I. Fair Market Value Defined:TETON VALLEY CORPORATIONCORPORATE FINANCE:AN INTRODUCTORY COURSEDISCUSSION NOTESMODULE #191VALUATIONI. Fair Market Value Defined:The "price at which the property would change hands between a willing buyer and a willing sellerwhen the latter is not under any compulsion to sell, and both parties have reasonable knowledgeof the relevant facts." (IRS Revenue Ruling 59-60, as amended)II. Factors that are Relevant to Valuation as Suggested by the IRS (IRS RevenueRuling 59-60, as amended):- The nature of the business and the history of the enterprise from its inception,- The economic outlook in general and the condition and outlook of the specific industry inparticular,- The earning capacity of the company,- The dividend-paying capacity of the company,- Sales of the stock and the size of the block of stock to be valued,- The market price of stocks of corporations engaged in the same or a similar line of businesshaving their stocks actively traded in a free and open market, either on an exchange or over-the-counter. III. Valuation Considerations- When valuing a company, a full financial analysis to identify the firm's strengths and weaknesses is recommended. Study financial ratio trends for the firm and relative to comparable firms. - To identify comparable firms, sources include Value Line (not always helpful for small firms),Standard & Poor's OTC Profiles, the appropriate Moody's publications, and relevant trade publication sources. See Appendix B of Copeland, et al., and Shannon Pratt's book for additional ideas (see footnote #2 below). The ideal set of comparable companies will be 1) publicly-traded firms, 2) in the same industry, 3) in the same size range, 4) located in the samegeneral geographic area, and 5) of similar capital structure. The idea is to hold constant on business risk and financial risk as closely as possible.Comparables must be justifiable to the courts and the IRS.1 This lecture module is designed to compliment chapter 19 in B&D.1IV. An Overview of Valuation Methodologies:2-Liquidation Value,3- Net Book Value,- Comparable Price to Earnings,- Comparable Price to Sales,- Comparable Price to Book,- Comparable Dividends to Price,- Capitalization of Income,- Capitalization of Dividends,- Recent stock sales,- Capitalization of "Free Cash Flow,"- Blended approaches (a combination of more than one approach) V. Discuss the Valuation Approaches in Turn:- Liquidation--slow or fast (fire sale!)? It makes a big difference. Remember, a firm may be worth more "dead than alive!" Thus it may depend upon the circumstances of the liquidation. The criterion for liquidation? The NPV of liquidation exceeds the NPV of continuation.- Net Book Value = Assets - Liabilities. Little logic exists to recommend this approach. Perhaps it appeals to accountants because of it conservative nature. It is based on historical accounting numbers. Why should net book value have a relationship to market value, which considers future cash flows and risk?- For all of the comparable firm approaches, calculate the average (or more appropriately the representative) financial relationships, e.g., the price/earnings, or P/E ratios, or the dividend yields (dividends per share divided by price per share). Establish the current levels of the base parameters (e.g., EPS, sales per share, book value per share, dividends per share) for the firm being valued. You may want to develop a weighted average of the base parameter levels for the last few years for the firm being valued with heavier weights on recent years.For instance, using the, P/E, approach, you would multiply the average P/E of the comparable firms times the EPS of the firm being valued to come up with an estimate of the equity value of 2 See Valuation: Measuring and Managing the Value of Companies, by T. Copeland, T. Koller, and J. Murrin, 2nd Edition, Wiley, 1994. This excellent book presents a rigorous discussion of valuation complete with excellent examples. Also, see Valuing a Business: The Analysis and Appraisal of Closely Held Companies, Shannon P. Pratt, 1988, Dow Jones-Irwin. This book presents a more "cookbook" discussion of valuation, but also includes examples. Other applicable references include "A Comparison of Stock Price Predictions Using Court Accepted Formulas, Dividend Discount, and P/E Models," K. Hickman and G. Petry, Financial Management, Summer 1990, pages 76-87, "Capitalization Rates and Valuation of Closely-Held Businesses," S. Choudhury, Journal of Financial Management and Analysis, July-December 1989, pages 15-18 and “The Valuation of Cash Flow Forecasts: An Empirical Analysis,” S. Kaplan and R. Ruback, Journal of Finance, September 1995, pages 1059-1093.3 All other procedures are designed to value the firm on a "going concern" basis.2this firm. In another example, say using dividend yields (dividend/price = dividend yield), you would divide the dividends of the firm being valued by the average dividend yield of the comparable firms to come up with an estimate of the equity value. The comparables approaches leave much to be desired. For instance, they are only loosely based on future cash flows and the risk adjustment is imprecise. Any differences in the expected growth between the comparable firms and the firm being valued are not accounted for in these methods.- Capitalization of Income approach. Equity Value = Σ Earningst/(1 + rs)t. Earnings can be growing at any rate. Alternatively, use EPS and find share price. rs is the cost of equity capital."Times 6 Rule" This “rule of thumb” is occasionally used to estimate the cost of equity, or rs. The SBBI small stock return (arithmetic average from 1925 through 2000) has been17.3%. Take the reciprocal of this number, or (1.000)/(0.173). The result is 5.78. Round this number to 6. Therefore, if the required discount rate of 17.3% is appropriate for a small firm being valued, and you assume that earnings are perpetual (zero growth), Equity Value = (Earnings)/(rs), or V = (Earnings)*(1/rs). If 1/rs = 6, you just multiply the earnings of the firm being valued by 6 to get an estimate of equity value.Other ways to estimate rs: 1) Gordon Constant Growth Model (E/P, if zero growth), 2) Risk Premium, or (rf + --- where rf is an estimate of the risk-free rate and - is an ad hoc estimate of the risk premium, 3) CAPM, 4) SBBI Small Stock Return +/- subjective adjustment.Fundamentally, this