Introduction

What do we mean by an integrated theory of business valuation?

We use the term integrated theory to refer to our rather dogged insistence that the key to answering thorny valuation questions is devoting one's attention to cash flow, risk, and growth. Simply put, we propose that any valuation question (or problem, or controversy, depending on your perspective) is ultimately answerable by analyzing expected cash flows, risk, or growth expectations.

In this book, we provide readers with both the conceptual basis for - and practical application of - the Integrated Theory, which we can summarize as follows:

The value of any business or business ownership interest is a function of the expected cash flows attributable to the business or business ownership interest, the expected growth in those cash flows over the relevant holding period, and the risks associated with achieving those expected cash flows.

The Integrated Theory provides a conceptual framework for disciplined analysis of valuation questions. Too often, valuation analysts are tempted to view individual components of a valuation assignment on a piecemeal basis. Adhering to the Integrated Theory helps valuation analysts develop base valuation conclusions, discounts, and premiums that are rooted in a shared perspective of the subject company and the subject ownership interest.

The most transparent application of the Integrated Theory is in developing the conceptual underpinnings of the so-called levels of value.

• Why are controlling interests in businesses generally assumed to be worth more than minority interests in those same businesses? In the chapters that follow, we propose - somewhat counterintuitively - that they are not, unless the owner of the controlling interest expects more cash flow, bears less risk, or experiences faster growth than the owner of a corresponding minority interest.
• Why are nonmarketable minority interests often worth less than otherwise comparable, but marketable, minority interests? Spoiler alert: nonmarketable minority investors often expect lower cash flows, bear more risk, or experience slower growth than the owner of a corresponding marketable minority interest.

As we will demonstrate throughout this text, the Integrated Theory, as manifest in the conceptual levels of value, provides a robust template for addressing other potential areas of valuation controversy.

WHAT'S NEW IN THE THIRD EDITION?

In the decade or so since the second edition of this book, valuation analysts have increasingly recognized the importance of evaluating private operating businesses from the perspective of the enterprise (equity plus net debt) rather than restricting the focus of analysis to the net equity of the business. The Integrated Theory is readily extended to the enterprise value perspective, and we demonstrate that extension in this third edition.

Further, recognizing the need for more practical guidance regarding the application of the Integrated Theory to the valuation of enterprise value, we have added new chapters on estimating enterprise cash flows and developing enterprise discount rates. This third edition also includes new chapters relating to the market and income approaches, using the Integrated Theory to expose the common conceptual underpinnings of the two approaches. Finally, we have added a new chapter dedicated to dissecting the oft-cited but less often understood restricted stock and pre-IPO studies using the Integrated Theory as our scalpel.

The twelve chapters in this edition are organized into three sections.

Part One: Conceptual Overview of the Integrated Theory

• Chapter 1, "The World of Value." We begin the book by laying out some fundamental principles that undergird the Integrated Theory. The principles of expectations, growth, risk and reward, present value, alternative investments, and rationality lay the necessary conceptual and theoretical foundation for the Integrated Theory.
• Chapter 2, "The Integrated Theory (Equity Basis)." In Chapter 2, we describe the Integrated Theory on an equity basis, giving particular attention to the conceptual scaffolding the Integrated Theory provides to discussions of the levels of value and the associated valuation discounts and premiums.
• Chapter 3, "The Integrated Theory (Enterprise Basis)." New to the third edition, Chapter 3 extends the conceptual basis for the Integrated Theory described in Chapter 2 to the enterprise value perspective.

Part Two: Valuing Enterprise Cash Flow

Each of the chapters in Part Two is new to the third edition.

• Chapter 4, "Income Approach (Cash Flows)." Our exposition of the Integrated Theory in Part One relies on the conventions of the single-period capitalization method. In Chapter 4, we demonstrate how valuation analysts can apply the Integrated Theory in forecasting cash flows, whether using a single-period capitalization or multi-period discounted cash flow method. We also explore the relationship between reinvestment and growth, and the role of normalizing adjustments to derive cash flows applicable to the valuation of interests on a marketable minority interest basis. Finally, we discuss potential control adjustments to cash flows and provide a roadmap for assessing the overall reasonableness of cash flow projections.
• Chapter 5, "Income Approach (Discount Rate)." We suspect that more is written about discount rates each year than any other valuation topic. In Chapter 5, we cast a somewhat skeptical eye over the discount rate terrain, concluding that valuation professionals devote far too much time and attention to competing techniques for sifting through the mountains of available historical return data, and too little time and attention on developing reasonable - although admittedly less precise - discount rates for valuation subjects. In addition, we consider the relationship between the discount rate and the level of value.
• Chapter 6, "Market Approach (Guideline Public Companies)." Although we develop the Integrated Theory using the language of the income approach, it is equally applicable to the market approach. In Chapter 6 we reveal the conceptual components of common valuation multiples and demonstrate how to use the Integrated Theory to make supportable adjustments to observed public company valuation multiples for application to private businesses.
• Chapter 7, "Market Approach (Guideline Transactions)." In Chapter 7, we turn our attention to the unique challenges that arise when analyzing guideline transactions to develop firmwide indications of value. This chapter is followed by an appendix providing a historical perspective on the control premium and minority interest discount, using the Integrated Theory to trace the evolution of these key concepts in practice.

Part Three: Valuing Shareholder Cash Flows

• Chapter 8, "Restricted Stock Discounts and Pre-IPO Studies." In this new chapter, we analyze restricted stock discounts and pre-IPO studies through the lens of the Integrated Theory. While restricted stock discounts provide meaningful benchmarks for marketability discounts applicable to private companies only by chance, we demonstrate how the restricted stock data confirms the existence of both an implied holding period and a holding period premium applicable to illiquid interests in restricted stock transactions and, by implication, for private companies. We also conclude that observed pre-IPO discounts actually capture two distinct phenomena: the marketability discount applicable prior to the IPO and the "pickup" in value associated with the IPO itself.
• Chapter 9, "Introduction to the QMDM (Quantitative Marketability Discount Model)." The Quantitative Marketability Discount Model is a shareholder-level discounted cash flow model. In Chapter 9, we describe the QMDM, showing that the marketability discount is ultimately attributable to differences in expectations for cash flow, risk, and growth for minority shareholders in private companies.
• Chapter 10, "The QMDM Assumptions in Detail." In Chapter 10, we present a more detailed review of the QMDM inputs: the expected holding period, dividend yield, growth in value, and required holding period return.
• Chapter 11, "Applying the QMDM." The QMDM is adaptable to the attributes of specific illiquid minority interests. In this chapter, we apply the QMDM to a variety of fact patterns, illustrating how to use the QMDM to identify the relevant cash flow, risk, and growth characteristics of the subject interest for a valuation.
• Chapter 12, "Applying the Integrated Theory to Tax Pass-Through Entities." We close by using the disciplined framework of the Integrated Theory for the valuation of shareholder interests in S corporations and other tax pass-through entities.

WHO SHOULD READ THIS BOOK?

A variety of business valuation, legal, and accounting professionals and students should read Business Valuation: An Integrated Theory, third edition.

Valuation Analysts (Business Appraisers)

The Integrated Theory provides the foundation for a deeper understanding of...