BUILD A WINNING PROPERTY TAX APPEAL: HOW TO ADJUST FOR DIFFERENCES & FINALIZE TRUE MARKET VALUE

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Capitalization and discounting valuation calculations become mathematically equivalent under the assumption that the business income grows at a constant rate. The capital asset pricing model CAPM provides one method of determining a discount rate in business valuation. The method derives the discount rate by adding risk premium to the risk-free rate. The risk premium is derived by multiplying the equity risk premium with "beta", a measure of stock price volatility.

Beta is compiled by various researchers for particular industries and companies, and measures systematic risks of investment. One of the criticisms of the CAPM is that beta is derived from volatility of prices of publicly traded companies, which differ from non-publicly companies in liquidity, marketability, capital structures and control. Other aspects such as access to credit markets, size, and management depth are generally different, too. The rate build-up method also requires an assessment of the subject company's risk, which provides valuation of itself. Where a privately held company can be shown to be sufficiently similar to a public company, the CAPM may be suitable.

However, it requires the knowledge of market stock prices for calculation. For private companies that do not sell stock on the public capital markets, this information is not readily available. Therefore, calculation of beta for private firms is problematic. The build-up cost of capital model is the typical choice in such cases. With regard to capital market-oriented valuation approaches there are numerous valuation approaches besides the traditional CAPM model.

Furthermore, alternative capital market models were developed, having in common that expected return hinge on multiple risk sources and thus being less restrictive:. Nevertheless, even these models are not wholly consistent, as they also show market anomalies. However, the method of incomplete replication and risk covering come along without the need of capital market data and thus being more solid. Among them the approximative decomposition valuation approach can be found.

The weighted average cost of capital is an approach to determining a discount rate. The WACC method determines the subject company's actual cost of capital by calculating the weighted average of the company's cost of debt and cost of equity. The WACC must be applied to the subject company's net cash flow to total invested capital. One of the problems with this method is that the valuator may elect to calculate WACC according to the subject company's existing capital structure , the average industry capital structure , or the optimal capital structure.

Such discretion detracts from the objectivity of this approach, in the minds of some critics. Indeed, since the WACC captures the risk of the subject business itself, the existing or contemplated capital structures, rather than industry averages, are the appropriate choices for business valuation. Once the capitalization rate or discount rate is determined, it must be applied to an appropriate economic income stream: The result of this formula is the indicated value before discounts.

Before moving on to calculate discounts, however, the valuation professional must consider the indicated value under the asset and market approaches. Careful matching of the discount rate to the appropriate measure of economic income is critical to the accuracy of the business valuation results. Net cash flow is a frequent choice in professionally conducted business appraisals.

The rationale behind this choice is that this earnings basis corresponds to the equity discount rate derived from the Build-Up or CAPM models: At the same time, the discount rates are generally also derived from the public capital markets data. The Build-Up Method is a widely recognized method of determining the after-tax net cash flow discount rate, which in turn yields the capitalization rate. The figures used in the Build-Up Method are derived from various sources. This method is called a "build-up" method because it is the sum of risks associated with various classes of assets.

It is based on the principle that investors would require a greater return on classes of assets that are more risky. The first element of a Build-Up capitalization rate is the risk-free rate, which is the rate of return for long-term government bonds. Investors who buy large-cap equity stocks, which are inherently more risky than long-term government bonds, require a greater return, so the next element of the Build-Up method is the equity risk premium. In determining a company's value, the long-horizon equity risk premium is used because the Company's life is assumed to be infinite.

The sum of the risk-free rate and the equity risk premium yields the long-term average market rate of return on large public company stocks. Similarly, investors who invest in small cap stocks, which are riskier than blue-chip stocks, require a greater return, called the "size premium. By adding the first three elements of a Build-Up discount rate, we can determine the rate of return that investors would require on their investments in small public company stocks.

These three elements of the Build-Up discount rate are known collectively as the "systematic risks. It arises from external factors and affect every type of investment in the economy.

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As a result, investors taking systematic risk are rewarded by an additional premium. In addition to systematic risks, the discount rate must include "unsystematic risk" representing that portion of total investment risk that can be avoided through diversification. Public capital markets do not provide evidence of unsystematic risk since investors that fail to diversify cannot expect additional returns. Unsystematic risk falls into two categories.

One of those categories is the "industry risk premium". It is also known as idiosyncratic risk and can be observed by studying the returns of a group of companies operating in the same industry sector. Morningstar's yearbooks contain empirical data to quantify the risks associated with various industries, grouped by SIC industry code. The other category of unsystematic risk is referred to as "company specific risk.

However, as of late , new research has been able to quantify, or isolate, this risk for publicly traded stocks through the use of Total Beta calculations. Pinkerton have outlined a procedure which sets the following two equations together:. While it is possible to isolate the company-specific risk premium as shown above, many appraisers just key in on the total cost of equity TCOE provided by the following equation: It is similar to using the market approach in the income approach instead of adding separate and potentially redundant measures of risk in the build-up approach.

The use of total beta developed by Aswath Damodaran is a relatively new concept. It is, however, gaining acceptance in the business valuation community since it is based on modern portfolio theory. Total beta can help appraisers develop a cost of capital who were content to use their intuition alone when previously adding a purely subjective company-specific risk premium in the build-up approach.

It is important to understand why this capitalization rate for small, privately held companies is significantly higher than the return that an investor might expect to receive from other common types of investments, such as money market accounts, mutual funds, or even real estate. Those investments involve substantially lower levels of risk than an investment in a closely held company.

Depository accounts are insured by the federal government up to certain limits ; mutual funds are composed of publicly traded stocks, for which risk can be substantially minimized through portfolio diversification. Closely held companies , on the other hand, frequently fail for a variety of reasons too numerous to name. Examples of the risk can be witnessed in the storefronts on every Main Street in America.

There are no federal guarantees. The risk of investing in a private company cannot be reduced through diversification, and most businesses do not own the type of hard assets that can ensure capital appreciation over time. This is why investors demand a much higher return on their investment in closely held businesses; such investments are inherently much more risky.

This paragraph is biased, presuming that by the mere fact that a company is closely held, it is prone towards failure. The value of asset-based analysis of a business is equal to the sum of its parts. That is the theory underlying the asset-based approaches to business valuation. The asset approach to business valuation reported on the books of the subject company at their acquisition value, net of depreciation where applicable.

These values must be adjusted to fair market value wherever possible. The value of a company's intangible assets, such as goodwill, is generally impossible to determine apart from the company's overall enterprise value. For this reason, the asset-based approach is not the most probative method of determining the value of going business concerns.

In these cases, the asset-based approach yields a result that is probably lesser than the fair market value of the business. In considering an asset-based approach, the valuation professional must consider whether the shareholder whose interest is being valued would have any authority to access the value of the assets directly. Shareholders own shares in a corporation, but not its assets, which are owned by the corporation.

A controlling shareholder may have the authority to direct the corporation to sell all or part of the assets it owns and to distribute the proceeds to the shareholder s. The non-controlling shareholder, however, lacks this authority and cannot access the value of the assets. As a result, the value of a corporation's assets is not the true indicator of value to a shareholder who cannot avail himself of that value. The asset based approach is the entry barrier value and should preferably to be used in businesses having mature or declining growth cycle and is more suitable for capital intensive industry.

Adjusted net book value may be the most relevant standard of value where liquidation is imminent or ongoing; where a company earnings or cash flow are nominal, negative or worth less than its assets; or where net book value is standard in the industry in which the company operates. The adjusted net book value may also be used as a "sanity check" when compared to other methods of valuation, such as the income and market approaches The market approach to business valuation is rooted in the economic principle of competition: Buyers would not pay more for the business, and the sellers will not accept less, than the price of a comparable business enterprise.

The buyers and sellers are assumed to be equally well informed and acting in their own interests to conclude a transaction. It is similar in many respects to the "comparable sales" method that is commonly used in real estate appraisal. The market price of the stocks of publicly traded companies engaged in the same or a similar line of business, whose shares are actively traded in a free and open market, can be a valid indicator of value when the transactions in which stocks are traded are sufficiently similar to permit meaningful comparison.

The difficulty lies in identifying public companies that are sufficiently comparable to the subject company for this purpose. Also, as for a private company , the equity is less liquid in other words its stocks are less easy to buy or sell than for a public company , its value is considered to be slightly lower than such a market-based valuation would give. When there is a lack of comparison with direct competition, a meaningful alternative could be a vertical value-chain approach where the subject company is compared with, for example, a known downstream industry to have a good feel of its value by building useful correlations with its downstream companies.

Such comparison often reveals useful insights which help business analysts better understand performance relationship between the subject company and its downstream industry. For example, if a growing subject company is in an industry more concentrated than its downstream industry with a high degree of interdependence, one should logically expect the subject company performs better than the downstream industry in terms of growth, margins and risk.

Guideline Public Company method entails a comparison of the subject company to publicly traded companies. The comparison is generally based on published data regarding the public companies' stock price and earnings, sales, or revenues, which is expressed as a fraction known as a "multiple. The public companies identified for comparison purposes should be similar to the subject company in terms of industry, product lines, market, growth, margins and risk.

However, if the subject company is privately owned, its value must be adjusted for lack of marketability. This is usually represented by a discount, or a percentage reduction in the value of the company when compared to its publicly traded counterparts. This reflects the higher risk associated with holding stock in a private company. The difference in value can be quantified by applying a discount for lack of marketability. This discount is determined by studying prices paid for shares of ownership in private companies that eventually offer their stock in a public offering.

Alternatively, the lack of marketability can be assessed by comparing the prices paid for restricted shares to fully marketable shares of stock of public companies. As above , in certain cases equity may be valued by applying the techniques and frameworks developed for financial options , via a real options framework.

In general, equity may be viewed as a call option on the firm, [7] and this allows for the valuation of troubled firms which may otherwise be difficult to analyse.

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Of course, where firm value is greater than debt value, the shareholders would choose to repay i. Thus analogous to out the money options which nevertheless have value, equity will may have value even if the value of the firm falls well below the face value of the outstanding debt—and this value can should be determined using the appropriate option valuation technique.

A further application of this principle is the analysis of principal—agent problems ; [4] see contract design under principal—agent problem. Certain business situations, and the parent firms in those cases, are also logically analysed under an options framework; see "Applications" under the Real options valuation references.

Just as a financial option gives its owner the right, but not the obligation, to buy or sell a security at a given price, companies that make strategic investments have the right, but not the obligation, to exploit opportunities in the future; management will of course only exercise where this makes economic sense. Thus, for companies facing uncertainty of this type, the stock price may should be seen as the sum of the value of existing businesses i. A common application is to natural resource investments.

The value of the resource is then the difference between the value of the asset and the cost associated with developing the resource.

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Where positive " in the money " management will undertake the development, and will not do so otherwise, and a resource project is thus effectively a call option. A resource firm may should therefore also be analysed using the options approach. Specifically, the value of the firm comprises the value of already active projects determined via DCF valuation or other standard techniques and undeveloped reserves as analysed using the real options framework. Product patents may also be valued as options, and the value of firms holding these patents — typically firms in the bio-science , technology , and pharmaceutical sectors — can should similarly be viewed as the sum of the value of products in place and the portfolio of patents yet to be deployed.

Similar analysis may be applied to options on films or other works of intellectual property and the valuation of film studios. Besides mathematical approaches for the valuation of companies a rather unknown method includes also the cultural aspect. The so-called Cultural valuation method Cultural Due Diligence seeks to combine existing knowledge, motivation and internal culture with the results of a net-asset-value method.

Especially during a company takeover uncovering hidden problems is of high importance for a later success of the business venture. The valuation approaches yield the fair market value of the Company as a whole. In valuing a minority, non-controlling interest in a business, however, the valuation professional must consider the applicability of discounts that affect such interests. Discussions of discounts and premiums frequently begin with a review of the "levels of value". There are three common levels of value: The intermediate level, marketable minority interest, is less than the controlling interest level and higher than the non-marketable minority interest level.

The marketable minority interest level represents the perceived value of equity interests that are freely traded without any restrictions.