The Justification of Purchase (JOP) test tells us that an equity value is economically reasonable if, the interest purchased for that value:
- Pays owner-managers reasonable (usually fair market) compensation.
- Adequately services (interest and principal) assumed and acquisition debt.
- Generates a satisfactory return on investment (dividends and appreciation).
For small buy-a-job businesses, only the first two criteria are relevant.
How does the JOP test work with the three approaches to value: Income, Asset, and Market? (Assume we are using just one in a given valuation.)
The Income Approach is self-evident, because we assume reasonable compensation and appropriate debt service in our financial forecast, and the equity value equals discounted cash flow (if the third criterion is applicable).
The Asset Approach is trivial. In it, we assume liquidation and reduce assets and liabilities to cash value, so there’s really no analysis to be done.
The Market Approach is where the JOP is powerful. We develop a value based on market data, but then develop a separate financial forecast, discount rate, and present value of cash flows which independently proves our value conclusion.
The JOP test is really designed to work with enterprise (100% equity) value or pro rata shares of it before consideration of fractional interest discounts and premiums for control and illiquidity. If you are working with a marketable minority interest, the cash flows may be different from that of a pro rata interest, and if you are working with a non-marketable minority interest, the illiquidity increases the required rate of return, and neither of these are easily handled in the JOP.