Fundamentals of Functional Business Valuation

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Manfred Jürgen MATSCHKE, Gerrit BRÖSEL and Xenia MATSCHKE,

Fundamentals of Functional Business Valuation,
in: Journal of Business Valuation and Economic Loss Analysis,
Volume 5, Issue 1 (2010)
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The Journal of Business Valuation and Economic Loss Analysis is the first and only peer-reviewed academic journal in the increasingly important field of business valuation studies. How to calculate the value of a business and how to quantify economic loss: these questions are essential to many areas of business and law, such as accounting and finance, estate law, mergers and acquisitions, litigation support, and forensic economics. To bridge the significant gap between academic and practitioner communities, each issue of the journal features three types of articles: scholarly studies that advance the field of business valuation or economic loss analysis; case studies in accounting, finance, litigation, and strategic management; and studies of recent legal rulings. Scholars of economics, finance, management, and law will find valuable real-world examples to complement their research, while accountants, attorneys, and financial analysts will find in-depth conceptual studies that inform their day-to-day work.

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Fundamentals of Functional Business Valuation

DISTINGUISHING BETWEEN FUNCTIONAL AND MARKET VALUE - ORIENTED BUSINESS VALUATION

The main differences between functional and market value-oriented business valuation shall now be discussed on the basis of the prior explanations.

Functional business valuation is strongly individualistic in its main functions, i.e., it is directed toward the concrete goals, plans, expectations and action possibilities of the valuation subjects in imperfect and incomplete markets. It is also conflict - oriented, i.e., directed at a possible interpersonal conflict in connection with ownership changes between only a few decision subjects and with several conflict - relevant issues. Functional business valuation considers real existing conditions that are illustrated in a model - theoretically simplified way, but may be examined intersubjectively.

In contrast, the today widespread so - called market value oriented valuation establishes an idealized model world based on the neo - classical finance theory. It is geared towards the anonymous, exchange - organized ideal and complete capital market and towards the capital providers acting in it, i.e., it is superindividually oriented. The starting point of this approach is not a specific task because the purpose - dependency of the value is not recognized. In addition, it has another serious deficiency: In contrast to the older objective theory, this younger objective valuation concept denies the difference between value and price and is thus incredibly unrealistic.

Regarding the market assumed by the representatives of the market - oriented valuation, it is assumed that homogeneous (equal) goods are traded at the same time (i.e., on the same market) at the same price. The degree of knowledge of all market participants is the same: the conclusions from the available information coincide. The individual market participant has no market power in this market. The price is given. Value and price must coincide under these ideal market conditions by assumption.

The so - called market - value oriented valuation has thus completely ignored and forgotten the simplest references to the conditions of real capital markets.

The representatives of the market - value - oriented valuation do not ask what the purpose of the valuation is, but concentrate on the valuation process by which one can allegedly determine the "market value". But even an economics freshman knows that the market value (market price) is derived as an exchange value determined by supply and demand and that gains of trade arise precisely because the average buyer valuation is higher and the average seller valuation is lower than this market price.

The market - value - oriented valuation was deliberately not discussed in this article. This concept that has covered business valuation theory like mildew should be sufficiently familiar, in particular since the so - called discounted cash flow method that allegedly determines the market value constitutes a consulting product offered worldwide. The "theoretical" discussions of these models revolves around the futile question of how different DCF methods can be made to lead to the same valuation result - a problem that already existed for the representatives of the older objective concept. At that time as well as today, different valuation results are considered annoying. They may undermine the belief in the validity of the presented "market value" and consequently the authority of the appraiser as secular "cast of priests" who know the secrets of the "market value", which may thus negatively affect their financial interests.

No single DCF method (WACC - approach, Entity - approach, Equity - approach, APV - approach) has a decision - theoretical foundation (Hering/Olbrich/Steinrücke, 2006, p 411). However, the DCF methods offer a fertile ground for argumentation values due to their numerous inherent possibilities of manipulation. From the viewpoint of the functional business valuation theory, these methods can be used to bolster arguments brought forward by a conflicting party during a negotiation under two conditions:

1. the value so determined may not violate the decision value of the arguing person;

2. the conflicting party using it as an argumentation aid must be convinced that it may impress the other negotiating party and lead to a result more favorable for the arguing party.

Any condlicting party should however know the exact limits of the applicability of the used DCF methods and should never forget that these methods cannot determine the limit of the concession willingness, i.e., the decision value.

CONCLUSION

This aricle gives an introduction to the concept of functional business valuation. Functional business valuation differs from other business valuation methods in that it recognizes that there does not exist just one value for an enterprise, but that there coexist different values of an enterprise depending on the person for whom the valuation is conducted and the purpose of the valuation. Functional business valuation also takes into account that the typical enterprise is not traded publicly, so that any valuation based on the assumption of perfect capital markets and perfect competition is out of place. Moreover, even if a company is publicly traded, the value for a whole business cannot be appropriately determined by just multiplying the market value of a single share with the total numbers of shares.

After having introduced the reader to the basic ideas and terminology of functional business valuation, we use detailed numerical examples to explain how a one - dimensional decision value for an undominated purchase / sale situation can be determined. In the example, we first work with a more complex framework, the so - called "state marginal price model", and the show under which conditions a simplified procedure, the so - called "future performance value method", can be employed. We also compare the popular market - based valuation methods, such as the discounted cash flow method, and the functional business valuation method.