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CHAPTER 2 Valuation Approaches: How We Value a Business
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income The excess returns are attributable to the presence of intangible assets One would then value the intangible assets by dividing the excess returns by a rate of return between 20 and 100 percent That means multiples of one to five of excess returns For example, if excess returns are \$100,000, then the Excess Earnings Method calculation of the intangible asset component of value would be between \$100,000 and \$500,000 (\$100,000/20% \$500,000, and \$100,000/100% \$100,000) That is a huge range of multiples, and there is no empirical evidence of what it should be, since we can only see stock market returns on entire equity interests in publicly traded companies; we do not get to see the return on intangible assets Finally, we add the value of the intangible assets to the book value of tangible assets to compute the value of the business using the Excess Earnings Method In a divorce, the in-spouse s (spouse who owns the business) valuator may be tempted to use the highest possible rate in order to lower the indication of value (however defined) thus having to pay less in a property settlement while the outspouse s valuator may be tempted to do the opposite Less sophisticated valuators rarely have the know-how to demonstrate that the weighted average cost of capital implied by the final product may be empirically inconsistent with historical market returns If it is a small business, the distortion may not be too material The larger the business and the higher its forecast growth rate, the more important it is to have a sophisticated valuator The reason some courts17 love the Excess Earnings Method and dislike the Discounted Cash Flow is that former makes no use of forecasts It is a mechanical extension of the past This eliminates haggling over what is likely to occur in the future, and overworked judges relish the opportunity to reduce the grounds for argument and abuse It is easy to abuse the process by using unrealistically optimistic or pessimistic sales forecasts, and it s clear why judges would prefer not to have to sort through technical arguments when each side has its own agenda In the
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Some divorce courts in particular are known for this
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real world, it is our perception of the future that drives value, and sweeping that under the rug is convenient, but it s not the most accurate valuation method
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MARKET APPROACH
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The definition of the Market Approach also known as the Market Comparison Approach or Comparable Companies is A general way of determining a value indication of a business, business ownership interest, security, or intangible asset by using one or more methods that compare the subject to similar businesses, business ownership interests, securities, or intangible assets that have been sold 18 Under the Market Approach, the most common methods are those of Guideline Companies There are two types of Guideline Companies: publicly held and privately held We will spend relatively little space in this book on the Market Approach, as it has theoretical and practical problems that render it impractical for most business owners However, due to its popularity, I will discuss it briefly, and I provide an example of the Guideline Public Company Method in the appendix to this chapter
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Guideline Public Company Method
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The definition of the Guideline Public Company Method (which we ll shorten to GPCM, for convenience) is A method within the Market Approach whereby market multiples are derived from market prices of stocks of companies that are engaged in the same or similar lines of business, and that are actively traded on a free and open market 19 The GPCM works well when the following conditions exist: 1 The subject company being valued is relatively the same size as the Guideline Companies I would feel uncomfortable if the Guideline Companies are more
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