mcgraw.hill-quantitative-business-valuation

490 Pages·2003·14.01 MB·English

Quantitative Business Valuation
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Quantitative
Business Valuation
A Mathematical Approach
for Today’s Professional
JAY B. ABRAMS, ASA, CPA, MBA
McGRAW-HILL
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DOI: 10.1036/007138595X
To my father, Leonard Abrams, who taught me how to write. To my
mother, Marilyn Abrams, who taught me mathematics. To my wife,
Cindy, who believes in me. To my children, Yonatan, Binyamin, Miriam,
and Nechamah Leah, who gave up countless Sundays with Abba (Dad)
for this book. To my youngest child, Rivkah Sarah, who wasn’t yet on
the outside to miss the Sundays with me, but who has brought us peace.
Tomyparentsandmybrother,Mark,fortheirtremendoussupportunder
difficult circumstances.
To my great teachers, Mr. Oshima and Christopher Hunt, who
brought me to my power to make this happen. And finally,toR.K.Hiatt,
who has caught my mistakes and made significant contributions to the
thought that permeates this book.
This page intentionally left blank.
Contents
Introduction xiii
Acknowledgments xvii
List of Figures xix
List of Tables xxi
PART I
FORECASTING CASH FLOWS
1. Cash Flow: A Mathematical Derivation 3
Introduction. The Mathematical Model. A Preliminary Explanation of
Cash Flows. Analyzing Property, Plant, and Equipment Transactions. An
Explanation of Cash Flows with More Detail for Equity Transactions.
Considering the Components of Required Working Capital. Adjusting for
Required Cash. Comparison to Other Cash Flow Definitions.
Conclusion.
2. Using Regression Analysis 21
Introduction. Forecasting Costs and Expenses. Adjustments to
Expenses. Table 2-1A: Calculating Adjusted Costs and Expenses.
Performing Regression Analysis. Use of Regression Statistics to Test
the Robustness of the Relationship. Standard Error of the y Estimate.
The Mean of a and b. The Variance of a and b. Selecting the Data Set
and Regression Equation. Problems with Using Regression Analysis
for Forecasting Costs. Insufficient Data. Substantial Changes in
Competition or Product/Service. Using Regression Analysis to
Forecast Sales. Spreadsheet Procedures to Perform Regression.
Examining the Regression Statistics. Adding Industry-Specific
Independent Variables. Try All Combinations of Potential Independent
Variables. Application of Regression Analysis to the Guideline
Company Method. Table 2-5: Regression Analysis of Guideline
Companies. Summary. Appendix: The ANOVAtable.
3. Annuity Discount Factors and the Gordon Model 57
Introduction. Definitions. Denoting Time. ADF with End-of-Year
Cash Flows. Behavior of the ADF with Growth. Special Case of ADF
vii
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when g (cid:1) 0: The Ordinary Annuity. Special Case when n → (cid:2) and r (cid:3)
g: The Gordon Model. Intuitively Understanding Equations (3-6) and
(3-6a). Relationship between the ADF and the Gordon Model. Table 3-1:
Proof of ADF Equations (3-6) through (3-6b). A Brief Summary.
Midyear Cash Flows. Table 3-2: Example of Equations (3-10) through
(3-10b). Special Cases for Midyear Cash Flows: No Growth, g (cid:1) 0.
Gordon Model. Starting Periods Other than Year 1. End-of-Year
Formulas. Valuation Date (cid:4) 0. Table 3-3: Example of Equation (3-11).
Tables 3-4 through 3-6: Variations of Table 3-3 with S (cid:5) 0, Negative
Growth, and r (cid:5) g. Special Case: No Growth, g (cid:1) 0. Generalized
Gordon Model. Midyear Formula. Periodic Perpetuity Factors (PPFs):
Perpetuities for Periodic Cash Flows. The Mathematical Formulas.
Tables 3-7 and 3-8: Examples of Equations (3-18) and (3-19). Other
Starting Years. New versus Used Equipment Decisions. ADFs in Loan
Mathematics. Calculating Loan Payments. Present Value of a Loan.
Relationship of the Gordon Model to the Price/Earnings Ratio.
Definitions. Mathematical Derivation. Conclusions.
PART II
CALCULATING DISCOUNT RATES
4. Discount Rates as a Function of Log Size 117
Prior Research. Table 4-1: Analysis of Historical Stock Returns.
Regression #1: Return versus Standard Deviation of Returns. Regression
#2: Return versus Log Size. Regression #3: Return versus Beta. Market
Performance. Which Data to Choose? Recalculation of the Log Size Model
Based on 60 Years. Application of the Log Size Model. Discount Rates
Based on the Log Size Model. Practical Illustration of the Log Size
Model: Discounted Cash Flow Valuations. Total Return versus Equity
Premium. Adjustments to the Discount Rate. Discounted Cash Flow or
Net Income? Discussion of Models and Size Effects. CAPM. The
Fama–French Cost of Equity Model. Log Size Models. Heteroscedasticity.
Industry Effects. Satisfying Revenue Ruling 59-60 without a
Guideline Public Company Method. Summary and Conclusions.
Appendix A: Automating Iteration Using Newton’s Method.
Appendix B: Mathematical Appendix. Appendix C: Abbreviated
Review and Use.
5. Arithmetic versus Geometric Means: Empirical Evidence and
Theoretical Issues 169
Introduction. Theoretical Superiority of Arithmetic Mean. Table 5-1:
Comparison of Two Stock Portfolios. Empirical Evidence of the
Superiority of the Arithmetic Mean. Table 5-2: Regressions of
Geometric and Arthmetic Returns for 1927–1997. Table 5-3: Regressions
of Geometric Returns for 1938–1997. The Size Effect on the Arithmetic
versus Geometric Means. Table 5-4: Log Size Comparison of Discount
Rates and Gordon Model Multiples Using AM versus GM. Indro and
Lee Article.
6. An Iterative Valuation Approach 179
Introduction. Equity Valuation Method. Table 6-1A: The First
Iteration. Table 6-1B: Subsequent Iterations of the First Scenario. Table
viii Contents
6-1C: Initial Choice of Equity Doesn’t Matter. Convergence of the Equity
Valuation Method. Invested Capital Approach. Table 6-2A: Iterations
Beginning with Book Equity. Table 6-2B: Initial Choice of Equity Doesn’t
Matter. Convergence of the Invested Capital Approach. Log Size.
Summary. Bibliography.
PART III
ADJUSTING FOR CONTROL AND MARKETABILITY
7. Adjusting for Levels of Control and Marketability 195
Introduction. The Value of Control and Adjusting for Level of
Control. Prior Research—QualitativeProfessional. Prior Research—
Academic. My Synthesis and Analysis. Discount for Lack of
Marketability (DLOM). Mercer’s Quantitative MarketabilityDiscount
Model. Kasper’s BAS Model. Restricted Stock Discounts. Abrams’
Economic Components Model. Mercer’s Rebuttal. Conclusion.
Mathematical Appendix.
8. Sample Restricted Stock Discount Study 293
Introduction. Background. Stock Ownership. Purpose of the Appraisal.
No Economic Outlook Section. Sources of Data. Valuation. Commentary
to Table 8-1: Regression Analysis of Management Planning Data.
Commentary to Table 8-1A: Revenue and Earnings Stability.
Commentary to Table 8-1B: Price Stability. Valuation Using Options
Pricing Theory. Conclusion of Discount for Lack of Marketability.
Assumptions and Limiting Conditions. Appraiser’s Qualifications.
9. Sample Appraisal Report 315
Introduction. Purpose of the Report. Valuation of Considerations.
Sources of Data. History and Description of the LLC. Significant
Terms and Legal Issues. Conclusion. Economic Outlook. Economic
Growth. Inflation. Interest Rates. State and Local Economics. Summary.
Financial Review. Commentary to Table 9-2: FMV Balance Sheets.
Commentary to Table 9-3: Income Statements. Commentary to Table 9-4:
Cash Distributions. Valuation. Valuation Approaches. Selection of
Valuation Approach. Economic Components Approach. Commentary to
Table 9-5: Calculations of Combined Discounts. Commentary to Table
9-5A: Delay-to-Sale. Commentary to Table 9-5C: Calculation of DLOM.
Commentary to Table 9-6: Partnership Profiles Approach—1999.
Commentary to Table 9-7: Private Fractional Interest Sales. Commentary
to Table 9-8: Final Calculation of Fractional Interest Discounts.
Conclusion. Statement of Limiting Conditions. Appraiser’s
Qualifications. Appendix: Tax Court’s Opinion for Discount for
Lack of Marketability. Introduction. The Court’s 10 Factors.
Application of the Court’s 10 Factors to the Valuation.
PART IV
PUTTING IT ALL TOGETHER
10. Empirical Testing of Abrams’Valuation Theory 357
Introduction. Steps in the Valuation Process. Applying a Valuation
Model to the Steps. Table 10-1: Log Size for 1938–1986. Table 10-2:
Contents ix