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Understanding Business Valuation: A Practical Guide to Valuing Small- to Medium-Sized Businesses, 4th edition

Understanding Business Valuation: A Practical Guide to Valuing Small- to Medium-Sized Businesses, 4th edition
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Written by Gary Trugman, Understanding Business Valuation: A Practical Guide to Valuing Small-to Medium-Sized Businesses simplifies a technical and complex area of practice with real-world experience and examples. Trugman's informal, easy-to-read style covers all the bases in the various valuation approaches, methods, and techniques. Readers at all experience levels will find valuable information that will improve and fine-tune their everyday activities.

Topics include valuation standards, theory, approaches, methods, discount and capitalization rates, S corporation issues, and much more. Author's Note boxes throughout the publication draw on the author's veteran, practical experience to identify critical points in the content. This edition has been greatly expanded to include new topics as well as enhanced discussions of existing topics.

New and expanded in this edition:

  • New content on statistics for business valuation and economic damage analyses.
  • Forecasting techniques for business valuation and economic damages.
  • Pass through entities including a discussion of the leading models used to estimate taxes.
  • An accompanying CD-ROM that includes new sample reports and one of the most comprehensive bibliographies in the business.
  • The discounts and premiums section has been greatly expanded to included discussion of additional types of discounts as well as quantification techniques used to calculate marketability discounts. This includes a discussion on how to use the Black-Scholes Option Pricing Model.

Table of Contents

Introduction
Steps of an Appraisal
Notation System Used in This Book

  • Chapter 1 Overview of Business Valuation
    • Chapter Goals
    • Introduction
    • A Brief Walk Down Memory Lane
    • Why Are Businesses Appraised?
    • Mergers, Acquisitions, Reorganizations, Spin-offs, Liquidations, and Bankruptcy
    • Allocation of Purchase Price
    • Estate, Gift, and Income Taxes
    • Marital Dissolution
    • Employee Stock Ownership Plans
    • Buy-Sell Agreements
    • Stockholder Disputes
    • Financing
    • Ad Valorem Taxes
    • Incentive Stock Option Considerations
    • Initial Public Offerings
    • Damages Litigation
    • Insurance Claims
    • Charitable Contributions
    • Eminent Domain Actions
    • Fairness Opinions
    • Who Values Businesses?
    • Business Valuation Analysts
    • Accountants (CPAs)
    • Business Brokers
    • College Professors
    • Commercial Real Estate Appraisers
    • Investment Bankers
    • Industry Experts
    • The Internet
    • Professional Appraisal Organizations
    • The AICPA
    • The American Society of Appraisers
    • The Institute of Business Appraisers, Inc.
    • The National Association of Certified Valuation Analysts
    • The CFA Institute
    • The Appraisal Foundation
    • Conclusion
  • Chapter 2 Business Valuation Standards
    • Chapter Goals
    • Introduction
    • AICPA Statement on Standards for Valuation Services No. 1
    • Foreword.
    • Why Issued
    • Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset
    • Introduction and Scope
    • Overall Engagement Considerations
    • Development
    • The Valuation Report
    • Effective Date
    • Interpretation No. 1-01, "Scope of Applicable Services" of Statement on Standards for Valuation Services No.1, Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset
    • Background
    • General Interpretation
    • Specific Illustrations
    • Illustrations Relating to Litigation Engagements and Certain Controversy Proceedings
    • Illustrations Relating to Tax Engagements
    • Illustrations Relating to Other Engagements
    • Illustrations for PFP-Specific Engagements
    • AICPA Statement on Standards for Consulting Services No. 1
    • AICPA Code of Professional Conduct-Rule 102
    • Professional Competence
    • Due Professional Care
    • Planning and Supervision
    • Sufficient Relevant Data
    • Client Interest
    • Understanding With the Client
    • Communication With the Client
    • IBA Standards
    • ASA Standards
    • Uniform Standards of Professional Appraisal Practice
    • NACVA Standards
    • Glossary of Business Valuation Terms
    • Conclusion
  • Chapter 3 Getting Started
    • Chapter Goals
    • Introduction
    • Learning About the Engagement
    • Deciding Whether to Accept the Engagement
    • Conflicts of Interest
    • Purpose and Function of the Engagement
    • Amount of Time Required to Do the Job
    • The Scope of the Assignment
    • The Type of Report to Be Issued
    • Engagement Letters
    • Description of the Scope of the Assignment
    • Detailed Description of the Appraisal Subject
    • Standard of Value That Will Be Used, Including the Definition of That Standard
    • Effective Date(s) of the Valuation
    • Type of Report That Will Be Issued to Communicate the Value Estimate
    • Client Responsibilities
    • Method of Determining Fees and the Terms of Payment
    • Five Steps of an Appraisal Assignment
    • Engagement Letter Considerations for Litigation Reports
    • The Initial Document Request
    • Using a Standard Checklist
    • Setting Up Multiple Checklists
    • Conclusion
  • Chapter 4 Appraisal Principles and Theory
    • Chapter Goals
    • Introduction
    • Principles of Appraisal
    • Principle of Alternatives
    • Principle of Substitution
    • Principle of Future Benefits
    • Standards of Value
    • Fair Market Value
    • Fair Value
    • Investment Value
    • Intrinsic Value
    • How the Purpose of the Valuation Influences the Standard of Value
    • Subsequent Events (Known or Knowable)
    • IRS Influence on Appraisals
    • Revenue Ruling 59-60
    • Revenue Ruling 65-192
    • Revenue Ruling 65-193
    • Revenue Procedure 66-49
    • Revenue Ruling 68-609
    • Revenue Procedure 77-12
    • Revenue Ruling 77-287
    • Revenue Ruling 83-120
    • Revenue Ruling 85-75
    • Revenue Ruling 93-12
    • Technical Advice Memorandum 94-36005
    • Chapter 14 of the IRC
    • Conclusion
  • Chapter 5 Data Gathering
    • Chapter Goals
    • Introduction
    • What Items Affect Value?
    • Internal Information
    • Nonfinancial Information
    • Financial Information
    • External Information
    • Economic Data
    • Industry Data
    • Publicly Traded Guideline Company Data
    • The Old Days (When the Dinosaurs Roamed the Earth)
    • Other Sources of Data
    • The On Site Interview
    • Conclusion
  • Chapter 6 Data Analysis
    • Chapter Goals
    • Introduction
    • Economic Analysis
    • Industry Analysis
    • Porter's Five Forces
    • Other Considerations
    • Subject Company Analysis
    • SWOT (Strengths, Weaknesses, Opportunities, and Threats) Analysis
    • Financial Analysis
    • Comparative Company Analysis
    • Common Size Financial Statements
    • Financial Ratios
    • Comparative Industry Analysis
    • Trend Analysis
    • Operational Analysis
    • Financial Statement Adjustments
    • Conversion of Cash or Income Tax Basis to GAAP
    • Tax Return Adjustments
    • Understanding Financial Statements for Valuation Purposes
    • Analysis of Historical Balance Sheets
    • Analysis of Historical Income Statements
    • Bardahl Analysis
    • Normalization Adjustments
    • Comparability Adjustments.
    • Nonoperating and Non-Recurring Adjustments
    • Discretionary Adjustments
    • Minority Interest Valuations
    • Conclusion
  • Chapter 7 Statistics for Valuation and Economic Damages
    • Chapter Goals
    • Introduction
    • Population and Sample: Descriptive and Inferential Statistics
    • Discrete and Continuous Variables
    • Frequency Distributions and Measures of Variation
    • Central Tendency (Mean, Median, Mode, and So Forth)
    • Relation Between Mean, Median, and Mode
    • Relation Between Arithmetic, Geometric, and Harmonic Means
    • Quartiles, Deciles, and Percentiles
    • Variation
    • Correlation
    • Let's Do Some Number Crunching
    • Calculation of the Mean
    • Calculation of the Harmonic Mean
    • Calculation of the Standard Deviation
    • Calculation of the Coefficient of Variation
    • Calculation of Median and Percentile
    • Be Careful Not to Drink the Statistics Kool-Aid: This Stuff Can be Misleading
    • Conclusion
  • Chapter 8 Developing Forecasts for Business
    • Valuations and Economic Damages
    • Chapter Goals
    • Introduction
    • Forecast Versus Projection
    • Management's Forecast
    • Factors to Consider When Evaluating Management's Forecast
    • Company Specific Factors
    • Economic Conditions
    • Industry Trends
    • Preparing the Forecast
    • The Sales Forecast
    • Revenue Factors for Certain Industries
    • Sales Forecasting Techniques.
    • Average Historical Growth Rate
    • Statistical Trend Models
    • Monte Carlo Simulation
    • Projecting Sales for a New Business
    • Cost of Goods Sold
    • Operating Expenses
    • Depreciation and Capital Expenditures
    • Interest Expense and Borrowing Needs
    • Balance Sheet Forecast
    • Applicable Standards for Forecasts in Business Valuation and Economic Damage Assignments
    • Court Acceptance
    • Conclusion
  • Chapter 9 The Market Approach-Part I
    • Chapter Goals
    • Introduction
    • Guideline Public Company Method
    • Creating a List of Potential Guideline Companies
    • Industry Research
    • Get the Business Description
    • Size Criteria.
    • Active Trading and Penny Stocks
    • Stock Pricing Reports and Active Trading
    • For Those That Pass Muster
    • Using Valuation Multiples
    • Price to Net Earnings
    • Price to Pretax Earnings
    • Price to Cash Flow
    • Price (MVIC) to Sales
    • Price to Dividend or Dividend Paying Capacity
    • Price to Book Value
    • Valuing Invested Capital Instead of Equity
    • Adjusting Public Company Multiples for Risk
    • Economic Risk
    • Business Risk
    • Operating Risk
    • Financial Risk
    • Asset Risk
    • Product Risk
    • Market Risk
    • Technological Risk
    • Regulatory Risk
    • Legal Risk
    • Valuation Considerations
    • What Price Do We Use in the Multiples?
    • Regression Analysis
    • Adjusting Multiples Based on SGLPTL
    • Making Quantitative Adjustments to Multiples
    • Adjusting the Market Multiple for Size
    • Adjusting the Market Multiple for Growth
    • How to Calculate the Present Value Weighted Perpetual Growth Rate
    • Advantages of Using the Guideline Public Company Method
    • Disadvantages of Using the Guideline Public Company Method
    • So Let's Be Honest
    • Let's Demo Pitchbook
    • Conclusion
  • Chapter 10 The Market Approach—Part II
    • Chapter Goals.
    • Introduction
    • Merger and Acquisition (Transaction) Method
    • IBA Market Database
    • BizComps
    • Pratt's Stats
    • Done Deals
    • Public Stats
    • Mergerstat/BVR's Control Premium Study
    • Thomson Financial Mergers & Acquisitions (TF Mergers & Acquisitions)
    • Business Brokers
    • Transaction Analysis
    • Qualitative Analysis
    • Quantitative Analysis
    • Let's Get Back to Valuation Theory
    • Advantages of Using the Merger and Acquisition Method
    • Disadvantages of Using the Merger and Acquisition Method
    • Internal Transactions
    • Industry Method
    • Conclusion
  • Chapter 11 The Asset-Based Approach
    • Chapter Goals
    • Introduction
    • Common Applications of the Asset-Based Approach
    • Advantages and Disadvantages of the Asset-Based Approach
    • Valuation Methods
    • Adjusted Book Value Method
    • Liquidation Value Method
    • Cost to Create Method
    • Working With Other Appraisers
    • How to Locate and Recognize Specialists
    • Conclusion
  • Chapter 12 The Income Approach
    • Chapter Goals.
    • Introduction
    • Value Is From an Investor's Viewpoint
    • Advantages and Disadvantages of the Income Approach
    • Advantages
    • Disadvantages
    • Selecting Benefit Streams
    • The Nature of the Business and Its Capital Structure
    • The Purpose and Function of the Appraisal
    • The Particular Subject of the Valuation
    • Using Pretax or After Tax Information
    • Valuing Invested Capital Instead of Equity
    • Using Cash Flow Instead of Earnings
    • Defining Cash Flow
    • Forecasting Future Benefit Streams
    • Income Approach Methods
    • Capitalization of Benefits Method
    • Discounted Future Benefits Method
    • The Excess Earnings (Formula) Method
    • Conclusion
  • Chapter 13 Discount and Capitalization Rates
    • Chapter Goals
    • Introduction
    • Discount Rates
    • Factors That Affect the Selection of a Discount Rate
    • Components of a Discount Rate
    • Comparing the Subject Company
    • Application of the Discount Rate
    • When All Else Fails, Go Back to the Theory
    • The Build Up Method
    • Capital Asset Pricing Model (CAPM).
    • Other Methods for Estimating a Discount Rate
    • Capitalization Rates
    • Factors Affecting the Selection of the Capitalization Rate
    • Sources of Data on Capitalization Rates
    • Deriving Discount and Capitalization Rates Applicable to Net Income Directly From the Market
    • Back to the Real World
    • Using Pretax or After Tax Rates
    • Discount Rates for Economic Damages
    • Conclusion
  • Chapter 14 Premiums and Discounts (Valuation Adjustments)-Part I
    • Chapter Goals
    • Introduction
    • Types of Discounts
    • Levels of Value
    • Valuation Adjustment-Control Premium.
    • Protecting the Minority Owner with Rights and Restrictions Through Agreements
    • Legal Remedies
    • More Control Premium Issues
    • Lack of Control (Minority) Discounts
    • Discount From Net Asset Value
    • Discount for Embedded Capital Gains
    • The Embedded Capital Gain Problem
    • Court Case Precedents on Embedded Capital Gains Tax with C Corporations
    • Embedded Capital Gains in Pass-Through Entities
    • Court Decisions on Embedded Capital Gains in Pass-Through Entities
    • Nonvoting Stock Discount
    • Conclusion
  • Chapter 15 Premiums and Discounts (Valuation Adjustments)-Part II
    • Chapter Goals
    • Introduction
    • Discount for Lack of Marketability (Illiquidity)
    • DLOM for Control
    • DLOM-The Qualitative Stuff
    • Private Company Discount.
    • Some More Empirical Data
    • Key Person Discount
    • Quantifying the Magnitude of the Key Person Discount
    • Court Cases Involving Key Person Discount
    • Blockage Discount
    • How About Some Court Cases?
    • Other Premiums and Discounts
    • Application of Valuation Adjustments
    • Conclusion
  • Chapter 16 Revenue Ruling 59-60
    • Chapter Goals
    • Introduction
    • Revenue Ruling 59-60
    • Conclusion
  • Chapter 17 The Valuation Report
    • Chapter Goals
    • Introduction
    • Components of a Valuation Report
    • Letter of Transmittal
    • Introduction
    • Description of the Assignment
    • Scope of Work
    • Assumptions and Limiting Conditions
    • Sources of Information
    • Analysis of Subject Entity and Related Nonfinancial Information
    • Financial Statement/Information Analysis
    • Valuation Approaches and Methods Considered
    • Valuation Approaches and Methods Used
    • Valuation Adjustments
    • Nonoperating Assets, Nonoperating Liabilities, and Excess or Deficient Operating Assets
    • Representation of the Valuation Analyst
    • Reconciliation of Estimates and Conclusion of Value
    • Qualifications of the Valuation Analyst
    • Appendices and Exhibits
    • Types of Valuation Reports
    • Detailed Reports
    • Summary Reports
    • Calculation Reports
    • Oral Reports
    • Preparing the Business Valuation Report
    • Federal Rules of Civil Procedure
    • Using Your Report as a Selling Tool
    • Using the Other Side's Report to Help Sell Your Opinion
    • Understanding the Weaknesses in the Valuation Process
    • Valuation Analyst, Protect Yourself!
    • Defending the Business Valuation Report
    • Common Errors in Business Valuation Reports
    • The Reconciliation Process
    • Conclusion
  • Chapter 18 Valuation of Pass-Through Entities
    • Chapter Goals
    • Introduction
    • What is an S Corporation?
    • Key Court Cases
    • So Where Do We Go From Here?
    • Valuation Issues
    • Standard of Value
    • Control Versus Minority
    • Distributing Versus Nondistributing
    • Corporate or Personal Income Tax Rates
    • Holding Period of the Investment
    • Timing of the Valuation
    • So, What Do We Do?
    • Back to the Future
    • S Corporation Models
    • How Our Firm Handled the S Corporation Issue
    • How Do the Models Compare?
    • Some Points to Consider
    • Other Pass-Through Entities
    • Conclusion
  • Chapter 19 Valuation in Financial Reporting
    • Chapter Goals
    • Introduction
    • Background of Valuation in Financial Reporting
    • FASB ASC 820, Fair Value Measurement
    • Definition of Fair Value
    • Example of Principal and Most Advantageous Markets
    • Market Participants Assumptions
    • Highest and Best Use Application Criteria Applied in Fair Value Measurements
    • FASB ASC 805, Business Combinations
    • Recognizing Identified Assets in Business Combinations
    • Fair Value Measurements in Impairment Testing
    • When to Test for Ongoing Impairment
    • Developing Best Practices in Valuation for Financial Reporting
    • Valuation Resource Group
    • AICPA
    • Working With Your Client's Outside Auditing Firm
    • Identification of Intangible Assets for Financial Reporting
    • Conclusion
  • Chapter 20 Valuing Intangible Assets:
    • An Overview
    • Chapter Goals
    • Introduction
    • What Is Intellectual Property?
    • Conducting a Valuation of Intangible Assets
    • Market Approach
    • Income Approach
    • Cost Approach
    • What Is a Remaining Useful Life Analysis?
    • What Is a Reasonable Royalty Rate and Where Do I Get This Stuff?
    • What Is an Amortization Benefit?
    • How About Some More Examples
    • Create a Lead Schedule for Your Analysis
    • Fair Value of the Customer List
    • Fair Value of Acquired Software
    • Fair Value of Customer Related Intangibles with an Excess Earning Model
    • Fair Value of Noncompete Agreements Using a "With and Without" Model
    • Fair Value of the Assembled Workforces
    • Personal Goodwill
    • Conclusion
  • Chapter 21 Estate and Gift Valuations
    • Chapter Goals.
    • Introduction
    • Penalties for Undervaluation on Estate and Gift Tax Returns
    • 2006 Pension Protection Act
    • Revenue Ruling 59-60
    • Chapter 14 Guidelines
    • Case Law
    • The Valuation Report
    • The FLP Report
    • What Is an FLP?
    • Why Are FLPs Attractive?
    • What Exactly Is the Assignment?
    • What Documents Are Necessary for Preparing the Appraisal Report?
    • How Does Revenue Ruling 59-60 Help?
    • What Is Chapter 14?756
    • How Does All This Affect the Valuation Assignment?
    • Section 2036
    • More Court Cases
    • Things to Consider in the Appraisal Process
    • What About Methodology?
    • Valuation Adjustments
    • The FLP Written Report
    • As Valuation Analysts, Do We Go for the Big Discounts?
    • Conclusion
  • Chapter 22 Divorce Valuations
    • Chapter Goals
    • Introduction
    • The Role of the Valuation Analyst
    • Definition of Value
    • Fair Market Value
    • Intrinsic Value
    • Fair Value
    • What do the Definitions Really Mean in a Divorce Context?
    • Valuation Dates
    • Date of the Marriage
    • Date of Gift or Inheritance
    • Date of the Separation
    • Date of the Divorce Complaint
    • Date Agreed to by the Parties
    • Date of the Trial
    • Valuation Methods
    • Valuation as of a Specific Date
    • Data Gathering and Analysis
    • Gathering Financial Data
    • The Valuation Process
    • Normalizing Financial Statements
    • Unreported Revenues
    • Stockholder Loans
    • Income Taxes
    • Explaining the Valuation
    • Reaching a Conclusion of Value
    • Divorce Valuations of Professional Practices
    • Professional Practices Differ From Regular Business Enterprises
    • Divorce Valuations and the Market Can Be Very Different
    • Financial Information
    • Professional Versus Practice Goodwill
    • Noncompete Agreements
    • Valuation of Other Marital Assets
    • Professional Licenses
    • Celebrity Goodwill
    • Conclusion
  • Chapter 23 Professional Practice Valuations
    • Chapter Goals
    • Introduction
    • Why Are Professional Practices Values?
    • Characteristics of the Professional Practice
    • Professional Practice Versus Other Business Valuations
    • Buy-Sell Agreements
    • Internal Transactions
    • External Transactions
    • Subsequent Events
    • More About Professional Practice Versus Other Business Valuations
    • The Valuation Process
    • History of the Practice
    • Economy and Industry Information
    • Cash Versus Accrual Accounting
    • Valuation Calculations-Unique Aspects of the Calculations
    • Rules of Thumb
    • Statutory Rule Value
    • Asset-Based Approach
    • Conclusion
  • Chapter 24 Shareholder Disputes
    • Chapter Goals
    • Introduction
    • Dissenting Shareholder Matters
    • Oppressed Shareholder Matters
    • Fair Value
    • The Valuation Date
    • Fair Value Methodology
    • Conclusion
  • Chapter 25 My Favorite Court Cases
    • Chapter Goals
    • Introduction
    • Estate of Joyce C. Hall v. Commissioner Issue: What Makes a Guideline Company?
    • Estate of Samuel I. Newhouse v. Commissioner Issue: Different Classes of Willing Buyers Result in Different Values
    • Charles S. Foltz v. U.S. News & World Report, Inc. Issue: Excess Asset and the Minority Interest
    • Bernard Mandelbaum, et al. v. IRS Commissioner Issue: Discount for Lack of Marketability
    • Mad Auto Wrecking Inc v. Commissioner Issue: Reasonable Compensation
    • Delaware Open MRI Radiology Associates P.A. v. Howard B. Kessler, et al. Issue: Treatment of S Corporation Taxes in Fair Value
    • Conclusion
  • Chapter 26 Economic Damages
    • Chapter Goals
    • Introduction
    • Lost Profits
    • Elements of a Lost Profits Claim
    • Types of Damages
    • The Lost Profits Analysis
    • Meet With the Client and Client's Attorney to Determine the Objectives of the Assignment
    • Plaster Your Files With Support
    • Obtaining Documents and Records From the Opposing Side
    • Should You Work With Original Documents or Copies?
    • Get Information From the Client and the Other Side
    • Performing the Lost Profits Computation
    • Mitigation of Damages
    • Period of Recovery
    • Variable Cost of Lost Revenues
    • Incremental Revenues and Expenses-Not Fixed or Variable
    • Should Lost Net Earnings Be Reduced for Income Taxes?
    • Prejudgment Interest
    • Projected Lost Revenues After Trial
    • Discounting Projected Lost Profits After Trial to Present Value4
    • Ex-Ante Versus Ex-Post
    • Don't Forget to Check the Lost Profits
    • Computation for Reasonableness
    • Other Situations
    • Lost Profits or Lost Business Value?
    • Other Types of Damages Measurements
    • Plaintiff or Defense?
    • Common Mistakes Made By Damages
    • Experts
    • Conclusion
    • Index
  • CD-ROM
  • Overview
  • Appendix 1 AICPA Statement on Consulting Services
  • Standards 1
  • Appendix 2 ASA Standards
  • Appendix 3 NACVA Professional Standards
  • Appendix 4 International Glossary of Business
  • Valuation Terms
  • Appendix 5 SSVS 1 Appendix C
  • Appendix 6 Revenue Ruling 59-60
  • Appendix 7 Revenue Ruling 65-192
  • Appendix 8 Revenue Ruling 65-193
  • Appendix 9 Revenue Procedure 66-49
  • Appendix 10 Revenue Ruling 68-609
  • Appendix 11 Revenue Procedure 77-12
  • Appendix 12 Revenue Ruling 77-287
  • Appendix 13 Revenue Ruling 83-120
  • Appendix 14 Revenue Ruling 85-75
  • Appendix 15 Revenue Ruling 93-12
  • Appendix 16 Technical Advice Memorandum 94-36005
  • Appendix 17 Private Letter Ruling 91-50001
  • Appendix 18 Business Valuation Resources
  • Sample Reports
  • Calculation of Value
  • Family Limited Partnership
  • Large Company Valuation
  • Shareholder Oppression Report
  • Small Company Valuation
  • Summary Report
Author/Editor: Gary Trugman
Publisher: AICPA
Published: September 2012

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