The Economics of Business Valuation Discounts and the Competitive Risk-Return Paradigm


Title:                            The Economics of Business Valuation Discounts and the Competitive Risk-Return Paradigm
Author:                       Peter C. Dawson, Ph.D.
Date Published:          September 10, 2010.
Publisher:                   Peter C Dawson Publishing, Ridgefield, Connecticut, USA.
Binding:                      Hardcover.
Pages:                          450.
ISBN:                           9780984491902.
Edition:                       First Edition, Third Printing.

Available at many local and online bookstores. List price = $68.00. Competitive retail price = $40.00-to-$45.00.

About the book:

     The Economics of Business Valuation Discounts and the Competitive Risk-Return Paradigm is a Business Valuation text written for practitioners. Business Valuation is a sub-field of Economics and Financial Economics.

     How can one claim to calculate a reliable Fair Market discount for lack of marketability (DLOM) when an explicit, or even a readily-apparent implicit, analysis of the Hypothetical Market—i.e., a supply and demand analysis—is not performed? All market value, including Fair Market Value (FMV), is founded on market supply and demand and the underlying factors that determine them.  Common valuation practice[1] focuses on the required DLOM from the Hypothetical Buyer’s perspective, which is the demand side of the Hypothetical Market, but, without a meaningful representation of the supply side, it necessarily neglects the Hypothetical Seller’s requirements (notwithstanding proclamations that consideration has been given to both Hypothetical Buyer and Seller).

     Subjective valuation adjustments allow flexibility to account for qualitative valuation factors not captured in the quantitative analysis, yet they also create opportunities to advocate for a client’s desired value conclusion, that advocacy being the natural result of client pressure for advocacy combined with the profit incentive faced by appraisers to succumb to that pressure (Chapter 10).  Advocacy concerns are justified because “Subjective valuation steps are, by definition, not objective” (p. 239) and cannot be made objectively, even by well-intentioned appraisers using “informed judgement” based on years of professional experience.  They are inherently arbitrary and, contrary to popular belief, cannot improve the reliability of any market value analysis, except by chance. Informed judgment is judgment that is informed, meaning an appraiser possesses the relevant quantitative information necessary to make a reliable valuation adjustment, that information being a valid, quantitative statistical/econometric analysis of the magnitude and direction of the net effect that all relevant marketability factors —including qualitative marketability factors, which, by their very nature, cannot be reliably quantified —have on market value.  Only in the unlikely event that an appraiser’s arbitrary adjustment is correct could he arrive at a reliable adjustment, yet one simply cannot know whether such an unlikely event has occurred.

     “Appraisers often recite the definition [of FMV] by rote. Unfortunately, rote recitations overlook or ignore important elements of meaning and nuance.  [A]ppraisers, attorneys and users of valuation reports should have more than a superficial understanding of the valuation implications of the standard of value known as fair market value” (Mercer and Brown 1999a, p.16).  James C. Bonbright, a recognized authority in valuation, in his 1937 treatise on valuation practice[2], acknowledged the “necessity of a fairly precise definition of value” (p.125) and the importance of “distinction, in all its implications, clearly recognized” between concepts of value (p.16) as a necessary “prerequisite to the intelligent discussion of the evidence” of value (p.125), noting the imprecise nature of such “question-begging phrases as ‘fair market value,’ or ‘price at which the property would be sold by a willing seller to a willing buyer’” (p.236).  He did not object to the fictitious hypothetical nature of the Fair Market Value Standard (FMVS), but rather to its imprecise definition, inconsistent application, and the characteristic failure to properly distinguish between concepts of value:  “Our objection to this fiction is, not that it is a fiction, but that it is indefinite and ambiguous” in its practical application (Bonbright 1937, p.361n; italics original).  The FMVS’s application today continues to suffer from these shortcomings.  Appraisal experts and courts recognize that that imprecision and inconsistency often stems from a failure to recognize the logical implications of the FMVS’s assumptions (Mercer and Brown 1999a; Fishman and O’Rourke 1998; Fishman, Pratt and Morrison 2007; Bank One Corp. v. Commissioner (120 T.C. 11 (2003)).[3]

     Common appraisal practice applies subjective valuation adjustments for non-systematic risk because real-world investors require a DLOM for non-systematic risk, a practice that fails to recognize and/or acknowledge the statutory difference between the Hypothetical Market Construct (within which Hypothetical Investors hypothetically invest) and the real-world market (within which real-world investors actually invest).  The relevant issue is not the FMVS’s definition; it is taken as it is given and generally accepted. The relevant question is, Is the FMVS’s accepted interpretation, as it is to be applied in appraisal practice, consistent with its definition as set forth in its assumptions?

     Chapter 3 shows that an internally consistent application of the FMVS’s assumptions defines Hypothetical Investors, by logical implication, to be owners of well-diversified asset portfolios, who therefore require no form of non-systematic risk valuation discount.  The author’s economic analysis of the DLOM is not, by any measure, a mere exercise in abstract theory.  It directly applies to, and is straightforward to apply in, appraisal practice; simply refrain from making non-systematic risk adjustments to the valuation input variables (e.g., see “Removing Non-Systematic Risk Adjustments” in Chapter 4).

     Without the guiding valuation structure that Economics’ supply and demand framework provides, appraisers have excess leeway to apply inherently arbitrary subjective valuation adjustments, necessarily reducing the reliability of FMV appraisals.  The explicit supply and demand analysis in Chapter 13 shows that, contrary to the long-standing practice of applying DLOMs, a small premium for lack of marketability (PLOM), rather than a DLOM, is the Fair Market result.  In broader context, the author explains how, through its very definition, the FMVS rules out DLOMs in all their forms. That these conclusions are not generally accepted does not undermine their credibility or significance.  The author’s assumptions (which are the FMVS’s assumptions), economic analyses, and conclusions fully stand on their own merits.  Susan W. Eldridge, Ph.D., in her 2012 book review[4], concludes “Dawson has provided careful analyses and discussions that challenge professional appraisers’ common practice of applying extensive DLOM in valuing minority interests in closely-held businesses” (p.139).

          [1] The author’s understanding of generally-accepted valuation practice has been obtained through reliable sources, including business appraisal reports by accredited appraisers, authoritative business valuation texts commonly cited in the valuation literature, business valuation education provided by the American Society of Appraisers (ASA) and National Association of Certified Valuators and Analysts (NACVA), and discussions with colleagues and peers.
[2] Bonbright, James C. 1937. Valuation of Property: A Treatise on the Appraisal of Property. Two volume set. New York: McGraw-Hill Book Company, Inc.
[3] Fishman, Jay E., and Bonnie O’Rourke. 1998. “Value: More Than a Superficial Understanding is Required”. Journal of the American Academy of Matrimonial Lawyers, Vol. 15, pp.315-335. Fishman, Jay E., Shannon P. Pratt, and William J. Morrison. 2007. Standards of Value: Theory and Applications. Hoboken, New Jersey: John Wiley & Sons, Inc.
[4] Published in Economics & Business Journal: Inquiries & Perspectives, Vol. 4, No. 1, Oct. 2012, pp.134-139.

Book Reviews:

Dohmeyer, Bob (2015). “Book Review”, Business Valuation Review, Vol. 34, No. 2, pp.82-85. [5]

          [5] Note from the publisher: Dawson provides clarifications for Business Valuation Review readers: “In Dohmeyer’s (2015) review of my 2010 book The Economics of Business Valuation Discounts and the Competitive Risk-Return Paradigm, he objectively discusses some of its important contributions to business valuation theory and practice. Dawson (2010) is packed with meaningful content, but my clarifications here focus only on the concerns raised by Dohmeyer (2015)”. Click here for Dawson’s clarifications.

Eldridge, Susan W. (2012). “Book Review: The Economics of Business Valuation Discounts and the Competitive Risk-Return Paradigm,” Economics & Business Journal: Inquiries & Perspectives, Vol. 4, No. 1, pp.134-139.

     “Overall, Dawson has provided careful analyses and discussions that challenge professional appraisers’ common practice of applying extensive DLOM in valuing minority interests in closely-held businesses. He reminds his readers, whether practitioners or academic researchers, to pay more careful attention to common practices and to assumptions underlying those practices. I encourage professional appraisers and economists to read this text and provide an appropriate independent peer review.”

Hitchner, Jim and Shannon Pratt (2011). Presentation at the AICPA National Business Valuation Conference, November 6-8, 2011 at the Aria Resort & Casino Las Vegas, NV.  Session 13 titled “Discounts for Lack of Marketability and Liquidity – What the Heck is Going on? A Practical Response to New Attacks and New Support”, which included a brief “Review of a new book by Peter C. Dawson criticizing both traditional DLOM data as well as the validity of a DLOM, including potential double discounting”:

     “I think Dawson has so many outrageously false premises in his book” (Pratt). That Dawson readily admits to his readers that he is not an expert on business valuation and his book has not been peer-reviewed “trouble me, alright, right off the bat”, says Hitchner.  In response to Dawson’s assessment that “‘… even when appraisers are as objective as they can be when making subjective adjustments, subjective adjustments are inherently unreliable.'”, Hitchner states “these are pretty severe attacks on the industry at large, and there just falsely, they’re just wrong, and … false” and they “ticked me off”. [6]

          [6] Note from the publisher: Readers, of course, can judge for themselves the merits of Dawson’s (2010) assumptions (or “premises”), whether or not his characterization of generally-accepted business valuation theory and practices are accurate, whether or not he actually “attacks” the business valuation profession (are his criticisms “severe”, or appropriate?), and whether or not his assessment of subjective appraisal adjustments is logically true.