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Professional valuation and investment-financial valuation: distinctions in valuations for private and public markets.

ABSTRACT

This article establishes clear theoretical distinctions between professional valuation, which focuses on assets with less than perfect liquidity (such as real estate) that are traded in private markets, and investment-financial valuation of assets exchanged in public markets. Such distinctions are illustrated by examining the widely-used techniques of the investment-financial valuation. The first part of the article reviews the concepts and processes engendered by professional valuation and its theory. The second part concerns new valuation techniques and the fundamental shift currently occurring in valuation practice.

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Worldwide discussions are underway revisiting the concepts in financial reporting and professional valuation. (1) Investment-financial valuation (IFV) includes methods of valuation flowing out of modern portfolio theory.

The objects of IFV are liquid, divisible, and mass traded, and are often denoted as financial titles, circulating on active competitive markets. Compared with IFV, professional valuation has a broader scope. It embraces assets that are not financial titles, such as real estate, specialized property, intangible assets, and other illiquid objects that are not customized and possess certain specific, unique features. The exchange of these assets is under circumstances different from the conditions in efficient markets.

The methodological basis of both areas of expertise is currently being mutually negotiated and conflated to a certain extent. Given this situation, it is important to examine the theoretical underpinnings of some of the new valuation concepts, especially where specific terms, such as fair value, may be used in a different sense in each area. (2)

New Concepts and Processes in Valuation

Certain new standards of financial reporting and valuation issued in Great Britain and the United States (countries that maintain the lead in the methodology for applied economic measurements), warn against the uncritical application in professional valuation practice of the methodologies that are based on assumptions of "effective" financial markets and "rational" economic behavior.

In Real Estate Appraisal: From Value to Worth, Sayce et al. present a brief overview of established and cutting-edge theoretical paradigms in financial economics and valuation.
 Within the real estate field, the appraisal techniques that
 deal with assets in a portfolio context relate in the main
 to the conventional finance theories developed between
 the 1960s and 1980s. Under these theories, there has
 been an assumption that investment decision-making is
 driven by rational economic behavior and that investors
 have sought always to maximize returns and minimize
 risk. Modern portfolio theory (MPT), developed by
 Markowitz (1959) and subsequently extended by others,
 such as Sharpe, Lintner and Mossen, adopted the rational
 assumption. Furthermore, these authors worked on
 the basis that markets are "efficient," that is, that prices
 fully reflect all relevant financial data (see, for example,
 Fama and Miller, 1972). Since the mid 1980s, and some
 twenty years after these theories began to be applied in
 the financial field, property analysts have sought to use
 them for real estate.

 In the meantime, just as these "modern" finance
 theories have begun to gain ground within the real
 estate field, new theories have emerged which relax
 the assumptions of rationality and efficiency. New finance
 models accept the reality of inefficient markets
 and adopt a range of techniques from econometrics to
 arbitrage (Chen et al., 1986) and behavioral models
 (Tversky and Kahneman, 1981) to explain investor
 behavior. (3) [Emphasis added]


Sayce et al. pointedly criticize the practical application of the modern portfolio theories named after their renowned authors: Eugene Fama, nominated for the Nobel Prize several times as well as other prestigious awards; and Harry Markowitz and William Sharpe, both recipients of the Nobel Prize in 1990 for their contribution to the theory of assets pricing. The following quotes are representative of their current economic views.

Eugene Fama: "The economists should teach equilibrium but business persons should be taught to exploit disequilibrium." (4)

Harry Markowitz: "I think it is perfectly reasonable for people to ask what about the real behavior of investors as distinguished from rational behavior. I do not necessarily subscribe to each article by the behavioral economist, but it is perfectly reasonable activity to pursue." (5)

William Sharpe: "There is a constant tension between positive theory and normative theory ... you can argue fairly convincingly perhaps, for the security market line, you can argue that you ought to use the market portfolio, but we certainly cannot argue that people do this, because most people do not. So if you want to hold your positive theory up, theory not only of assets pricing, but also how people in fact choose portfolios, it obviously fails." (6)

Such views reflect the benefit of hindsight, as the fundamental theories of these living legends and their followers (who also have received Nobel Prizes for economics) have had deplorable track records. The 1997 Nobel Prize laureates, Robert Merton and Myron Scholes (who with Fisher Black developed the options pricing model), applied their theoretical convictions in real practice by investing their Nobel Prize awards in sophisticated financial schemes that in 1998 nearly led the world financial markets to the brink of unraveling. (7) In hindsight, one cannot be too fazed by their record. Real markets rarely operate in the fashion prescribed by a pure economic theory and its derivatory models, and the ideal world of theory and the real world of marketplace are not one and the same.

Practical Valuation Theory and Related Valuation Concepts

Stieglitz and an array of other Nobel Prize laureates for economics, including such prominent figures as Daniel Kahneman, Vernon Smith, and Amartya Sen, are the heralds and initiators of the global post-neoclassic movement, which theoretically rebuffs the priority of econometrics over substantive economic theory. The theoretical output of these authors is to a certain degree related to the issue of how value can be practically assessed in the real-life economy. Some economists often quote the words of 1998 Nobel Prize winner Amartya Sen, "The advance in 'pure theory' is closely connected with the development of the "practical economic theory."'

Practical valuation theory has a long history, starting with the works of Alfred Marshal, who is considered the architect of theoretically justified valuation practice. However, it is generally recognized that practical valuation theory is now undergoing a transformation within the confines of the global new economy. In the world of valuation, the interconnectedness between practical theory of valuation and pure or fundamental theory of value has grown exceedingly intricate.

It can be assumed that practical valuation theory softens the tight postulates of models based on the ideal or perfect rational economic behavior, effective markets, instant liquidity of capital assets, etc. But, of course, this entails the loss of purity in theoretical formulas or other formulations based on the axioms or paradigms assumed by researchers. This has led to endless heated debates in the area of pure economic theory.

The discussion here will not delve deeper into the problems of the paradigm shift in economics, but will address what is taking place in the disciplines attributed to practical economic theory, which can only be called normative in a very specific sense. Such a sense is now attained by the various standards of valuation, financial reporting, and audit that express the generally accepted best practices gaining wider recognition and influence in the global economy. Thus, the emerging distinguishing feature of practical valuation theory is its integral link with the standardization of professional practice; its approaches and methods; and an array of practical tools called techniques.

In recent years there has been growing recognition of the theoretically justified distinctions between valuation concepts that were introduced by Martin Hoesli and Bryan D. MacGregor. (8)

* Price is the actual observable money exchanged when a property investment is bought or sold. In most other markets price is given, but in the property market every property interest is different and requires an individual estimate of value to guide the buyer and seller in their negotiations to agree on a price. Price can be fixed by negotiation, through tender bids or at auction.

* Value is therefore an estimation of the likely selling price. In other markets, where homogenous goods are sold, the price is not estimated but is determined from market trading and is usually used to describe an assessment of worth.

* Individual worth [also known as investment value] is the true value to an individual investor using all the market information and available analytical tools and can be considered as the value in use.

* Market worth is the price a property [or any other non-homogenous illiquid] investment would trade at in a competitive and efficient market using all market information and available analytical tools. [Also termed fundamental or intrinsic value.] A valid model of calculation of market worth should reflect the underlying conditions of the market at the time. This should therefore be distinguished from market value, which accepts a less than perfect knowledge of market information. (9)

Note that two of these concepts, market worth and individual worth, are not manifested directly, and are located at various polarities of the subjective/objective continuum of economic theory.

Neoclassical market worth should be attributed to the realm of pure theory, existing subject to meeting the strictest conditions of the theoretical perfect market where such worth has a purely objective stationary meaning such that it is "market-determined," not "market determining."

Austrian-style individual worth exists subjectively, i.e., it is subject-specific and is not immediately measurable except by a procrustean bed of certain discounted cash flow investment appraisals designed to elucidate it. However, such worth is objective in its influence in that it determines whether or not to enter a transaction at a given price and, hence, determines those prices when aggregated. Paradoxically, the market-clearing, economically rational notion of market worth is ultimately price determined, while the subjective notion of individual worth is price determining.

Many practical-minded valuers regularly quote from Investment Valuation, by Aswath Damodaran. (10) In his recent fundamental theoretical paper, "Valuation Approaches and Metrics: A Survey of the Theory and Evidence," (11) Damodaran offers a weighty theoretical exposition on value estimates.
 Valuation can be considered the heart of finance. In
 corporate finance, we consider how best to increase
 firm value by changing its investment, financing and
 dividend decisions. In portfolio management, we expend
 resources trying to find firms that trade at less than their
 true value and then hope to generate profits as prices
 converge on value. In studying whether markets are
 efficient, we analyze whether market prices deviate
 from value, and if so, how quickly they revert back.
 Understanding what determines the value of a firm and
 how to estimate that value seems to be a prerequisite
 for making sensible decisions.

 Given the centrality of its role, you would think that
 the question of how best to value a business, private or
 public, would have been well researched. However, the
 research into valuation models and metrics in finance
 is surprisingly spotty, with some aspects of valuation,
 such as risk assessment, being deeply analyzed and
 others, such as how best to estimate cash flows and
 reconciling different versions of models, not receiving
 the attention that they deserve.


Estimating cash flows in the best way requires mathematical literacy and relevant information and software. No doubt, all this needs perfecting, picking and choosing, but these practical matters are covered in a diverse and contradictory body of practical publications and manuals in which valuation is ultimately reduced to the formal estimates performed under one of the many models. It has to be said that these models are usually the products of another theoretical discipline--the theory of corporate finance, which is mainly the preoccupation and perspective of Damodaran and his school of thought on valuation.

In his quote, Damodaran comments on the potential to reconcile the different estimating models. This perspective is traceable to the substantive methodological foundations of valuation, which Damodaran calls the philosophic essence of valuation. (12) Elsewhere, he has stated that "there is a significant philosophical difference between discounted cash flow and relative valuation." (13) Damodaran states, discounted cash flow valuation was a search (albeit unfulfilled) for intrinsic [fundamental] value. In relative valuation, we have given up on estimating intrinsic value and essentially put our trust in markets ... we are making a judgment on how much an asset is worth by looking at what the market is paying for similar assets. (14)

Thus, the distinction is drawn between the investment and the market valuation.

Damodaran perceives changes unfolding not only in the formulations of the approaches per se but in the very philosophy of valuation. In An Introduction to Valuation, Damodaran states that asset prices cannot be justified by merely using the "bigger fool" theory, and he attempts to debunk myths related to valuation theory:

Misconceptions about Valuation

Myth 1: A valuation is an objective search for "true" value.

* Truth 1.1: All valuations are biased. The only questions are how much and in which direction.

* Truth 1.2: The direction and magnitude of the bias in your valuation is directly proportional to who pays you and how much you are paid.

Myth 2: A good valuation provides a precise estimate of value.

* Truth 2.1: There are no precise valuations.

* Truth 2.2: The payoff to valuation is greatest when valuation is least precise.

Myth 3: The more quantitative a model, the better the valuation.

* Truth 3.1: One's understanding of a valuation model is inversely proportional to the number of inputs required for the model.

* Truth 5.2: Simpler valuation models do much better than complex ones.

Manifestations of Bias

* Inputs to the valuation-Our assumptions about margins, returns on capital, growth and risk are influenced by our biases.

* Post-valuation tinkering-The most obvious manifestation of bias occurs after we finish the valuation when we add premiums (synergy, control) and assess discounts (illiquidity) for various factors. If we are biased towards higher values, we tend to use premiums; if biased towards lower values, we discount.

* Qualitative factors--When we run out of all other choices, we tend to explain away the difference between the price we are paying and the value obtained by giving it a name (strategic considerations, etc.)

The issues mentioned by Damodaran--intrinsic (true or fundamental) value and bias--are consequences of the view of valuation as the objective process of measuring a certain amount (value) that is inherent to the market independent of the actions of the valuer. Such a viewpoint can only be engendered where valuers are mostly engaged in work with certain types of assets; namely, liquid assets for which it is possible to draw a correspondence between actual observed prices (on identical and/or comparable assets) or other leading factors (e.g., a broad market index) and their value-in-exchange based on those.

The next part of this article shows how such a perspective, while valid for certain valuation areas in the general spectrum of valuations, is generally misplaced in the area of the professional valuation and fails to embody the practical, characteristic roles and matters incident to professional valuation.

Professional and Investment-Financial Valuation: Distinctions in Practice and Theory

The comments of leaders in valuation and economic theory show their desire to clarify the areas of applicability of their valuation theories. Indeed, they sometimes give the impression that valuation theory has hardly been addressed. The basic practices of professional valuation have been incorporated into many renowned valuation standards-such as the Uniform Standards of Professional Appraisal Practice (USPAP) in the United States, the RICS Valuation Standards ("The Red Book") in the United Kingdom, and up to a point, the International Valuation Standards--and these are connected with efforts to clarify concepts.

It is not entirely fortuitous that professional valuation currently is seeing an active drive to "revisit the concepts" Precursor discussions harken back to the 1960s and the work by P. Wendt, R. Ratcliff, and W. Kinnard who reacted against abuses and forcing of neoclassical valuation theory on situations it was poorly equipped to handle. This process directly touches not only on valuation particulars such as which technique is best, but affects the very essence and coexistence of the various kinds of valuation.

As a result of developments in the area of professional valuation, and attempts at its standardization, a specific set of objectives has been identified for dealing with subject properties. Developments in the area of professional valuation have also made apparent the distinct features of the subject property being valued as well as the distinct differences between it and the subject property in other types of valuations.

A legitimate question arises: is there one valuation or many? Within the multiplicity of valuations, and from the general economic point of view, is there a single theory and principle underlying these valuations, or does each valuation possess its own separate worldview, principles, and theory?

Such questions have never been set forth with clarity by valuation theorists, mostly because of the universal hold of the modern portfolio theory (MPT) over the area. Often, it is implied that the answer is apparent' and those who attempt to spot cracks in the uniform edifice of valuation theory (predicated on MPT) are unreasonable hairsplitters. The only recent exception to the general consensus appears to be the work of Robert T. Slee, (15) where the issue is boldly and elegantly articulated with some urgency and given a practical and empirical twist. Sayce and her colleagues also have taken some tentative steps in questioning the uniformity doctrine. (16)

The next part of this article will discuss the two kinds of valuation that might seem the same at the first blush: investment-financial valuation (IFV) and professional valuation (PV). The inference is made that professional valuation incorporates its own perspective on the pricing processes, which broadens and appends the objectives of investment-financial valuation. Table 1 provides a comparison of professional valuation and investment-financial valuation.

Investment-Financial Valuation

The current' universally accepted practice is to borrow and apply concepts from investment-financial valuation to professional valuation-especially when valuing illiquid interests in private businesses. (17) This is, generally speaking, an unsubstantiated fad from the point of view of theoretical deliberations.

Within IFV are those areas of valuation described in works by Damodaran and by T. Copeland et al. (18) As can be gleaned from these works, the subject assets of IFV are corporate shares circulating on active public markets and exchanges; traded debt instruments; financial options; and to a certain extent, all equity of corporate entities (when taken against the background of the market mechanisms of a liquid stock market). The major, overarching feature among these assets is their liquidity, i.e., general interest of investors toward these assets and the potential to dispose of them in no time on an active market (mass-traded or homogenous assets).

The notions of IFV are based on the economic theory called modern portfolio theory (MPT) developed since the end of the 1950s in the works of Modigliani and Miller; Markowitz; Sharpe; Lintner; Fama; and others and applied to a broad range of assets for which the underlying assumptions are valid or nearly valid. These assumptions are characterized by concepts implied in the notion of efficient markets. (19)

Investment-financial valuation includes methods of valuation flowing out of MPT, together with the objectives and objects (assets) to which the MPT is, or can be, applied and for which the notions of efficient markets are relevant. As previously mentioned, the objects of IFV (also called subject assets or properties) are liquid, divisible, and mass traded, and are often denoted as financial titles. (20)

Investment-financial valuation represents a certain outlook in the area of assets circulating in efficient or near-efficient markets. In comparison, professional valuation is defined in this article as the valuation profession and practice that is pursued in accordance with certain professional valuation standards such as IVS, USPAP, EVS, etc. Professional valuation (PV) often reaches beyond the characteristic area of IFV. For example, professional valuation reaches beyond the liquidity barrier of IFV, which circumscribes active mass markets, and deals with the valuation of investment or in-exchange values of illiquid or rarely-traded real properties, unique intangible assets, investment projects, etc. That is why PV unavoidably develops its own perspective or paradigm and draws distinctions not characteristic of IFV.

Although IFV and PV have some elements in common, IFV and PV (and their underlying theories) are not identical. There are irreconcilable differences between the two areas, some of which are highlighted in this article. It may be best to avoid applying hard-and-fast labels in order to describe these practices. For example, the discussion can address the valuation of liquid or less-liquid assets, or valuation in efficient (ideal) and inefficient (real) markets. That is why this article uses the acronym labels PV or IFV for the sake of convenience and to embrace under these terms all the differences and similarities between the types of valuation.

Financial titles are represented by instruments circulating on active competitive markets with a multiplicity of transactions in them. In these markets, there is a substantial, publicly available array of statistical information (prices). Under these conditions, it is conceivable to entertain the notions of efficient markets or at least the notion that the price for such objects will over time revert to a price that is justified under efficient market conditions. This implies that although the current price of an object may deviate from its market worth (i.e., fundamental or intrinsic value), an investment-financial valuer will be able to ascertain whether the current price is inflated or deflated in comparison with the object's market worth and thus determine the investment attractiveness of the object in question. Such an analysis makes use of statistical techniques and assumes investment strategies that, according to the MPT premises of rational behavior, lead to adoption of unambivalent, optimized solutions.

Needless to say, IFV-related techniques are based on the assumption that there is a substantial array of quotations available in the market, the treatment of which in the light of probability theory is relevant. In other words, IFV assumes that the market information (quotations, prices) possesses the mathematical properties of random variables that incorporate all the qualitative expectations of market participants (the "efficiency" of such information). However, this represents a realistic (or near-realistic) assumption only in the environment where the financial titles are traded.

Professional Valuation

Does the IFV perspective conform to the everyday experience of valuers engaged in professional valuation as understood by the recognized valuation standards (IVS, EVS, USPAP, or others)? (21) No, it does not.

Compared with IFV, modern PV has a broader scope. It embraces assets that are not financial titles, such as real estate, specialized property, intangible assets, and other illiquid objects that are not customized and possess certain specific, unique features. The exchange of these assets occurs under circumstances different from the conditions in efficient or even weakly-efficient markets.

Although these objects are generally not considered liquid, they have a market value, which is defined in the International Valuation Standards as
 The estimated amount for which a property (asset)
 should exchange on the date of valuation between a
 willing buyer and a willing seller in an arm's-length
 transaction after proper marketing wherein the parties
 had each acted knowledgeably, prudently, and without
 compulsion. (22)


The principle and essential requirement for market value, as implied in this definition, is the availability of a legal opportunity to exchange a property. (23) Such an exchange is a hypothetical exchange or transaction and certain assumptions or judgments about the most likely or willing buyers and sellers must be made. The "most likely" in this context is not expressed in the statistical sense, but as a judgmental degree of confidence established by persons familiar with the features of a valued object.

As a result, determining the market value of items in PV calls for solution of the behavioral interactions (and mental deductions) of the two parties who possess the satisfactory knowledge about the object and certain alternative investment opportunities and also have a certain implied relationship.

The IVS definition of market value does not assume that the object trades in an efficient market or that there is information available about past transactions with the object that can be interpreted using statistical techniques. The IVS definition does not even assume that the object has a sufficient degree of comparability with any other objects for which such information is obtainable. But market value should reflect the deductive (thinking) processes of the participants in the stated hypothetical transaction to satisfying its description in the market value definition. In other words, a professional valuer is required to resolve a behavioral situation of two interacting parties, which generally is not equivalent to situations arising on the active mass markets implied in the investment-financial valuation perspective where the market worth of financial titles is determined with reference to the general market environment in equilibrium. This distinction is acknowledged by Irving Fisher in his famed Theory of Interest:
 It is a fact long recognized by price theorists that the
 theoretical determination of any price in a special
 trade, or haggle, between two persons, each of whom
 is conscious of his influence on that one price, is more
 complicated than in a full-fledged competitive market
 [the mass market] in which each individual is so small
 a factor as to be unconscious of his influence on the
 market price. (24)


In professional valuation, with the noncustomized nature of its objects, a specific (even hypothetical) trade is the basic reference point of market value. In contrast, IFV deals mainly with homogenous mass-traded assets in a competitive market that determines their market worth.

Modern Portfolio Theory

In professional valuation, the behavioral situations of two interacting parties can be analyzed and resolved by the practical theory of valuation, which is predicated on the notions and methodology of behavioral finance and is distinct from traditional finance theory, MPT, and IFV practices. (25) While modern portfolio theory has proposed and perfected pricing methods that adequately reflect pricing in mass-trading processes (active markets, customized trading products, developed informational infrastructure and other approximations to the ideal efficient market), the exchange and valuation in other circumstances (individualized bilateral and infrequent transactions with a nonstandard object) do not possess the features that are compatible with the efficient market. Under the circumstances, the attempt to apply by analogy the techniques of MPT and IFV may prove to be ill-founded due to insufficient comparability of the information on similar objects in an active market with the features of the subject (illiquid) asset. To quote Robert T. Slee, "Public and private markets have no positive correlation. If we're grabbing data from one side to measure the other, we're doing a disservice." (26)

Unfortunately, by-analogy reasoning requires a leap into the gulf that separates financial titles (the primary IFV objects) from illiquid assets, which are the basic objects of PV. However, by-analogy reasoning is still a universal standard in professional valuation theory and methodology. Sometimes there are even attempts to spread MPT thinking, and even the capital asset pricing model, into the area of illiquid assets. (27) But it is impossible to fly a hot-air balloon on the moon. Those who assume that the pricing behavior of illiquid assets can be described by some statistical standard deviation (28) or that the income arising from them is susceptible to description by the regularities of a stochastic process (29) are doomed to fail.

Other inconsistencies result from attempts to use IFV to value illiquid assets based on the broad market perspective of MPT and comparative techniques such as regressions. These problems pervade most of the standard practical methods and techniques in professional valuation. In business valuations, the following inconsistencies can be seen:

* The application of discounting models in the income approach based on the MPT perspective. In these situations, the objects are barely connected with active securities' markets. For example, when valuing entire strategic enterprises (in the defense and nuclear sectors) and controlling stakes of illiquid plants in industries not represented on stock exchanges, the capital asset pricing model is assumed, which is the typical model of a financial buyer's behavior on an active stock market.

* The application of discounts for lack of marketability (DLOMs) to minority stakes in illiquid enterprises not associated with active securities markets, based on the conception of illiquidity borrowed from the IFV and its empirical concepts regarding financial titles.

* Notions about a range of illiquid assets (patents, interests in the mineral extractive enterprises, etc.) possessing the features of real options, which are most often valued by analogy, based on the financial option's pricing models, such as the Black-Scholes model or other models that assume a stochastic process. (30)

The next sections will address these issues in greater detail and remark on the most recent research in the practical theory of valuation. This research shows why it is not supportable to apply instruments and perspectives underlying IFV to illiquid asset valuation, and why this may lead to distorted analysis of the rational behavior of buyers and sellers of illiquid assets.

The Income Capitalization Approach and Discount Rates in Valuing Illiquid Assets

Recently, income capitalization theory and discounting principles for illiquid assets have been examined by economists such as A. Smolyak; V. Galasyuk, M. Soroka, and V. Galasyuk; and V. Michaletz. (31) Research by Smolyak; and by Galasyuk, Soroka, and V. Galasyuk, is related to analysis of the income approach, development of discount rates for the estimates of investment value of illiquid assets, and efficiency assessment of investment projects. Their analysis follows the reasoning on income approach concepts proposed by L. Kantorovich (a Nobel Prizewinning economist) with A. Lurje, while the work of V. Michaletz deals with the general theory of the income approach and discounting principles for the exchange values of illiquid assets. Michaletz's work is based on mathematical formalization of the principle of transaction equilibrium or the principle of fair exchange. (32) The consensus that discount rates represent the expected return on the investment opportunities available to an investor in a hypothetical transaction is traceable to these series of research.

The concept of discount rates should encompass neither the inclusion of risk premia for investing in a subject asset, nor any other normative notions/assumptions characteristic of the MPT and IFV but barely relevant to contiguous kinds of valuation.

For example, the capital asset pricing model (CAPM) is assumed to be appropriate for describing the behavior of investors on the liquid effective markets. However, when it is applied to other, illiquid assets, one faces an array of inconsistencies entailing an attempt to twist the reality to fit the ideal theoretical pattern. Most often this is caused by the lack of comparable objects. It causes an instinctive disbelief in the results obtained and stimulates the desire to create additional risk premia. After all, as P. Boettke and others have observed, the lack of data can always be overcome without changing assumptions:
 The point we want to highlight is more subtle; economists
 have to assume that certain data exist for them to
 manipulate, which we contend does not in fact exist ...
 Science, after all, is measurement, as everyone likes to
 say. And if you cannot measure, measure anyway rather
 than threaten the scientific stature of a discipline. (33)


But, there are also a number of inconsistencies when the CAPM or other broad market models are applied in valuing illiquid assets.

First, a discounted cash flow analysis implies a number of forecast periods. For that reason it is difficult to justify its use in conjunction with the discount rates based on the CAPM which is explicitly a one-period model.

Second, the CAPM assumes a rational composition of investment portfolios with only liquid assets. However, the investment portfolios of parties transacting in illiquid assets are often themselves illiquid, and it is often impossible to describe them in terms required for the CAPM (e.g., any covariance is often impossible to establish or quantify).

Third, it is hard to justify the homogeneity of expectations that is often assumed in deductions of the CAPM. (34) Transactions of illiquid assets dealt with in professional valuation often involve different expectations of the transacting parties regarding the attainable efficiency of the use of the assets. Transactions with illiquid assets also assume the receipt of positive net present value (NPV), in contrast to transactions taking place in efficient markets where it is reasonable to act on the assumption of zero NPV due to the operation of the law of diminishing returns in the equilibrium setting. (35)

Transactions with illiquid assets do not occur in an equilibrium market, and the application of CAPM in such situations can only be justified using the uncharacteristic assumption that the parties transacting in the illiquid asset being valued have a practice of composing their investment portfolios mostly out of financial titles. That is why, when using the income approach to value illiquid assets, it is out of place to talk about equilibrium in any market that does not immediately pertain to the asset being exchanged. It seems possible to introduce the concept of equilibrium of benefits obtainable by the parties in an assumed exchange transaction with the valued illiquid asset. This fair exchange principle allows looking anew at practically all methods and notions underlying the income approach in the professional valuation and understanding why, despite the seeming resemblance, those are nevertheless distinct from the respective IFV concepts. (36)

Fourth, the CAPM assumes a function for assessing the utility of any investments based on the systematic risk-return criterion, which is a universally recognized criterion for rationally acting, portfolio-forming financial investors.

In real life, many investors pursue investment strategies that are at odds with the CAPM and MPT assumptions. For example, strategic investors build up their portfolios based on the principles of a vertically integrated holding, "putting all their eggs in one basket" in the eyes of financial investors, but are nevertheless acting rationally from many other perspectives.

Any theory fit to describe the objects of professional valuation should acknowledge that it is quite unlikely that a uniform set of rules for rational investing is possible, and ditto for any singular comprehensive discounting model. This is in contrast to what has been possible within the MPT and IFV with the emergence of the CAPM and other models of the ideal broad equilibrium markets.

Valuers of illiquid assets should inquire into how their model of establishing discount rates compares with the investment strategies pursued by the most likely buyers and sellers of the assets being valued. Under such analysis, it is often the case that investors in illiquid assets are not comparable to financial portfolio investors. For that reason, establishing discount rates that are representative of investors of illiquid assets should not rely on models having wide currency in the IFV world (like the CAPM), which are based on the strategies pursued by rational financial investors. Moreover, valuers are no longer limited in their model choice. The practical theory of valuation is able to offer a number of general behavioral principles and models that are more relevant to the situations encountered in professional valuation than those models borrowed from the MPT and IFV.

Differences in Discounts for Lack of Marketability in PV and IFV

Of interest is the issue of discounts for lack of marketability (DLOMs) in connection with valuation of private businesses. Such discounts are most often necessary because of the application of IFV notions to the area of illiquid assets valuation. Discounts for lack of marketability arise out of the desire to smooth over the inherent disparities when the empirical data for pricing of illiquid assets gives different indications than can be justified or predicted by the IFV framework. The need to prepare such discounts vanishes on the realization that the pricing of illiquid assets is predicated on deductive processes, models, and principles different from those sanctioned in MPT and IFV.

Currently, in U.S. literature there are a variety of theoretical DLOM concepts, and the illiquidity can be conceived in different ways.

On the one hand, Damodaran conceives illiquidity as a consequence of heightened transaction costs that are incurred in transactions of assets traded on public exchanges, but with less liquidity than, say, blue chip stocks. Needless to say, transaction costs on such markets are receptive to empirical treatment.

For example, there often are market-makers in U.S. public capital markets that maintain the liquidity of shares by assuming the liability to enter into share transactions with any external party. But, if those market-makers perceive that it would be difficult to resell the purchased stocks, they compensate for this risk by assigning higher bid-ask spreads for stocks with lesser liquidity. The less liquid a stock is perceived to be, the greater the spread-which is supposed to represent the value of liquidity under such an approach. It is possible to identify relationships between the spreads in the universe of stocks by studying the dependence of the spreads on such factors as the trading volume of the stocks in question as well as on any related revenue and net profit of associated corporations.

The question is whether the stocks of entities that are not represented on the public exchanges or markets-truly illiquid stocks-belong in that universe. Damodaran provides assurances that such stocks should be treated as public stocks with a trading volume of 0 (with the insertion of this zero into a respective influencing variable within the multiple regression model based on public markets data to obtain the discount). However, such a procedure may be too great a leap. Shouldn't the illiquidity of private stocks be treated as a concept different in kind from the one prevalent under the circumstances of public markets trading?

This issue has been raised in the works of Z. Christopher Mercer, currently the chairman of the Standards Subcommittee of the American Society of Appraisers. His publications offer a deductive framework, called the quantitative marketability discount model, for determining DLOMs. (37) In this model, the illiquidity of stocks is viewed in its strong form, i.e., as the impossibility to dispose of a stock over a rather long period of time-the holding period or investment horizon. The events that could signal the termination of the holding period include events of significant moment for the private firm concerned. These might include an IPO, sale of the owner's controlling stake to a third party, or any other event showing external demand. It is assumed that a rather long stretch of time would elapse, separating the date of valuation from the event that gives rise to liquidity. (38)

In such a setting, two issues arise: whether such strongly illiquid stocks have market value, and, if so, what would the DLOM represent. It is possible to answer in the affirmative to the first issue considering the international definition of market value, since the definition assumes a hypothetical exchange between the two parties as the minimal condition for an asset to have market value. (39) The second issue concerns the pricing of such shares.

According to Mercer's point of view, if such shares were traded on stock exchanges under the conditions of competition, then the competitive market forces would produce the price of the present value of all benefits accruing to them. This assumes that those benefits are to be distributed in the pro rata fashion among the holders of the majority and minority equity interests and assumes the highest and best use of the assets employed by the firm.

However, the lack of liquidity implies that (1) the minority shareholders are dependent on the actions of the controlling owners, who can distribute the benefits disproportionately to their own account and for their sake; and (2) controlling owners that are free from the threat of takeover via the accumulation of shares in public market may not feel disposed to run the business in the efficient, highest and best use way. Therefore, the illiquidity of the stock may mean that its value is less than that it would be flit freely circulated in the public markets. Whether the value actually is less depends on the circumstances of a particular business; the quality and propensities of its management; and the features of the dividend policy.

In the end, the in-exchange value of stocks is determined by the discounted value of cash flows that are expected to accrue on them, and the DLOM reflects the difference between the value of an illiquid stake (the present value of all expected payoff) compared to the value that they would have if they were traded on the public exchanges (highest and best use based valuation given the pro rata distributions of equity payoffs).

As shown, the DLOMs for interests in private companies cannot be derived from an analysis of empirical data gleaned on public markets. It is precisely the lack of access to public quotation that creates potential grounds for DLOMs for private companies. To determine the size of such a discount, it is necessary to make a judgment concerning the value of equity interests on the different levels. The empirical averages from the public side are not enough.

The deductive approach proposed by Mercer idealizes the optimizing effect of "the invisible hand" on (real) public capital markets. Nevertheless, it is spot-on in its emphasis on the distinctions of kind in pricing of financial titles within efficient markets compared to illiquid assets. It also illustrates the inappropriateness of transferring the pricing on efficient markets to valuation of illiquid assets, where the pricing occurs on its own level. This strongly contrasts with the prevailing tendencies in IFV where, even though some differences between liquid and illiquid assets are recognized, the differences are treated as differences of degree, not differences of kind. For example, illiquid private stock is considered equal to publicly traded stock with the trading volume of zero; and the risk of investing into a private firm is considered equal to total beta, which is for some reason assumed to be empirically determinable even for a fully illiquid stock.

Mercer's stance on DLOMs is often the object of unjustified criticism emanating from IFV quarters. Damodaran has remarked that the need for judgmental inputs is the deficiency. (40) However, it would be possible to avoid such a confused state of affairs in the debate if there were a wider understanding that each valuation area-PV and IFV-is characterized by its own locus standi, and an understanding that it is impossible to automatically transfer the concepts of one area to another by analogy and without proper justification.

The IFV notions and concepts related to discount rates and illiquidity should be applied within IFV as they are. But, it should be understood that the broadening of valuation practice and its diffusion into areas beyond normal IFV scope often requires the development of a new concepts, principles, and techniques. This does not mean that the emerging new perspective is incorrect, but that it is pointed at other types of assets and the specific deductive processes of the parties transacting them. (41) Therefore, a different type of rationality is called for when the rationality for resolving seemingly comparable situations in a by-analogy fashion appears dubious.

Approaches to Pricing Illiquid Assets

Unfortunately, too much intellectual effort has been spent trying to solve the pricing problems of illiquid assets using purported analogies with IFV problems. A vivid example can be seen in the use of real options-based thinking in attempts to value illiquid assets.

Although a number of illiquid assets possess the characteristics of options (for example, patents on new products or new technology, or mineral extracting licenses), they cannot automatically be valued by applying standard pricing models borrowed from the IFV area for valuing financial options or by applying other models (42) that are predicated on a stochastic process. Nick Antill and Kenneth Lee in their book remark that the real options pricing method is a work-in-progress. (43) For example, although oil is a liquid asset, this does not mean that its price volatility corresponds to the volatility of the asset underlying the real option in valuing an undeveloped production field. This method should be treated with caution when valuing illiquid assets that seemingly can be valued with its help. On the other hand, the presence of options characteristics within an asset can be explicitly modeled using the scenario method or simulations method, (44) without recourse to the assumptions underlying the financial options pricing models, which seem to be too strict and inappropriate in the circumstances of real options. (45)

There also has been some opinion of late that illiquid (in particular, specialized) assets can be valued using the contingent method, which combines the results of expert judgments with the empirical safety of numbers. (46) This method is a market simulation, where investors who are knowledgeable about the features of a valued asset, and could potentially be transacting parties, are asked about the amount they would be willing to pay for the asset. The results of such a survey are analyzed statistically as if the data represented real market quotations. A measure of the central tendency (average, median, etc.) is deduced and taken to be the indication of value, with the standard error (the deviation of the results) referenced.

To make the surveys reflect the "real," unbiased opinion of "price," an attempt is made to eliminate perception heuristics by asking neutrally framed questions or by repeating the same question twice but in a different framing. The fact that this is an issue testifies to the high subjectivity of the responses, which is quite understandable. It also raises doubts over the appropriateness of averaging the obtained results and treating the averages as the indications of any value. Some pairs of respondents (hypothetical buyers or sellers) may come to widely-differing estimates of the exchange price depending on the logic applied or mental reflexes. In this regard, many different exchange prices may arise in the bilateral, hypothetical transactions between willing and knowledgeable buyers and sellers. It would be difficult to tell which of these prices is the most likely one and can be treated as the value.

The application of the contingent method seems to be a labor-consuming and expensive exercise, but the outwardly convincing appearance of the attained (quasi-) empiricism hardly warrants such efforts. Despite the emergence of appropriate literature, the contingent method has not yet attained any practical recognition within professional valuation and this seems fair.

Since an illiquid asset (by definition) does not have any broad market to trade it in, simulating it may be considered to be a vain attempt. Ultimately, it is believed that the market value for illiquid assets is predicated on the conditions of the equilibrium exchange (the principle of the equivalence of interests) (47) in a bilateral hypothetical transaction (as per the IVSC definition of market value) in which the parties are assumed to have such pricing deductions that valuers consider reasonable. In other words, valuers can talk only of the stand-alone pricing of illiquid assets, i.e., of assigning prices that under such circumstances are called values. However, such fair exchange value and the full-bodied market value of liquid assets are distinct. In the latter case, market value is an attempt to empirically observe or make inferences about the prices that are the most likely, i.e., values as defined in the "value as the most probable price" family of market value definitions, such as the former USPAP definition of market value.

In the case of illiquid assets, valuers can treat only the aspirations of reasonable (rational, realistic) pricing without providing any assurances as to the objective degree of likelihood of the judgment. But here the role of professional valuation judgments-coupled with the underlying deductive reasoning logic and the set of situational models of assets pricing-grows to be of primary importance since the valuer already assumes the role of a "market maker." Any empiricism steps into the background, though it remains implicit in the process of forming a judgment. The broad market of liquid assets should be considered whenever possible, but it does not automatically establish the environment of a specific hypothetical transaction that represents a more or less autonomous exchange with its own equilibrium point, specific features, and unique behavior of the exchanging parties, depending on the nature of the object being valued.

It was reasonable for the accounting profession to separate its measurements of fair value into three levels depending on the extent to which the liquidity of an asset allows application of certain valuation techniques. (48) However, these levels are viewed as hierarchies, which leads one to think that the Level 3 fair value measurements that include valuations of illiquid assets carried out with the aid of indirect or deductive methods based on remote empiricism are less precise than the Level I fair value measurements that are applied when an asset is nearly fully liquid and its value is determined by the sales comparison approach based on its current public market quotations. Under these circumstances it is hardly appropriate to talk about precision or hierarchies.

Precision is a comparative notion that only has meaning in relation to something in an objective reality, such as when one examines subject-object relations that arise in the perception processes or in literal measurements of the length of some material body. It is easy to fall under the influence of the idea that the measurements in professional valuation or, specifically, in IFV are of such subject-object variety. In valuing liquid or unspecialized assets with the aid of the sales comparison (market) approach, valuers might indeed conceive that they read the information, process certain literal objects, and deduce the value based on it. But valuers should not forget that the value-both in the theory of value and in the practical theory of valuation-represents the relations between individuals. This includes subject-subject relations and their coordination, (49) the shaping of which is not without a contribution from valuers. Here it is barely appropriate to talk about precision or the hierarchy of precision. In this regard, the notion of market or fair value of illiquid assets and its determination are not lower down the hierarchy or less precise than the respective notions and measurement processes for liquid assets, but they may have a different meaning. (50)

A certain notion or form of valuation practice is not right or wrong, precise or imprecise, but it can be relevant in certain situations and redundant in others. (51) In other words, making new distinctions--in paradigms, concepts, techniques of practice-as valuation expands in practice and theory is an integral part of its development and realization as an area of human inquiry. Valuation needs both to maintain the segmenting of its areas and fields (the division) and to seek out the commonalities (the unification), which together can be conceived as the process of extending the practice and mutual complementation.

Each area of valuation has the need for steady patterns as well as new general concepts, notions, and perspectives on the studied objects and processes. From this point of view, many of the current debates, frictions, and processes in the practical theory of valuation can be understood if valuers keep in mind the distinctions between professional valuation and investment-financial valuation, and the liquidity of the assets customary dealt with in the respective valuations. Each side in these debates-be they related to the discounting principles or rates, discounts for lack of marketability, or some other matters not covered in this article-is certainly right, but right subject to the assumed area of practice and within the perspective taken.

Conclusion

Professional valuation has borrowed many elements from corporate finance's modern portfolio theory and investment-financial valuation, where general finance theory is based on the optimized behavior of investors in liquid assets. Some observers assume that the theories underlying PV and IFV are no different. However, the characteristic features of the objects being valued most frequently in professional valuation demonstrate why the concepts in modern portfolio theory and the theory of value are insufficient when applied to the spectrum of objectives and objects of professional valuation.

Unjustified and inadaptable borrowings of MPT and IFV techniques and notions hinder the development of techniques and notions of professional valuation applicable to real-as opposed to "ideal" pricing situations. It also delays the realization of the independent standing of professional valuation vis-a-vis investment-financial valuation. Discussion of the distinctions between professional valuation and investment-financial valuation contributes to the evolution of the practical theory of valuation and its stand-alone recognition separate from the general economic theory of value and modern portfolio theory. This, of course, does not mean the segregation of each of the areas of valuation, as in certain situations the techniques and general notions of either valuation approach can adapt the techniques and notions of its counterpart, forming a single continuum of valuation, as illustrated in Figure 1.

[FIGURE 1 OMITTED]

(1.) See discussion in G. I. Mikerin, and M. A. Fedetova, "Professional Estimation of Value of Property for Financial Reporting and Revision of Concepts of the International Standards" (12.04.2006), available in Russian at http:/ /www.appraiser.ru/default.aspx?Sectionld=255&Id=2168.

(2.) See discussion in G. I. Mikerin, "Insights into the Essence of Estimation of the Value of Intangibles for the Purpose of Financial Reporting," in Business Valuations Guide, 1st ed. (Questo Consulting, 2007), available in Russian at http://www.nsfo.ru/news.php?sec_id=25.

(3.) Sarah Sayce et al., "New Financial Paradigms," chapter 12 in Real Estate Appraisal: From Value to Worth (Oxford: Blackwell Publishing, 2006).

(4.) This catchphrase can be found in Eugene F. Fama, "Efficient Markets: A Review of Theory and Empirical Work," The Journal of Finance 25, no. 2 (May 1970): 383-417, and is repeated in Fama's later statements and texts.

(5.) The Journal of Finance in 2004 recorded detailed interviews with prominent economists; transcripts of these interviews are available at http://www.afajof.org/association/historyfinance.asp.

(6.) Ibid.

(7.) In this, they were aided and abetted by the Russian default, where their fund was heavily implicated in the GKO- OFZ and the ruble-dollar forwards gambles and lost $4 billion as a result. Worldwide, the fund had positions amounting to $1.25 trillion and only the advance of a gigantic bailout credit on the initiative of the U.S. Federal Treasury allowed the fund to wind down its operations quietly.

(8.) Martin Hoesli and Bryan D. MacGregor, Property Investment: Principles and Practice of Portfolio Management (Edinburgh Gate: Pearson Education Ltd., 2000); and Angela Black, Patricia Fraser, and Martin Hoesli, "House Prices, Fundamentals and Bubbles," Journal of Business Finance and Accounting 33, no. 9-10 (Nov./Dec. 2006): 1535-1555; the latter work caused quite an uproar among professionals. The work of Hoesli and MacGregor was further developed and refined by Hoesli in his later works.

(9.) Hoesli and MacGregor.

(10.) Aswath Damodaran, Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, 2nd ed. (New York: John Wiley & Sons, 2002). For practical purposes, valuers often visit the Damodaran Web page to borrow formulas, spreadsheets, and other informational items, which are often used in valuation estimates even without references to their source.

(11.) Aswath Damodaran, "Valuation Approaches and Metrics: A Survey of the Theory and Evidence," Stern School of Business, November 2006, available at http://pages.stern.nyu.edu/~adamodar/New_Home_Page/.

(12.) Damodaran has devoted an entire book to the discussion of the philosophic essence of valuation, see Aswath Damodaran, Investment Philosophies (New York: John Wiley & Sons, 2002), also available at http://pages.stern.nyu.edu/~adamodar/New_Home_Page/invphilbook.htm.

(13.) Damodaran, "Basis for the Approach," in Valuation Approaches and Metrics, 58. Valuers view discounted cash flow as the basic methodology underlying the income approach and Damodaran views the application of this approach as investment valuation; relative valuation is known among valuers as the sales comparison or market approach.

(14.) Ibid., 59. He also briefly discusses the fair value concepts introduced by regulators, and only by reference to other works reports that "fair value judgments made by accountants provide useful information to financial markets in a variety of contexts."

(15.) Robert T. Slee, "Public and Private Markets Are Not Substitutes," Business Appraisal Practice (Spring 2005), republished in Voproci Ocenki (RSA Quarterly) no. 2 (2007).

(16.) Sayce et al.

(17.) This is analyzed with some anxiety, but nevertheless much favored, by Damodaran in chapter 24 of Investment Valuation.

(18.) Damodaran, Investment Valuation; and T. Copeland et al., Valuation: Measuring & Managing the Value of Companies, 3rd ed. (New York: John Wiley & Sons, 2000). Although Damodaran's book is called Investment Valuation, the name does not seem well chosen, as the book is mostly concerned with establishing fundamental or intrinsic value (i.e., market worth), which represents the value-in-exchange on idealized efficient markets. Since investment valuation has been established as the accepted term to denote this area, at this juncture it would be difficult to replace it with another term. But to highlight the remoteness of such valuations from the investment value, in the present article the collocation is noted by using the term investment-financial valuation (IFV).

(19.) Fama.

(20.) S.A. Smolyak, Valuation of Investment Projects Under Conditions of Risk and Uncertainty (Moscow: Nauka Publishers, 2002).

(21.) For example, there is a distinction of kind in the perspectives: For an IFV expert, determining the value (market worth) of an instrument traded on the active market is a serious analytical task, while for a professional valuation expert, or even for an accountant engaged in accounting measurements, it will suffice to pick up a pricing quotation (or closing price) from a relevant active market and call it the value (respectively, the market value or accounting fair value).

(22.) This definition is excerpted from IVS Standard 1. It is often said that the IVS's market value definition and the former definition in USPAP (which still exists in Russian valuation law) are tantamount, but a careful perusal and comparison of those definitions shows that such an opinion is erroneous. The former USPAP market value definition directly appeals to the notion of "... open markets under the conditions of competition ..." At the same time, the IVS definition makes no reference to such conditions of exchange. In truth, the assumption of competition implies that the object is of interest to more than one buyer--and under such circumstances it is hardly credible to speak about the illiquidity of the object. So, under the former USPAP market value definition it follows that specialized properties can have no market value as they are by definition illiquid. In other words, the former USPAP definition was much closer in spirit to the theoretical perspective underlying IFV.

(23.) IVSC Letter to the IASB regarding fair value in Discussion Paper "Measurement Bases for Financial Accounting--Measurement on Initial Recognition" (May 17, 2006), available at http://www.ivsc.org/pubs/comment/2006may.cica.pdf.

(24.) Irving Fisher, "First Approximation in Geometric Terms," in The Theory of Interest (New York: Macmillan Co., 1930).

(25.) G. I. Mikerin, "Valuation Standards 2007: 'Revisiting the Concepts' or a 'Paradigm Shift'," posted 12.01.2007, available at http://www.valuer.ru/files/ds/Standards_07.doc and http://www.appraiser.ru/default.aspx?SectionID=255&Id=2511 (in Russian).

(26.) Robert T. Slee (speech at the Institute of Business Appraisers (US) National Symposium, June 2007).

(27.) Michael C. Jensen, "The Foundations and Current State of Capital Market Theory," in Studies in the Theory of Capital Markets (Praeger Publishers, 1972), available at http://ssrn.com/abstract=350428.

(28.) Gerald T. Garvey, "What Is an Acceptable Rate of Return for an Undiversified Investor?" (September 2001), available at http://ssrn.com/abstract=281432.

(29.) E. Schwartz and C. Tebaldi, "Illiquid Assets and Optimal Portfolio Choice" (NBER Working Paper No. 12633, October 2006), see http://www.nber.org/papers/w12633.

(30.) Kanak Patel, "A Review of the Practical Uses of Real Property Options," RICS Research Paper Series 5, no. 1 (April 20, 2005).

(31.) S. A. Smolyak, Cash Flow Discounting in the Context of Assessment of the Efficiency of Investment Projects and Property Valuation (Moscow: Nauka Publishers, 2006); Valeriy V. Galasyuk, Maria P. Soroka, and Victor V. Galasyuk, "The Notion of Economic Risk in the Context of the Conventionality Cash Flows Method," Ukrainian Accounting and Auditing Herald no. 15-16 (2002): 26-34, available at http://www.galasyuk.com.ua/stat/riski.doc (in Russian); and V. B. Michaletz, "Encore on Discount Rates," Voproci Ocenki (RSA Quarterly) no. 1 (2005): 3-11, English version available as V. Michaletz, A. Artemenkov, I. Artemenkov "Income Approach and Discount Rates for Valuing Income-Producing Illiquid Assets--Outlines of New Framework," http://papers.ssrn.com/so13/papers.cfm?abstract_id=996016.

(32.) Compare this with the principle of broad market equilibrium implied in the CAPM model as discussed in William E Sharpe, "Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk," The Journal of Finance 19, no. 3 (September 1964): 425-442, available at http://www.jstor.org/pss/2977928.

(33.) Peter Boettke, Christopher Coyne, and Peter Leeson, "High Priests and Lowly Philosophers: The Battle for the Soul of Economics" (Global Prosperity Initiative Working Paper 44, 2006), available at http://economics.gmu.edu/pboettke/pubs/2OO6/high_priests.pdf.

(34.) Sharpe.

(35.) Smolyak, Cash Flow Discounting.

(36.) Michaletz.

(37.) Z. Christopher Mercer, Valuing Enterprise and Shareholder Cash Flows: The Integrated Theory of Business Valuation (Memphis, TN: Peabody Publishing, 2004); see also I. L. Artemenkov, A. I. Artemenkov, and G. I. Mikerin, "On the Integrated Theory of Business Valuation," The State University of Management Review 1, no. 19 (2007).

(38.) This period can potentially be longer than 3-, 6-, or 12-month terms, which are the typical terms of illiquidity characterizing DLOMs deduced from empirical research such as pre-IPO studies.

(39.) Sellers will be ready to sell illiquid shares provided that the benefits they expect to receive over the course of the illiquidity period (i.e., the holding period), discounted to the present value, do not exceed the amount offered by buyers. A buyer purchasing these illiquid shares steps into the shoes of the seller and so has no reason to pay over and above the discounted benefits arising from the shares. This is why under such circumstances the state of expectations respecting the benefits of the buyer and the seller can be said to be in equilibrium, and the transaction, therefore, hypothetically consumable, as it does not contradict to the interests of either party.

(40.) Aswath Damodaran, "Marketability and Value: Measuring the Illiquidity Discount" (research paper, July 2005), available at http://pages.stern.nyu.edu/~adamodar/New_Home_Page/papers.html.

(41.) Robert T. Slee, "Public and Private Markets Are Not Substitutes," Business Appraisal Practice (Spring 2005).

(42.) Patel.

(43.) Nick Antill and Kenneth Lee, "Conclusion" in Company Valuation Under IFRS: Interpreting and Forecasting Accounts Using International Financial Reporting Standards (Petersfield, Hampshire: Harriman House Ltd., 2005).

(44.) Aswath Damodaran, "Probabilistic Approaches: Scenario Analysis, Decision Trees, and Simulations" (research paper, 2007), available at http://pages.stern.nyu.edu/~adamodar/New_Home_Page/papers.html.

(45.) Mark E. Rubenstein, "Great Moments in Financial Economics: IV. The Fundamental Theorem (Part II)," Journal of Investment Management (First Quarter 2006).

(46.) Olusegun A. Ogunba and Terry P. Boyd, "How Suitable Are Contingent Valuation Techniques for Valuing Properties in Non-Market Situations" (RICS research paper, presented at the Queensland University of Technology Research Week International Conference, July 4-8, 2005), available at http://www.rics.org.

(47.) Michaletz.

(48.) See the SFAS 157 Statement of Standard on Fair Value Measurement, available at http://www.fasb.org, and also G. I. Mikerin and S. A. Smolyak, "Measurements of Fair Value for Financial Reporting: Applying Valuation Techniques and Present Value Models in Accounting Estimates," Voproci Ocenki (RSA Quarterly) no. 3 (2006): 2-14 (in Russian).

(49.) This perspective is brilliantly articulated in Valeriy V. Galasyuk, Maria P. Soroka, and Victor V. Galasyuk, "On the Subjective-Oriented Discounting Concept" Security Market no. 22 (2003): 32-43, available in Russian at http://www.galasyuk.com.ua/publications.html?lang=ru#theme_4; and Valeriy V. Galasyuk, Maria P. Soroka, and Victor V. Galasyuk, "An Anthropological Approach to Discount Rate Estimates (GAD-theorem in the Conventionality Cash Flows Framework)," State Privatization Bulletin of Ukraine no. 11 (2002): 57-60, available in Russian at http://www.galasyuk.com.ua/publications.html?lang=ru#theme_4.

(50.) It should be noted that expiring Russian Valuation Standard no. 519 made a reasonable distinction between market value (which in Russian valuation law and in the former USPAP is theoretically defined as the value related to liquid assets) and value on a restricted market (which is also an in-exchange value but the one which is associated with illiquid assets). However, in practice this distinction is ignored and the value of illiquid assets is most often certified in reports as the market value. Similar to the levels in the accounting fair value measurements, it would have been possible in PV to introduce a stratification of market value, drawing distinctions between its varieties depending on the liquidity of assets being valued and on the degree of activity in the respective market. The situation could have been clarified if the valuation standards (including the IVS) made clearer interpretations of what constitutes the market and whether a stand-alone bilateral transaction constitutes a "market." Unfortunately, the International Valuation Standards Committee (IVSC) correspondence with the International Accounting Standards Board gives confusing indications as to the IVSC stance on this issue, see IVSC Letter to the IASB regarding fair value available at http://www.ivsc.org/pubs/comment/2006may-cica-pdf, and also the IVSC Comment on the IASB Discussion Document on SFAS 157 (May 2007).

(51.) In this connection, the concept of the fair value hierarchy levels in professional accounting circles indicates that such a consensus regards the "accounting measurements" as an art of empirical observation, and only then as the art of professional judgments and deductive procedures of pricing.

by A. I. Artemenkov, G. I. Mikerin, and I. L. Artemenkov

A. I. Artemenkov, FRSA, is a senior economist with the Russian Society of Appraisers, and a lecturer and faculty member in the Economic Measurements Department at the State University of Management (Moscow). Contact: artemenkov@rambler.ru

G. I. Mikerin, PhD, is a professor, and serves as the head of the Economic Measurements Department at the State University of Management (Moscow). He is also a managing board member of the Russian Society of Appraisers and a member of the Expert Advisory Valuation Council at the RF Ministry for Economic Development and Trade. Contact: gmikerin@mail.ru

I. L. Artemenkov, FRICS, CCIM, FIABCI, is a senior vice president with the Russian Society of Appraisers, and serves as a managing board member with the International Valuation Standards Committee. Contact: artemenkov@inbox.ru
Table 1 Comparison of Methods and Applications of Professional and
Investment-Financial Valuation

 Investment-Financial
 Professional Valuation Valuation

Basis of Real or hypothetical Ideal markets.
Methodological exchange processes.
Perspective The concepts of perfect
 Approach from the point markets (efficient
 of view of the behavior markets in equilibrium);
 of transacting parties in the sup- position of
 a possible or rational, optimized
 hypothetical transaction behavior of the
 with an asset. Avoidance participants on such
 of the idealization of markets and, in some
 exchange processes and of cases, of the
 their conception in the homogeneity of
 form of mass exchange on expectations of all
 ideal liquid markets. market participants.

 The approach is based on, These concepts have been
 and reflects, the developed in the area of
 deductive processes of corporate finance and
 the participants in modern portfolio theory
 individuated, bilateral (MPT), where the utility
 transactions. The utility of assets is viewed only
 of the property (objects through the risk-return
 being valued) has many criteria and the assets
 facets (different are supposed to be liquid
 heuristics, biases, and and interconnected in
 other second-order that they can be easily
 rationalities) and is substituted by others or
 regarded not only on the properly proportioned
 risk-return plane. within the portfolio.

Applicability Pricing of exchanges with Developed active
in Real non-standard assets (real securities markets
Circumstances property); nonpublic (markets where the
 companies and interests financial titles are
 in them; intangible traded) with the
 assets; and other assets available statistical
 exchanged on inactive history of trading of
 markets. sufficient volume.

Scope of Assessment of market Estimation of the
Objectives value and investment intrinsic or fundamental
 value associated with the value (i.e., market
 assets, the valuation of worth) of securities,
 which falls within the financial options and of
 scope of practice of other derivatives
 professional valuation. associated with the
 financial titles and
 standardized commodities;
 the constituting of
 optimized investment
 portfolios of financial
 titles based on such
 exercises; and the
 forecasting of returns
 under conditions close to
 the ideal ones.
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