How do purpose, standard of value, and premise of value differ?

Purpose explains why the valuation is needed, such as a transaction, tax matter, or dispute. The applicable assignment determines the standard, which defines whose perspective and which conditions govern value. Premise describes the assumed use or disposition of the business or assets, such as continued operation or orderly liquidation. A profitable factory valued as a going concern may exceed the sum of its equipment sale proceeds, so the premise can change both the method and the result.

Which cash flow and discount rate belong together?

Free cash flow to the firm is available to debt and equity providers, so discount it at a rate reflecting both sources of capital, generally WACC, then deduct interest-bearing debt to reach equity value. Free cash flow to equity is after debt service and belongs with a cost of equity. Keep tax treatment, expected growth, currency, and nominal or real terms consistent. Mixing firm cash flow with a cost of equity can materially misstate value.

When should a control premium or marketability discount be applied?

First identify the ownership rights and the level of value produced by the starting method. A cash flow already normalized for decisions a controlling owner can make may reflect control; adding a control premium could count the same benefit twice. A marketability adjustment concerns the ability to sell the particular interest and requires evidence about its restrictions, expected holding period, and available buyers. Apply any adjustment to a stated starting value and explain why the underlying risk is absent from the cash flows and rate.

Certified Valuation Analyst (CVA) Study Guide

Start with concept 1 Choose a topic

A business valuation begins with a precise question: what interest is being valued, for whom, under which standard, and on what date? Those choices govern the evidence, cash flows, methods, and adjustments that follow. This guide moves from engagement decisions and company analysis through financial normalization, income, market, and asset methods. It then addresses discount rates, ownership interests, and special securities. The worked examples use stated assumptions so you can follow the calculation and judge what its result means. Pay particular attention to matching each benefit stream with its rate and to identifying the level of value already reflected in an indicated value. A sound conclusion depends as much on those distinctions as on correct arithmetic.

Overview

1. Purpose and standard of value

Start with the reason the business is being valued: a transaction, tax matter, dispute, or financial report can call for different definitions of value. Then identify the specified standard before choosing assumptions about buyers and benefits. Fair market value considers a hypothetical willing buyer and seller under its applicable definition; investment value reflects benefits to a particular investor. Strategic value may include advantages from combining businesses. A saving available only to one buyer therefore needs separate treatment from earnings that a typical market participant could obtain. The same forecast can produce different conclusions because the permitted benefits differ, even when the arithmetic is sound. Record the valuation date and the facts known or reasonably knowable then. The NACVA Core Body of Knowledge identifies these distinctions as part of the CVA curriculum.

Worked example: Assume a buyer can save $200,000 a year by combining facilities, with no growth and a stated 10% capitalization rate. The saving has a value of $200,000 ÷ 0.10 = $2 million to that buyer. Add it when estimating that buyer’s investment value, if the saving is feasible and incremental. Do not automatically add it to fair market value when ordinary buyers cannot achieve it.

Watch the distinction: A signed offer does not prove every dollar is transferable business value. Identify buyer-specific benefits in the price before using the offer as evidence for the assignment’s standard.

Reference: [3]

2. Premise, date, and level of value

The premise describes how the assets are assumed to be used: continuing operations, an assembled group of assets, or liquidation. The valuation date fixes the information set and the point at which the value estimate applies. The level of value describes the economic rights represented by the interest, including control and ability to sell. These are separate choices. A profitable business may be worth more in operation than its assets would yield in an orderly sale, yet neither whole-business figure directly measures a minority unit with limited voting or transfer rights. First identify the asset or interest and date, then select the appropriate premise and benefit stream. Finally compare the rights embedded in the resulting indication with the rights being valued. Any adjustment must address a real difference in rights or expected benefits without repeating an effect already in the cash flows.

Worked example: At the stated valuation date, assume the operating business is worth $5 million as a going concern. Orderly asset sales would yield $3 million, less $400,000 of obligations, leaving $2.6 million before other sale costs. The premise changes the whole-business indication by $2.4 million. A restricted minority interest requires further analysis of distributions, voting rights, and transfer limits; taking a percentage of either total alone does not complete that valuation.

Watch the distinction: A liquidation estimate is not automatically a floor for every owner’s interest. Sale costs, priority claims, timing, and the owner’s rights can change what that interest receives.

Reference: [3]

NACVA/GACVA Professional Responsibilities and Standards

3. Developing a supportable conclusion

A supportable conclusion begins with work broad enough to answer the defined valuation question. Identify the benefit stream, gather evidence for its major drivers, and test management’s explanations against contracts, operating records, and external conditions. A projection is an assumption to examine, not a fact merely because it appears in a spreadsheet. Material unsupported inputs can be revised, bracketed in scenarios, or left as explicit limitations, depending on what the evidence permits. The selected methods must fit the standard, premise, interest, and available data. Keep a trail from source documents through adjustments, rate selection, calculations, and reconciliation so another competent analyst can understand the judgment. Professional standards govern development and reporting; the curriculum’s scope outline establishes their relevance, while the engagement’s facts determine what evidence and explanation the particular conclusion needs.

Worked example: Management projects 20% growth on $1 million of revenue, giving $1.20 million next year. Signed contracts support only 8%, or $1.08 million. The $120,000 difference needs separate evidence, such as credible orders or a demonstrated sales pipeline. Use $1.08 million as the contract-supported base, document the unresolved increment, and test later years independently rather than extending 20% mechanically.

Watch the distinction: Management approval does not validate a forecast. An analyst who reproduces unsupported growth without testing its drivers cannot make the conclusion traceable by adding a disclosure.

Reference: [3]

4. Independence and ethical conflicts

A conflict can arise from ownership, fees, personal relationships, prior advocacy, or an interest in the outcome. Assess both whether judgment could be influenced and whether a reasonable user would question the analyst’s objectivity. Disclosure gives users information, but it does not erase an economic stake or justify an inaccurate independence statement. Before accepting, identify the client, intended users, dispute context, relevant professional requirements, and any role the analyst can properly perform. A party may retain an expert to analyze facts, yet the value opinion still needs defensible methods and fair treatment of unfavorable evidence. Advocacy for a desired number is a different service and should never be disguised as an independent valuation. If the conflict prevents the required role or credible performance, decline or change the engagement only where the applicable requirements and users allow.

Worked example: An analyst owns 5% of the company in a shareholder dispute. A higher company value could increase the analyst’s own economic interest, creating a direct conflict. The analyst should identify the stake before accepting, assess applicable independence requirements, and tell the prospective client. Merely disclosing the 5% holding does not support a claim of independence; an unconflicted analyst may be needed.

Watch the distinction: Being hired by one side does not automatically make analysis advocacy. The error is shaping assumptions to that side’s desired outcome while presenting the result as objective.

Reference: [3]

5. Reporting and valuation review

Developing a value conclusion requires the analyst to select inputs, apply methods, and reconcile indications for the defined interest. A valuation review instead examines another analyst’s work within a specified review scope. It may test internal consistency, evidence, calculations, and whether the report explains its assumptions, without producing a replacement value opinion. State precisely which procedures were performed and which were outside scope. A useful review identifies the consequence of a defect and its possible materiality, while avoiding certainty beyond the information reviewed. For example, firm cash flow belongs with a rate for all capital providers; equity cash flow belongs with an equity rate. The ABV study guide is a related resource for practicing this rate and benefit alignment, though the applicable CVA assignment still controls the work and report.

Worked example: A report capitalizes next-year firm cash flow of $1 million growing 2% at a 16% equity cost, giving $1 million ÷ 14% = about $7.14 million. At the stated 12% WACC, the consistent firm calculation is $1 million ÷ 10% = $10 million. The reviewer can identify this $2.86 million model difference without claiming a complete new valuation.

Watch the distinction: Finding one serious error does not establish the correct final equity value. Other assumptions, nonoperating assets, and debt may still require work outside the review scope.

Reference: [3]

6. The analyst in a dispute

Dispute work often supplies competing narratives, but the analyst’s task is to test economically relevant facts against the valuation date and defined legal question. Separate documented events from assumptions about what those events will cause. A known customer departure can affect projected revenue, margins, replacement costs, and risk; uncertainty about duration calls for scenarios, not omission. Record who supplied each assumption, why it was used, and how sensitive the conclusion is to it. Counsel can frame the issues and provide evidence, while the expert remains responsible for the analytical opinion. A defensible report explains contrary evidence and avoids selective use of records. In testimony, concise calculations and clear limits are often more robust than a point estimate that hides uncertainty. The selected standard and premise still govern which losses and potential recoveries belong in value.

Worked example: Before the valuation date, a customer representing 30% of $10 million annual sales leaves. On a simple unchanged-volume basis, sales fall by $3 million to $7 million before replacement business. Suppose the analyst considers rapid, partial, and no replacement scenarios. Each must have evidence for timing and contribution margin. Counsel’s request to omit the known loss cannot substitute for that analysis.

Watch the distinction: Treating a known loss as irrelevant because its long-term effect is uncertain confuses fact with forecast. Model the uncertainty while retaining the fact in the record.

Reference: [3]

Engagement Acceptance and Planning

7. Define the interest and assignment

Define the subject before gathering multiples or choosing a discount rate. Specify the legal entity, class and percentage of ownership, voting and distribution rights, transfer restrictions, and any agreements that alter those rights. State the valuation date, intended use, intended users, standard, and premise. These details determine whose cash flows are relevant and whether an indication reflects control, a marketable minority interest, or a restricted interest. An LLC’s pass-through tax treatment and governing agreement may also affect the benefit available to its owners; a simple corporate-equity template can miss those features. A pro rata share of whole-equity value is an arithmetic reference, not a conclusion about a particular unit. Work from the whole-business indication to the defined interest only after checking what rights and limitations are already reflected in the starting value.

Worked example: Assume all LLC equity has a hypothetical $5 million value. A 20% pro rata share is 0.20 × $5 million = $1 million. If that unit lacks voting rights and cannot be freely transferred, examine distributions, governance, and likely buyers before concluding its value. The same $5 million whole-equity figure could support a different per-unit result for a controlling block.

Watch the distinction: A 20% holding is not necessarily worth exactly 20% of enterprise or equity value. Debt, class preferences, control, and transfer rights can interrupt that simple proportion.

Reference: [3]

8. Make engagement terms operational

An engagement agreement turns the assignment definition into working responsibilities. It should identify who supplies records, whether the analyst may verify them, what assistance specialists may provide, how confidential information is handled, who pays, and what happens if material information is unavailable. These terms help avoid a silent shift from a valuation opinion to a calculation based on incomplete data. They also establish how limitations, changed facts, or withdrawal will be handled. A fixed fee sets compensation; it does not reduce the need to investigate information that could materially change value. For events after the valuation date, ask whether they reveal a condition already present on that date or instead arose later. Document the chronology before deciding how the event informs the estimate. If essential records remain unavailable, reassess whether the agreed scope can support the requested conclusion.

Worked example: The client provides year-end statements but withholds notice that a major contract was cancelled soon afterward. Request the contract, cancellation notice, correspondence, and dates. If the cancellation reflects a dispute already underway at year-end, it may inform the date-specific forecast; a wholly new later cause may be treated differently. A fixed fee of any amount does not make the missing evidence immaterial.

Watch the distinction: Labeling every post-date event irrelevant is too broad. Later evidence can clarify conditions that existed at the valuation date, even when the later event itself is excluded.

Reference: [3]

9. Accept, staff, or decline

Acceptance requires more than enough calendar time to write a report. Compare the assignment’s technical demands with the team’s experience, data access, and ability to obtain qualified help. A patented process may require evidence about enforceable rights, remaining useful life, competing technology, and royalty or profit effects. The valuation analyst can integrate those findings into the business model, while a suitable specialist may address technical life or patent-related facts beyond the analyst’s competence. Define the specialist’s task and examine the assumptions and limitations of that work. Staffing should also allow independent review of calculations and adequate time for management questions. If the client blocks access to information central to a material asset, a broad disclaimer does not manufacture support. Narrow the assignment where appropriate or decline when a credible conclusion cannot be developed.

Worked example: Suppose a patented process appears to drive much of a company’s margin, but the analyst cannot assess technical obsolescence. A qualified specialist could evaluate remaining useful life and relevant royalty evidence while the analyst tests the resulting cash-flow effect. If the client refuses access to patent records and technical staff, the analyst must reconsider whether the requested opinion is supportable.

Watch the distinction: Hiring a specialist does not transfer responsibility for the final valuation logic. The analyst must understand how the specialist’s assumptions connect to revenue, risk, and remaining life.

Reference: [3]

Qualitative Analysis

10. Triangulate information sources

Management interviews explain operations, but recorded transactions test what actually happened. Reconcile production, purchases, inventory movement, invoices, and cash receipts before using a volume figure in a sales forecast. The basic inventory identity is beginning inventory plus production or purchases, less ending inventory, equals units sold, subject to losses and other movements. Contracts and customer records can then test whether reported sales are repeatable. Site observations may reveal unused capacity, obsolete stock, or dependence on a particular employee. External price and demand data provide another check, though they must fit the company’s location and product mix. Differences are diagnostic clues rather than reasons to average sources. Determine whether they arise from timing, accounting classification, returns, or inaccurate records, and carry that explanation into the forecast.

Worked example: Management says 10,000 units were produced in the year. Invoices support 8,500 units sold, and inventory increased by 1,500 units. Assuming no losses, returns, or other movements, 8,500 sales + 1,500 added inventory = 10,000 production. Revenue should start from 8,500 sold units; the extra 1,500 require evidence of future demand before becoming projected sales.

Watch the distinction: Production and sales are not interchangeable. Unsold units can raise inventory without generating revenue, and their eventual sale may need discounts or additional holding costs.

Reference: [3]

11. Translate macro conditions into forecasts

Economic conditions matter through specific operating channels. Inflation can raise input prices, wages, selling prices, inventory investment, and replacement capital spending at different rates. Interest rates can change borrowing costs, customer demand, and discount rates. Employment changes can affect both local spending and the availability or cost of labor. Trace each condition into units, prices, margins, working capital, reinvestment, or risk rather than adding one broad economic adjustment. Check timing: supplier increases may arrive before customers accept price changes. A nominal cash-flow forecast should use a nominal rate, and a real forecast should use a compatible real rate. If expected inflation is already built into both prices and costs, applying another blanket margin haircut duplicates part of its effect. Sensitivity analysis helps where pass-through or volume response is uncertain.

Worked example: Assume annual purchases cost $2 million and input prices rise 6%, adding $120,000. Annual sales are $4 million and selling prices rise 3%, adding $120,000 if volume holds. Gross profit dollars therefore remain unchanged under these limited assumptions. The conclusion fails if customers reduce orders, other costs rise, or inventory and payment timing create extra financing needs.

Watch the distinction: Equal percentage changes in prices and costs need not cancel. Apply each percentage to its own dollar base, then test volume, timing, and other affected costs.

Reference: [3]

12. Analyze the local market

A national industry trend may describe broad demand while missing the customers who actually buy from a local business. Map revenue by customer location, employer, channel, and product. Then examine local population, wages, major employers, competing stores, travel patterns, and labor supply. A nearby closure can reduce spending even during national growth; it might also free workers or premises and create opportunities. Estimate the exposed revenue first, then test how much could be retained through other customers or locations. Avoid assuming every exposed dollar disappears or automatically applying the national growth rate to the entire base. Local evidence should drive the scenario weights and timing. Where the company serves both local and distant markets, split the forecast so each segment responds to the conditions relevant to it.

Worked example: A retailer has $2 million of annual sales, and employees of a closing local plant account for an estimated 15%. The exposed amount is $2 million × 15% = $300,000. If none is replaced, sales fall to $1.7 million before other changes. A 4% national demand increase does not resolve this exposure; investigate customer recapture, timing, and margin before forecasting.

Watch the distinction: National growth is not a ready-made local sales forecast. It can coexist with a local decline, particularly when one employer or customer group dominates demand.

Reference: [3]

13. Industry structure and life cycle

Industry growth does not automatically convert into owner cash flow. In an emerging industry, capacity expansion, customer acquisition, inventory, and technology may consume cash before sales arrive. Mature industries may offer steadier volume but face price competition and replacement spending. Declining industries may require restructuring or a shorter terminal period. Examine capacity utilization, rivals’ expansion, regulation, customer adoption, and the reinvestment needed to support projected units. Forecast revenue and operating margin alongside capital expenditures and working capital, rather than treating growth as a free addition to historical cash flow. A terminal assumption deserves particular care: a perpetual growth rate implies an ongoing ability to reinvest and earn an adequate return. If margins rise despite new entrants and unused industry capacity, the forecast needs a defensible competitive explanation.

Worked example: Assume the market grows 12% and the subject plans to capture that demand. It must spend $500,000 annually on capacity, versus $100,000 in its historical maintenance budget. A forecast using the higher growth revenue but retaining $100,000 of spending overstates annual cash available by $400,000, before any extra working capital. Test whether the added capacity can earn enough to justify it.

Watch the distinction: Fast sales growth does not prove fast value growth. The required investment, timing, and durability of margins determine how much growth benefits owners.

Reference: [3]

14. Competitive position and pricing power

Pricing power depends on customers’ alternatives, switching costs, supplier choices, and barriers facing new rivals. A company with a concentrated customer base can be profitable yet have weak bargaining power when a large buyer demands concessions. Translate each proposed price or volume change into revenue and contribution margin, then examine whether costs move with volume. Supplier concentration can offset apparent pricing strength if replacement inputs are scarce or expensive. Product differentiation, contracts, service quality, and capacity at competing firms help judge whether customers will accept increases. A forecast that raises prices while keeping all units assumes demand is insensitive to price; test that assumption against history and substitutes. Where a large customer might leave, compare the economics of accepting a concession with the costs and timing of finding replacement business.

Worked example: One customer supplies 40% of $5 million annual revenue, or $2 million. A 5% cut to that customer’s prices reduces revenue by $100,000. If unit volume and operating costs truly stay fixed, annual profit also falls $100,000. If rejecting the cut risks losing the account, compare that concession with lost contribution margin and realistic replacement sales before choosing a forecast.

Watch the distinction: A five percent price cut for one customer does not reduce total revenue by five percent. Apply it to that customer’s sales and examine any resulting volume change.

Reference: [3]

15. Verify company-specific claims

A claimed advantage becomes valuable when evidence connects it to durable economic benefits. Interviews can explain a production process, but ownership documents, maintenance records, site observations, customer orders, and product margins test whether the advantage exists and can earn returns. Unused capacity alone has no positive cash flow; it is an option to serve demand if orders, labor, inputs, and working capital are available at attractive margins. Consider whether rivals can imitate the process and whether rights to equipment or intellectual property are secure. Separate current operating earnings from a growth scenario so the same capacity benefit is not counted in both. If the valuation uses projected expansion, include any setup costs, incremental overhead, and reinvestment. The more speculative the demand, the clearer the scenarios and supporting evidence should be.

Worked example: A line can produce 1,000 units weekly but currently makes 500, leaving 500 units of physical capacity. Management calls it a growth asset, yet a site visit shows it idle half the week. If no additional orders are documented, incremental contribution is zero for now. Test demand, contribution per unit, staffing, and setup costs before projecting the unused 500 units as sales.

Watch the distinction: A machine’s maximum output is not a revenue forecast. Capacity creates value only when profitable demand and the resources needed to fulfill it are credible.

Reference: [3]

Quantitative Analysis

16. Assess financial statement reliability

Financial statements offer different levels of external work. An audit provides an opinion based on audit procedures; a review offers limited assurance; a compilation presents information without comparable assurance. Internal statements and tax returns can still be useful, but their purposes and accounting choices differ. None eliminates the need to understand the company’s revenue recognition, related-party items, and unusual transactions. Compare several years and reconcile material differences among sources through the general ledger, invoices, bank records, and tax schedules. An unexplained gap can affect both forecast reliability and selected risk assumptions. Avoid simply preferring the largest or smallest number. The FMVA study guide provides related modeling practice; for a CVA analysis, the key is linking each adjusted historical amount to verifiable records and a defined benefit stream.

Worked example: Internal records show $4.2 million of sales; the tax return shows $4.0 million, a $200,000 gap. Suppose year-end accrual entries total $200,000. Trace those entries to invoices, delivery dates, and the tax reconciliation. If the entries represent valid book revenue recognized in a different tax period, explain the timing. Averaging the totals to $4.1 million would hide the cause.

Watch the distinction: An audited figure is not automatically the right normalized forecast base. Assurance concerns the statements; valuation still requires adjustments for economics, timing, and the defined interest.

Reference: [3]

17. Read common-size statements and ratios

Common-size statements express each income item as a percentage of sales and each balance-sheet item against a relevant total. They reveal changes that rising dollar amounts can obscure. Gross margin equals sales less cost of sales, divided by sales; operating margin also reflects selling and administrative expenses. Pair margins with ratios such as receivable days, inventory turnover, and debt coverage to locate the operating driver. Then compare periods and suitable peers, allowing for changes in product mix, accounting, and scale. A declining gross margin during revenue growth may signal discounts, rising input costs, or a shift toward lower-margin products. Do not treat the ratio as an explanation by itself. Trace it to quantities and prices so the forecast can model whether the deterioration continues, reverses, or requires additional spending.

Worked example: Sales rise from $8 million to $10 million, while cost of sales rises from $4.8 million to $6.5 million. Prior gross profit is $3.2 million, or 40% of sales. Current gross profit is $3.5 million, or 35%. Thus $2 million more sales produce only $300,000 more gross profit, an incremental gross margin of 15%, which warrants a mix or pricing investigation.

Watch the distinction: Higher gross profit dollars do not prove improving economics. Check the margin percentage and the incremental margin before extending the sales trend into a valuation forecast.

Reference: [3]

18. Separate trend from industry difference

Company improvement and peer comparison answer different questions. A rising operating margin shows progress within the subject, while a remaining peer gap may reflect opportunity, weaker operations, or structural differences. Use several years to determine whether the trend is persistent and compare peers with similar products, size, accounting, and cost allocation. A benchmark gap is a diagnostic estimate, not an automatic normalization. Ask which expenses or prices account for it and whether management can realistically change them. If a forecast closes the gap, identify the actions, timing, and costs required. Conversely, a company may deserve a lasting gap because it serves lower-margin customers or lacks peer scale. The CVA practice questions can help rehearse the distinction between calculating a margin difference and justifying its use in value.

Worked example: A company’s operating margin rises from 8% to 11%, while comparable peers show a 14% median. The remaining gap is 3 percentage points. On $10 million of sales, that equals $300,000 of operating income. Before adding $300,000 to normalized earnings, identify a feasible cause and remedy, such as documented excess costs, and account for any expense needed to achieve the improvement.

Watch the distinction: A peer median is not the company’s entitled margin. Different business mix, scale, accounting, and risk can make the gap persistent and economically appropriate.

Reference: [3]

19. Normalize owner-related expenses

A controlling owner may set compensation above or below the market cost of the services performed. Normalize earnings by comparing actual pay, benefits, and related expenses with the cost of a qualified replacement. The difference may be discretionary from a control perspective, but necessary work still has a cost. Examine the owner’s duties, hours, revenue relationships, and whether one replacement person can truly perform them. A minority owner may lack power to change compensation, so the appropriate adjustment depends on the interest and level of value. Keep tax treatment and payroll-related costs consistent with the chosen benefit stream. If forecast cash flow already uses replacement compensation, do not add the excess again as a separate control premium. Support the adjustment with role-specific pay evidence rather than an arbitrary industry average.

Worked example: An owner is paid $400,000 annually. Evidence indicates a qualified replacement for the same duties would cost $250,000 under the stated assumptions. Excess compensation is $150,000, so add $150,000 to reported earnings for a control-level normalization. The remaining $250,000 stays as an operating expense. Check benefits and payroll costs separately if they are material and not included in those figures.

Watch the distinction: Removing the entire owner salary assumes the services are free. It overstates sustainable earnings unless the buyer can operate without replacing those duties.

Reference: [3]

20. Identify nonrecurring results

Normalization seeks a sustainable historical earnings base, not the highest possible number. Identify an unusual item, verify its amount and purpose, then ask whether similar spending will recur in ordinary operations. A relocation charge may be nonrecurring, while periodic moves or restructuring could be part of the business model. Distinguish the historical adjustment from forward benefits caused by the event. If a move lowers future rent, that saving belongs in the forecast when supported; adding it to historical EBITDA and also projecting it would duplicate it. Apply the same discipline to gains: remove a one-time gain if it does not belong in ongoing operating earnings. Document where each adjustment enters the analysis and reconcile normalized history to projected cash flow, including any remaining transition costs or working-capital effects.

Worked example: Reported historical EBITDA is $900,000 after a documented $120,000 one-time relocation charge. Adding back that charge gives normalized historical EBITDA of $1.02 million. The move also saves $30,000 of annual rent, already included in the forward forecast. Do not add that $30,000 to the normalized historical figure and again retain it in projected EBITDA; test whether other moving costs will recur.

Watch the distinction: Calling an expense unusual is insufficient. Verify that it is genuinely nonrecurring and keep any related future saving or cost in only the appropriate forecast period.

Reference: [3]

21. Separate operating and nonoperating items

First define the operating benefit stream and the assets needed to produce it. Interest earned on surplus cash does not arise from selling the company’s products or services, so including that interest in operating cash flow can distort a capitalization of the business. Remove the nonoperating return, value the operating stream at a rate suited to its risk, then add the surplus asset at its separately supported value. Check whether the cash is truly surplus: payroll, seasonal working capital, debt covenants, and planned investment may require part of the balance. Also check whether the selected market multiple or income indication already includes cash. This operating-to-equity bridge follows the distinction between benefit streams and asset adjustments in the Core Body of Knowledge. State the valuation date and the cash balance at that date.

Worked example: Suppose next-year cash flow of $600,000 includes $20,000 interest on $200,000 of cash demonstrably beyond operating needs. With zero growth and a hypothetical 10% operating capitalization rate, operating value is ($600,000 minus $20,000) / 0.10 = $5.8 million. Add the surplus cash once to reach $6 million, assuming no further debt adjustment. Capitalizing the full $600,000 and adding cash would overstate value by $200,000.

Watch the distinction: A tempting shortcut is to capitalize every reported dollar and then add cash. That values the cash interest as an operating perpetuity and counts the cash asset again.

Reference: [3]

22. Model product contribution and capacity

For an incremental order, begin with revenue the business would gain and subtract costs that change because it accepts the order. Existing fixed overhead usually stays outside this calculation unless the order triggers extra shifts, equipment, supervision, or other capacity costs. Contribution per unit equals selling price less variable cost per unit; total incremental profit then subtracts order-specific fixed costs. Capacity is a decision constraint, not merely a production statistic. If the plant is full, include the contribution lost from displaced regular sales or the cost of expanding capacity. Check payment timing and working capital when moving from incremental profit to a valuation cash flow. A profitable order can still reduce value if it consumes scarce capacity needed for higher-margin work, creates unusual collection risk, or requires investment beyond the apparent setup charge.

Worked example: A one-time order requests 2,000 units at $50 each. Variable cost is $35 per unit and setup costs $20,000. Revenue is $100,000; variable costs are $70,000; contribution is $30,000. Incremental profit is therefore $10,000. Accepting it improves earnings under the stated assumptions that unused capacity exists, normal sales are unaffected, the customer pays, and there are no further incremental costs.

Watch the distinction: Allocating existing rent to the order can make a worthwhile sale look unprofitable. Conversely, ignoring displaced regular orders treats scarce capacity as free when it has an opportunity cost.

Reference: [3]

23. Choose meaningful summary statistics

A comparable-data summary should describe both the typical observation and the spread. The arithmetic mean uses every observation and is sensitive to extreme multiples. The median identifies the middle of an ordered sample and is less sensitive to an outlier. Neither statistic determines which transactions are genuinely comparable. Inspect the denominator definition, company size, growth, leverage, deal terms, and whether a high multiple reflects a strategic buyer or an unusual asset. A trimmed set may be defensible after investigating and documenting exclusions, but deleting a number solely because it changes the answer is unsound. Dispersion also matters: a wide range limits the precision of any indicated value. For positive financial ratios, geometric or harmonic means can answer different questions, so choose the statistic according to the economic quantity being summarized rather than by habit.

Worked example: Four comparable enterprise-value-to-EBITDA multiples are 4, 5, 6, and 15. Their mean is (4 + 5 + 6 + 15) / 4 = 7.5 times; their median is (5 + 6) / 2 = 5.5 times. The 15 materially pulls up the mean. Investigate its transaction terms before applying either summary to the subject, and communicate the sample’s broad spread.

Watch the distinction: Calling 7.5 times the objective market multiple conceals the outlier’s influence. Calling 5.5 times correct without checking comparability substitutes a robust statistic for transaction analysis.

Reference: [3]

24. Interpret correlation and regression

Regression can organize a valuation question when a plausible operating driver predicts a financial result. In a straight-line model, the intercept estimates the result at zero units of the driver, while the slope estimates the change associated with one additional unit. Inspect the observed range before using either coefficient: an intercept far outside that range may have no useful economic meaning. Compare fitted values with actual results through residuals, and examine fit measures such as the coefficient of determination alongside residual patterns. A strong correlation can arise from shared trends, omitted variables, or a few influential observations. It does not establish that opening another store will cause the estimated revenue increase. Use the model to ask why the subject differs, then test store maturity, location, capacity, and accounting consistency before adjusting a forecast.

Worked example: A hypothetical model predicts annual revenue, in millions of dollars, as 2 + 0.4 × store count. Five stores imply 2 + 0.4(5) = $4 million. Actual annual revenue is $3.2 million, so the residual is $3.2 million minus $4 million = negative $0.8 million. That gap calls for investigation of store age or productivity; the formula alone does not prove $800,000 of missing sales.

Watch the distinction: Treating the slope as a guaranteed $400,000 gain from each new store confuses association with causation. New stores may differ from those used to estimate the model.

Reference: [3]

25. Select the benefit stream and timing

Choose a benefit stream that corresponds to the interest being valued: cash available to all capital providers supports an enterprise value, while cash after borrowing and debt payments supports equity value. Historical results can anchor a stable business, but changing margins, capacity, or contracts may require an explicit forecast. Translate accounting earnings into cash by considering taxes, reinvestment, and working capital. Next, specify when each period’s cash is expected to arrive. A year-end convention discounts a year-one amount for a full year; a midyear convention approximates cash earned evenly during that year. The latter increases present value because receipt occurs earlier. Timing conventions must also govern terminal value placement and avoid implying an early receipt for cash that is actually concentrated late in a period. The financial modeling and valuation guide provides related practice with forecast timing.

Worked example: Assume a single $1 million cash flow arrives halfway through year one and the compatible annual discount rate is 10%. Its present value is $1,000,000 / 1.10^0.5, approximately $953,463. If the same amount arrives at year-end, value is $1,000,000 / 1.10, or $909,091. Earlier receipt adds about $44,372 of present value; no growth or terminal value is assumed.

Watch the distinction: Using a midyear factor because it produces a higher value is unjustified when receipts arrive near year-end. The timing convention should follow the expected cash pattern.

Reference: [3]

Valuation Approaches

26. Capitalize firm cash flow

Free cash flow to the firm is the cash available to debt and equity providers after operating taxes, necessary investment, and changes in working capital, but before financing payments. Capitalize next-period firm cash flow when a stable perpetual growth assumption is credible. The capitalization rate equals weighted average cost of capital, or WACC, less perpetual growth, with growth below WACC. This gives operating enterprise value. To reach common equity, account for interest-bearing debt and any other senior claims, and handle nonoperating assets separately. Check that the projected cash flow reflects sustainable operations rather than a temporary peak and that its growth can be supported by reinvestment. Using an equity rate for this firm stream would mismatch the cash flow recipient and required return. The rate, growth, tax treatment, and valuation date must describe one coherent set of assumptions.

Worked example: Assume next-year firm cash flow is $900,000, WACC is 11%, perpetual growth is 2%, and interest-bearing debt is $2 million. The capitalization rate is 11% minus 2% = 9%. Operating enterprise value is $900,000 / 0.09 = $10 million. With no other claims or surplus assets, common equity value is $10 million minus $2 million = $8 million.

Watch the distinction: Applying the 11% discount rate directly as a capitalization rate omits growth. Calling the $10 million enterprise indication equity value also overlooks the debt claim.

Reference: [3]

27. Capitalize equity cash flow

Free cash flow to equity measures what remains for common owners after operating needs, taxes, capital spending, working capital, interest, principal repayments, and net borrowing. Because financing effects are already inside this stream, discount or capitalize it with a cost of equity, not WACC. A constant-growth capitalization works only when next-period equity cash flow and the financing policy are sustainable; aggressive new borrowing can make a short-lived distribution look permanent. The equity rate must exceed the assumed perpetual growth rate. Review whether preferred distributions or other senior equity claims have already been deducted, since the precise recipient of the stream defines the value obtained. This approach can be useful where borrowing policy is predictable, but a firm cash flow model may be easier to interpret when leverage changes substantially. State which period’s cash flow is used.

Worked example: Suppose next-year cash flow available to common equity is $600,000 after all assumed debt service. With a hypothetical 14% cost of equity and 2% perpetual growth, the capitalization rate is 12%. Common equity value is $600,000 / 0.12 = $5 million. Debt has already affected the cash flow; subtracting its balance from this $5 million would count financing twice.

Watch the distinction: A frequent mismatch is to apply WACC to cash remaining after debt service. WACC compensates all capital providers, while this cash flow belongs only to equity.

Reference: [3]

28. Discount a changing firm forecast

When operating cash flow changes before stabilizing, forecast the exceptional years individually and calculate a terminal value only when a sustainable pattern begins. For each explicit year, estimate firm cash flow after operating taxes and reinvestment, then discount it with a compatible WACC. At the end of the final explicit year, divide the next year’s stabilized firm cash flow by WACC minus perpetual growth. Discount that terminal amount back from its placement date. Terminal value often dominates the result, so test whether its margin, capital spending, working capital, and growth are economically sustainable. A year-three cash flow used to calculate a value at the end of year two is not separately added as another explicit receipt. Finally, bridge enterprise value to equity using debt and nonoperating assets measured at the valuation date.

Worked example: Suppose firm cash flows are $1 million in year one, $1.2 million in year two, and a stabilized $1.224 million in year three. At 12% WACC and 2% perpetual growth, year-two terminal value is $1.224 million / 0.10 = $12.24 million. Present value is $1 million / 1.12 + ($1.2 million + $12.24 million) / 1.12², approximately $11.61 million in enterprise value.

Watch the distinction: Adding year-three cash flow separately after using it to calculate year-two terminal value counts that cash flow twice. The terminal value already represents year three onward.

Reference: [3]

29. Discount changing equity cash flow

An equity cash flow forecast follows distributions available to common owners after the business funds operations and satisfies debt obligations. Explicit periods can reflect uneven capital spending, new borrowing, and principal repayment; these financing assumptions affect both equity cash flow and risk. Discount each explicit amount at an appropriate equity rate. Once leverage and operations reach a sustainable pattern, calculate terminal equity value from the next period’s common equity cash flow divided by the equity rate less perpetual growth. Put the terminal value at the end of the last explicit year, then discount it to the valuation date. Review whether growth requires continuing reinvestment and whether projected borrowing can be maintained. Because the result is already an equity value, an enterprise-to-equity debt subtraction would be a second charge for the same financing.

Worked example: Assume common equity cash flows of $300,000 in year one and $500,000 in year two. Year-three sustainable cash flow is $510,000, the equity rate is 15%, and perpetual growth is 2%. Year-two terminal equity value is $510,000 / 0.13 = $3,923,077. Present equity value is $300,000 / 1.15 + ($500,000 + $3,923,077) / 1.15², approximately $3.61 million.

Watch the distinction: Treating net borrowing as free recurring earnings can inflate terminal value. Financing must be sustainable, and debt already reflected in equity cash flow should not be subtracted again.

Reference: [3]

30. Use excess earnings carefully

The excess earnings method divides a business’s normalized benefit into a return attributable to supporting tangible assets and a residual attributed to intangible assets. First identify the tangible asset base needed for operations on a consistent valuation premise. Apply a supported required return to that base, subtract the resulting charge from normalized earnings, and capitalize the residual at an intangible rate suited to its duration and risk. The result depends heavily on the asset base, two rates, and the chosen earnings measure. A residual is not automatically transferable goodwill: it may reflect temporary customer demand, owner effort, an omitted asset, or an understated tangible return. For United States assignments, the curriculum specifically flags consideration of the Treasury Method. Check whether the calculated intangible amount is already present in a separate whole-business income indication before adding values together.

Worked example: Assume normalized annual earnings of $700,000 and required operating tangible assets worth $2 million. At a hypothetical 12% required return, the tangible charge is $240,000. Residual earnings are $700,000 minus $240,000 = $460,000. At a stated 20% intangible capitalization rate and zero growth, indicated intangible value is $460,000 / 0.20 = $2.3 million, subject to the method’s assumptions.

Watch the distinction: Calling all $700,000 goodwill earnings ignores the return investors require on tangible assets. Adding the $2.3 million to a whole-business value can also duplicate intangibles.

Reference: [3]

31. Value dividend-paying capacity

A dividend model should consider what the business can sustainably distribute, not just the amount its owners happen to declare. Begin with cash from operations and subtract required capital spending, working capital investment, and debt payments. Retained cash may fund growth or protect liquidity; the analyst must decide whether it is necessary or discretionary. Actual dividends can be informative for a noncontrolling interest that cannot direct distributions, while capacity may better describe what a controlling owner could withdraw under the assignment’s rights. If payouts stay below capacity, investigate financing policy, planned acquisitions, covenants, taxes, and governance before assuming the entire difference is immediately accessible. Match the benefit to an equity return and avoid adding retained surplus cash twice. A constant payout can be capitalized only when the underlying earnings and reinvestment pattern support its persistence.

Worked example: A company distributes $100,000 annually, yet its forecast leaves $500,000 each year after required reinvestment and debt payments. With hypothetical zero growth and a 10% equity capitalization rate, sustainable distribution capacity indicates $500,000 / 0.10 = $5 million. Capitalizing actual payouts gives $1 million. The gap requires analysis of control rights and why $400,000 is retained each year.

Watch the distinction: Low actual dividends do not prove low earning capacity. Equally, a minority holder may lack the rights needed to compel distribution of the full available amount.

Reference: [3]

32. Evaluate subject-company transactions

A prior transaction in the subject company can be strong evidence because it concerns the same business, but the interest and circumstances still require examination. Identify the trade date, percentage sold, voting and transfer rights, buyer-seller relationship, information available, financing terms, and whether consideration included employment or other agreements. Then compare the company’s condition at that date with the valuation date. Earnings growth may support a higher current value, but it does not prove that price rises in the same proportion: margins, risk, rates, debt, and expected growth may also have changed. A small interest’s observed price need not indicate the value of control. Reconcile the transaction with current income and market evidence, explaining any adjustment rather than treating either the old price or a mechanical update as conclusive.

Worked example: Two years before the valuation date, a 10% interest sold for $400,000, implying $400,000 / 0.10 = $4 million pro rata. Annual earnings have since risen from $500,000 to $750,000, a 50% increase. Holding the old price-to-earnings relationship constant would suggest $6 million today, but that is only a sensitivity. Confirm rights, deal terms, risk, and earnings durability before using it.

Watch the distinction: Multiplying a two-year-old minority trade by ten does not automatically price the entire company. The trade may carry different rights and reflect earlier information.

Reference: [3]

33. Select private transaction comparables

Private transactions offer observed prices, but database entries require reconstruction before their multiples can be compared. Screen for business model, customer mix, size, geography, growth, profitability, and transaction date. Confirm what the reported price bought: equity or enterprise assets, surplus cash, assumed debt, working capital, real estate, and contingent payments can all change the numerator. Normalize the target’s EBITDA using information available around the transaction date, and match that denominator to an operating enterprise numerator. Distinguish an arm’s-length completed sale from a listing, a distressed sale, or a buyer-specific strategic purchase. A precise-looking median cannot repair inconsistent deal definitions. After adjusting each candidate deal, explain why the selected transactions inform the subject’s defined level of value and whether further differences need valuation adjustments.

Worked example: A completed deal lists an $8 million price and $1 million of operating EBITDA. Assume the price includes $2 million of surplus cash and no debt or other adjustments. Operating enterprise value is $8 million minus $2 million = $6 million, giving 6 times EBITDA. The unadjusted 8 times figure includes a nonoperating asset and should not be applied to the subject’s operating EBITDA.

Watch the distinction: Using the database’s headline price without checking included assets can overstate the operating multiple. Applying that multiple to EBITDA then gives surplus cash value indirectly, perhaps again explicitly.

Reference: [3]

34. Use guideline public companies

Public-company prices supply observable market evidence, but a guideline company must resemble the subject in its economic drivers. Compare products, margins, growth prospects, customer concentration, capital intensity, and geographic exposure. Enterprise multiples also require consistent debt and cash treatment; equity multiples require a matching equity denominator. Public shares are readily traded minority interests, so consider how their level of value relates to the subject interest before any control or marketability adjustment. Smaller size alone does not justify an arbitrary multiple reduction: identify the associated risk, its presence in the subject’s forecast, and whether peer selection already accounts for it. Use several credible peers when possible and investigate dispersion. The accredited senior appraiser valuation guide offers related context for comparing public and private valuation evidence.

Worked example: A public peer has $12 million enterprise value and $2 million EBITDA, producing a 6 times multiple. Applied without adjustment to the subject’s $1 million EBITDA, it indicates $6 million operating enterprise value. The subject’s lower growth and greater customer concentration may justify a lower multiple, but no amount follows from those facts alone. Retain $6 million as a reference point while testing supported adjustments.

Watch the distinction: A public peer’s 6 times multiple is an observation, not the subject’s final multiple. Differences in growth, concentration, liquidity, and capital structure require analysis.

Reference: [3]

35. Match the multiple to its denominator

A valuation multiple is a fraction whose numerator and denominator must describe claims on the same cash generation. Enterprise value belongs to all financing providers, so EV/EBITDA or EV/firm cash flow can be used with a similarly defined subject measure. Equity value belongs to owners after senior claims, so price/earnings or price/equity cash flow requires the corresponding equity measure. EBITDA also differs from cash flow because it excludes taxes, investment, and working capital. Check whether debt, preferred stock, cash, leases, and nonoperating assets are treated consistently when calculating enterprise value. A high equity multiple and a lower enterprise multiple can coexist because they have different numerators and denominators. Converting an enterprise indication to equity requires a separate bridge; using an equity multiple already produces an equity indication.

Worked example: A peer has $15 million enterprise value, $5 million debt, $3 million EBITDA, and $1 million net income. Assuming no surplus cash or other claims, equity value is $10 million. EV/EBITDA is $15 million / $3 million = 5 times; equity price/earnings is $10 million / $1 million = 10 times. Ten times a subject’s EBITDA would mix an equity multiple with an enterprise denominator.

Watch the distinction: Multiples with different labels are not interchangeable scaling factors. Using price/earnings on EBITDA ignores the debt claim and the expenses separating EBITDA from net income.

Reference: [3]

36. Revalue net assets

Adjusted net asset value begins with book equity, then remeasures identifiable assets and liabilities on the premise required by the assignment. An operating going concern may use asset values reflecting continued use; liquidation needs expected disposal proceeds and costs. Reconcile land, equipment, inventory, receivables, identifiable intangibles, debt, and unrecorded obligations without mixing premises. Each adjustment changes equity by the difference between the chosen value and the carrying amount. Consider associated tax effects where the assignment’s assumptions call for them, and distinguish a contingent claim from a fixed liability. The method can be especially informative for asset-rich businesses, but the adjusted balance sheet may omit earning capacity that depends on an assembled workforce or other going-concern attributes. Conversely, adding an income-based goodwill figure requires checking that it has not already been captured in revalued intangibles.

Worked example: Book equity is $2 million. At the stated valuation date and premise, land is worth $900,000 more than book, equipment $200,000 less, and an unrecorded obligation is $100,000. Adjusted net assets equal $2 million + $900,000 minus $200,000 minus $100,000 = $2.6 million. This is before any other identified assets, liabilities, or applicable tax effects.

Watch the distinction: Adding the full market value of land to book equity counts its existing book amount twice. The adjustment is the difference between market and carrying values.

Reference: [3]

37. Value identifiable intangibles

An identifiable intangible needs a defined economic benefit, a remaining useful life, and a method that isolates its contribution. A trademark may be assessed through a relief-from-royalty method: estimate revenue attributable to the branded products, apply a supported royalty rate, account for taxes and required costs, then discount the savings over the period the mark is expected to remain useful. Customer relationships may instead call for an attrition-based income model, while certain assets have meaningful market evidence. Check whether the selected royalty rate and revenue forecast describe comparable rights and whether continued marketing spending is needed. The discount rate should reflect uncertainty in the intangible cash flows. When reconciling to whole-business value, avoid adding a separately valued asset if its cash benefits are already fully represented in the enterprise cash flow forecast.

Worked example: Suppose a trademark supports $2 million of annual revenue for five years, with a hypothetical 3% royalty saving and 25% tax rate. Annual after-tax savings are $2 million × 0.03 × 0.75 = $45,000. At a stated 12% annual discount rate and year-end receipts, the five-year annuity factor is about 3.605, giving approximately $162,225. The estimate assumes flat revenue and no terminal benefit.

Watch the distinction: Capitalizing royalty savings forever when the mark’s supported life is finite overstates value. Adding its separately estimated value to a business DCF can count the same benefit twice.

Reference: [3]

38. Apply a liquidation premise

A liquidation premise estimates what owners receive after assets are sold and obligations settled. Orderly liquidation allows a planned marketing period; forced liquidation assumes more severe time pressure. For each major asset, estimate realizable proceeds under the chosen timing, subtract selling and shutdown costs, then satisfy liabilities according to their claims. Receivables may collect at less than face value, inventory may require discounts, and specialized equipment may have few buyers. Timing matters because delayed proceeds and payments may need discounting. The difference between orderly and forced outcomes arises from the assumptions about sale conditions, not from applying a generic percentage. State whether the calculation values assets gross, invested capital, or residual equity. A going-concern value cannot be compared meaningfully with liquidation equity without matching liabilities and other adjustments.

Worked example: Under an orderly sale assumption, assets realize $4 million, selling costs are $300,000, and liabilities to be settled are $1 million. Residual equity is $4 million minus $300,000 minus $1 million = $2.7 million. If a forced sale yields $3.2 million while costs and liabilities remain the same, residual equity is $1.9 million, or $800,000 less.

Watch the distinction: A lower forced-sale price does not eliminate transaction costs or liabilities. Omitting either converts gross asset proceeds into a misleading equity figure.

Reference: [3]

39. Check industry rules of thumb

Industry pricing formulas can help detect a model that deserves a second look, but their inputs and included assets must be understood. A sales multiple may reflect an industry’s typical margins, working capital, equipment, real estate, and owner involvement. If the subject differs, the formula’s implied value may diverge sharply from an income indication for sound reasons. Ask when and where the rule was observed, whether prices represent completed sales, and whether the numerator is equity or enterprise value. Then compare implied earnings yields and asset inclusion with the subject’s own economics. A rule of thumb should prompt investigation rather than override a supported forecast or transaction analysis. You can use CVA practice questions to rehearse the distinction between a plausibility check and a concluded value.

Worked example: A hypothetical industry rule gives 0.6 times annual sales. On $5 million sales, it indicates $3 million. A separately supported income analysis indicates $5 million. If the subject has unusually high sustainable margins, the rule’s typical-margin assumption may explain the $2 million gap. Check whether both figures include the same operating assets and debt before treating either as erroneous.

Watch the distinction: Choosing the $3 million rule simply because it is common ignores the subject’s earnings. Choosing the $5 million income figure without checking its forecast also misses the rule’s diagnostic value.

Reference: [3]

40. Test a buyer’s ability to justify price

A proposed purchase price can be tested against the cash a buyer expects to receive and the financing needed to pay it. Build a buyer case with operating cash after required reinvestment, then subtract acquisition debt service to see what remains for equity investors. Consider the buyer’s equity contribution, debt maturity, covenant cushion, taxes, and any integration costs or synergies. A positive remainder alone does not show that the buyer earns an adequate return or that principal can be refinanced. Conversely, one buyer’s borrowing limit does not define fair market value or another assigned standard. Use the test to challenge assumptions in the main valuation: a price supported only by unusually optimistic growth or fragile financing deserves scrutiny. Keep buyer-specific savings separate unless the assignment’s standard permits their inclusion.

Worked example: Assume a buyer pays $4 million. Expected annual cash available before acquisition debt service is $700,000, and scheduled service is $500,000. The annual remainder is $200,000, with cash coverage of $700,000 / $500,000 = 1.4 times. This suggests room for debt service under the assumptions, but the buyer’s equity investment and required return are still needed to judge the price.

Watch the distinction: Calling the $200,000 remainder profit on a $4 million investment ignores the buyer’s equity contribution, debt principal, taxes, and future cash flows. Affordability is only one price check.

Reference: [3]

41. Reconcile value indications

Reconciliation starts with the question each method answered. An income indication reflects the forecast benefit stream and its risk; a market indication reflects transactions whose terms, dates, and businesses may differ; an asset indication reflects identified assets less obligations under a stated premise. Put all three on the same valuation date, equity or enterprise basis, and level of value before comparing them. Then trace material gaps to growth, margins, intangible assets, transaction terms, or discount rates. Greater weight belongs to evidence that fits the subject and assignment and can be checked independently. A simple average would give a weak comparable sale the same influence as a well-supported forecast. The Core Body of Knowledge identifies reconciliation as a valuation topic; your conclusion still needs an explanation of the evidence and remaining uncertainty.

Worked example: Suppose all indications measure equity on the same date: income $8 million, market $6 million, and adjusted assets $4 million. The asset analysis excludes supported going-concern intangibles, while the available deals involve smaller, slower-growing firms. The $8 million income result deserves greatest consideration if its forecast is credible. Report a conclusion near that indication with sensitivity to its key assumptions, rather than averaging to $6 million.

Watch the distinction: Averaging $8 million, $6 million, and $4 million produces $6 million arithmetically, but it silently treats three unequal evidence sets as equally reliable and comparable.

Reference: [3]

Cost of Capital Concepts and Methodology, and Other Pricing Models

42. Identify risks already captured

A valuation rate compensates capital providers for risk in a specified benefit stream. Broad market exposure belongs in a market-based required return; company events often belong first in scenarios or probability-weighted forecasts. For each material uncertainty, ask what could happen, how cash flow changes, when it changes, and whether the forecast already reflects the expected loss. A rate adjustment may still address uncertainty about outcomes or risks absent from comparable market data, but it needs a distinct rationale. Do not add a premium merely because a problem has a name. Check whether the selected cash flow is an expected amount or an optimistic case: the same discount rate can produce very different values from those two inputs. Also keep firm cash flow with a firm rate and equity cash flow with an equity rate.

Worked example: A contract has a hypothetical 70% renewal probability. Next-year cash flow is $1 million if renewed and $400,000 otherwise, so expected cash flow is 0.70($1 million) + 0.30($400,000) = $820,000. The $180,000 expected reduction from the renewal case is already in that forecast. A rate premium meant to reflect the same expected contract loss would count it again.

Watch the distinction: Applying a company-risk premium to every named uncertainty can penalize value twice. First identify the loss already embedded in projected cash flow and the different risk, if any, left for the rate.

Reference: [3]

43. Calculate a CAPM equity rate

The capital asset pricing model estimates an equity investor's required return as a risk-free rate plus beta times an equity risk premium. Beta measures exposure to broad equity-market movements; it does not measure every operational weakness of a private company. Use a risk-free yield, premium, and beta that refer to compatible currency, date, and investment horizon. A historical premium paired with a current yield also requires a coherent premium convention. For a private subject, beta commonly comes from public peers, whose financing and business mix need examination before transfer. The result is a cost of equity for cash available after debt claims. A separate, supported adjustment may be needed for risks outside the model, but first test whether forecasts or peer selection already capture them.

Worked example: Assume a 4% risk-free rate, a 6% equity risk premium, and beta of 1.2, all stated on compatible terms. The hypothetical CAPM cost of equity is 4% + 1.2(6%) = 11.2% annually. The beta component contributes 7.2 percentage points. Use this rate with an equity benefit stream, then assess separately whether the chosen peer beta fits the subject.

Watch the distinction: Multiplying beta by the entire market return overstates the calculation. Beta multiplies the equity risk premium; the risk-free rate is added once.

Reference: [3]

44. Unlever and relever beta

A public peer's observed equity beta reflects both operating exposure and financing. Debt can amplify the variability borne by common shareholders because fixed claims are paid first. To transfer peer evidence to a subject with different leverage, estimate an asset beta by removing the peer's debt effect, then apply the subject's supportable capital structure. A common simplified relation is equity beta = asset beta × [1 + (1 − tax rate) × debt/equity]. This assumes debt beta is negligible and the tax effect is usable. Use market-value debt and equity where possible, consistent tax treatment, and a debt/equity ratio appropriate to the valuation. If peers have materially different operations, unlevering alone cannot make them comparable. Recheck the resulting equity rate against cash flow and financing assumptions.

Worked example: A peer has equity beta 1.4, market debt/equity 0.5, and an assumed 25% tax rate. Its asset beta is 1.4 ÷ [1 + 0.75(0.5)] = 1.4 ÷ 1.375 ≈ 1.018. At subject debt/equity 0.25, the relevered beta is 1.018 × [1 + 0.75(0.25)] ≈ 1.209. The subject's lower assumed leverage reduces equity beta.

Watch the distinction: Using a leveraged peer beta unchanged for a less-leveraged subject carries over the peer's financing risk. The adjustment also fails if operating differences are ignored.

Reference: [3]

45. Build up an equity rate

A build-up cost of equity starts with a risk-free return and adds estimated compensation for equity-market exposure and any separately supported size, industry, or company risks. Unlike beta-based CAPM, its basic form does not scale the market premium by a measured beta. Each component needs a source, date, and clear economic role. A size premium drawn from public-company evidence may be an imperfect fit for a private subject, so examine the data definition and the subject's characteristics. Company-specific additions should address uncertainty not already reflected in expected cash flows, comparable selection, or another premium. Assemble components in the same nominal or real terms and currency as the equity forecast. The final rate is a required return, not an automatic correction for weak projections.

Worked example: Assume annual components of 4% risk-free return, 6% equity risk premium, 2% supported size premium, and 1% supported company risk. The build-up equity rate is 4% + 6% + 2% + 1% = 13%. If the 1% addresses a customer loss already modeled in cash flow, remove or reconsider that component before applying the rate.

Watch the distinction: Adding every available published premium creates a plausible-looking total without showing that the risks are distinct. A build-up schedule is evidence only when its inputs fit the subject.

Reference: [3]

46. Assess size and company risk premiums

Premium selection requires two separate tests: does the data fit the company, and does the proposed premium price a risk left out of the forecast? Size studies may reflect differences in observed public-company returns, but a small private company is not automatically comparable to every firm in a size portfolio. Examine the study's metric, period, and treatment of financially distressed firms. For company-specific risk, identify the event and whether it changes expected revenue, margins, investment, or the uncertainty around those amounts. A probability-weighted cash flow captures an expected loss; a further rate premium needs another defensible exposure, such as outcome variability that a market investor would price. Sensitivity analysis is useful: show how value responds to the proposed premium and to the underlying forecast instead of hiding judgment in one rate.

Worked example: A concentrated customer produces $1 million next year if retained and $400,000 if lost. At a hypothetical 70% retention probability, expected cash flow is $820,000. Compared with the retained case, $180,000 of expected loss is already modeled. A proposed 3% company premium for that same loss lacks a separate basis; assess any size premium against its source data independently.

Watch the distinction: A size premium and a company premium are not interchangeable labels for smallness. Both require applicable evidence, and neither should repeat losses already in the forecast.

Reference: [3]

47. Measure debt and preferred costs

Cost of debt is the return lenders currently require on financing with comparable credit risk, term, security, and priority. An old coupon can differ sharply from today's required yield. For an after-tax firm rate, multiply debt cost by one minus the applicable tax rate only to the extent the interest deduction is expected to be usable under the assignment's assumptions. Preferred stock is another capital claim: its cost can be estimated from expected preferred distributions relative to market value, with attention to redemption, growth, and conversion terms. Preferred distributions generally do not receive the same interest tax adjustment in this simplified framework. Calculate each source's cost on terms consistent with its cash flows, then use appropriate market-value weights in a firm discount rate. Contractual labels alone do not establish economic priority or cost.

Worked example: Assume new comparable debt requires 8% annually and interest is fully deductible against income taxed at a hypothetical 25%. After-tax debt cost is 8% × (1 − 0.25) = 6%. Nonconvertible preferred stock pays $9 annually on a $100 market price, giving a 9% current cost if distributions are level and perpetual. Issuance and redemption effects are excluded.

Watch the distinction: Using debt's 6% after-tax cost for preferred stock assumes its distributions receive the same tax deduction. The simplified preferred calculation uses its own cash payments and market price.

Reference: [3]

48. Compute WACC

Weighted average cost of capital combines required returns for all providers of operating capital. Use market-value or economically supportable target weights that sum to 100%, then multiply each weight by its corresponding cost. In a simplified taxable-company case, WACC equals equity weight times cost of equity plus debt weight times after-tax debt cost, with preferred and other financing added when present. This rate discounts firm cash flow before payments to debt and equity providers; it yields enterprise value when the forecast and terminal treatment are consistent. A rate built from current capital structure may be unsuitable if the forecast assumes a different long-run structure. Check tax deductibility, currency, inflation, and the risk of the benefit stream. The FMVA study guide is useful for further practice aligning model cash flows and rates.

Worked example: Assume a supportable capital mix of 60% equity at a 14% required return and 40% debt at 8%, with a fully usable hypothetical 25% interest tax benefit. WACC = 0.60(14%) + 0.40(8%)(0.75) = 8.4% + 2.4% = 10.8% annually. Discount firm cash flow at 10.8%; equity cash flow requires an equity rate instead.

Watch the distinction: Weighting by book values solely because they appear on the balance sheet can misstate investors' economic stakes. The rate must also match the firm benefit stream.

Reference: [3]

49. Resolve capital structure circularity

Capital structure creates a feedback problem. More debt can provide a tax benefit, but it also makes common equity riskier and may increase borrowing costs or restrict operations. If a valuation assumes target leverage, use that structure to estimate equity risk and WACC, value the business, and check whether the implied debt and equity amounts are financeable and consistent with the target. Iterate when the chosen weights materially change with value. A target should reflect sustainable financing for this business, not the leverage that produces the lowest spreadsheet rate. Consider volatility, collateral, debt covenants, and expected reinvestment. The same operating forecast should be used when comparing alternative structures unless financing changes operations. Higher debt is not automatically a source of higher enterprise value.

Worked example: Under hypothetical structure A, debt is 20%, equity is 80%, equity cost is 12%, and after-tax debt cost is 6%. WACC is 0.80(12%) + 0.20(6%) = 10.8%. Under structure B, 50% debt raises equity cost to 16%; WACC becomes 0.50(16%) + 0.50(6%) = 11%. The added leverage does not reduce the rate here.

Watch the distinction: Holding equity cost fixed while increasing debt weights makes borrowing look artificially attractive. Equity holders bear greater residual risk as fixed debt claims grow.

Reference: [3]

50. Convert discount rates to capitalization rates

A capitalization rate converts one representative future benefit into value when long-run growth can reasonably be treated as constant. Under the Gordon growth relationship, capitalization rate equals discount rate minus sustainable growth, and value equals next period's benefit divided by that rate. The discount rate compensates for risk; growth changes the amount expected in later periods. Both must describe the same cash flow, capital provider, tax basis, and nominal or real terms. Confirm that growth is supportable relative to reinvestment and the economy over the long run. The model is especially sensitive when growth approaches the discount rate, so small changes can produce large value swings. If margins or growth are still changing, forecast those years explicitly before capitalizing a stable terminal benefit.

Worked example: Assume next-year equity cash flow of $500,000, an equity discount rate of 13%, and sustainable growth of 3%. The equity capitalization rate is 13% − 3% = 10%, giving $500,000 ÷ 0.10 = $5 million. If $500,000 instead describes last year's cash flow, grow it to $515,000 first; value would be $5.15 million under the same assumptions.

Watch the distinction: Dividing last year's benefit by discount rate minus growth without advancing it one period understates value in a growing perpetuity. Verify the cash-flow date first.

Reference: [3]

51. Keep tax and rate conventions aligned

Tax treatment is part of the benefit stream, not a cosmetic rate label. An after-tax discount or capitalization rate belongs with after-tax cash flow. A pretax rate that reproduces the same value can sometimes be derived for a simplified, level-income case, but it is not generally the after-tax rate divided by one minus a statutory tax rate. Interest deductions, depreciation, loss carryforwards, entity tax status, and changing earnings can make effective taxes vary by year. For a United States pass-through entity, also define whose taxes the assignment models and keep that convention consistent across forecasts, comparables, and rates. When taxes vary materially, project them explicitly and discount the resulting cash flows. State assumptions about available deductions and timing rather than presenting a universal pretax conversion.

Worked example: Assume perpetual pretax cash flow of $1 million annually, a flat hypothetical 25% tax with no timing differences, zero growth, and a 10% after-tax capitalization rate. After-tax cash flow is $750,000, so value is $750,000 ÷ 0.10 = $7.5 million. An equivalent pretax capitalization rate for this level stream is $1 million ÷ $7.5 million = 13.33%.

Watch the distinction: Calling 10% an appropriate pretax rate simply because it valued after-tax cash flow is inconsistent. The simplified equivalent here is 13.33%, and variable taxes require fuller modeling.

Reference: [3]

Discounts, Premiums, and Other Adjustments

52. Locate the starting level of value

Before applying a premium or discount, identify what the starting indication already represents. A quoted public share price generally reflects a marketable, noncontrolling interest; a forecast based on freely changed policies may reflect control; a strategic offer may include buyer-specific synergies. A nonmarketable minority interest adds transfer and governance constraints that the starting evidence may lack. Trace both economic benefits and ownership rights: who can replace management, set distributions, sell assets, or force a sale? A numerical adjustment should bridge a documented difference between the starting and target levels, with attention to the valuation standard. Do not assume every control transaction premium is pure control value, since deal prices can include synergies or other terms. Also test whether cash-flow normalization has already incorporated control benefits.

Worked example: Guideline public shares imply $10 million for all equity on a marketable minority basis. A buyer can save $2 million in present value by combining its own facilities with the subject. Its investment value could be $12 million if the saving is available and the assignment includes that buyer's advantage. The public indication remains $10 million before any separately supported adjustment.

Watch the distinction: Treating a strategic buyer's $2 million synergy as an automatic control premium attributes that buyer's unique benefit to every holder or buyer. Define the permitted value standard first.

Reference: [3]

53. Test a control adjustment

Control has value only to the extent its rights can produce incremental economic benefits that the starting indication excludes. Review voting provisions, board appointment, distribution authority, asset-sale rights, compensation, and practical limits imposed by other owners or contracts. Then estimate specific changes a controlling holder could implement, their costs, timing, and sustainability. The resulting benefit may appear in normalized cash flow, a separate value adjustment, or both in a carefully separated analysis. It must appear only once. Published acquisition premiums are imperfect evidence because transaction prices may include buyer synergies, competitive bidding, or differences in information. Compare like levels of value and ask whether the buyer could actually exercise the assumed right. For calculation practice, CVA practice questions can reinforce the link between rights, cash flow, and value.

Worked example: Assume control permits removal of $100,000 in annual excess expense without harming operations, starting next year. At a hypothetical 10% capitalization rate and zero growth, its value is $100,000 ÷ 0.10 = $1 million. If the income indication already uses earnings after that saving, add no further $1 million control adjustment. If it uses unadjusted earnings, the benefit may be added once.

Watch the distinction: A control premium is not an automatic percentage attached to a majority stake. Demonstrate usable rights and incremental benefits absent from the starting cash flow.

Reference: [3]

54. Evaluate marketability constraints

Marketability concerns the ability to convert an ownership interest into cash at a reasonably predictable time and price. Start by examining transfer restrictions, consent rights, rights of first refusal, likely buyers, expected holding period, distribution history, and prospects for a company sale or redemption. These facts affect the cost and uncertainty of waiting. Empirical restricted-share or private-transaction studies may inform a range, but their restrictions and company characteristics must fit the subject. A discount is applied to a marketable indication for the same ownership rights and benefit stream; otherwise the adjustment can mix marketability with control or operating risk. Avoid counting weak distributions twice if reduced expected distributions or delayed proceeds are already in a cash-flow model. State the assumed exit path and test sensitivity to its timing.

Worked example: A hypothetical 10% interest has a $1 million pro rata marketable equity indication. Its agreement prevents outside transfer for five years, and expected distributions are weak. If those facts support an assumed 20% marketability discount for this example, indicated value is $1 million × (1 − 0.20) = $800,000. The $200,000 difference represents the modeled liquidity constraint, not a universal discount.

Watch the distinction: Applying a customary discount without examining transfer rights and distributions hides the actual liquidity problem. Check whether those restrictions were already reflected in projected receipts.

Reference: [3]

55. Interpret an option-based discount

Option-based marketability models estimate the economic cost of being unable to sell an interest during a restriction period. One interpretation uses the cost of protection against a decline in value while a holder must wait. Longer holding periods and greater assumed price volatility generally increase that cost, all else equal. Dividends or distributions, expected exit timing, and the chosen model also matter. A private business's observed accounting volatility is not necessarily the market-value volatility an option model requires. Test whether public-company proxies are comparable and whether contractual restrictions truly prevent a sale for the modeled period. Model output is evidence to evaluate alongside actual transfer rights and buyer demand, not a mechanical discount. Keep the model's starting value and target ownership interest at consistent levels.

Worked example: Two otherwise identical interests each have a hypothetical $1 million marketable indication. Suppose a calibrated option analysis estimates protection costs of 8% for a one-year restriction and 20% for a five-year restriction. The indicated values would be $920,000 and $800,000, respectively. The $120,000 gap reflects these assumed model inputs; verify volatility, distributions, and restriction terms before adopting either figure.

Watch the distinction: A five-year restriction does not justify simply multiplying a one-year discount by five. Option costs respond nonlinearly to time and depend on volatility and distributions.

Reference: [3]

56. Separate key-person risk from value

When a company's earnings depend on one person, identify the cash flow at risk and the mechanisms that could preserve it. Client contracts, employee relationships, a transition plan, enforceable noncompete terms, succession capacity, and key-person insurance can change both expected loss and timing. Estimate which revenue or margin would disappear if the person left, then subtract the share likely retained by the business. Distinguish an ongoing operating loss from a one-time transition cost or insurance receipt. If the forecast already reduces expected earnings, a broad key-person discount for the same exposure would double count it. Insurance proceeds may offset a particular financial loss but do not automatically replace relationships or management skill. The analysis should reflect rights and information known at the stated valuation date.

Worked example: A founder is responsible for $200,000 of annual client contribution margin. Under a hypothetical supported transition plan, 75% of that margin is expected to remain after departure. Expected annual loss is $200,000 × 25% = $50,000. Model that $50,000 and any separate transition cost explicitly. A further discount assuming loss of the full $200,000 would overstate the same exposure.

Watch the distinction: Treating all founder-generated revenue as personal goodwill ignores transferable contracts and transition evidence. Conversely, insurance cash alone does not prove customers will stay.

Reference: [3]

57. Handle liabilities and later events

A contingent liability requires attention to probability, amount, payment timing, and whether it is already recorded or embedded in forecast cash flows. First determine what condition existed on the valuation date. Information learned later may clarify that condition, while a genuinely new post-date event ordinarily describes a different state of affairs. For a claim, examine alleged damages, legal status, defense costs, insurance, and possible outcomes without presenting a single expected amount as certain. Discount a future expected payment on a basis consistent with its risk treatment. If the claim is already included in adjusted net assets or cash-flow projections, do not subtract it again from equity value. Document how later evidence was used so the valuation still describes the specified date.

Worked example: At the valuation date, a lawsuit exists with a hypothetical 30% chance of a $1 million payment and no other outcomes or defense costs assumed. Expected undiscounted exposure is 0.30 × $1 million = $300,000. Timing, risk, and insurance could alter its present value. A later ruling may inform the date-specific estimate; subtracting both $300,000 and a full $1 million settlement would double count.

Watch the distinction: Using every later ruling as though it were known on the valuation date imports new information indiscriminately. Determine whether it illuminates an existing condition or creates one.

Reference: [3]

Special Purposes and Circumstances

58. Distinguish forms of goodwill

Practice goodwill is the economic benefit that can continue with the organization after a particular professional leaves. Personal or professional goodwill depends on that individual's reputation, referrals, relationships, or skill and may be difficult to transfer. Examine who owns client contracts and records, whether staff and systems maintain service, whether clients can choose another professional, and whether a credible transition agreement exists. Earnings tied to a person's referrals need a retention estimate before being treated as a transferable business stream. Replacement compensation and the costs of maintaining relationships also matter. The legal treatment of goodwill can vary by assignment and jurisdiction, so define the requested interest and value standard. An income indication for the practice should capitalize only benefits available to the hypothetical owner under those assumptions.

Worked example: Assume normalized annual earnings of $600,000, including $200,000 from one professional's referrals that the stated facts say cannot transfer. Transferable earnings are $600,000 − $200,000 = $400,000 before any other adjustments. Under a hypothetical 10% capitalization rate and zero growth, that stream indicates $4 million. This is a practice-stream illustration, not proof that all $4 million is goodwill.

Watch the distinction: Capitalizing all $600,000 as practice income assumes personal referrals pass to a buyer. First separate transferable earnings and account for the services needed to retain them.

Reference: [3]

59. Value claims with different rights

Security claims divide value according to contractual priority and optional rights. Begin with the correct pool: enterprise value is reduced by senior claims to reach equity available for allocation, while an already stated equity value should not have debt subtracted again. Read liquidation preference, accrued distributions, participation, conversion ratio, option exercise price, and voting terms. A preferred holder with a choice between its preference and conversion compares the payoff under each path; conversion also changes the common holders' share. Options may dilute equity only when exercise is economically favorable, and exercise proceeds may enter the allocation. The payoff can change across value levels, so one fixed percentage may be misleading. Voting power can influence control value but does not override cash-flow priority written into the security terms.

Worked example: Assume $12 million equity value after debt and a nonparticipating preferred class entitled either to a $3 million liquidation preference or 30% of equity on conversion. Preference pays $3 million and leaves $9 million for common. Conversion pays 30% × $12 million = $3.6 million and leaves $8.4 million. Preferred holders choose conversion under these simplified terms, before taxes or transaction costs.

Watch the distinction: Subtracting the $3 million preference and then awarding preferred 30% of the remaining $9 million combines mutually exclusive choices. Apply each contractual payoff path separately.

Reference: [3]

60. Adapt methods to the assignment

The assignment determines the unit of account, value standard, premise, date, and evidence that matter. Financial reporting may ask for a defined asset or reporting unit; a transaction analysis may examine a specific buyer; tax or employee ownership work may require a different ownership interest and valuation assumptions. Insurance can focus on a covered loss, while a dispute may require a date and hypothetical facts set by the matter. The analyst should keep the same economic engine, expected benefits adjusted for risk, but adapt the model to the requested rights and purpose. Transaction prices can test a conclusion, yet their financing, synergies, and conditions must be separated. State whether a benefit is available to ordinary market participants or only one buyer. The ABV study guide offers related valuation practice, though the defined assignment still governs this conclusion.

Worked example: A buyer offers $15 million for a company, and analysis attributes $3 million of that price to savings available only from combining the buyer's facilities. A stand-alone indication is $12 million; $15 million − $3 million = $12 million reconciles the figures. The offer is useful transaction evidence. Whether the extra $3 million belongs in the conclusion depends on the specified standard and buyer perspective.

Watch the distinction: Treating every observed offer as transferable market value imports buyer-specific benefits without testing who can realize them. Define the assignment's value standard before using the price.

Reference: [3]

Official references and further reading

All study guides

Overview

1. Purpose and standard of value

2. Premise, date, and level of value

NACVA/GACVA Professional Responsibilities and Standards

3. Developing a supportable conclusion

4. Independence and ethical conflicts

5. Reporting and valuation review

6. The analyst in a dispute

Engagement Acceptance and Planning

7. Define the interest and assignment

8. Make engagement terms operational

9. Accept, staff, or decline

Qualitative Analysis

10. Triangulate information sources

11. Translate macro conditions into forecasts

12. Analyze the local market

13. Industry structure and life cycle

14. Competitive position and pricing power

15. Verify company-specific claims

Quantitative Analysis

16. Assess financial statement reliability

17. Read common-size statements and ratios

18. Separate trend from industry difference

19. Normalize owner-related expenses

20. Identify nonrecurring results

21. Separate operating and nonoperating items

22. Model product contribution and capacity

23. Choose meaningful summary statistics

24. Interpret correlation and regression

25. Select the benefit stream and timing

Valuation Approaches

26. Capitalize firm cash flow

27. Capitalize equity cash flow

28. Discount a changing firm forecast

29. Discount changing equity cash flow

30. Use excess earnings carefully

31. Value dividend-paying capacity

32. Evaluate subject-company transactions

33. Select private transaction comparables

34. Use guideline public companies

35. Match the multiple to its denominator

36. Revalue net assets

37. Value identifiable intangibles

38. Apply a liquidation premise

39. Check industry rules of thumb

40. Test a buyer’s ability to justify price

41. Reconcile value indications

Cost of Capital Concepts and Methodology, and Other Pricing Models

42. Identify risks already captured

43. Calculate a CAPM equity rate

44. Unlever and relever beta

45. Build up an equity rate

46. Assess size and company risk premiums

47. Measure debt and preferred costs

48. Compute WACC

49. Resolve capital structure circularity

50. Convert discount rates to capitalization rates

51. Keep tax and rate conventions aligned

Discounts, Premiums, and Other Adjustments

52. Locate the starting level of value

53. Test a control adjustment

54. Evaluate marketability constraints

55. Interpret an option-based discount

56. Separate key-person risk from value

57. Handle liabilities and later events

Special Purposes and Circumstances

58. Distinguish forms of goodwill

59. Value claims with different rights

60. Adapt methods to the assignment

Official references and further reading

Frequently Asked Questions

Related Study Guides

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