Acquisition Premium – The premium over fair market value (FMV) that a strategic investor pays for an enterprise. The acquisition premium recognizes anticipated value creation resulting from synergies and other factors attributable to the strategic investor's involvement.
Alpha (α) – A measure of a business or financial asset's unsystematic (or diversifiable) risk. Alpha is alternatively referred to as the company-specific risk premium (CSRP). The Capital Asset Pricing Theory (CAPM) assumes that the investor can diversify away alpha by assembling a portfolio of publicly traded securities. For the owner of a nonpublic entity, offsetting company-specific risk through diversification is generally not feasible. As a result, alpha must be considered when valuing a closely held business.
Asset Approach – One of the three major approaches to valuing a privately held business (the others are the income approach and the market approach). Under the asset approach, value is estimated by subtracting the current market value of liabilities from the current market value of assets. The asset approach assumes that the entity's value is equal to the hypothetical net cost, as of the valuation date, of assembling from scratch the company's specific collection of assets and liabilities. The asset approach is most often used in cases of liquidation, and generally does not produce meaningful results when valuing going concerns.
Beta (β) – The degree of correlation between the return on an individual security and the return on a market index. A measure of market-related, or systematic, risk assumed by the owner of an individual security. Beta is a component of the Capital Asset Pricing Model (CAPM) equation, which assumes that systematic risk is non-diversifiable.
Book Value – Assets minus liabilities as reported on the balance sheet. In the case of a specific asset, initial cost less accumulated depreciation or amortization. Since book value is based on historical cost, adjusted by depreciation and amortization as dictated by accounting convention, it generally does not serve as a meaningful indication of true economic value.
Breakup Value – The total value that could be realized by dividing a multi-business enterprise into separate entities and selling each individually.
Capital Asset Pricing Model (CAPM) – An economic theory and methodology for estimating the value of risky securities. CAPM defines the relationship between risk and expected return by determining the sensitivity of an individual security's price to broader market movements. It assumes that unsystematic, or company-specific, risk can be diversified away by assembling a portfolio of publicly traded securities. When valuing privately held entities, a modified version of the CAPM that takes into account company-specific risk (alpha) must be used.
Capital Expenditures – In order for a business to grow and create value, it must make capital expenditures – outlays related to acquiring, maintaining, and improving long-term assets, such as property, plant, and equipment. Capital expenditures, in and of themselves, represent a reduction to net cash flow available to investors. Ideally, capital expenditures, combined with additions to working capital, produce an overall increase in net cash flow that, adjusted for risk, creates value for the enterprise.
Capital Rationing – Establishing a fixed limit on new investment undertaken, forcing the company to allocate limited capital among worthwhile (i.e. value enhancing) projects.
Capitalization Rate (Cap Rate) – A figure, expressed as a percentage, typically applied to the coming year's projected net cash flow (NCF) to arrive at an indication of the entity's overall value (NCF/cap rate = value). In order for the cap rate calculation to be meaningful, projected NCF must grow at a consistent rate. If that condition is not met, the present value of each discrete year's projected NCF is calculated by applying a discount rate.
Control Premium – See Discount for Lack of Control (DLOC).
Cost of Capital – The rate of return required to attract investment funds to a particular company or business initiative. The cost of capital is a return, expressed as a percentage, that compensates the investor for the risk assumed. (It also takes into account the expected inflation rate and other factors.) A common error when evaluating new projects is to apply the firm's existing blended cost of capital – the combined required rate of return for all existing projects. In reality, each initiative carries a unique risk profile, and therefore must be assigned its own cost of capital within the context of the broader enterprise. Cost of capital is alternatively referred to as opportunity cost of capital, required rate of return, or hurdle rate.
Discount for Lack of Control (DLOC) – A reduction in the estimated pro rata value of an equity stake that accounts for the absence of benefits associated with control, such as the ability to influence business strategy. In general, a DLOC must be considered when valuing a minority (i.e. < 50%) stake in a privately held business. The value of control is alternatively expressed as a control premium paid for a majority stake.
Discount for Lack of Marketability (DLOM) – A reduction in the estimated pro rata value of a stake in a privately held company that accounts for lack of marketability, or lack of ability to sell or transfer that stake. In general, a DLOM must be considered when comparing a stake in a privately held entity with publicly traded shares in a similar business.
Discount Rate – Rate of return used to compute the present value of cash flows. The discount rate used should be equal to the cost of capital, or required rate of return, which reflects the degree of risk assumed in investing in a particular entity or business initiative.
Discounted Cash Flow (DCF) – The method of calculating the value of an entity or business initiative by converting projected net cash flows into present value using a discount rate.
Economic Profit – The net economic benefit realized by the investor during a specific time period. Economic profit is defined as net cash flow less the capital charge, which is the amount that compensates the investor for the degree of risk assumed and other factors. If economic profit is positive for a specific period, value is created during that period. Accounting profit, by contrast, is net income as presented in the financial statements. Since accounting profit is calculated based on accounting convention, and does not take cost of capital into consideration, it is not a precise measure of the true economic benefit realized by the investor.
Fair Market Value (FMV) – The price at which a hypothetical financial investor would buy a business in an arm's length transaction in an open and unrestricted market. FMV assumes that both buyer and seller have reasonable knowledge of the relevant facts, and that neither is acting under compulsion. FMV is typically lower than investment value, which is the value to a strategic investor who can introduce various synergies and other value creating factors to the entity. FMV is the most commonly used standard in business appraisals related to tax and estate planning and other purposes.
Financial Investor – An investor who is interested purely in a financial return in the business in its present form. Unlike a strategic investor, a financial investor does not contribute synergies or other value creating factors to the entity.
Free Cash Flow (FCF) – See Net Cash Flow.
Income Approach – One of the three major approaches to valuing a privately held business (the others are the asset approach and the market approach). Under the income approach, anticipated net cash flow is converted into value by applying a rate of return that reflects the uncertainty, or risk, associated to the projections. In other words, the income approach calculates the present value of all estimated future net cash flows, taking into account the risk that those cash flows may not materialize as anticipated.
Invested Capital – The sum of all capital contributed to the entity by all equity and debt investors.
Investment Value – The maximum value of an entity to a particular strategic investor. Investment value is the sum of the fair market value of the standalone entity in its present form and the value expected to be created by the strategic buyer through synergies and other means.
Liquidity – The ability to convert an asset, such as an ownership stake in an entity, into cash quickly and without significant loss of value. The more liquid an ownership stake, all other factors being equal, the greater its value.
Market Approach – One of the three major approaches to valuing a privately held business (the others are the asset approach and the income approach). The market approach is comprised of two primary methods:
- Guideline Public Company Method – Multiples observed in comparable publicly traded companies (e.g. price/earnings, market value/revenue, market value/EBITDA) are applied to a privately held company to arrive at an indication of value.
- Merger & Acquisition Method – Multiples observed in public and/or private market M&A transactions are applied to a privately held company to arrive at an indication of value.
Marketability – The ease with which an asset, such as an equity stake in a privately held business, can be transferred or sold. In general, a discount for lack of marketability (DLOM) must be considered when valuing a privately held business.
Net Cash Flow (NCF) – Cash flow available to investors after necessary capital expenditures and additions to working capital have been made.
- Equity NCF – The relevant benefit stream when calculating equity value. Alternatively referred to as free cash flow, the amount available to pay out to stockholders in the form of dividends. Calculated as net income plus non-cash charges, minus additions to working capital, minus capital expenditures, plus/minus changes in debt principal.
- Invested Capital NCF – The relevant benefit stream when calculating the value of an entity independent of how it is financed. The amount available to pay out to all investors (stockholders and lenders) in the form of dividends, principal, and interest. Calculated as earnings before interest and taxes (EBIT), minus taxes on EBIT, plus non-cash charges, minus additions to working capital, minus capital expenditures.
Non-Operating Assets – Assets that are unrelated to or not necessary for the entity's ongoing operations. Non-operating assets are valued separately from the operations of the entity.
Strategic Investor – An investor who can enhance the value of an entity through synergies with other owned businesses or through the contribution of specific managerial or other capabilities. The strategic investor is typically willing to pay more than fair market value (FMV) for the enterprise, since that particular investor benefits not only from the value of the standalone entity in its present form, but also from the additional value produced as a result of the investor's involvement.
Unsystematic Risk – The risk that is unique to a particular business entity, also commonly referred to as company-specific risk. According to the Capital Asset Pricing Model (CAPM), unsystematic risk can be diversified away by assembling a portfolio of publicly traded securities. The owner of a nonpublic entity, however, is typically unable to offset company-specific risk through diversification. As a result, unsystematic risk, quantified in terms of alpha, must be explicitly accounted for when valuing privately held businesses.
Working Capital – Typically, as a business grows, it must make additions to working capital – current assets (e.g. inventory, accounts receivable) less current liabilities (e.g. accounts payable, deferred income). Additions to working capital, in and of themselves, represent a reduction to net cash flow available to investors. Ideally, additions to working capital, combined with capital expenditures, produce an overall increase in net cash flow that, adjusted for risk, creates value for the enterprise.