Chapter 1 Important Valuation Concepts

• Jurisdiction: United States

Chapter 1 Important Valuation Concepts

This chapter introduces the discussion of prospective (forward-looking) financial information by asking about the context of the valuation analysis and what measurements of income and cash flows are being used. We introduce common language and nomenclature used in valuation analysis to guide the reader in our discussion. These and other items necessarily drive the initial inquiry into prospective financial information. Finally, we outline the scope of this text and introduce the perspectives offered for our intended audiences.

Whether estimating the value of a business or measuring commercial damages, the business's ability to generate cash is king. Particularly in the world of corporate bankruptcy litigation, courts making valuation determinations "plac[e] considerable weight on the income approach to determine the market value of [the] property, as it is the most meaningful appraisal method available. . . ."¹ Also, "in arriving at a value ... an estimate must be made of the present value of future earnings. The discounted cash flow approach [DCF] . . . achieves this objective."²

Valuation Nomenclature

One of the initial difficulties to overcome in discussions of business valuation lies in the varied nomenclature that has been adopted. This nomenclature describes the types of analyses and the analytical techniques employed to calculate a valuation amount that is then used to reach a valuation conclusion. Texts, articles, court opinions, professional standards and related training materials, and other sources have mixed their descriptions and vocabulary over time. This nomenclature continues to evolve in a search for meaning, to facilitate explanation to others (as in court filings and opinions), and due to the emergence of new concepts used in valuation. For example, the words "approaches," "methods" and "procedures" seem to be used interchangeably. Yet, under all valuation professional standards, there are three generally accepted business valuation "approaches," and there are several "methods" within each approach. Then there are numerous "procedures" within each method, and different analytical "techniques" may be applied. These terms are not synonymous.

In recent decades, professional associations and contributors to the business-valuation field have taken the nomenclature toward increasing levels of commonly accepted definitions and applications. The professional associations described later in this publication have increasingly adopted common language in their training materials and their professional standards, reflecting more general acceptance and use of common terminology. Note that an exploration of this history is outside the scope of this publication.

For purposes of this publication, we consider the structure of business valuation analyses and techniques discussed below to be generally applicable for our discussion. Note in particular the distinction between "approaches" and "methods." For purposes of our discussion, we do not draw distinctions between the language and definitions employed by other authors or professional associations beyond pointing out that differences may exist, then highlighting those differences that may be useful for our presentation. Reconciliation among those other authors and professional standards is left to the courts and to professional judgment as applied in each situation.

In general, we consider the following organizing structure to be relevant for our discussion of business valuation analysis. Note that this is a general structure, which is provided for purposes of this publication based on our review of the current literature at the time of publication. Over time, the descriptions and classifications have evolved in the valuation profession and in important decisions of the courts. The language has changed; and, as noted above, in many instances the language may be mixed or misapplied. Particular authors of commonly cited texts may adopt slightly different language. We provide the general structure shown below as an example to highlight the range of "approaches" and "methods" that valuation analysts, valuation experts and counsel may encounter. We recommend that valuation analysts, valuation experts and counsel apprise themselves of, and pay particular attention to, the language used in the relevant regulatory and/or litigation setting for each matter.³

Note that the following conceptual structure of business valuation is presented for illustrative purposes only and might not include all possible methods or techniques. For additional discussion, please refer to the cited source materials.

CONCEPTUAL STRUCTURE OF BUSINESS VALUATION
Income Approach Assumes that the fair market value of an asset is equal to the present value of all future benefits expected to be generated by the asset. • (Single Period) Capitalization of Earnings Method - a single period of earnings divided by a capitalization rate represents the total future value of all future earnings. • Discounted Cash Flow Method - multi-period earnings over a specified time horizon, with perpetuity earnings thereafter, are all summed to present value after applying a discount rate to compute the period and perpetuity present values. • Income Methods for Intangible Assets: o Split Profits (Residual Profits) Method; o Excess Income (With/Without) Method; o Residual Income (Excess Income) Method; o Royalty Income Method; o Incremental Income/Cost Decrement Methods; o Build-Out Method (Greenfield Method); o Comparative Income Method	Market Approach Assumes that the fair market value of an asset is equal to comparative values assessed in the marketplace for similar guideline transactions. • Guideline Public Company Method - based on transaction prices for public company comparisons, i.e., stock market equity, debt or total invested capital prices. • Merger and Acquisition Method - based on transaction prices for completed mergers and acquisitions. • Observable Market Value Method - based on aggregated publicly traded equity and debt securities. • Historical Internal Transactions Method, a.k.a. Company Specific Sales Method - based on actual or offered transaction prices made to the subject company itself. • Comparable Uncontrolled Transactions Method - based on arm's-length sales or licenses of guideline intangible assets. • Market Methods for Intangible Assets: o Comparable Uncontrolled Transactions Method; o Comparable Profit Margin Method, a.k.a. Profit Split Method; o Relief from Royalty Method
Asset-Based Approach Assumes that the fair market value of an asset is equal to the cost to acquire or replace the asset based on valuing distinct subclasses or subgroupings of assets and by valuing each class or group separately; some asset classes may require separate income or market methods for their valuation. • Adjusted Net Asset Method, a.k.a. Cost to Create Method - all assets are evaluated for their cost to create them, including intangible assets and net of economic obsolescence (i.e., depreciation). • Adjusted Book Value Method - all assets and liabilities, including intangible assets, are adjusted to their fair market values and may include tax effects. • Liquidation Value Method - assets and liabilities are restated to their liquidation values, including costs of liquidation as appropriate for the situation. • Asset-Based Methods for Intangible Assets - reproduction cost new less depreciation method, and historical cost less depreciation method.

Premise of Value and Standard of Value⁴

Valuation engagements require many items to be defined that together set the context and expectations of the scope of work and the intended uses of the data gathering, due diligence, analyses and calculations, conclusions, and finally the opinions reached. For example, who will receive the future economic benefits? Whose interest is being valued (equity or total invested capital, including all debt and equity)? What is the ownership interest (controlling or noncontrolling, marketable or non-marketable)? Are there restrictions or other contractual rights or limitations involved? These and many other defining items, along with the valuation methodology, data, analytical assumptions, techniques used and their calculations, and the final opinions of value, should be internally consistent among themselves in order for the final valuation opinion to be considered logically reasoned, in conformity with generally accepted methods, internally sound, and credible.

Among the items that require definition are the premise of value and standard of...