex-
hibit 18.12 for her calculations. Her analysis indicates a value of ACME’s eq-
uity at December 31, 2000, of $35.2 million on an as-if-freely-traded basis.
Since Victoria made adjustments to the 2000 income statement (see the
resulting pro forma column in Exhibit 18.5) for discretionary items (officers’
compensation and rent expense), she explains that the 2000 earnings and re-
sulting value of $35.2 million represents a value to an owner of a control eq-
uity interest. Thus, Victoria concludes that there is no need to add a control
premium. A control premium is an upward adjustment to the value that re-
flects the power of control as compared to the value of a noncontrol equity in-
terest. (However, many analysts believe that a control premium would be
necessary simply because of the use of public minority share multiples even
though the income was adjusted upward to reflect the discretionary expenses
of a control owner. Many of these people, however, would not use the median
multiple of the public companies as Victoria did but adjust it [usually down]
Median
Price
Multiple
Market value of invested capital to sales 0.54
Market value of invested capital to EBITDA 5.80
Market value of invested capital to EBIT 7.26
Market value of equity to pre-tax income 6.72
620
EXHIBIT 18.12 ACME Manufacturing Inc.: Public
ly Traded Guideline Co. method of valuation.

ACME ($m
illion)
Median
Market Value
Multiple of Pro Forma of Invested
Market Value
Weighted
Price Multiple
Guidelines Amounts
a
Capital Less: Debt of Equity Weight Avera
ge
Market value of invested capital
to sales
0.54 Sales $50.29 $27.16 $10.41
$16.75 25% $ 4.19
Market value of invested capital
to EBITDA
5.80 EBITDA 8.21 47.62 10.41
37.21 25% 9.30
Market value of invested capital
to EBIT
7.26 EBIT
7.21 52.34 10.41 41.93 25%
10.48
Market value of equity to pretax
income
6.72 Pretax income 6.66 N/A
N/A 44.76 25% 11.19
Value of Equity

$35.16
a
See Exhibit 18.5 for 2000 pro forma amounts after valuat
ion adjustments were made.
Business Valuation 621
for funda
mental differences between the selected public companies and the
private business. Thus, if these analysts first adjust the price multiple down-
ward as a fundamental adjustment and then apply an upward control premium,
the result may be similar to Victoria’s valuation conclusion.)
However, since the $35.2 million value is based on freely traded mar-
ketable securities, Victoria will take a valuation discount for lack of liquidity at
the end of her analysis.
RECONCILIATION OF VALUATION METHODS
The results of Victoria’s valuation analysis are:
Method Value
Income approach $31.7 million
Market approach 35.2 million
Average 33.5 million
Victoria chooses to weigh each method equally resulting in an average
value of $33.5 million. This value represents 100% of the common stock of
ACME at December 31, 2000, on an as-if-freely-traded and control basis.
DISCOUNT FOR LACK OF LIQUIDITY
A freely traded basis means an investment can be sold and converted to cash
within several days. When shares of stock are sold on a public exchange, the
seller will usually receive cash within a few days making them freely traded in-
vestments. Under the income approach, Victoria used rates of returns from
publicly traded securities. Under the market approach, she used price multi-
ples of publicly traded shares. Thus, the values under both of Victoria’s ap-
proaches result in as-if-freely-traded values. Because it would likely take Bob

(or any other owner of the business) several months or longer to sell ACME and
receive cash, the liquidity of an investment in ACME’s shares is significantly
different than the liquidity of publicly traded shares of stock. Therefore, Vic-
toria takes a discount from the as-if-freely-traded value of $33.5 million for
ACME’s equity.
The preceding provides the rationale for applying a discount for lack of
liquidity. However, the amount of the discount must be quantified. The closest
empirical evidence to quantify the discount comes from studies of restricted
public stock prices and studies of share prices just prior to companies’ initial
public offerings. These studies indicate discounts for lack of marketability of
35% to 45% on average. Since these studies relate to minority equity positions
in the companies instead of control positions, Victoria uses a discount below
the averages of the studies. Based on her analysis and judgment, she applies a
10% lack of liquidity discount to the as-if-freely-traded $33.5 million equity
622 Making Key Strategic Decisions
value. This represents the discount an investor would require for buying shares
in ACME instead of an investment that is freely traded.
VALUATION CONCLUSION FOR ACME
Victoria concludes that the fair market value of the common stock of ACME as
of December 31, 2000, was $30,150,000 ($33.5 million less 10% discount for
lack of liquidity).
VALUING MINORITY INTERESTS
The preceding ACME case study valued 100% of the equity (stock) in the
business. Had Bob owned only, say, 25% of the common stock, Victoria would
have to apply some additional analysis to value his minority interest. With a
25% interest, Bob would no longer have the ability to control the company.
A minority interest is a business ownership of less than 50% of the voting
shares. The owner of a minority interest in most private businesses cannot con-
trol the company. A control interest in a company has the power to direct man-
agement and policies of a business usually through ownership of enough shares

to influence voting and other decisions. Intuitively, someone would rather own
a control interest in a private business (51%) instead of a minority interest
(49%) because of the power to control the company. Buyers would typically
pay a significantly different price when comparing a 51% interest to a 49%
interest. This phenomenon is called a discount for lack of control (or minority
discount).
The second area of additional analysis for Victoria would be for the typi-
cal difficulty in selling a minority interest in a closely held business. Mar-
ketability is the ability to quickly convert property (an investment) to cash at
minimal cost. Hypothetically, if Bob owns only 25% of ACME’s stock and
someone else owns the other 75%, the number of buyers interested in buying
Bob’s shares is significantly less than if he owns 100%. Since Bob actually
owns the entire company, he has several ways to sell it. For example, he can sell
the company through an investment banker or business broker. He can also
take the company public. If Bob hypothetically only owns 25% of ACME’s
stock, these options are not realistically available to him. Therefore, his minor-
ity interest is less marketable. Intuitively, investors prefer owning marketable
investments over nonmarketable ones. Therefore, buyers of minority interests
in private companies typically pay less since the shares are not marketable.
This is called a discount for lack of marketability.
In valuing a minority interest, a major consideration is the timing and
amount of the anticipated future economic benefits flowing directly to the mi-
nority owner. This consists of the company’s periodic distributions to the mi-
nority owner and the estimated holding period for owning the equity interest
Business Valuation 623
until it is sold and the sales proceeds are received. We saw through the DCF
model that the value of the asset is the present value of the expected future
benefits. In valuing a minority interest, the emphasis shifts toward the future
benefits flowing to the minority shareholder as opposed to the business overall.
For example, if a minority owner expects not to receive any distributions from

the business for 10 years even though the business is profitable, this is signifi-
cantly different from a business that makes annual shareholder distributions of
the profits. The values in these two situations would be considerably different.
BUSINESS VALUATION STANDARDS
Professional business appraisers follow certain standards when doing business
valuations. Business valuation standards include the following:
Uniform Standards for Professional Appraisal Practice—The Appraisal
Foundation.
Standards issued by various membership organizations such as American
Society of Appraisers, Institute of Business Appraisers, and National As-
sociation of Certified Valuation Analysts.
VALUE ENGINEER ING
Just as the CEO of a public company tries to enhance the value of the shares,
management of a private company can work on increasing the value of the
business in anticipation of a future sale. Certain factors can have a significant
effect on the value of a typical closely held business. Management can focus on
these factors to potentially increase the future value of the business. Some of
the factors are obvious, while some are not. They include the following:
• Decrease expenses (increases cash flow/income).
• Increase revenues (increases cash flow/income).
• Significantly increase the earnings growth rate (may increase earnings
projections, lower capitalization rate due to growth factor).
• Eliminate the owners’ personal expenses and perquisites (increases cash
flow/ income, lowers buyer risk of inaccurate financial statements).
• Report all income on the financial statements and tax return (increases
cash flow/income).
• Develop the management team for the possibility that the current
owner(s) may leave the business upon a sale (lowers buyer risk of earn-
ings volatility).
• Plan for the current owner-managers’ continuing employment under the

new owner for a fixed period (lowers buyer risk of earnings volatility and
loss of customers, employees, and vendors).
624 Making Key Strategic Decisions
• Have annual financial statements audited or reviewed by a certified pub-
lic accountant and improve interim financial reporting (lowers buyer risk
of inaccurate financial statements).
• Develop a list of potential synergistic buyers and identify the ones with
the most to gain from an acquisition of the subject company (search for
the highest synergistic value to be paid).
• Decrease dependency on major customers and vendors (lowers buyer risk
of earnings volatility in the event of the loss of any of these customers or
vendors).
• Begin assembly of key business information for potential buyers (lowers
buyer risk of perceptions of potential earnings volatility without having
such knowledge).
• Improve any existing poor financial statistics or ratios (lowers buyer fi-
nancial risk).
Public companies report earnings and performance on a quarterly basis
and the share prices frequently react quickly. On the other hand, private com-
pany values generally react more slowly to changes. Thus, management may
need to work on value improvement factors one to two years in advance of mar-
keting a business.
SUMMARY
The fair market value of a private business is essentially an estimate of the
price that a willing buyer would pay and a willing seller would accept. Buyers
have different motives for buying a business. Financial buyers are looking for a
return on their investment. Strategic buyers are usually looking to integrate
their company with the business for unique strategic reasons. Financial buyers
pay fair market value while strategic buyers usually pay a price reflective of
the unique strategic advantages to the specific buyer. Often, strategic buyers

pay more than fair market value. Although it is possible to conduct a business
valuation that is not overly complex, the question remains whether the result-
ing value is accurate. Many variables go into a valuation analysis. A business
valuation is both a quantitative and qualitative process that is focused on as-
sessing investment risk and investment return. It is largely an assessment of the
risks a buyer is taking in acquiring and owning the company. In addition, a val-
uation attempts to project the earnings an owner of the business can expect in
the future as a return on investment.
Author’s Note. This chapter is not intended to be a complete text on business
valuation. It is meant to illustrate through examples many of the fundamentals
of business valuation and their application. The proper application of valuation
theory depends on the actual facts and circumstances of the investment being
valued.
Business Valuation 625
FOR FURTHER READING
Desmond, G. and J. Marcell, Handbook of Small Business Valuation Formulas and
Rules of Thumb, 3rd ed. (Los Angeles: Valuation Press, 1993).
Pratt, S., R. Reilly, and R. Schweihs, Valuing a Business: The Analysis and Appraisal
of Closely Held Companies, 4th ed. (New York: McGraw-Hill, 2000).
Pratt, S., R. Reilly, and R. Schweihs, Valuing Small Businesses and Professional Prac-
tices, 3rd ed. (New York: McGraw-Hill, 1998).
Reilly, R. and R. Schweihs, Valuing Intangible Assets (New York: McGraw-Hill,
1998).
Smith, G. and R. Parr, Valuation of Intellectual Property and Intangible Assets (New
York: John Wiley, 2000).
Trugman, G., Understanding Business Valuation: A Practical Guide to Valuing Small-
to Medium-Sized Businesses (New York: AICPA, 1998).
, Handbook of Business Valuation, 2nd ed. T. West and J. Jones, Eds. (New
York: John Wiley, 1999).
, Stocks, Bonds, Bills, and Inflation Yearbook Valuation Edition (Chicago:

Ibbotson Associates, published annually).
INTER NET LINKS
www.aicpa.org American Institute of Certified Public
Accountants
www.appraisers.org American Society of Appraisers
www.appraisalfoundation.org Appraisal Foundation
www.gofcg.org Financial Consulting Group
www.ibbotson.com Ibbotson Associates
www.instbusapp.org Institute of Business Appraisers
www.nacva.com National Association of Certified
Valuation Analysts
NOTES
1. International Glossary of Business Valuation Terms, jointly published by the
American Institute of Certified Public Accountants, American Society of Appraisers,
Canadian Institute of Chartered Business Valuators, National Association of Certi-
fied Valuation Analysts, and Institute of Business Appraisers. Further terminology
from this jointly published international glossary is included in glossary at the end of
this book.
2. American Society of Appraisers, Statement on Business Valuation Standards 1.
626
Glossary
Accounting exposure: Increases or decreases in assets and liabilities resulting from
exchange rate movements, which may not be associated with either current or
prospective cash inflows or outflows. Accounting exposure is distinguished from
economic exposure where cash inflows and outflows are expected to be associated
with exchange rate movements.
Accrual accounting: An accounting method that recognizes revenues as they are
earned and expenses as they are incurred. The timing of revenue and expense
recognition is not tied to the timing of the inflow and outflow of cash. Accrual ac-
counting is seen as essential in order to develop reliable measures of periodic finan-

cial performance.
Acquisition: The purchase—not necessarily for cash—of a controlling interest in a
firm.
Activity-based costing: A process of identifying the different activities that gener-
ate costs.
Adapter: Typically, a small circuit board inside a computer that lets the computer
work with hardware external to the computer. Examples: A network adapter allows a
computer to be hooked into a network; a display adapter allows a computer to drive
(display text, graphics) a computer monitor.
AICPA: The American Institute of Certified Public Accountants. This is the na-
tional professional association of certified public accountants (CPAs).
All-current method: A method of translating foreign-currency financial state-
ments whereby all assets and liabilities are translated at the current (balance sheet
date) exchange rate, contributed capital accounts are translated at historical ex-
change rates (rates in existence when the account balances first arose), and all rev-
enues and expenses are translated at the average exchange rate in existence during
the reporting period. Translation adjustments resulting from fluctuating exchange
rates are accumulated and reported with accumulated other comprehensive income
in shareholders’ equity.
Amortization: the periodic, noncash charge used to reduce an intangible asset.
Application Service Providers (ASP): Companies that rent out applications and
process data for other companies, similar to service bureaus in the 1960s and 1970s.
Glossary 627
Asset (asset-based) approach: A general way of determining a value indication of
a business, business ownership interest, or security by using one or more methods
based on the value of the assets of that business net of liabilities.
Asset acquisition: an acquisition executed by purchasing the assets of the target
firm.
Asymmetric risk: An exposure that results in profits or losses only if the underlying
price or economic variable moves in one direction.

At-the-money: The condition of a call or put option when the strike price equals
the stock price. Some economists define at-the-money as being the case when the
stock price equals the present value of the strike price.
B2C e-commerce: The sale of goods and services between a company and a con-
sumer over the Internet.
Balanced scorecard: A comprehensive set of performance measures intended to
capture a more balanced picture of management’s success in achieving goals than can
be captured by financial measures only.
Bearish: Pessimistic. Anticipating a decrease in an asset value.
Best efforts underwriting: An agency arrangement by which underwriters agree
to use best efforts to sell all, or a certain minimum number of, shares of a public
offering.
Beta: A measure of systematic risk of a security; the tendency of a security’s returns
to correlate with swings in the broad market.
Bidder: The firm that initiates a merger or acquisition; the bidder usually retains
control of the surviving firm.
Bit: The smallest gradation of data stored in a computer. Technically, a bit is either
a 1 or a 0. Computers use groups of bits, called bytes, to represent character data.
Blue-sky laws: State laws regulating securities that provide for licensing
brokers/dealers and registering new securities issuances.
Budget: A comprehensive, quantitative plan for utilizing the resources of an entity
for some specified period of time—showing planned revenues, expenses, and result-
ing earnings—together with a planned balance sheet and cash flow statement. If bud-
gets adjust for volume they are called flexible; otherwise, they are static.
Budget entity: Any accounting entity, such as a firm, division, department, or
project, for which a budget is prepared.
Budget performance report: An internal accounting report that shows the differ-
ence between actual results and expected performance planned in a budget.
Budget review process: The process of evaluating budget proposals and arriving
at the master budget.

Budget variance: The difference between the budgeted data and actual results.
Bullish: Optimistic. Anticipating an increase in an asset value.
Business valuation: The act or process of determining the value of a business en-
terprise or ownership interest therein.
Byte: Typically, eight bits in a computer, which as a unit, represent one character of
data. A computer diskette can store 1,400,000 bytes of data, or 1,400,000 characters
of data. This represents about 500 pages of single-spaced text.