Most of my valuations involve equity ownership interests, whether they are operating businesses or holding entities like FLP’s. I develop cash flow to equity using normal procedure, apply a discount or capitalization rate, applicable valuation discounts, and that is that. If it is an operating business, I use the Income Approach and prepare a multi-year financial forecast (income statements, balance sheets, and cash flow statements) and develop cash flow to equity directly. If it is a holding company, I use the Asset Approach to develop cash flow to equity (with an assumption as to when, if ever, the assets will be sold, or I may use the Income Approach, or both).
Cash flow to equity is straightforward because the (common) equity gets everything that is left after taxes, interest, debt principal, working capital changes, capital expenditures, asset sales, and preferred dividends are accounted for. Sometimes I need the help of a CPA if there are special circumstances like recapture of value for “S” corporations.
In some situations, however, cash flow to equity (or the subject ownership interest) is not as easy to develop.
I recently did my first valuation of a self-canceling installment note, which pays out normal interest and principal as long as the note holder (creditor) lives. If he or she dies before it matures, however, the creditor loses some portion of principal (thus the self-canceling feature). In this case, I had to calculate the cash flows that might occur given various death dates, the cash flows foregone, the probability of death (with the help of mortality tables supplied by an actuary), and probability-weight (as well as discount to present value) the expected cash flows.
When businesses are sold via asset sales, care must be taken to identify which assets (and liabilities, if any) are going to be sold and which will be retained by the seller. I always prepare a reconciliation table that shows this, to make sure I have not forgotten anything. Similarly, if a business is going to spin off owned real estate to an affiliated entity, the preceding must be done, and there will probably be rent charged to the original company by the spin-off.
When owner-managers are bought out of a multi-shareholder business, there may be a question as to whether the selling manager will be replaced, and at what cost.
Several years ago I did a complicated valuation of eight companies with six owners in which the companies owned parts of each other, and the shareholders had different interests in each entity. The shareholders wished to untangle the ownership at the corporate and individual levels so that there were no corporate cross-ownerships and to end up with each shareholder owning the same percentage of each company. Although the valuations of each individual company were straightforward, the allocation of cash flows to reflect corporate cross-ownerships and individual interests was a nightmare!
In another common situation, assets are going to be sold (in more than a year) or may be subject to options to purchase. The cash flows from holding as well as selling the assets have to be accounted for properly.
You can probably think of other examples in which it is not simple to identify the relevant cash flows (either from owning the business or selling assets). The moral of the story is: be sure you have accounted for all of the assets and liabilities, and factored in the appropriate cash flows to each entity or owner. This has to be done before you get into the discount (or capitalization) rate as well as discounts (for lack of control and / or marketability).