A book to keep at hand

By Stephen Cole

Chris Mercer’s integrated theory is really that good of a read for the valuation, litigation or M & A professional

Every so often a great technical book comes along. Chris Mercer, ASA, CFA and one of the US’s leading business valuators, has pulled it all together in his recent text, The Integrated Theory of Business Valuation. It’s not for casual readers but for interested valuation, litigation or merger and acquisition professional. It is writtenin simple language and is full of wise commentary and observations borne of a long career in business valuation, investment banking and expert testimony.

At the heart of his integrated theory is the obligation to reconcile value using a range of alternative valuation approaches, both with each other and with market-based data. Mercer’s book provides concise summaries not only of his own approaches but of alternative approaches — all of which are practical. While recommendations are strongly put, they are not dogmatic. He gives full and generous credit to other US authors, practitioners and colleagues, as well as to Canadians Ian Campbell and Richard Wise. The book contains extensive reference sources.

Proof of every good expert’s work is that it can be reduced to a half-dozen essential charts, graphs or pictorial representations. After a brief introduction, Integrated Theory can be summarized just that way.

Mercer summarizes the essential value drivers with the acronym GRAPES: Growth and time; Risk and reward; Alternative investments as market-based benchmarks; Present value; Expectations and future orientation; and Sanity, rationality and consistency (fairness and balance are also recurring themes in the book).

Some interesting and current substantive thoughts Mercer explores include:

Levels of value

Mercer plots the evolution of the levels of value chart and provides genuine insight into the fundamentals and the subtleties that have emerged over time. The chart on page 43 best reflects his current thinking and highlights a number of points.

• The value of a marketable minority interest is a function of the expected cash flows of the whole enterprise — because the public market pricing of the marketable minority interest does, generally, capture the expected cash flows of the whole enterprise, notwithstanding there is no outbound cash flow to the shareholders of an equivalent amount. Note that Robert Reilly, in the “Business Valuation Digest,” Vol. 12, Issue 1, February 2006, puts forward a very informative levels of value chart and discussion where the marketable minority interest is a function of the expected cash flows only at the security or shareholder level.
• Control premiums must be stratified between strategic, synergistic and other such attributes and, separately, those attributable to financial control, if any. Mercer, with full credit to Eric W. Nath, ASA, supports the view that the freely traded price in the public marketplace (normal pricing or pricing of a marketable minority interest) most likely represents a controlling interest value, rather than a minority interest price. This is in large part due to the increasing efficiencies of the public marketplace, much improved governance practices in both public and private companies, the increasing beneficial presence of private equity buyers and the related lift in value. Note, for example, if there was a conspicuous difference between the market cap of a publicly traded company (marketable minority value at normal pricing) and financial control value, it would likely quickly become a target for takeover for private equity firms. In an efficient market, the pricing would quickly move up to modestly less than financial control value at a minimum.
• Contrary to traditional thought, it follows that when moving from marketable minority value in a public company to a controlling interest value in a private company in many cases there may be no discount required on account of a lack of control. However fundamental adjustments will still generally be required to account for factors such as risk and expected growth relative to the guideline public companies.
• The value of a nonmarketable minority interest in a private company is a function of expected cash flows to the shareholder or partner. The most direct method of valuation being the quantitative marketability discount model advanced by Mercer and described later
• Recognition that there are frequent times when speculative or frothy market activity produces irrational pricing for public minority interests. That is to say, price will often exceed value in such circumstances.

Direct determination of strategic-control and financial-control premium

The control premiums are best determined by directly adjusting the following components of the valuation model:

• Net income (or cash flow): adjustments to capture the financial control premium would include those economies or efficiencies available to the typical financial buyer that may not be present in the company at the time of the appraisal; adjustments necessary to capture the strategic control premium are unique to the specific buyer, and include all forms of synergies — subject to adjustment for probability of realization.
• Discount rate or cap rate reflecting both the specific company risk and the specific company growth rate.

Comparing public and private value

A bedrock principle is the need to reconcile business value, when practical, with the market-based price of a comparable marketable minority interest — a publicly traded share.

In order to stress test his findings and to honour the relative nature of value, Mercer recommends “what if” or scenario analyses to ensure valuation is in the high comfort zone. For example, he determines the relevant range of public company values by both iteratively and simultaneously adjusting company-specific risk and growth rates.

In determination of a discount rate, whether using market-based comparables or the adjusted capital asset pricing model, Mercer seeks specificity where possible. The comparison and parsing of cap rates and multiples speaks to this. With the benefit of this type of analysis one can more objectively move to a private company value from comparable public guideline companies.

The quantitative marketability model

The essence of the Mercer model is that the value of a minority interest in a private company is a function of expected cash flows to the shareholder and therefore ultimately equal to the sum of the following net present values: dividends and terminal value/ultimate sale price.
In turn, the above factors are influenced predominantly by valuation of the underlying whole business, because it is the whole business that will support the dividend flow and because the terminal value will be in large part dominated by the underlying business value, though not necessarily equal to a pro rata share of it.

Unlike the valuation of an entire private business or the minority interest in a public company, it is necessary to determine a holding period for the private minority interest. Otherwise, there is no date at which terminal value will be realized.

The versatility of the quantitative marketability discount is a function of five key inputs:

• expected growth in value necessary to determine terminal value;
• expected dividend yield;
• expected growth in dividend yield;
• expected holding period; and
• required holding period return, which is equal to the enterprise discount rate utilized or implied in an appraiser’s conclusion as to value of the subject business at the marketable minority level of value plus a holding period premium compensating for the long and indeterminate holding period until the liquidity is expected, uncertainties over distributions and innumerous other risk factors.

Valuators, the courts and others often wrongly focus on the implied marketability or minority discount and it does provide a time-honoured benchmark. It is only a by-product of a minority interest valuation. The rate of return required at the marketable minority level and the holding period premium are market-driven inputs and are far more meaningful.

Conclusion

Charlie Munger, Warren Buffett’s partner, says he learned from Benjamin Franklin never to be without a book at hand — that reading the works of others provides an enormous head start.

Mercer’s Integrated Theory really is that good.

Stephen Cole, FCA, FCBV, is partner at Cole & Partners and is Technical editor for business valuation.