For decades, the market, asset, and income approaches to business valuation have taken center stage in the assessment of the firm. This book brings to light an expanded valuation toolkit, consisting of nine well-defined valuation principles hailing from the fields of economics, finance, accounting, taxation, and management. It ultimately argues that the "value functional" approach to business valuation avoids most of the shortcomings of its competitors, and more correctly matches the actual motivations and information set held by stakeholders.
Much of what we know about corporate finance and mathematical finance derives from a narrow subset of firms: publicly traded corporations. The value functional approach can be readily applied to both large firms and companies that do not issue publicly traded stocks and bonds, cannot borrow without constraints, and often rely upon entrepreneurs to both finance and manage their operations. With historical side notes from an international set of sources and real-world exemplars that run throughout the text, this book is a future-facing resource for scholars in economics and finance, as well as the academically minded valuation practitioner.
For decades, the market, asset, and income approaches to business valuation have taken center stage in the assessment of the firm. This book brings to light an expanded valuation toolkit, consisting of nine well-defined valuation principles hailing from the fields of economics, finance, accounting, taxation, and management. It ultimately argues that the "value functional" approach to business valuation avoids most of the shortcomings of its competitors, and more correctly matches the actual motivations and information set held by stakeholders.
Much of what we know about corporate finance and mathematical finance derives from a narrow subset of firms: publicly traded corporations. The value functional approach can be readily applied to both large firms and companies that do not issue publicly traded stocks and bonds, cannot borrow without constraints, and often rely upon entrepreneurs to both finance and manage their operations. With historical side notes from an international set of sources and real-world exemplars that run throughout the text, this book is a future-facing resource for scholars in economics and finance, as well as the academically minded valuation practitioner.
The Economics of Business Valuation: Towards a Value Functional Approach
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Overview
For decades, the market, asset, and income approaches to business valuation have taken center stage in the assessment of the firm. This book brings to light an expanded valuation toolkit, consisting of nine well-defined valuation principles hailing from the fields of economics, finance, accounting, taxation, and management. It ultimately argues that the "value functional" approach to business valuation avoids most of the shortcomings of its competitors, and more correctly matches the actual motivations and information set held by stakeholders.
Much of what we know about corporate finance and mathematical finance derives from a narrow subset of firms: publicly traded corporations. The value functional approach can be readily applied to both large firms and companies that do not issue publicly traded stocks and bonds, cannot borrow without constraints, and often rely upon entrepreneurs to both finance and manage their operations. With historical side notes from an international set of sources and real-world exemplars that run throughout the text, this book is a future-facing resource for scholars in economics and finance, as well as the academically minded valuation practitioner.
Product Details
| ISBN-13: | 9780804783224 |
|---|---|
| Publisher: | Stanford Economics and Finance |
| Publication date: | 04/10/2013 |
| Sold by: | Barnes & Noble |
| Format: | eBook |
| Pages: | 440 |
| File size: | 12 MB |
| Note: | This product may take a few minutes to download. |
About the Author
Read an Excerpt
THE ECONOMICS OF BUSINESS VALUATION
Towards a Value Functional Approach
By PATRICK L. ANDERSON
Stanford University Press
Copyright © 2012 Board of Trustees of the Leland Stanford Junior UniversityAll rights reserved.
ISBN: 978-0-8047-5830-7
CHAPTER 1
MODERN VALUE QUANDARIES
THE FIRM IN ECONOMICS AND FINANCE
For at least two millennia, private businesses have been undertaken by farmers, traders, and artisans across the globe. Such businesses—including small farms, fishing and herding enterprises, textile and clothing producers, and larger ventures—have been the world's primary employers and wealth producers for centuries. Furthermore, for at least the past two centuries society has benefited from the formal study of economics, accounting, and the precursors of finance. What we call a business, enterprise, undertaking, or "firm" figures prominently in all of these fields. Yet with all of this scholarship, we really know very little about the definition and value of the firm. Addressing this poverty is the prime motivation of this book.
For graduates and holders of professional credentials in the fields of accounting, finance, economics, and business, this bold assertion of our lack of knowledge may seem overwrought. However, in this chapter, we pose several quandaries that illustrate this poverty. If we really had a complete, coherent, and valid theory of the firm and its value, these quandaries would not exist. The fact that they do exist, and that similar serious self-contradictions exist in related fields of study, motivates this book.
TWO MILLENNIA OF BUSINESS: A BRIEF RECAP
Business from 500 BC to AD 1500
Two millennia ago, accounts of business activity and rules for business behavior appeared in ancient texts such as the books of the Old Testament of the Bible (including the books of the Torah), the books of the New Testament, the Vedas of Hindu literature, and ancient legal codes such as those of the Roman Empire and the Babylonian empire of Hammurabi.
During these twenty centuries, agriculture, hunting, fishing, and herding of game animals were the primary occupations. These farmers, hunters, fishermen, and herders were all engaged in business, and the prospect of hunger and famine made their business very important indeed.
For roughly the last thousand years, the emerging civilizations of the world benefited from mathematics, customs of trade, and other knowledge recorded in Greek and Roman literature, as well as lesser-known literature from other lands. Critical scientific advances that occurred in Egypt, China, India, and the Near East—including the creation of the number system we use today, as well as basic algebra—were transmitted to the West, sometimes with the actual origins forgotten. Much of this knowledge was directly used in business and trade, including weights and measures, arithmetic and numbering, geometry, timekeeping, navigation, water distribution, and cultivation.
Of course, such knowledge was not nicely recorded and widely distributed. Human and civil rights, such as the right to property and the fruits of one's own labor, were denied to many. Life expectancy, literacy, and the need for subsistence were such that relatively few people received a formal education as we now understand it. However, businesses were organized, grew, and failed; trade flourished, was interrupted, and then resumed; people received wages for their work and paid for their purchases; wars and pestilence came and went; and somehow civilization survived—and with it, the institution of business survived and grew.
Business Since AD 1500
In the last five hundred years, business practices were further developed, as were a number of related fields of study, particularly the following:
1500s
• Traders and other businesspeople developed a formal system of accounting to record transactions within a firm. Such practices allowed commerce to grow and are still the bases for trade, contracts, and business investment.
1700s & 1800s
• Economists began writing about the economies of modern societies. Classical economists such as Adam Smith and David Ricardo proposed an explicit labor theory of value.
1900s
• Neoclassical economics emerged as a dominant influence in the whole of social science. It introduced the concepts of marginal cost, consumer utility, and profit maximization, which are now used in economics, law, government, sociology, and commerce. The pervasive idea that prices are set when supply meets demand in an open market took hold.
1940s
• A school of modern finance emerged as a separate discipline. Building on both neoclassical microeconomics and mathematics, modern finance developed notions of arbitrage, martingale pricing, portfolio choice, and mean-variance analysis.
1950s
• Formal credentials were developed for professionals engaged in selling securities of firms, providing advice for individuals investing in firms, accounting or auditing the accounts of firms, and appraising business property. The Modigliani-Miller proposition emerged as a pillar of modern finance. The basis for modern portfolio theory was established.
1970s–2010
• A specialized professional literature in the valuation of business developed. Alongside it grew a smaller literature for forensic economists, who estimate the change in value of firms for the purpose of estimating damages to businesses caused by breaches of contract and natural disasters. A formula for the valuation of certain financial options became widely available. Financial engineering and discounted cash flow analysis became ubiquitous.
We must acknowledge this tremendous progress in the fields of economics, finance, and accounting, and the ongoing efforts of scholars and professional societies dealing with businesses and business value. Indeed, we will devote several chapters to doing exactly that!
THE QUANDARIES
With all this knowledge, we should have a very well-developed theory of the firm and a very well-developed theory of the value of a firm. These theories should be amply tested by reality, comprehensive, and internally consistent.
Unfortunately, few theories provide a sound basis for determining the market value of a privately held firm. Moreover, we still have large gaps in our knowledge about the rationale of firms in the modern economy, and no workable universal definition of the firm. Notions of the firm used in microeconomics, accounting, corporate finance, and option pricing all differ. Finally, professionals who seek practical guidance on the definition and value of a firm routinely find it—at least in the United States—from an unlikely source for intellectual enlightenment: the federal taxation authorities.
This unsatisfactory state of affairs can be illustrated by the seven quandaries posed next. Each illustrates a significant gap in the orthodox theories of business drawn from economics, finance, and accounting.
Quandary 1: Mainstream Economics Ignores the Firm
The Neglect of the Firm in Economics
This quandary dates back to the creation of the mathematical models that form the basis of general equilibrium economics. Consider this statement by Léon Walras, the pioneer of welfare economics, writing in the nineteenth century:
Once the equilibrium has been established in principle, exchange can take place immediately. Production, however, requires a certain lapse of time. We shall resolve the second difficulty purely and simply by ignoring the time element at this point. (Walras, 1874, p. 242)
Walras developed the early model of exchange equilibrium, meaning that the buyers and sellers in a market reach agreements at market-clearing prices. However, in order to do this he had to ignore the fact that production took some time. It is the firm (or set of firms) that directly internalizes the time, cost, and uncertainty of production. Walras dealt with important issues in economics, and his thought is the basis for much of what we call microeconomics today. But he explicitly ignored the inner workings of the firm. In essence, the firm vanishes from the theoretical model of production, exchange, and consumption.
Next we quote an influential modern-era microeconomist:
The firm fits into general equilibrium theory as a balloon fits into an envelope: flattened out! Try with a blown-up balloon: the envelope may tear, or fly away: at best, it will be hard to seal and impossible to mail.... Instead, burst the balloon flat, and everything becomes easy. Similarly with the firm and general equilibrium—though the analogy requires a word of explanation.
Jacques H. Drèze, "Uncertainty and the Firm in General Equilibrium Theory," Economic Journal, 1985, p. 1.
These observations about the state of economic science are telling. In more than a hundred years, economics had moved quite far—but still typically viewed the firm as a "flattened balloon" abstraction. A few decades later, the standard presentation of the firm in both microeconomics and macroeconomics remains quite primitive.
In the standard microeconomics model, firms are typically assumed to sell homogenous goods using a simple production function. Workers adjust their consumption according to their wages and interest rates. To the extent that firms' production plans are even considered, they are often presented as solutions to single-period profit maximization problems, or as the intersections of average cost curves, assuming static production technology and market structure. Entrepreneurial interests, uncertainty, institutional factors, and numerous financial, managerial, and practical considerations in the organization and operation of the firm are largely assumed away.
To be sure, even this primitive specification of the firm leaves plenty of room for issues such as monetary policy, fiscal policy, trade policy, labor policy, regulation of markets with oligopoly structures, causes of business cycles, and so on. However, it also leaves a rather large void.
The Fulsome Importance of the Firm in the Real Economy
Consider the dimensions in which the firm has an essential, if not dominant, role in society:
• Most firms in the United States are "small" and privately held. Furthermore, these firms appear to employ most of the private-sector workers in the country.
• Equity interests in firms appear to be a very large portion of household wealth.
• One cannot endure an election cycle—at least in the United States—without some businesses, or entire industries being pilloried in campaign rhetoric.
• Much of popular media, entertainment, and sporting events are financed by advertising by firms.
• Successful entrepreneurs have often used their riches to create or endow important charitable, cultural, and educational institutions.
• Finally, a significant portion of the tax revenue of most state and national governments consists of taxes imposed on, or collected by, firms.
The firm is relegated to such inferior status in economics, but not because it is an inferior part of the economy.
Quandary 2: Mainstream Economics Ignores the Entrepreneur
The Much-Loved, but Ignored, Entrepreneur
To understand business value, we must recognize the motivations of those who create businesses and run them. However, neoclassical economics—the dominant school within economics for the past century—largely ignores such people. We discussed earlier how neoclassical economics ignores the inner workings of firms; the entrepreneur can be seen as the inner-inner working of all firms. The relegation of entrepreneurs to an abstraction within neoclassical economics means that these inner workings—so critical to the understanding of business creation, destruction, and value—are also abstracted away. Outside microeconomics, the entrepreneur enjoys a much better public reputation.
Although the notion of the "greedy business executive" is a staple of movies and television shows, the entrepreneur is usually shown in a more favorable light. A good part of popular culture appears to accept the notion that entrepreneurs typically focus on much more than money during their (often long and sometimes unsuccessful) efforts.
Perhaps the most influential modern philosopher of entrepreneurship is George Gilder, whose 1981 book Wealth and Poverty became a best-seller and something of a touchstone of the presidency of Ronald Reagan. Gilder writes of the entrepreneur's desire to create, to give, even to love.
This idea of the entrepreneur actually goes back centuries. The Irish economist Richard Cantillon described the entrepreneur as a risk-bearer in the eighteenth century, before Adam Smith wrote his Wealth of Nations. Among classic economists, John Stuart Mill and others recognized the vital role of the entrepreneur.
The great twentieth-century economist Joseph Schumpeter coined a phrase that should resonate with anyone who ever worked to build a business, or rebuild it, or expand it. The term is creative destruction:
The opening up of new markets, foreign or domestic, and the organizational development from the craft shop and factory to such concerns as U.S. Steel illustrate the same process of industrial mutation—if I may use that biological term—that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism.
Every piece of business strategy acquires its true significance only against the background of that process and within the situation created by it. It must be seen in its role in the perennial gale of creative destruction; it cannot be understood irrespective of it or, in fact, on the hypothesis that there is a perennial lull. (Schumpeter, 1975, pp. 83–84; emphasis in original)
Modern Brush-Asides
However prescient Gilder, Cantillon, and Schumpeter's ideas about entrepreneurship may have been, they were not adopted by the mainstream of the economics profession. The importance of entrepreneurship in the dominant economics paradigm diminished greatly in the twentieth century and is still largely missing from general equilibrium economic theory. Some reasons for this disappearance are as follows:
• The neoclassical model relies on equilibrium in a nearly perfect market. This leaves little room for the risk-taking and judgment (not to mention animal spirits) that are the lifeblood of the true entrepreneur.
• The reliance on (some would say infatuation with) mathematical models in modern economics requires much abstraction. Such abstraction cuts against the inclusion of complicated—and mathematically messy—factors such as transaction costs, barriers to entry, uncertainty, and limited ability to finance, all of which are ubiquitous concerns of the entrepreneur.
• A cultural bias exists against "boot strappers" among the well-credentialed academics who write most economics and finance textbooks. This is probably due to a predictable sympathy toward the traditions, mores, and work habits common where one lives and works, and the large differences between the typical life experiences of professors and entrepreneurs.
• There are readily available data on very large, publicly traded firms—providing a convenient basis for academic research and publication opportunities—but relatively little data on privately held firms.
(Continues...)
Excerpted from THE ECONOMICS OF BUSINESS VALUATION by PATRICK L. ANDERSON. Copyright © 2012 Board of Trustees of the Leland Stanford Junior University. Excerpted by permission of Stanford University Press.
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Table of Contents
The Economics of Business Valuation: Towards a Value Functional ApproachAuthor(s): Patrick L. AndersonFor decades, the traditional approaches to business valuation (market, asset, and income) have taken center stage in the assessment of the firm. This book presents an expanded valuation toolkit, consisting of nine well-defined valuation principles hailing from the fields of economics, finance, accounting, taxation, and management. It ultimately argues that the "value functional" approach to business valuation avoids most of the shortcomings of its competitors, and more correctly matches the actual motivations and information held by stakeholders. To remedy the shortcomings of existing theory, the author proposes a new definition of the firm that is consistent with the principle that entrepreneurs maximize value, not profit.
1Modern Value QuandariesThe author traces the importance of the business, company, or firm in Economics, society, and world history over two millennia. The author notes that, given its importance and centrality in modern economies, there should be a well-developed theory of the firm that pervades both Economics and Finance. However, a series of "quandaries" are posed that illustrate that this is not the case. These include the fact that neoclassical economics essentially ignores the firm, that mainstream Economics largely ignores the entrepreneur, and that real entrepreneurs do not maximize profits. Furthermore, much of Finance focuses on publicly-traded firms, while 99% of firms are privately held, and mathematical finance often assumes complete markets, which are a rarity in the actual world. These provocative statements motivate much of the theory and applications developed in the rest of the book.
2Methods and Theories of ValueThis chapter reviews the common definition of "market value" in Economics, and the practical use of the term in tax, accounting, and other fields. It then introduces ten different valuation theories. Among these are three different valuation principles derived from the Economics literature, three traditional methods of valuation, three from Mathematical Finance, and one novel principle that emerges from both Economics and Control Theory. Each of these is based on principles distinct from each other, in the sense that each fundamentally derives "value" from a different source.
3The Failure of the Neoclassical Investment RuleThis chapter presents telling evidence that the value of a firm is not the net present value of its expected profits. This is a provocative statement, and deserves careful support: the notion that the value of investments in firms is the expected net present value of their earnings is a pillar of Finance. The author summarizes the intellectual history of this notion, and then presents six major failings of the "NPV rule," in particular, that decision-makers often don't follow this rule.
4The Nature of the FirmThis chapter presents three competing definitions of the firm, including a common definition of any organization that has a profit motive, a modern neoclassical definition of a transaction institution whose incentives differ from those of its owners, and a new three-part definition. The elements of the new definition of the firm include an organization with a profit motive for its investors, a separate identity, and replicable business practices.
5The Organization and Scale of Private BusinessThis chapter presents the available information on the number of businesses in the United States, and the number by size class, the share that fulfill a common definition of "small" business, and the data on survivorship rates for newly-established businesses in multiple countries. It critically examines the stylized facts about such businesses in the United States. Finally, it provides updated data on the value of privately-held businesses in the U.S., following the methodology of Anderson (2009). Those data suggest that equity in privately held firms form a larger share of household assets than stocks in publicly-traded firms among U.S. households.
6Accounting for the FirmThis chapter focuses on the history, proper role, and limitations of accounting. It covers the vital role of accounting in business, why accounting is not the same as valuation, management, or finance, the history of accounting, and principles of accounting, starting with the most important one: ethics, as well as the historical cost principle.
7Value in Classical EconomicsThe author begins a review of 10 different theories of value with this chapter on classical economic thought. The labor theory of value dates as least as far back as Adam Smith and the 18th century, and may have independently been articulated by the Indian sage Kautilya in the 3rd century BC. The author observes that the labor theory fails to explain the actual determination of prices in a market economy, but still provides valuable insight into human behavior in the modern economy.
8Value in Neoclassical EconomicsThe neoclassical model is familiar to generations of college students. This chapter reviews the emergence of the neoclassical or "marginalist" school of economics in the late 19th century, and its formal elements and basic mathematics. It notes elements of the theory that are not settled: utility, risk aversion, and time preference, and discusses the critique of the "behaviorist." The author then tests the neoclassical model as a practical valuation tool for a business, applying it to three actual businesses. This analysis shows the neoclassical model is not a practical valuation tool.
9Modern Recursive Equilibrium and the Basic Pricing EquationThe author introduces the "recursive" model that has emerged within micro-economics over the past few decades. This modern recursive equilibrium model is contrasted with the neoclassical model, in terms of the optimization and time periods involved. The modern, multi-period consumer savings problem is introduced, as well as the "cake eating" problem and basic pricing equation. The author argues these form the basis of a modern microeconomic theory, and that the stochastic discount factor that emerges from the basic pricing equation provides a valuable insight that is lacking in the neoclassical and classical worlds. As with other valuation principles, the author tests the principle as a practical valuation tool for three actual businesses, demonstrating that is provides an incomplete basis for valuation of private firms.
10Arbitrage-Free Pricing in Complete MarketsThe author describes one of the breakthrough concepts of modern finance: the use of the no arbitrage principle in complete markets as the basis for the powerful mathematics of "risk neutral" or "equivalent martingale" pricing. This neoclassical finance model relies on two intertwined assumptions: the existence of complete markets, and the assumption that market participants will act to ensure that no arbitrage profits are possible. The author then presents strong evidence that both of these assumptions are lacking for private businesses and their investors, because markets for the equity in these firms are incomplete. The author argues that this severely undermines this model as a practical valuation tool. As with other principles, this assertion is tested by applying it to three actual companies.
11Portfolio Pricing MethodsThe idea of business investments assembled as part of an investment portfolio is a powerful one with ramifications that extend to the pricing of individual investments. The author describes the mean-variance framework, as outlined by Harvey Markowitz in the 1950s, as establishing the basis for an entire class of Modern Portfolio Theory models. The author then outlines the relationship between portfolio models and the Basic Pricing Equation, the most familiar of the portfolio models, the Capital Asset Pricing Model, including a recursive derivation of the CAPM that is somewhat closer to actual household behavior than the typical presentation, and the Roll critique of CAPM and similar models, and extends that critique noting that equity in 99% of firms do not fit into portfolio models. Portfolio models are then tested to see if they provide a practical basis for valuing three actual firms.
12Real Options and Expanded Net Present ValueThis chapter demonstrates the importance of management flexibility regarding the timing, scale, and type of investments, which is the basis for the study of "real options." The chapter describes an opportunity and its contractual equivalent, an option, the history of option contracts, the classic Black-Scholes-Merton option model of the firm, and the formula for pricing, under ideal conditions, a pure financial call option. From this basis, the author draws the conclusion that the existence of an option premium alone renders invalid the Net Present Value rule for the value of the firm. The author then describes techniques for valuing "real options," including extensions of financial options methods, Decision Tree Analysis, Monte Carlo, stochastic control, and value functional models, and "good deal" bounds. Finally it describes a recently-proposed synthesis of traditional income methods and real options analysis, which the author calls "expanded net present value" or XNPV.
13Traditional Valuation MethodsThis chapter describes the three traditional methods of valuing a business: the market approach, asset approach and income approach. For each, he describes a valuation principle and an underlying mathematical equation. The author describes the income or "discounted cash flow" approach is a workhorse of practical valuation. He observes the heavy reliance on subjective adjustments in actual use of this approach, which he argues supports the critique of the net present value rule and the weakness of this and other approaches in which subjective judgment, rather than actual use of a method, is the dominant factor. Finally, two of these traditional approaches are used to value three example firms, with the weaknesses in certain methods and the dominance of subjective adjustments made apparent.
14Practical Application of the Income MethodThe author focuses in this chapter on the workhorse income approach to valuation. Based on his extensive practical experience, he discusses the essential steps of forecasting future business revenue, identifying income arising from that revenue, and discounting that future income for time and risk. The author argues that, while each of these tasks are important, forecasting business revenue is often the most important.
15The Value Functional: TheoryThis chapter presents the theory behind the novel value functional method. This includes the importance of the definition of the firm introduced in this book, which includes separation, replicable business practices, and an objective of the firm that is not restricted to profit maximization, the maximization of value, rather than profit, a whirlwind introduction to control theory, and the distinction between the familiar concept of a function and the obscure notion of a functional. The author then presents a functional equation (or Bellman equation) that relates the value of a firm to specific optimization by the manager or entrepreneur. This theory is the basis for the tenth approach to valuation described in this book: the "recursive" or "value functional" approach. The author concludes by proposing conditions for the existence of a solution to the value functional equation for actual firms, basing these in human transversality conditions that he outlines.
16The Value Functional: ApplicationsThis chapter demonstrates practical uses of the value functional approach in the estimation of the value of operating businesses. It includes a detailed discussion of state and control variables, a presentation of four different ways to formulate and solve a value functional problem, including dynamic programming (also called "stochastic control"), Markov Decision Problem ("MDP"), Hamilton-Jacobi-Bellman ("HJB") method, and "by hand." The author also presents computational designs for these methods, and observations on the practical difficulties of using them. Finally, the author demonstrates the use of this approach on three actual companies. This allows the reader to see the difference in results (and of the necessity for subjective adjustments) among the value functional and other valuation methods described in this book.
17Applications: Finance &ValuationThe author argues that start-up firms, distressed firms, and near-bankrupt firms are the exception, not the rule, in the modern economy. This raises the question of whether such firms, which are commonly small and financed largely by the entrepreneurs involved, have value. The chapter also discusses the applicability of traditional valuation methods for such firms, compared with the novel value functional or recursive method. The author concludes that, when properly evaluated, start-ups and distressed firms do have value.
18Applications: Law&EconomicsThis chapter demonstrates applications of the value functional or recursive approach to topics in law and economics, including the effects of government policy on business decisions, and the estimation of economic damages incurred due to breaches of contracts. The effect of uncertainty in future government policies on private sector hiring decisions is one topic for which the value functional method provides an insight that is lacking in the standard neoclassical model. The author presents a model in which managers maximize value, rather than maximize profit. In such a model, businesses may rationally reduce current hiring due to the risk of policies that would impose higher costs in the future. The value functional approach also provides powerful methods to estimate commercial damages in breaches of contract involving intellectual property, new businesses, the ability to open or expand operations, and other situations commonly arising in business.