After developing his new method, he was able to demonstrate that the Guideline public and private companies had implied constant growth rates of 9% and 16%, which were exceedingly high, compared to his forecast of less than 2% for his client.
Los Angeles, CA; New York City, New York; Chicago, Illinois; San Francisco, CA (PRWEB) April 10, 2014
Business Valuation Review is publishing the article, “Correcting for Selection Bias in Reconciling the DCF and Market Methods—There is No Substitute for Good Professional Judgment,” by Jay B. Abrams, founder and President of Abrams Valuation Group, Inc., in its Spring 2014 issue.
Mr. Abrams first developed this technique, which is a method to reverse engineer the implied growth rates in market multiples, in the late stages of valuing a large business. The Discounted Cash Flow (DCF) method measured Fair Market Value (FMV) at $25 million, while the Market methods calculated an FMV of $85 million.
Originally, he felt compelled to weight the two methods 50-50, as he did not have any hard evidence that the Market method results were inapplicable to the client. After developing his new method, he was able to demonstrate that the Guideline public and private companies had implied constant growth rates of 9% and 16%, which were exceedingly high, compared to his forecast of less than 2% for his client, a firm with little growth and very conservative management.
A key insight in resolving the vastly different valuation results is that firms with low forecast growth cannot become public and often do not make it onto the radar screen in private merger and acquisition (M&A) transactional databases. Thus, selection bias can be a serious problem in the business valuation process, and blindly using market method valuation results is dangerous, often resulting in overvaluation of the business.
With his new invention, Mr. Abrams weighted the DCF method 90% and the Market methods 10% with solid empirical evidence to substantiate his choice of weights. The initial valuation at 50-50 weighting resulted in an FMV of $55 million, and with the new weighting it was $31 million, for a difference of $24 million. At a 40% gift tax rate, this resulted in gift tax savings of $9.6 million, or roughly $10 million.
This situation is very common. Business appraisers regularly find market methods yielding indications of value anywhere from 2 to 4 times the DCF. Until this article, there has been no objective method to adjust the Market method results to their appropriate size. This is a very powerful tool to increase the accuracy of the business valuation process.
Mr. Abrams has published numerous quantitative articles on a wide range of business valuation topics. He is the author of the books Quantitative Business Valuation: A Mathematical Approach for Today’s Professionals, 2nd Edition ©2010, Wiley & Sons and How to Value Your Business and Increase its Potential ©2005, McGraw-Hill.
Mr. Abrams is nearly finished with his fourth book, Valuing S Corporations and Pass-Through Entities and is about to submit another very quantitative article for publication, “How Does Value Grow?” He has invented more than 150 mathematical formulas in business valuation and several valuation models and methods.
Mr. Abrams has over 30 years of business valuation experience. Abrams Valuation Group, Inc. (http://www.abramsvaluation.com) maintains its headquarters in North Hollywood, California and has offices in New York and San Diego. Abrams Valuation Group, Inc. and its sister company, Abrams M&A Advisors, Inc., provide business valuation, investment banking, and exit planning services.