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Statements on Management Accounting

B U S I N E S S P E R F O R M A N C E M A N A G E M E N T

C R E D I T S

T I T L E

IMA®would like to acknowledge the work of Nicholas J. Mastracchio, Jr., Ph.D, CPA on whose work this SMA is based. Dr. Mastracchio practices in valuations and related financial areas. He may be reached at [email protected]. Thanks also go to Hugh Grove, PhD, University of Denver who served as a reviewer andRaef Lawson, Ph.D., CFA, CMA, CPA, of IMA who serves as series editor.

Business Valuation

Published byInstitute of Management Accountants10 Paragon DriveMontvale, NJ 07645www.imanet.org

Copyright © 2009 in the United States of America by Institute of ManagementAccountants

All rights reserved


T A B L E O F C O N T E N T S

Business Valuation


I. Introduction . . . . . . . . . . . . . . . . . . . . . 1

II. Reasons for the Valuation and Premise . . . . . . . . . . . . . . . . . . . . . . . . .1

III. Standards of Value . . . . . . . . . . . . . . . . .2Fair Market Value . . . . . . . . . . . . . . . . . .2Intrinsic Value . . . . . . . . . . . . . . . . . . . . .2Investment Value . . . . . . . . . . . . . . . . . .2

IV. Valuation Analysis . . . . . . . . . . . . . . . . .2General Economic Factors . . . . . . . . . . . .2Industry Economic Factors . . . . . . . . . . . .3

Rivalry . . . . . . . . . . . . . . . . . . . . . . . . .3Threat of new entrants . . . . . . . . . . . . .3Threat of substitution . . . . . . . . . . . . . .3Bargaining power of customers . . . . . . .3Bargaining power of suppliers . . . . . . . .3

Company Analysis . . . . . . . . . . . . . . . . . .4SWOT analysis . . . . . . . . . . . . . . . . . . .4Historical financial analysis . . . . . . . . . .4Normalization . . . . . . . . . . . . . . . . . . . .4

Related party transactions . . . . . . . . .4Unusual transactions . . . . . . . . . . . .5Non-operating activities . . . . . . . . . . .5Accounting applications . . . . . . . . . . .6Taxing the income stream . . . . . . . . .6

V. Valuation Methods . . . . . . . . . . . . . . . . .6Earnings-Based Methods . . . . . . . . . . . . .6

Determining discount rates using the buildup method . . . . . . . . . . . . . . . . . .6

Determining the discount rate using CAPM . . . . . . . . . . . . . . . . . . .8Using the rate in a weighted average cost of capital calculation . . . . . . . . .9Earnings capitalization . . . . . . . . . . . .9

Discounted cash flow . . . . . . . . . . . .9Excess earnings . . . . . . . . . . . . . . .11

Market-Based Methods . . . . . . . . . . . .13Sale of stock in the same company .13

Sale of similar companies . . . . . . . .13

Guideline companies . . . . . . . . . . . .14Asset-Based Methods . . . . . . . . . . . . .16

Operating asset value . . . . . . . . . . .16Liquidating value . . . . . . . . . . . . . . .18

VI. Discounts and Premiums . . . . . . . . . . .18Lack of Marketability Discount . . . . . . . .18

IPO studies . . . . . . . . . . . . . . . . . . . .18Restricted stock studies . . . . . . . . . . .18Controlling interest . . . . . . . . . . . . . . .19

Lack of Control Discount . . . . . . . . . . . .20Key Person Discount . . . . . . . . . . . . .20

Control Premium . . . . . . . . . . . . . . . . . .21Trapped-in Capital Gains . . . . . . . . . . . .21

VII. Valuation Conclusions . . . . . . . . . . . . . .21

VIII. Valuation Report . . . . . . . . . . . . . . . . . .21Detailed Report . . . . . . . . . . . . . . . . . . .22

Introductory section . . . . . . . . . . . . . .22Sources of information . . . . . . . . . . . .22Economic analysis . . . . . . . . . . . . . . .22Normalization . . . . . . . . . . . . . . . . . . .22Valuation approaches and methods considered . . . . . . . . . . . . . . . . . . . . .22Valuation approaches used . . . . . . . . .22Other factors . . . . . . . . . . . . . . . . . . .22Reconciliation of calculations . . . . . . .23Representations . . . . . . . . . . . . . . . . .23Assumptions and limiting conditions . .23Background of the valuator . . . . . . . . .23


T A B L E O F C O N T E N T S

Summary Report . . . . . . . . . . . . . . . . . .23Calculation Report . . . . . . . . . . . . . . . . .23Oral Report . . . . . . . . . . . . . . . . . . . . . .24

IX. International Glossary of Business Valuation Terms . . . . . . . . . . . . . . . . . .24

ExhibitsExhibit 1: Revenue Ruling 59-60 . . . . . . .31

TablesTable 1: S Corporation Benefit . . . . . . . . . .7

Table 2: Buildup Determination of Earnings Capitalization Rate . . . . .10

Table 3: Discounted Cash flow . . . . . . . . . .12

Table 4: Excess Earnings . . . . . . . . . . . . .14

Table 5: Guideline Data . . . . . . . . . . . . . . .16

Table 6: Guideline Data . . . . . . . . . . . . . . .17

Business Valuation


I . INTRODUCTIONThe valuation of closely held businesses hasgreatly matured over the years. Valuation stan-dards have been developed by various profes-sional organizations and there are a multitude ofindividuals performing valuations for closely heldbusinesses. The valuation report you will reviewwill most likely have been prepared using someprofessional standards. The following organiza-tions provide professional standards:

The American Institute of Certified PublicAccountants (AICPA)American Society of Appraisers (ASA)The Institute of Business Appraisers (IBA)The National Association of Certified ValuationAnalysts (NACVA)The Canadian Institute of Chartered BusinessValuators (CICBV)

The purpose of this Statement on ManagementAccounting (SMA) is to familiarize the reader withthe methodologies in a valuation report and toenable the reader to perform valuation calculations.

This SMA provides a detailed description of howa valuation of a closely held business is per-formed. The first step is to describe the varioustypes of premises and standards (types) of valuethat may be appropriate in different circum-stances depending on the reason for the valua-tion. The second step describes the initial analy-sis that should be undertaken before any valua-tion methodologies are considered. The thirdstep is a consideration of what common valua-tion methodologies exist and their relevance tothe purpose of the valuation. Fine tuning the val-uation process is discussed next. This includesconsideration of items outside normal opera-tions that may be present. Finally a reconciliation

of results from the different methods is consid-ered. The SMA explains what to expect in a valu-ation report.

The valuation process starts with an understand-ing of the purpose for the valuation and the stan-dard of value to use. Then there is an analysis ofthe economy, the industry, and the company. Atthat point the various valuation methodologiesare considered to determine the most appropri-ate approaches given the circumstances. Thenext step in the process is to normalize thefinancial data to make any adjustments to whata new owner might experience. Appropriate dis-count and capitalization rates are developed andthe various methodologies selected are appliedand a conclusion is reached. At this point dis-counts and premiums are considered and, final-ly, adjustments for excess assets, asset defi-ciencies, and non-operating activities are made.

I I . REASONS FOR THEVALUAT ION AND PREMISE Valuations of closely held businesses are con-ducted for a multitude of purposes. The reasonsinclude actual mergers, acquisitions, and initialpublic offerings, but may also include many rea-sons that do not include an arm’s length transac-tion, and consequently, the value may hinge onthe persuasiveness of the valuation report. Thevaluations that do not result in an arm’s lengthtransaction include estate and gift tax valua-tions, employee stock ownership plan (ESOP)valuations, litigation—including stockholderactions—and equitable distribution actions. Thepurpose of the valuation will dictate the standardof value used. Typically the premise used is thatthe company is a going concern. If not, then a liq-uidating value is determined and the assetmethodology is typically used.

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I I I . STANDARDS OF VALUEThere are four standards of value that relate tovaluations. They are: fair market value, fair value,intrinsic value, and investment value.

Fair Market ValueFair market value is the standard of value thattypically comes to mind in business valuations.The profession has adopted a standard glossaryof valuation terms, which is provided at the endof the SMA. The definition of fair market value isthe price, expressed in terms of cash equiva-lents, at which property would change handsbetween a hypothetical willing and able buyerand a hypothetical willing and able seller, actingat arm’s length in an open and unrestricted mar-ket, when neither is under compulsion to buy orsell and when both have reasonable knowledgeof the relevant facts.

Fair ValueFair value is the standard that is used in somelitigation and is defined in state laws. For exam-ple, in some states there is no lack of mar-ketability discount for minority shareholders inan oppressed minority shareholder action. Also,in many cases the state describes the value inthe hands of the owner just prior to the action.For example, a single practitioner’s surgery prac-tice may not have any fair market value without acovenant not to compete. Yet in some states, foran equitable distribution divorce action, thevalue may be the value in the hands of the sur-geon, and therefore have significant value.

Intrinsic ValueIntrinsic value is the value that an individualinvestor considers to be the true value based onan evaluation of the available facts. Typically thisis not used in an independent valuation.

Investment ValueInvestment value is the value that is based uponthe needs and situation of an individual investor.This value may come into play in a merger oracquisition where the synergistic value to a par-ticular investor is determined. This may result inthe individual investor being willing to offer morethan what all others would consider the fair mar-ket value for a target company and is importantto that investor. But it is not the fair market valueof the target company.

IV. VALUAT ION ANALYSISThe theoretical description of value can bedefined as the present value of future benefits.To get a present value one must determine anincome stream and a rate of return. The rateused in valuations is based upon the risk theinvestor takes when purchasing the business. Todetermine the risk, the valuator must know theimpact of economic conditions in general, theimpact of economic conditions of the industry,and the impact of economic conditions on thespecific company.

General Economic FactorsThe economic outlook for the economy in gener-al and for the region in particular will have animpact on the valuation to varying degrees,depending on the nature of the business and itssensitivity to economic conditions.

The state of the economy can be researchedthrough government sources such as the CensusBureau’s data on its website—Factfinder andStatistical Abstract of the United States, theEconomic Report of the President, FederalReserve Bulletins, Bureau of Economic Analysis;and U.S. Department of Commerce websites.There are also commercial organizations thatprovide information, sometimes for a fee. Theseinclude Business Valuation Resources, Mercer

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Capital Management, Moody’s, and the NationalAssociation of Certified Valuation Analysts. Inaddition there are numerous newspapers,newsletters, and periodicals that address eco-nomic issues.

The valuator must decide what economic factshave an impact on the risk associated with thecompany being valued. In some cases local eco-nomic conditions are the most important, whilein others the national picture is very important.The size of the business, the geographic range ofits customers, the nature of its competitors, andthe source of its products all play a part.

Industry Economic FactorsAn assessment of the industry is important inany business valuation. This assessment can bedone using one’s own approach or through amore recognized structured approach. One suchapproach that is well recognized is MichaelPorter’s Five Forces.1 This model describes anindustry as being influenced by five forces: rival-ry, threat of new entrants, threat of substitution,bargaining power of customers, and bargainingpower of suppliers.

RivalryRivalry consists of an analysis of the competitionin the industry. There are several factors to con-sider in weighing the intensity of the rivalry in anindustry. The concentration of firms within anindustry is important. The Census Bureau tabu-lates some industry concentration data, themost recent being 2002. It tabulates the concen-tration in the top 4, 8, 20, and 50 firms. Whenthere are a number of firms in an industry that isnot concentrated, the competition tends to bemore intense. Slow market growth also tends to

increase rivalry. Inability to convert equipment toalternative uses may keep companies in theindustry and increase competition. Typically alarge number of small companies tends toincrease rivalry as does low differentiationbetween rivals’ products. When there are highfixed costs there is more of an inclination tospread these costs over more units, and thistends to increase rivalry.

Threat of new entrantsThreat of new entrants is also a factor to consid-er. When there are barriers to entry the rivalry isless than when higher profits attract more com-petitors and profit margins drop. Attributes to con-sider include start-up costs and the amount ofcapital needed for the business, patents, licens-es, territorial rights or other restrictions, special-ized assets with little alternative uses, brand loy-alty, and access to distribution channels.

Threat of substitutionThe ability of customers to switch to alternativeproducts is also a risk to consider. Prices for thealternatives provide a competitive ceiling forprices within the industry.

Bargaining power of customersThe bargaining power of the customers to drivedown the selling price, demand more services, ordemand higher quality is another factor to con-sider. If the industry’s customers have a strongbargaining power they are able to lower prices,demand higher quality, or get more services.Attributes to consider include the concentrationof customer market share or concentration ofportion of output, standardization of product, andthe economic health of the customers.

Bargaining power of suppliersThe suppliers of the company may also have animpact on the industry. Some of the attributes to

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1 Michael Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors (Free Press, 1998).

consider include: concentration of suppliers, con-centration of purchasers, cost to switch suppliers,industry’s ability to integrate and produce sup-plies, and suppliers’ ability to integrate into theindustry.

Company AnalysisRegardless of whether a specific Porter’s five-factor analysis is undertaken, the industry riskneeds to be understood. After gaining an under-standing of the economic conditions facing theindustry, the valuator can now apply those factorsto the target company along with specific risk fac-tors inherent to the company. The attributes thatare considered are information obtained fromfinancial statements and financial analysis, includ-ing forecasts and ratios, along with non-quantita-tive information obtained through site visits toassess quality of management, quality of product,and customer satisfaction.

SWOT analysisA SWOT analysis may be applied to focus on keyareas of the company operations. A SWOT analysis is a method to evaluate the objectives ofthe company. It describes the Strengths,Weaknesses, Opportunities, and Threats the com-pany faces in meeting its objectives. Thus itassists in determining the risks in investing in thecompany.

Historical financial analysisHistorical financial information can be useful indetermining trends of the business, in addition tobeing a tool to compare the company with com-petitor information available. Analytical review pro-cedures are often employed to compare resultswith prior years, forecasts, and industry statistics.The historical financial information should go backfar enough to capture the business cycle in theindustry. Typically at least five years of historicalresults are used. If there have been significant

changes in the company operations, historicalinformation prior to the change will probably havelimited use. Five years is suggested in RevenueRuling 59-60, which is provided in Exhibit 1. 2

NormalizationHistorical information is only useful if it is lookedat in light of future operations. A process callednormalization must be executed to accomplishthis. Normalization considers related party trans-actions, non-recurring items, and non-operatingitems.

Related party transactionsIn most closely held businesses where theowner is the manager of the business there is anattempt to minimize the tax at the corporatelevel. This is often accomplished by transactionsthat are with related parties being at a monetaryamount that does not represent what would bepaid in non-related party transactions. This mayinclude compensation, benefits, rent, intercom-pany transactions, travel and entertainment,charitable contributions, and loan terms. Thecompensation of owners and related parties in aclosely held business may be significantly differ-ent from what would be paid for similar work bya non-related party. Other than the need for earn-ings to be reinvested for the business’s capitalrequirements, rarely are earnings retained in thecompany, then a tax paid on the earnings, andthen a dividend issued to the owner. Conversely,if the company is an S corporation, the compen-sation may be minimized in an effort to reducepayroll taxes. An elderly parent may be kept onthe payroll or a relative in college paid a lucrativesummer position to assist the family. If the com-pany is not doing well, the owners will probably

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2 Rev. Rul. 59-60, 1959-1 C.B. 237.

pay themselves less than what would be paid toa third party. Therefore, it is always important todetermine what a person would be paid for thework performed if the person were not an owneror related to the owner.

Sources for determining fair compensationinclude industry trade associations, U.S.Government Bureau of Labor Statistics annualoccupational handbook, and Internet sites thatprovide information, such as the EconomicResource Institute, which provides compensa-tion data by location, SIC code, years of experi-ence, or sales volume for most occupations.

Benefits can also be skewed for the businessowners and their related parties. If a benefit onlyapplies to a related party and not to others insimilar positions, it probably is a benefit thatshould be eliminated in the normalizationprocess.

Another consideration is retirement benefits. Insome cases an owner of a closely held companymay structure a retirement plan that favors theowners in a manner that is unlikely to survive atransition of ownership. If this is the case, thebenefit should be restructured to reflect a typicalplan or possibly eliminated. Data on benefitcosts can be found on the U.S. GovernmentBureau of Labor Statistics site. Trade associa-tions may also publish benefit data.

In many closely held corporations the real estateproperty occupied by the business is not ownedby the operating corporation but by a separaterelated entity that rents the property to the busi-ness. This provides an opportunity to charge rentthat is not at market rates and needs to beadjusted. An appraisal report will provide whatmarket rents should be. If an appraisal is notavailable, the value of the property may be inter-

polated from property tax appraisals and equal-ization rates. A real estate professional can pro-vide the going rate of return for commercial prop-erty in the area.

Travel and entertainment expenses are a commonarea of normalization. Frequently the owner is pro-vided benefits in this area that would not be givento a non-owner employee in similar circumstances.

If there are loans to or from related parties, theremay be a need to normalize. Frequently theseloans are not at market rate and should be adjust-ed. They may also need to be eliminated if theyare non-operating in nature or a form of invest-ment that should be restructured into equity.

Unusual transactions No business is worth anything because of whatit has done in the past. The past is only useful ifthere is an expectation that it is a predictor offuture results. If there are transactions that haveoccurred in the past that are not expected torecur, then the consequences of the eventshould be eliminated. This includes extraordi-nary items as defined in GAAP, but may alsoinclude other events that technically do not qual-ify for extraordinary but are still not predictive ofthe future.

Non-operating activitiesIt is not unusual for a closely held company to beinvolved in different enterprises or in non-operatingactivities. The business may have to be segment-ed into two different businesses and then the val-ues combined. There is a famous tax case whereVictor Borge had a corporation that booked hismusical performances and raised Rock Cornishgame hens. The business would have to be seg-mented to be valued. Perhaps more common isthe closely held business that has non-operatingassets such as a beach house that is sometimes

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rented, a personal aircraft, or some other asset notessential to the operation of the business. Theseassets need to be separated and valued apartfrom operations.

Accounting applicationsThe accounting methodology may also have to beadjusted. One reason may be to use accountingmethods more common in the industry so thatcomparisons can be made to other firms orindustry averages. Sometimes GAAP, in its effortto be conservative, does not capture economicreality. The full expensing of research and devel-opment expenses is an example. Sometimesdepartures from GAAP may have to be adjusted.An example might be the understatement ofinventory.

Taxing the income streamWhen a normalized pre-tax operating income isdetermined, the next step is to consider taxes.Here there is an issue regarding pass-throughentities. If the company is of such a nature thatit can pass through the entire income it gener-ates, there is an advantage in avoiding the sec-ond layer of taxes on dividends. The magnitudeof the advantage is measured by the differencein total taxes between the corporate tax and thedividend tax in a C corporation and the share-holders tax in an S corporation. This comparativebenefit was reduced in 2003 when the dividendand capital gain rate was reduced to 15% fromordinary income tax rates. The magnitude of thebenefit depends upon the ability to distribute theearnings to the owners.

Table 1 illustrates the benefits of an S corpora-tion assuming a corporate tax rate of 39%, a div-idend tax rate of 15%, a personal tax rate of35%, and a capitalization rate (CR) of 20%. Thetable illustrates that a company with $200,000of annual earnings has the benefit of being able

to distribute $130,000 to shareholders, while aC corporation would only be able to distribute$103,000. This benefit capitalized at anassumed rate of 20% has a total value of$131,500.

V. VALUAT ION METHODS

AICPA Valuation Standard No. 1, along with otherprofessional standards, states that the valuatorshould consider the three most common valua-tion approaches: an earnings capitalizationmethod, a market-based method, and an asset-based method.

Earnings-Based MethodsThe most common method of valuing a goingclosely held operating business is one based onearnings capitalization. There are a few methodsthat come under this category. They include dis-counted cash flow, earnings capitalization, cashflow capitalization, and excess earnings. All ofthese methods calculate the present value ofthe future benefits. Therefore, these methodsrequire the determination of a discount rate anda capitalization rate. This may be accomplishedusing the buildup method or the capital assetpricing model.

Determining discount rates using thebuildup method The buildup method is frequently used in smalland medium-size businesses where compar-isons to publicly traded company betas are notdeemed to be applicable or it is felt they shouldbe supplemented.

The equation for this method can be written asfollows:

Re = Rf +ERP + Rs + Rc

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where

Re = Expected rate of return of the company

Rf = Risk-free rate of return

ERP = Equity risk premium

Rs = Size premium

Rc = Specific company risk

The first component is the risk-free rate. Theassumption for the valuation is that there is agoing concern. Therefore, the 20-year Treasuryrate at the date of the valuation is usually usedas the risk-free rate.

The second component in the buildup method isthe equity risk premium. The determination ofthis factor has been a matter of controversy late-ly. Historically, the equity risk premium estimatedannually in the book Stocks, Bonds, Bills andInflation (SBBI), currently published byMorningstar, has been used to appropriate theequity risk premium. Roger Grabowski has chal-lenged this rate as being too high. His estimatesare available through the Duff & Phelps, LLC RiskPremium Report (D&P), which is also availablefrom Morningstar. Some valuators continue touse SBBI, while others are using D&P. The ratedifferential is usually less than two points.

There are some academic manuscripts that chal-lenge the use of the equity risk premium at all,

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TABLE 1. S CORPORATION BENEFIT

C Corporation S Corporation

Earnings before taxes

$200,000.00 $200,000.00

Corporate tax (39%) 78,000.00 –– ––

Remainder $122,000.00 $200,000.00

Distribution to shareholders $122,000.00 $200,000.00

Shareholder tax (15%/35%) 18,300.00 70,000.00

Cash flow to shareholder $103,700.00 $130,000.00

Capitalized value (NCF/CR) $518,500.00 $650,000.00

S corporation benefit $131,500.00

claiming the historic rates are not evident in themarketplace. This claim has not been acceptedby valuators.

The size premium recognizes the higher risk ininvesting in smaller cap public companies. Thesize premium can also be found in SBBI.Typically the premium for the ninth and tenthdeciles firms is used.

In publicly traded firms there is no recognition ofspecific company risk, called non-systematicrisk. The marketplace does not factor this risk insince a prudent investor will diversify his/herinvestments and the risk will be diversified away.But in closely held company investment, there istypically no opportunity to diversify. It is unusualfor an owner to own 30 different closely heldcompanies.

There is currently no empirical data that can beused to estimate the company specific risk orthe unsystematic risk, so it is heavily dependenton the valuation analyst’s judgment and experi-ence. The types of items usually consideredinclude: ● Management depth● Management expertise● Access to capital● Leverage● The five Porter threats● Product diversification● Geographic distribution● Demographics● Availability of labor● Employee stability● Economic factors● Fixed asset age and condition● Distribution system● Location● Technological risk● Socio-cultural risk

● Political risk● Global risk● Size

Some valuators will assign numbers to each rel-evant item, while others will assign plusses andminuses and just give a total number.

At this point in the buildup method a discountrate can be determined. To obtain a capitaliza-tion rate the estimated growth rate is subtractedfrom the discount rate. Table 2 provides anexample of the buildup method using 20-yearTreasuries, Ibbottson risk data, numbers foreach specific risk, and an assumed growth rateof 3%.

Determining the discount rate using CAPM Another way of determining the discount rate isby using the Capital Asset Pricing Model(CAPM). The CAPM method measures the com-pany volatility compared to the overall marketplace (beta).

The equation for CAPM is as follows:

Re = Rf +B (Rm-Rf)

where

Re = Expected rate of return of the company

Rf = Risk-free rate of return

B = The company beta

Rm = Return for the market as a whole, usu-ally represented by a market-wide index,such as S&P 500

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Closely held companies do not have a publicmarket and therefore do not have beta informa-tion. Typically an industry beta is used. A groupof publicly traded companies are identified andthen their beta is calculated. If the company isnot large enough to have similar publicly tradedcompanies, the method should not be used.3

Using the rate in a weighted averagecost of capital calculationIn many cases the degree of leverage in a close-ly held company is not at optimal level. In somebusinesses the owner may be very aggressiveand use a high degree of leverage, often backedby personal guarantees, while in other business-es the owner may be very conservative and uselittle or no debt financing. If either is the case, aweighted average cost of capital (WACC) shouldbe considered in determining the value of thecompany.

This method estimates an appropriate percent-age of the capital structure coming from debt andfrom equity. The formula for WACC is as follows:

WACC = keWe + kd [1-t] Wd

where

ke = Cost of common equity (equity dis-count rate)

We = Percent of the capital structure that iscommon stock

kd = Pretax cost of debt (debt interest rate)

t = Tax rate

Wd = Percent of the capital structure thatis debt

If WACC is used, interest expense is eliminatedand the value determined is the market value ofinvested capital (MVIC). It is then necessary toreduce this value by interest bearing debt todetermine the value of equity.

Earnings capitalizationWhen a perpetual income stream is used and aconstant growth rate is estimated, the growthrate can be subtracted from the discount rate toobtain a capitalization rate. This is an adaptationof the Gordon model used to determine a stockvalue.

where

V = Value of the company

E= Next year’s earnings

k = Required rate of return for equity investor

g = Growth rate (in perpetuity)

Discounted cash flowIf forecasts are used and specific values aredetermined each year, the discount rate wouldbe used since growth is already factored in toeach year’s forecast. Theoretically, theDiscounted Cash Flow (DCF) method is the mostappropriate.

The first step is to determine the net cash flow(free cash flow) for future years. Typically, fiveyears is used.

V= E

k - g

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3 Shannon Pratt, with Alina Niculita, Valuing a Business TheAnalysis and Appraisal of Closely Held Companies (NewYork: McGraw Hill, 2007), p. 220.

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TABLE 2. BUILDUP DETERMINATION OF EARNINGS CAPITALIZATION RATE

Riskless rate:

Long term government rates 4.7

Equity capital premium:

Difference large company stock & govt. bond 7.2

Small company premium:

Difference large and small company stock 4.0

Total public small company 15.9

Specific risk factors:

Lack of management depth 1.5

Threats of new entrants 0.5

Threrat of negative legislation 0.5

Total specific risks 2.5

Net discount rate 18.4

Less: growth -3.0

Net capitalization rate 15.4

Net income + Depreciation/Amortization +/- Change in Working Capital – Capital Expenditure ____________________________= Net cash flow (Free Cash Flow)

At the end of the forecast period, the value of thefuture cash flows (terminal value) is calculated,similar to the capitalization of earnings, and dis-counted back to the current period.

The formula for DCF is:

where

DCF= Value using discounted cash flow

fcf = The free cash flow in a given year

r = The discount rate

e = The capitalization rate

n = The final terminal calculation

Table 3 provides an example of the discountedcash flow method. Five years of projectedincome is used and then a terminal value is cal-culated. A discount rate of 16.6 percent is usedwith a capitalization rate of 12.6 percent. Thereare two ways of determining the terminal value.The most common method is the capitalizationof the ongoing cash flow. This is the methodfavored by most business valuators. A methodused by investment bankers and used as acheck by some valuators is the use of a marketmultiple. If the discounting is a return on equity,

some measure related to that, such as a P/Emultiple, may be used. If the method is usingoverall capital, then a measure such as EBIT orEBITDA related might be used. Although this isthe most theoretically sound method, it requiresa sound set of forecasts. The effects of uncer-tainty are a component of the risk factor deter-mined. However, in some circumstances a singlenumber is not possible and a range of numbersmay be used. The probability for each outcome isassessed and a probability distribution is usedto determine the forecasted DCF. Similarly in aless precise manner a best, worse, and mostlikely case scenario can be used with a weightedaverage result. Sensitivity analysis should beconsidered to determine the impact of changesin the assumptions on the estimated value.

In many small closely held businesses the pro-jections are not available and the method cannotbe used.

Excess earningsAnother earnings-based method is excess earn-ings. This method capitalizes the company’s earn-ings based on two rates, one being a rate ofreturn on tangible assets and the other based ona higher rate for earnings beyond the return onassets (goodwill). The method is often describedas a hybrid method because it takes into accountthe company’s asset values. It takes the capital-ization rate and separates it into different riskassessments and rates, one for earnings backedby tangible assets and one for earnings fromgoodwill as illustrated in the following equation.

DCF = f c f 1(1 + r)1

f c f 2(1 + r)2+ +. . .+ f c f n

(1 + r)n

11


12


2009 2010 2011 2012 2013 Terminal

Projected net income $ 998,200 $ 1,048,110 $ 1,205,327 $ 1,386,125 $ 1,497,016 $ 1,497,016

Depreciation 232,000 232,000 232,000 232,000 232,000 232,000

Capital needs (175,000) (180,000) (180,000) (200,000) (220,000) (220,000)

Working capital needs – – – (100,000) (100,000) (60,000)

Projected cash flow $ 1,055,200 $ 1,100,110 $ 1,257,327 $ 1,318,125 $ 1,409,016 $ 1,449,016

Present Value $ 977,205 $ 873,752 $ 856,449 $ 770,037 $ 705,947

Terminal value

Capitalization rate 12.60%

Terminal value 11,500,123

Present value $ 4,941,519

Value (sum of presentvalues)

$ 9,124,909

Less lack ofmarketability at 20%

1,824,909

Estimated value $ 7,300,000

TABLE 3. DISCOUNTED CASH FLOW

where

V = The value of the business

E a = The earnings attributable to a return onassets

R a = The appropriate rate of capitalization forearnings attributable to net tangibleassets

E g = The earnings in excess of those attributa-ble to a return on assets

C g = The appropriate rate of capitalization forearnings attributable to goodwill

In its most common form, the value is calculatedas follows:

where

V = The value of the small business

E = The adjusted earnings of the firm

A = The net tangible assets of the firm

Ra = The appropriate rate of capitalization forearnings attributable to net tangibleassets

Cg = The appropriate rate of capitalization of goodwill

An example of excess earnings is provided inTable 4. In this example a return on assets wasdetermined to be 8.6% and a capitalization ratefor goodwill of 27.4% was used. The earningswith respect to assets of $14,595,602 was$1,255,222. With actual earnings of$4,431,829 this left $3,176,607 of excessearnings to be capitalized at 27.4% to yield agoodwill number of $11,593,456 and a totalvalue of $26,189,058.

Market-Based MethodsAnother common approach to valuations can beclassified as market-based methods. This canthen be broken down into three categories: saleswithin the same company, sales of similar close-ly held companies, and, if the company is of suf-ficient size, publicly traded guideline companies.

Sale of stock in the same companyThe sale of stock in the same company soundslike a good approach; however, this may not bethe case. The sale may not have been at fairmarket value due to a forced sale, perhapsrestricted by an internal agreement, or similarreason that may distort the price. In addition, thesale may have been for a minority interest whenone is trying to determine a value for the wholecompany or a controlling interest. The oppositemight be true and one might be trying to value aminority interest when the sale was of a control-ling interest. Finally, the proximity in time needsto be considered. A sale that took place in aprior period may have been made when econom-ic conditions were different.

Sale of similar companiesData regarding sales of similar closely held com-panies may be available. There are also databas-es that can be obtained. When available andadequate data is provided, the information canbe helpful in determining the value of a compa-

V = E – AR aC g

+ A

V = E aR a

E gE g

+

13


ny. It is very difficult to determine whether allaspects of the transaction are disclosed. Forexample, there may be a consulting agreementat favorable terms that is not shown as part ofthe sale. In addition, the actual similarity of thecompany can be problematic. For example, asimilar company in a different market may facedifferent economic factors. One type of businessthat has a better chance at comparability is fran-chise operations, such as a fast food establish-ment. Professional practices also may have sim-ilar attributes. There are various databases forprivate company comparables. DoneDeals(www.donedeals.com) is a comprehensivesource of unique mid-market transaction data,with approximately half of deals under $15 mil-lion and half over $15 million, and approximate-ly 79% of the selling companies being privatelyowned. The Institute of Business Appraisers(IBA) “Market Database” (www.go-iba.org) is thelargest database of guideline transactions forvaluing mid-sized and smaller businesses. Thedatabase includes information on over 30,300sales of closely held businesses in more than

725 SIC Codes. Access to the database is freeto IBA members. Pratt’s Stats® (www.bvmarket-data.com) contains details on approximately11,500 private and closely held business salesfrom 1990 to the present, ranging in deal pricefrom under $1 million to $16.6 billion.

Guideline companiesFinally there may be publicly traded companiesthat have similar risk factors as the companybeing valued. The criterion in selecting companiesis to try to find companies with the same patternof operations in the past and the same risk fac-tors in the future. Although a match with compa-nies that are close to identical is desirable, it isnot necessary. Companies in the same industrycan be looked at in addition to companies in relat-ed industries that are subject to the same risks.Thus a company that manufactures parts used inthe assembly of recreational vehicles may have

14


TABLE 4. EXCESS EARNINGS

Net Assets $ 14,595,602

Return on Assets 8.60%

Expected Return $ 1,255,222

Actual Earnings 4,431,829

Excess Earnings $ 3,176,607

Capitalization rate 27.40%

Goodwill $ 11,593,496

Total value $ 26,189,058

more similar risks to the actual manufacturing ofthe vehicles than a company that manufacturesparts for the assembly of automobiles.

If guideline companies are used, some of thefactors to consider include: ● Nature of the company● Similarity of operations● Geographic similarity● Demographic similarity● Percentage of ownership transferred

If guideline companies are used, then a decisionhas to be made as to what the indicators ofvalue are. These indicators are typically variousearnings figures and perhaps a couple of bal-ance sheet numbers. Similar to the decision onwhether to use WACC or not, a decision has tobe made as whether to use Market Value of Invested Capital (MVIC) or Market Value of Equity(MVE).

MVIC is defined as the entire invested capitalvalue of the firm, including equity investment anddebt investment. Because of the nature of close-ly held companies, there may be dissimilar lever-age used between the guideline companies andthe company being valued. In these cases MVICis the better measure. The income data used isbefore interest expense. Some indicators usedare: ● Earnings before interest and taxes (EBIT)● Earnings before interest, taxes, amortiza-

tion, and depreciation (EBITDA)● Sales● Cash flow excluding debt● Book value of invested capital

Typically the factors that are most closely corre-lated with each other will be chosen. Some valu-ators will use the coefficient of variance to judgethe relationship.

where

Cv= Coefficient of variance

d = standard deviation

= mean

Thus, the variable with the lowest coefficient ofvariation has the least dispersion.

When a value is determined under MVIC, the com-pany interest bearing debt must be subtracted todetermine the value of the equity ownership interest.

When the debt equity structure is similar to theguideline companies, then it may be appropriateto determine the market value of equity. It is alsoappropriate when determining the value of aminority interest where the interest would not beable to change the company leverage. Factors toconsider when using MVE are:

● Net income before tax● Net income after tax● Sales● Cash flow● Net equity book value

There are a variety of sources to find guidelinecompanies. The SEC 10-k filings are accessiblethrough the SEC website. Commercial sites suchas Yahoo Finance can supplement the data.There are also a number of subscription sitessuch as Mergent Online, a fully searchable data-base of 15,000 U.S. public companies (activeand inactive) listed on the NYSE, AMEX, and

m

C v = dm

15


NASDAQ exchanges, and Compustat providesdata on companies that can be sorted by SICcode.

When the guideline company method is used it isstill appropriate to adjust for normalization, size,and unsystematic risk. Since publicly tradedstocks are minority shares, if a controlling inter-est is being valued a control premium should beconsidered.

For example:A manufacturing company is being valued. Fourguideline companies are identified. MVIC isused. The factors utilized are sales, EBITDA, andnet assets. The multiples and coefficients ofvariance are calculated. The data results in thefollowing calculations in Table 5.

Based upon the above, the valuator decides tobase the determination 60% on EBITDA, 25% onsales, and 15% on net assets. In addition a 20%discount is decided upon based on the

increased risk of the company being valued anda 15% control premium is also used. The calcu-lation of value is provided in Table 6.

Asset-Based MethodsThe third category of valuation is based on theassets. Since asset approaches do not measuregoodwill, most of the time operating companiesare valued based on the earnings capitalizationor market approaches. In these cases the assetapproach may act as a floor or the lowest thevalue can be.

Operating asset valueIf the company is a going concern, then the oper-ating value of the assets is used. This presumesthat the company will stay in business but hasno goodwill. The book value of the company isthe starting point. Because GAAP provides a mix-ture of fair values and historical costs, adjust-ments are needed to bring the values to fairvalue. This method may also provide informationneeded for an excess earnings calculation, inwhich case non-operating assets and liabilitiesneed to be separated. The issue of built-in gains

16


TABLE 5. GUIDELINE DATA

Guideline Company MVIC/Sales MVIC/EBITDA MVIC/Net assets

A .29 6.26 .68

B .90 9.72 1.94

C 1.24 11.04 4.35

D .79 10.32 2.91

Median .84 10.02 2.43

Standard deviation .39 2.12 1.55

Coefficient variation .49 .23 .63

needs to be considered when using this method.That is, when the fair value is in excess of thebook value, there is a potential for a tax that willbe needed or a lack of a tax deduction for theasset. For a C corporation, the built-in gain is thetax that would have to be paid if the asset wassold. This is a controversial issue, with the IRSreluctant to reduce the value while the tax courtshave been more receptive for C corporations.Pass-through entities such as S corporationsand partnerships complicate the issue. Typicallythe built-in gain is recognized in an S corpora-tion. But since partnerships can get a stepped-up basis, if elected, they usually do not get aconsideration of the built-in tax.

Minority interests are another consideration.Since they cannot cause the company to selltheir assets, this method is usually not used

when valuing minority shares.

There are various adjustments to consider.

Current assets are the easiest to adjust to fairvalue and in most cases GAAP provides a fairvalue number. If another comprehensive basis ofaccounting is in use, there may need to beadjustments for allowance for uncollectibleaccounts among other items. Under GAAP, held-to-maturity securities may not be reflected at fairvalue and may need to be adjusted. The FIFOmethod of inventory usually provides the bestindicator of fair value for inventory.

The value of plant, property, and equipment istypically not at fair value and will need anappraisal if the amounts are significant. If theamount is not significant an adjusted deprecia-

17


TABLE 6. GUIDELINE DATA

Factor MVIC/Sales MVIC/EBITDA MVIC/Net assets Total

Multiple 0.84 10.02 2.43

Company $5,000,000 $ 450,000 $ 2,000,000

Value $4,200,000 $ 4,509,000 $ 4,860,000

Weight 60% 25% 15%

Value $ 2,520,000 $ 1,127,000 $ 729,000 $ 4,376,000

Risk Discount 20% (504,000) (225,000) (146,000) (875,000)

Net $ 2,016,000 $ 902,000 $ 583,000 $ 3,501,000

Control Premium15%

302,000 135,000 87,000 524,000

MVIC $ 2,318,000 $ 1,037,000 $ 670,000 $ 4,025,000

Less company debt (725,000)

Estimated value $ 3,300,000

tion using reasonable useful lives and a non-accelerated depreciation method may result inan acceptable estimate of fair value.

Other assets may also need a separate apprais-al, depending on their nature. Liabilities are usu-ally at fair value. But loans from related partiesmay need to be adjusted to reflect their fair valueusing market interest rates.

Liquidating valueAnother asset method is liquidating value. Thismethod is not appropriate for a going concern, butmay be appropriate if there is doubt regarding theprobability of the company staying in business.

V I . D ISCOUNTS AND PREMIUMSRegardless of what method was used to deter-mine an indicator of value, discounts and premi-ums are usually a factor in closely held compa-nies. Marketability and control are the most fre-quent issues encountered. Other factors thatmay be considered are discounts for the loss ofa key executive, and trapped-in capital gaintaxes. There is also a control premium.

Lack of Marketability DiscountThere is no universally accepted method fordetermining the lack of marketability discount.Two methods using empirical data have beenused. One is based on restricted stock studiesand the other initial public offerings (IPO).

IPO studiesA series of studies known as the Emory studieswas conducted from 1980 through 2000. It com-pared prices of stock transactions prior to an ini-tial public offering (IPO) with the prices at whichthe stock was initially offered to the public (atthe IPO). The median discount was 47%.Willamette Management Associates has studiedIPO transactions over a period of many years and

has published the results on their website.4

Restricted stock studiesIn 1971, the Securities and ExchangeCommission published a study it made onrestricted stock values from 1966 to 1969. Itfound a mean discount of 25.8%.5 Four closed-end investment companies that had significantinvestment in restricted security investments were examined by Milton Gelman.6 The meanand median in the above study was 33%.Willamette Management Associates has studied33 transactions that took place primarily in1983. The median discount was 31.2%.7

Michael Maher conducted a study of restrictedsecurities from 1969 to 1973. He determined amedian discount of 33%.8 Robert Trout foundsimilar results in the same time period. He stud-ied transactions from 1968 to1972 and deter-mined a mean discount of 33%.9

In Business Valuation Methods written by Alan S.Zipp, JD, and published by the American Instituteof Certified Public Accountants, the authorstates: “As a general rule of thumb, courts havegenerally approved discounts for lack of

18


4 http://www.willamette.com/.5 Security and Exchange Commission, Discounts Involved

in Purchase of Common Stock (1966 – 1969), InstitutionalInvestor Study Report of the Security and ExchangeCommission. Government Printing Office Document No.92-64, Part 5, pp. 2444-2456.

6 Milton Gelman, “An Economist-Financial Analyst’s Approach to Valuing Stock of a Closely-Held Company,” Journal of Taxation, June 1972, pp. 353-354.

7 Shannon Pratt, with Alina Niculita, Valuing a Business:The Analysis and Appraisal of Closely Held Companies(New York: John Wiley, 2007), p. 425.

8 Michael J. Maher, “Discounts for Lack of Marketability forClosely Held Business Interests,” Taxes, Sept. 1976, pp.562-571.

9 Robert R. Trout, “Estimation of the Discount Associated with the Transfer of Restricted Securities,” Taxes, June1977, pp. 381-385.

marketability in the range of 15% to 50%, withthe mean in the vicinity of 35%.” Zipp alsostates:

In the June 1992 edition of Fairshare, TheMatrimonial Law Monthly. [Vol. 12, No. 6,p. 15] several studies were summarizedwhich analyzed the average discountfound between listed securities and theirrestricted counterparts. These restrictedstocks were considered identical in allrespects to freely traded stocks of publiccompanies, except for their lack of mar-ketability. These studies included theCongressional “Institutional InvestorStudy Report of the Security ExchangeCommission” [H.R. Doc. No. 64, Part 5,92nd Cong., 1st Sess. 1971. pp. 2444-2456] and several private studies. Theresult of these studies reported the aver-age discount for lack of marketabilityranged from 25.8% to 45%.10

The article cites two studies by Robert W.Baird & Co., which compared companiesin private stock transactions to those ofsubsequent public offerings of stock inthe same companies. The results ofthose studies reflected average discountfrom 1980 to 1981 of 60% and between1985 and 1986 of 43%. The median dis-count between 1980 and 1981 was 66%and during 1985 and 1986 it was 43%.

According to the article, “There is consid-erable evidence, however, suggesting thatthe marketability discount for a closelyheld stock compared with a publicly trad-

ed counterpart should average between35 percent and 50 percent, in theabsence of special circumstances thatwould tend to reduce the discount for lackof marketability.”11

Controlling interestAlthough the marketability discount is usuallygreater for a minority interest that cannot decideto sell the company, there is also a marketabilitydiscount for a controlling interest. A truly mar-ketable stock is one where you can call your bro-ker, sell the stock instantly, and receive cash inthree days. Obviously, the sale is not possible fora controlling interest in a closely held company.Shannon Pratt states: “The three bases most often encountered from which a controlling inter-est discount for lack of marketability is deductedare:

1. Control buyout value

2. Publicly traded stock value

3. Net asset value.”12

The courts have also commented on lack of mar-ketability discounts for controlling interest. In theEstate of Andrews they said:

The minority shareholder discount isdesigned to reflect the decreased valueof shares that do not convey control of aclosely held corporation. The lack ofmarketability discount, on the otherhand, is designed to reflect the fact thatthere is no ready market for shares in aclosely held corporation. Although there

19


10 Alan S. Zipp, Business Valuation Methods (AICPA,1993).

11 Ibid.

12 Shannon Pratt, Business Valuation Discounts andPremiums (New York: John Wiley & Sons, 2001), pp.168-169.

may be some overlap between these twodiscounts in that lack of control mayreduce marketability, it should be bornein mind that even controlling shares in anonpublic corporation suffer from lack ofmarketability because of the absence ofa ready private placement market andthe fact that flotation costs would haveto be incurred if the corporation were topublicly offer its stock.13

In the Estate of Dougherty the court allowed a35% discount on net asset value for a 100%interest based on a valuation using net assetvalue. “Discounting this figure by 35 percent fornonmarketability and operating and liquidationcosts.” 14

Lack of Control DiscountWhen the valuation is of an interest that cannotcontrol the activities of the company, a lack ofcontrol discount is appropriate. Although a shareof publicly traded stock lacks control, this issueis more serious in a closely held company wherethere is an interest that has control.

There are various factors to consider in deter-mining a lack of control discount. In some statesthe standard of value becomes important. Forexample, in New York, if there is an oppressedminority shareholder action, a fair value is deter-mined that excludes a lack of control discount.When the guideline method is used to determine

value, the calculations were done on shares thatlack control. A study publish by Shannon Prattused control premium data to determine a lackof control discount resulting in discounts from 24.3%t to 25%.15 A study conducted on realestate holding companies calculated a mediandiscount of 34.8%.16

Key Person Discount In some smaller closely held companies or thosethat are highly technical, there is the possibilitythat the company would be at a serious disadvan-tage if the owner, whose skills are relied upon,were not actively involved. This may be caused byexclusive technical knowledge or by the relation-ships between the owner and the customers. Therisk associated with the absence of this individ-ual can be accounted for in the determination ofthe unsystematic risks or by applying a separatekey person discount. The valuator needs to con-sider the difficulty in replacing the individual andthe backup within the company.

There have not been many studies on the quan-tity of this type of discount. A study that lookedat stock price changes when senior managementchanges were announced concluded that smallerpublic companies had a decline of 8.65% whilelarger companies had a decline of 4.83%.

The courts have varied considerably on theamount of this discount. One court allowed 25%while another allowed 10%.17 Yet another court

20


15 Shannon Pratt, with Alina Niculita, Valuing a BusinessThe Analysis and Appraisal of Closely Held Companies(New York: McGraw Hill, 2007), p. 404.

16 Peter J. Patchin “Market Discounts for UndividedMinority Interests in Real Estate,” Real Estate Issues,Winter 1988, pp. 14-16.

17 Estate of Milton Feldmar v. Commissioner, T.C. Memo1988-429. Estate of Paul Mitchell v. Commissioner,T.C. Memo 1997-461.

13 Estate of Woodbury G. Andrews, Deceased, WoodburyH. Andrews, Executor, Petitioner v. Commissioner ofInternal Revenue, Respondent 79 T.C. 938; 1982 U.S.Tax Ct. LEXIS 12; 79 T.C. No. 58.

14 Estate of Albert L. Dougherty, deceased, Allen L..Dougherty and Charlotte K. Dougherty, co-executors,Petitioner v. Commissioner of Internal Revenue,Respondent T.C. Memo 1990-274; 1990 Tax Ct. memo LEXIS 292; 59 T.C.M. (CCH) 772; T.C.M. (RIA) 90274.

concluded that forecasts used already factoredin the issue and did not allow a discount.18

Control PremiumThere is more empirical information on controlpremiums than on lack of control discounts. Thediscount can be derived from the inverse rela-tionship between the two. The relationship is asfollows:

where

M = Minority discount

P = Control premium

The amount of the premium can be diminishedby the need for super majorities that are legislat-ed or contractual if the interest being valueddoes not have a sufficient percentage to carry asuper majority decision. Other contractual fac-tors can also diminish the control premium.These may include how the board of directors isappointed, shareholder agreements restrictingthe sale or gift of stocks, or the state’s laws onoppressed minority shareholders.

The data provided previously regarding aShannon Pratt study was actually an interpola-tion of his conclusions on control premiums of16.7% to 33.3%.19

Trapped-in Capital GainsTrapped-in capital gains were discussed underthe net asset method of valuations. This issuealso needs to be considered under other valua-tion methods. The fact is that a buyer is not will-ing to pay fair market value for assets that can-not be depreciated using the fair market value asa tax basis. The actual capital gain tax would bethe appropriate adjustment if there was antici-pated sale of the asset. Even if a sale is not con-templated, an alternative method might be to determine the present value of the tax benefitlost by not being able to take depreciation.

V I I . VALUAT ION CONCLUSIONSAt this point the various results obtained fromthe different valuation methods utilized are sum-marized and the valuator will reconcile the differ-ent results. The valuator may decide that there isone method that is most persuasive and decideto use the value indicated by that method. Thealternative is that the valuator decides that mul-tiple methods will be used and decides on whichmethods are more persuasive than others. Aweighted average of the methods used isemployed. This will provide an estimate of theoperating value of the company. The valuatormay have to adjust this value for non-operatingassets and liabilities and excess or undercapital-ized operating assets.

V I I I . VALUAT ION REPORTSeveral types of valuation reports are available.The most common is the detailed report. This isfull comprehensive report that has sufficientinformation for the reader to understand whatthe valuator did and how the conclusions werereached. A condensed version of this report isalso possible and is called a summary report. Itis also possible for a valuator to perform calcu-lations requested by a client and use hypotheti-cal assumptions. For litigation and government

M = 1-( ) 1 1 + P

21


18 Estate of James J. Riener v. Commissioner, T.C. Memo200-298.

19 Shannon Pratt, with Alina Niculita, Valuing a BusinessThe Analysis and Appraisal of Closely Held Companies(New York: McGraw Hill, 2007), p. 392.

proceedings the content of the report may vary.A discussion of the comprehensive report con-tent, a summary report, and a calculation reportbased upon AICPA standards follows.

Detailed Report

Introductory section The detailed report may start with a letter oftransmittal followed by an introductory section.The introductory section includes sufficient infor-mation to enable the reader to understand theengagement and includes identifying the client;the purpose of the valuation; the date of the val-uation and what is being valued; if it is a partialinterest, the degree of control; marketabilityinformation; the standard of value; any scopelimitations; hypothetical assumptions used; andany specialists used.

Sources of informationSources of information are detailed in the sec-ond section, including site visits and who wasinterviewed. It also describes what financialinformation was available. If the statementswere looked at by a CPA, whether it was an audit,review, or compilation will be noted. If the infor-mation came from tax returns, then who pre-pared the returns should be identified.

Economic analysisThe third section reports on economic condi-tions. An analysis of the overall economic condi-tions is included if it has an impact on the com-pany. The industry analysis and the companyanalysis are also found in this section. The com-pany will be described in qualitative terms,including the background and history of the com-pany, products and services, demographic infor-mation, customers and suppliers, threat of newentrants, technological risks, environmentalrisks, regulatory risks, socio-cultural risks, and

global risks. The section may also have strategicplans of the company, workforce makeup, andbreakdown of ownership interest. The companywill also be described in quantitative terms.Typically multi-year financial statements are pre-sented with comments on sales and profittrends, along with liquidity ratios, profitabilityratios, activity ratios, and leverage ratios.

NormalizationNext, the fourth section will describe the normal-ization adjustments based upon the financialanalysis and the ownership interest being val-ued. The normalization will consider related partytransactions, unusual items, non-operatingitems, and adjustments regarding the applicationof the basis of accounting used.

Valuation approaches and methods consideredValuation approaches and methods that were con-sidered are usually discussed in the fifth section.

Valuation approaches usedThe sixth section discusses which valuationmethods were used. This section will have thecalculated estimates of value under the variousmethodologies. Any applicable discounts or pre-miums will also be applied.

Other factorsOther adjustments are discussed in the seventhsection. This may arise because the companyhas a deficiency in operating assets, excessoperating assets, or non-operating assets or lia-bilities. Excess assets are treated as non-operating assets. Sometime in a sale theowner leaves with cash or other assets. If theseneed to be replaced for normal operations, thevalue is reduced by the cost to replace. Non-operating assets and liabilities were not part ofthe calculation of operating value, and the value

22


of the company as a whole will be adjusted toinclude these items.

Reconciliation of calculationsThe report typically will include commentary onthe differences on value between the methods.It will also reflect on the persuasiveness of thevarious methods used. It will also calculate thefinal opinion of value.

RepresentationsEither a section will be included that includes therepresentations and conclusions of the valuatorand the signature of the person taking responsi-bility, or this information will be found some-where else in the report.

Assumptions and limiting conditionsThe assumptions and limiting conditions willeither be in a separate section of the report orthey may appear in an appendix. The assump-tions and limiting conditions typically discuss thereliability of the source information, any restric-tion on use, the fact that the fee is independentof the conclusions, disclose the use of any spe-cialists, and the fact that the valuator is notresponsible for updates to the report.

Background of the valuatorA summary of the background and qualificationsof the valuator should be provided.

Summary ReportA summary report may also be issued. It will beless comprehensive than a detailed report andmay be restricted to the client. The report wouldinclude the following portions of a comprehen-sive report:● Introduction● Who the client is● The purpose of the valuation● What is being valued

● What time period● Report date● The intended users● The degree of control● The marketability of the interest● The standard of value being utilized● Scope limitations● Specialists● Sources of information● Financial information● Economic data● Industry data● Other empirical data● Valuation approaches and methods used● Income approach● Market approach● Asset approach● Representations of the valuator ● Professional standards followed ● Assumptions and limiting conditions● Restricted use solely for the purpose

intended ● Conclusion of value

Calculation ReportThe valuator can agree to just do requested cal-culations for a client. Since the valuator does notdecide what procedures should be executed, theengagement does not include a conclusion ofvalue and is restricted to the client’s internaluse. This is similar to an agreed upon procedureunder generally accepted auditing standards.The report may include the following: ● Introduction● Who the client is● The nature of the calculations● Any hypothetical conditions● Report date● The intended users● Specialists● Summary of calculated value● Scope of work

23


● Representations of the valuator ● Professional standards followed ● Assumptions and limiting conditions● Any restricted use

Oral ReportIt is permissible to give an oral report, but thevaluator may be reluctant to accept the engage-ment because of the risk of being misunder-stood. The presentation should be inclusive andshould go over key areas of research, analysis,valuation methods, conclusions, and assump-tions and limiting conditions.

IX . INTERNATIONAL GLOSSARYOF BUSINESS VALUAT IONTERMS

To enhance and sustain the quality of businessvaluations for the benefit of the profession andits clientele, the below identified societies andorganizations have adopted the definitions forthe terms included in this glossary.

American Institute of Certified PublicAccountants

American Society of Appraisers

Canadian Institute of Chartered BusinessValuators

National Association of Certified ValuationAnalysts

The Institute of Business Appraisers

The performance of business valuation servicesrequires a high degree of skill and imposes uponthe valuation professional a duty to communi-cate the valuation process and conclusion in amanner that is clear and not misleading. This

duty is advanced through the use of termswhose meanings are clearly established andconsistently applied throughout the profession.

If, in the opinion of the business valuation pro-fessional, one or more of these terms needs tobe used in a manner that materially departs fromthe enclosed definitions, it is recommended thatthe term be defined as used within that valuationengagement. This glossary has been developedto provide guidance to business valuation practi-tioners by further memorializing the body ofknowledge that constitutes the competent andcareful determination of value and, more particu-larly, the communication of how that value wasdetermined. Departure from this glossary is notintended to provide a basis for civil liability andshould not be presumed to create evidence thatany duty has been breached.

Adjusted Book Value Method—a method withinthe asset approach whereby all assets andliabilities (including off-balance sheet, intan-gible, and contingent) are adjusted to theirfair market values. {NOTE: In Canada on agoing concern basis}

Adjusted Net Asset Method—see AdjustedBook Value Method.

Appraisal—see Valuation.Appraisal Approach—see Valuation Approach.Appraisal Date—see Valuation Date.Appraisal Method—see Valuation Method.Appraisal Procedure—see Valuation Procedure.Arbitrage Pricing Theory—a multivariate model

for estimating the cost of equity capital,which incorporates several systematic riskfactors.

Asset (Asset-Based) Approach—a general wayof determining a value indication of a busi-ness, business ownership interest, or secu-rity using one or more methods based on thevalue of the assets net of liabilities.

24


Beta—a measure of systematic risk of a stock;the tendency of a stock’s price to correlatewith changes in a specific index.

Blockage Discount—an amount or percentagededucted from the current market price of apublicly traded stock to reflect the decreasein the per-share value of a block of stockthat is of a size that could not be sold in areasonable period of time given normal trad-ing volume.

Book Value—see Net Book Value.Business—see Business Enterprise.Business Enterprise—a commercial, industrial,

service, or investment entity (or a combina-tion thereof) pursuing an economic activity.

Business Risk—the degree of uncertainty ofrealizing expected future returns of the busi-ness resulting from factors other than finan-cial leverage. See Financial Risk.

Business Valuation—the act or process of deter-mining the value of a business enterprise orownership interest therein.

Capital Asset Pricing Model (CAPM)—a modelin which the cost of capital for any stock orportfolio of stocks equals a risk-free rateplus a risk premium that is proportionate tothe systematic risk of the stock or portfolio.

Capitalization—a conversion of a single periodof economic benefits into value.

Capitalization Factor—any multiple or divisorused to convert anticipated economic bene-fits of a single period into value.

Capitalization of Earnings Method—a methodwithin the income approach whereby eco-nomic benefits for a representative singleperiod are converted to value through divi-sion by a capitalization rate.

Capitalization Rate—any divisor (usuallyexpressed as a percentage) used to convertanticipated economic benefits of a singleperiod into value.

Capital Structure—the composition of the

invested capital of a business enterprise;the mix of debt and equity financing.

Cash Flow—cash that is generated over a peri-od of time by an asset, group of assets, orbusiness enterprise. It may be used in a gen-eral sense to encompass various levels ofspecifically defined cash flows. When theterm is used, it should be supplemented by a qualifier (for example, “discretionary” or“operating”) and a specific definition in thegiven valuation context.

Common Size Statements—financial state-ments in which each line is expressed as apercentage of the total. On the balancesheet, each line item is shown as a percent-age of total assets, and on the income state-ment, each item is expressed as a percent-age of sales.

Control—the power to direct the managementand policies of a business enterprise.

Control Premium—an amount or a percentageby which the pro rata value of a controllinginterest exceeds the pro rata value of a non-controlling interest in a business enterpriseto reflect the power of control.

Cost Approach—a general way of determining avalue indication of an individual asset byquantifying the amount of money required toreplace the future service capability of thatasset.

Cost of Capital—the expected rate of return thatthe market requires in order to attract fundsto a particular investment.

Debt-Free—we discourage the use of this term.See Invested Capital.

Discount for Lack of Control—an amount or per-centage deducted from the pro rata share ofvalue of 100% of an equity interest in a busi-ness to reflect the absence of some or all ofthe powers of control.

25


Discount for Lack of Marketability—an amountor percentage deducted from the value of anownership interest to reflect the relativeabsence of marketability.

Discount for Lack of Voting Rights—an amountor percentage deducted from the per-sharevalue of a minority interest voting share toreflect the absence of voting rights.

Discount Rate—a rate of return used to converta future monetary sum into present value.

Discounted Cash Flow Method—a method with-in the income approach whereby the presentvalue of future expected net cash flows iscalculated using a discount rate.

Discounted Future Earnings Method—a methodwithin the income approach whereby thepresent value of future expected economicbenefits is calculated using a discount rate.

Economic Benefits—inflows such as revenues,net income, net cash flows, etc.

Economic Life—the period of time over whichproperty may generate economic benefits.

Effective Date—see Valuation Date.Enterprise—see Business Enterprise.Equity—the owner’s interest in property after

deduction of all liabilities.Equity Net Cash Flows—those cash flows avail-

able to pay out to equity holders (in the formof dividends) after funding operations of thebusiness enterprise, making necessary cap-ital investments, and increasing or decreas-ing debt financing.

Equity Risk Premium—a rate of return added toa risk-free rate to reflect the additional riskof equity instruments over risk-free instru-ments (a component of the cost of equitycapital or equity discount rate).

Excess Earnings—that amount of anticipated eco-nomic benefits that exceeds an appropriaterate of return on the value of a selected assetbase (often net tangible assets) used to gen-erate those anticipated economic benefits.

Excess Earnings Method—a specific way ofdetermining a value indication of a business,business ownership interest, or securitydetermined as the sum of a) the value of theassets derived by capitalizing excess earn-ings and b) the value of the selected assetbase. Also frequently used to value intangi-ble assets. See Excess Earnings.

Fair Market Value—the price, expressed interms of cash equivalents, at which propertywould change hands between a hypotheticalwilling and able buyer and a hypothetical will-ing and able seller, acting at arms length inan open and unrestricted market, when nei-ther is under compulsion to buy or sell andwhen both have reasonable knowledge ofthe relevant facts. {NOTE: In Canada, theterm “price” should be replaced with theterm “highest price.”}

Fairness Opinion—an opinion as to whether ornot the consideration in a transaction is fairfrom a financial point of view.

Financial Risk—the degree of uncertainty ofrealizing expected future returns of the busi-ness resulting from financial leverage. SeeBusiness Risk.

Forced Liquidation Value—liquidation value, atwhich the asset or assets are sold as quick-ly as possible, such as at an auction.

Free Cash Flow—we discourage the use of thisterm. See Net Cash Flow.

Going Concern—an ongoing operating businessenterprise.

Going Concern Value—the value of a businessenterprise that is expected to continue tooperate into the future. The intangible ele-ments of Going Concern Value result fromfactors such as having a trained work force,an operational plant, and the necessarylicenses, systems, and procedures in place.

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Goodwill—that intangible asset arising as aresult of name, reputation, customer loyalty,location, products, and similar factors notseparately identified.

Goodwill Value—the value attributable to goodwill.

Guideline Public Company Method—a methodwithin the market approach whereby marketmultiples are derived from market prices ofstocks of companies that are engaged in thesame or similar lines of business and thatare actively traded on a free and open mar-ket.

Income (Income-Based) Approach—a generalway of determining a value indication of abusiness, business ownership interest,security, or intangible asset using one ormore methods that convert anticipated eco-nomic benefits into a present single amount.

Intangible Assets—non-physical assets such asfranchises, trademarks, patents, copyrights,goodwill, equities, mineral rights, securities,and contracts (as distinguished from physi-cal assets) that grant rights and privilegesand have value for the owner.

Internal Rate of Return—a discount rate atwhich the present value of the future cashflows of the investment equals the cost ofthe investment.

Intrinsic Value—the value that an investor con-siders, on the basis of an evaluation or avail-able facts, to be the “true” or “real” valuethat will become the market value whenother investors reach the same conclusion.When the term applies to options, it is thedifference between the exercise price andstrike price of an option and the marketvalue of the underlying security.

Invested Capital—the sum of equity and debt ina business enterprise. Debt is typically (a)all interest-bearing debt or (b) long-term,interest-bearing debt. When the term is

used, it should be supplemented by a specif-ic definition in the given valuation context.

Invested Capital Net Cash Flows—those cashflows available to pay out to equity holders(in the form of dividends) and debt investors(in the form of principal and interest) afterfunding operations of the business enter-prise and making necessary capital investments.

Investment Risk—the degree of uncertainty asto the realization of expected returns.

Investment Value—the value to a particularinvestor based on individual investmentrequirements and expectations. {NOTE: inCanada, the term used is “Value to theOwner.”}

Key Person Discount—an amount or percentagededucted from the value of an ownershipinterest to reflect the reduction in valueresulting from the actual or potential loss ofa key person in a business enterprise.

Levered Beta—the beta reflecting a capitalstructure that includes debt.

Limited Appraisal—the act or process of deter-mining the value of a business, businessownership interest, security, or intangibleasset with limitations in analyses, proce-dures, or scope.

Liquidity—the ability to quickly convert propertyto cash or pay a liability.

Liquidation Value—the net amount that wouldbe realized if the business is terminated andthe assets are sold piecemeal. Liquidationcan be either “orderly” or “forced.”

Majority Control—the degree of control providedby a majority position.

Majority Interest—an ownership interest greaterthan 50% of the voting interest in a businessenterprise.

Market (Market-Based) Approach—a generalway of determining a value indication of abusiness, business ownership interest,

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security, or intangible asset by using one ormore methods that compare the subject tosimilar businesses, business ownershipinterests, securities, or intangible assetsthat have been sold.

Market Capitalization of Equity—the shareprice of a publicly traded stock multiplied bythe number of shares outstanding.

Market Capitalization of Invested Capital—themarket capitalization of equity plus the mar-ket value of the debt component of investedcapital.

Market Multiple—the market value of a compa-ny’s stock or invested capital divided by acompany measure (such as economic bene-fits, number of customers).

Marketability—the ability to quickly convertproperty to cash at minimal cost.

Marketability Discount—see Discount for Lackof Marketability.

Merger and Acquisition Method—a methodwithin the market approach whereby pricingmultiples are derived from transactions ofsignificant interests in companies engagedin the same or similar lines of business.

Mid-Year Discounting—a convention used in theDiscounted Future Earnings Method thatreflects economic benefits being generatedat midyear, approximating the effect of eco-nomic benefits being generated evenlythroughout the year.

Minority Discount—a discount for lack of controlapplicable to a minority interest.

Minority Interest—an ownership interest lessthan 50% of the voting interest in a businessenterprise.

Multiple—the inverse of the capitalization rate.Net Book Value—with respect to a business

enterprise, the difference between totalassets (net of accumulated depreciation,depletion, and amortization) and total liabili-ties as they appear on the balance sheet

(synonymous with Shareholder’s Equity).With respect to a specific asset, the capital-ized cost less accumulated amortization ordepreciation as it appears on the books ofaccount of the business enterprise.

Net Cash Flows—when the term is used, itshould be supplemented by a qualifier. SeeEquity Net Cash Flows and Invested CapitalNet Cash Flows.

Net Present Value—the value, as of a specifieddate, of future cash inflows less all cash out-flows (including the cost of investment) cal-culated using an appropriate discount rate.

Net Tangible Asset Value—the value of the busi-ness enterprise’s tangible assets (excludingexcess assets and non-operating assets)minus the value of its liabilities.

Non-operating Assets—assets not necessary toongoing operations of the business enter-prise. {NOTE: in Canada, the term used is“Redundant Assets.”}

Normalized Earnings—economic benefits adjust-ed for non-recurring, non-economic, or otherunusual items to eliminate anomaliesand/or facilitate comparisons.

Normalized Financial Statements—financialstatements adjusted for non-operatingassets and liabilities and/or for non-recur-ring, non-economic, or other unusual itemsto eliminate anomalies and/or facilitatecomparisons.

Orderly Liquidation Value—liquidation value atwhich the asset or assets are sold over areasonable period of time to maximize pro-ceeds received.

Premise of Value—an assumption regarding themost likely set of transactional circum-stances that may be applicable to the sub-ject valuation; for example, going concern,liquidation.

Present Value—the value, as of a specifieddate, of future economic benefits and/or

28


proceeds from sale, calculated using anappropriate discount rate.

Portfolio Discount—an amount or percentagededucted from the value of a business enter-prise to reflect the fact that it owns dissimi-lar operations or assets that do not fit welltogether.

Price/Earnings Multiple—the price of a share ofstock divided by its earnings per share.

Rate of Return—an amount of income (loss)and/or change in value realized or anticipat-ed on an investment, expressed as a per-centage of that investment.

Redundant Assets—see Non-operating Assets.Report Date—the date conclusions are transmit-

ted to the client.Replacement Cost New—the current cost of a

similar new property having the nearestequivalent utility to the property being val-ued.

Reproduction Cost New—the current cost of anidentical new property.

Required Rate of Return—the minimum rate ofreturn acceptable by investors before theywill commit money to an investment at agiven level of risk.

Residual Value—the value as of the end of thediscrete projection period in a discountedfuture earnings model.

Return on Equity—the amount, expressed as apercentage, earned on a company’s commonequity for a given period.

Return on Investment—See Return on InvestedCapital and Return on Equity.

Return on Invested Capital—the amount,expressed as a percentage, earned on acompany’s total capital for a given period.

Risk-Free Rate—the rate of return available inthe market on an investment free of defaultrisk.

Risk Premium—a rate of return added to a risk-free rate to reflect risk.

Rule of Thumb—a mathematical formula devel-oped from the relationship between priceand certain variables based on experience,observation, hearsay, or a combination ofthese; usually industry specific.

Special Interest Purchasers—acquirers whobelieve they can enjoy post-acquisitioneconomies of scale, synergies, or strategicadvantages by combining the acquired busi-ness interest with their own.

Standard of Value—the identification of the typeof value being utilized in a specific engage-ment; for example, fair market value, fairvalue, investment value.

Sustaining Capital Reinvestment—the periodiccapital outlay required to maintain opera-tions at existing levels, net of the tax shieldavailable from such outlays.

Systematic Risk—the risk that is common to allrisky securities and cannot be eliminatedthrough diversification. The measure of sys-tematic risk in stocks is the beta coefficient.

Tangible Assets—physical assets (such ascash, accounts receivable, inventory, proper-ty, plant and equipment, etc.).

Terminal Value—See Residual Value.Transaction Method—See Merger and

Acquisition Method.Unlevered Beta—the beta reflecting a capital

structure without debt.Unsystematic Risk—the risk specific to an indi-

vidual security that can be avoided throughdiversification.

Valuation—the act or process of determining thevalue of a business, business ownershipinterest, security, or intangible asset.

Valuation Approach—a general way of determin-ing a value indication of a business, businessownership interest, security, or intangibleasset using one or more valuation methods.

Valuation Date—the specific point in time as ofwhich the valuator’s opinion of value applies

29


(also referred to as “Effective Date” or“Appraisal Date”).

Valuation Method—within approaches, a specif-ic way to determine value.

Valuation Procedure—the act, manner, and tech-nique of performing the steps of an apprais-al method.

Valuation Ratio—a fraction in which a value orprice serves as the numerator and financial,operating, or physical data serve as thedenominator.

Value to the Owner—see Investment Value.Voting Control—de jure control of a business

enterprise.Weighted Average Cost of Capital (WACC)—the

cost of capital (discount rate) determined bythe weighted average, at market value, of thecost of all financing sources in the businessenterprise’s capital structure.

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31


EXHIBIT 1. REVENUE RULING 59-60

Rev. Rul. 59-60, 1959-1 CB 237 -- IRC Sec. 2031 (Also Section 2512.) (Also Part II, Sections 811(k), 1005, Regulations 105,

Section 81.10.)

Reference(s): Code Sec. 2031 Reg § 20.2031-2

In valuing the stock of closely held corporations, or the stock of corporations where market quotations are not available, all

other available financial data, as well as all relevant factors affecting the fair market value must be considered for estate tax

and gift tax purposes. No general formula may be given that is applicable to the many different valuation situations arising in

the valuation of such stock. However, the general approach, methods, and factors which must be considered in valuing such

securities are outlined.

Revenue Ruling 54-77, C.B. 1954-1, 187, superseded.

Full Text:

Section 1. Purpose.

The purpose of this Revenue Ruling is to outline and review in general the approach, methods and factors to be considered

in valuing shares of the capital stock of closely held corporations for estate tax and gift tax purposes. The methods discussed

herein will apply likewise to the valuation of corporate stocks on which market quotations are either unavailable or are of such

scarcity that they do not reflect the fair market value.

Sec. 2. Background and Definitions.

.01 All valuations must be made in accordance with the applicable provisions of the Internal Revenue Code of 1954 and the

Federal Estate Tax and Gift Tax Regulations. Sections 2031(a), 2032 and 2512(a) of the 1954 Code (sections 811 and 1005

of the 1939 Code) require that the property to be included in the gross estate, or made the subject of a gift, shall be taxed

on the basis of the value of the property at the time of death of the decedent, the alternate date if so elected, or the date of

gift.

.02 Section 20.2031-1(b) of the Estate Tax Regulations (section 81.10 of the Estate Tax Regulations 105) and section

25.2512-1 of the Gift Tax Regulations (section 86.19 of Gift Tax Regulations 108) define fair market value, in effect, as the

price at which the property would change hands between a willing buyer and a willing seller when the former is not under any

compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant

facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as

willing, to trade and to be well informed about the property and concerning the market for such property.

.03 Closely held corporations are those corporations the shares of which are owned by a relatively limited number of stock-

holders. Often the entire stock issue is held by one family. The result of this situation is that little, if any, trading in the shares

takes place. There is, therefore, no established market for the stock and such sales as occur at irregular intervals seldom

reflect all of the elements of a representative transaction as defined by the term “fair market value."

Sec. 3. Approach to Valuation.

.01 A determination of fair market value, being a question of fact, will depend upon the circumstances in each case. No for-

mula can be devised that will be generally applicable to the multitude of different valuation issues arising in estate and gift

tax cases. Often, an appraiser will find wide differences of opinion as to the fair market value of a particular stock. In resolv-

ing such differences, he should maintain a reasonable attitude in recognition of the fact that valuation is not an exact sci-

ence. A sound valuation will be based upon all the relevant facts, but the elements of common sense, informed judgment and

reasonableness must enter into the process of weighing those facts and determining their aggregate significance.

.02 The fair market value of specific shares of stock will vary as general economic conditions change from “normal” to “boom”

32


or “depression,” that is, according to the degree of optimism or pessimism with which the investing public regards the future

at the required date of appraisal. Uncertainty as to the stability or continuity of the future income from a property decreases

its value by increasing the risk of loss of earnings and value in the future. The value of shares of stock of a company with

very uncertain future prospects is highly speculative. The appraiser must exercise his judgment as to the degree of risk attach-

ing to the business of the corporation which issued the stock, but that judgment must be related to all of the other factors

affecting value.

.03 Valuation of securities is, in essence, a prophesy as to the future and must be based on facts available at the required

date of appraisal. As a generalization, the prices of stocks which are traded in volume in a free and active market by informed

persons best reflect the consensus of the investing public as to what the future holds for the corporations and industries rep-

resented. When a stock is closely held, is traded infrequently, or is traded in an erratic market, some other measure of value

must be used. In many instances, the next best measure may be found in the prices at which the stocks of companies

engaged in the same or a similar line of business are selling in a free and open market.

Sec. 4. Factors To Consider.

.01 It is advisable to emphasize that in the valuation of the stock of closely held corporations or the stock of corporations

where market quotations are either lacking or too scarce to be recognized, all available financial data, as well as all relevant

factors affecting the fair market value, should be considered. The following factors, although not all- inclusive are fundamen-

tal and require careful analysis in each case:

(a) The nature of the business and the history of the enterprise from its inception.

(b) The economic outlook in general and the condition and outlook of the specific industry in particular.

(c) The book value of the stock and the financial condition of the business.

(d) The earning capacity of the company.

(e) The dividend-paying capacity.

(f) Whether or not the enterprise has goodwill or other intangible value.

(g) Sales of the stock and the size of the block of stock to be valued.

(h) The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively

traded in a free and open market, either on an exchange or over-the-counter.

.02 The following is a brief discussion of each of the foregoing factors:

(a) The history of a corporate enterprise will show its past stability or instability, its growth or lack of growth, the diversity or

lack of diversity of its operations, and other facts needed to form an opinion of the degree of risk involved in the business.

For an enterprise which changed its form of organization but carried on the same or closely similar operations of its prede-

cessor, the history of the former enterprise should be considered. The detail to be considered should increase with approach

to the required date of appraisal, since recent events are of greatest help in predicting the future; but a study of gross and

net income, and of dividends covering a long prior period, is highly desirable. The history to be studied should include, but

need not be limited to, the nature of the business, its products or services, its operating and investment assets, capital struc-

ture, plant facilities, sales records and management, all of which should be considered as of the date of the appraisal, with

due regard for recent significant changes. Events of the past that are unlikely to recur in the future should be discounted,

since value has a close relation to future expectancy.

(b) A sound appraisal of a closely held stock must consider current and prospective economic conditions as of the date of

appraisal, both in the national economy and in the industry or industries with which the corporation is allied. It is important

to know that the company is more or less successful than its competitors in the same industry, or that it is maintaining a sta-

ble position with respect to competitors. Equal or even greater significance may attach to the ability of the industry with which

33


the company is allied to compete with other industries. Prospective competition which has not been a factor in prior years

should be given careful attention. For example, high profits due to the novelty of its product and the lack of competition often

lead to increasing competition. The public's appraisal of the future prospects of competitive industries or of competitors with-

in an industry may be indicated by price trends in the markets for commodities and for securities. The loss of the manager

of a so-called “one-man” business may have a depressing effect upon the value of the stock of such business, particularly if

there is a lack of trained personnel capable of succeeding to the management of the enterprise. In valuing the stock of this

type of business, therefore, the effect of the loss of the manager on the future expectancy of the business, and the absence

of management-succession potentialities are pertinent factors to be taken into consideration. On the other hand, there may

be factors which offset, in whole or in part, the loss of the manager's services. For instance, the nature of the business and

of its assets may be such that they will not be impaired by the loss of the manager. Furthermore, the loss may be adequate-

ly covered by life insurance, or competent management might be employed on the basis of the consideration paid for the for-

mer manager's services. These, or other offsetting factors, if found to exist, should be carefully weighed against the loss of

the manager's services in valuing the stock of the enterprise.

(c) Balance sheets should be obtained, preferably in the form of comparative annual statements for two or more years imme-

diately preceding the date of appraisal, together with a balance sheet at the end of the month preceding that date, if corpo-

rate accounting will permit. Any balance sheet descriptions that are not self-explanatory, and balance sheet items compre-

hending diverse assets or liabilities, should be clarified in essential detail by supporting supplemental schedules. These state-

ments usually will disclose to the appraiser (1) liquid position (ratio of current assets to current liabilities); (2) gross and net

book value of principal classes of fixed assets; (3) working capital; (4) long-term indebtedness; (5) capital structure; and (6)

net worth. Consideration also should be given to any assets not essential to the operation of the business, such as invest-

ments in securities, real estate, etc. In general, such nonoperating assets will command a lower rate of return than do the

operating assets, although in exceptional cases the reverse may be true. In computing the book value per share of stock,

assets of the investment type should be revalued on the basis of their market price and the book value adjusted according-

ly. Comparison of the company's balance sheets over several years may reveal, among other facts, such developments as the

acquisition of additional production facilities or subsidiary companies, improvement in financial position, and details as to

recapitalizations and other changes in the capital structure of the corporation. If the corporation has more than one class of

stock outstanding, the charter or certificate of incorporation should be examined to ascertain the explicit rights and privileges

of the various stock issues including: (1) voting powers, (2) preference as to dividends, and (3) preference as to assets in the

event of liquidation.

(d) Detailed profit-and-loss statements should be obtained and considered for a representative period immediately prior to the

required date of appraisal, preferably five or more years. Such statements should show (1) gross income by principal items;

(2) principal deductions from gross income including major prior items of operating expenses, interest and other expense on

each item of long-term debt, depreciation and depletion if such deductions are made, officers' salaries, in total if they appear

to be reasonable or in detail if they seem to be excessive, contributions (whether or not deductible for tax purposes) that the

nature of its business and its community position require the corporation to make, and taxes by principal items, including

income and excess profits taxes; (3) net income available for dividends; (4) rates and amounts of dividends paid on each

class of stock; (5) remaining amount carried to surplus; and (6) adjustments to, and reconciliation with, surplus as stated on

the balance sheet. With profit and loss statements of this character available, the appraiser should be able to separate recur-

rent from nonrecurrent items of income and expense, to distinguish between operating income and investment income, and

to ascertain whether or not any line of business in which the company is engaged is operated consistently at a loss and might

be abandoned with benefit to the company. The percentage of earnings retained for business expansion should be noted when

34


dividend-paying capacity is considered. Potential future income is a major factor in many valuations of closely-held stocks, and

all information concerning past income which will be helpful in predicting the future should be secured. Prior earnings records

usually are the most reliable guide as to the future expectancy, but resort to arbitrary five-or-ten-year averages without regard

to current trends or future prospects will not produce a realistic valuation. If, for instance, a record of progressively increas-

ing or decreasing net income is found, then greater weight may be accorded the most recent years' profits in estimating earn-

ing power. It will be helpful, in judging risk and the extent to which a business is a marginal operator, to consider deductions

from income and net income in terms of percentage of sales. Major categories of cost and expense to be so analyzed include

the consumption of raw materials and supplies in the case of manufacturers, processors and fabricators; the cost of pur-

chased merchandise in the case of merchants; utility services; insurance; taxes; depletion or depreciation; and interest.

(e) Primary consideration should be given to the dividend-paying capacity of the company rather than to dividends actually paid

in the past. Recognition must be given to the necessity of retaining a reasonable portion of profits in a company to meet com-

petition. Dividend-paying capacity is a factor that must be considered in an appraisal, but dividends actually paid in the past

may not have any relation to dividend-paying capacity. Specifically, the dividends paid by a closely held family company may be

measured by the income needs of the stockholders or by their desire to avoid taxes on dividend receipts, instead of by the

ability of the company to pay dividends. Where an actual or effective controlling interest in a corporation is to be valued, the

dividend factor is not a material element, since the payment of such dividends is discretionary with the controlling stockhold-

ers. The individual or group in control can substitute salaries and bonuses for dividends, thus reducing net income and under-

stating the dividend-paying capacity of the company. It follows, therefore, that dividends are less reliable criteria of fair mar-

ket value than other applicable factors.

(f) In the final analysis, goodwill is based upon earning capacity. The presence of goodwill and its value, therefore, rests upon

the excess of net earnings over and above a fair return on the net tangible assets. While the element of goodwill may be

based primarily on earnings, such factors as the prestige and renown of the business, the ownership of a trade or brand name,

and a record of successful operation over a prolonged period in a particular locality, also may furnish support for the inclusion

of intangible value. In some instances it may not be possible to make a separate appraisal of the tangible and intangible

assets of the business. The enterprise has a value as an entity. Whatever intangible value there is, which is supportable by

the facts, may be measured by the amount by which the appraised value of the tangible assets exceeds the net book value

of such assets.

(g) Sales of stock of a closely held corporation should be carefully investigated to determine whether they represent transac-

tions at arm's length. Forced or distress sales do not ordinarily reflect fair market value nor do isolated sales in small amounts

necessarily control as the measure of value. This is especially true in the valuation of a controlling interest in a corporation.

Since, in the case of closely held stocks, no prevailing market prices are available, there is no basis for making an adjust-

ment for blockage. It follows, therefore, that such stocks should be valued upon a consideration of all the evidence affecting

the fair market value. The size of the block of stock itself is a relevant factor to be considered. Although it is true that a minor-

ity interest in an unlisted corporation's stock is more difficult to sell than a similar block of listed stock, it is equally true that

control of a corporation, either actual or in effect, representing as it does an added element of value, may justify a higher value

for a specific block of stock.

(h) Section 2031(b) of the Code states, in effect, that in valuing unlisted securities the value of stock or securities of corpo-

rations engaged in the same or a similar line of business which are listed on an exchange should be taken into consideration

along with all other factors. An important consideration is that the corporations to be used for comparisons have capital

stocks which are actively traded by the public. In accordance with section 2031(b) of the Code, stocks listed on an exchange

are to be considered first. However, if sufficient comparable companies whose stocks are listed on an exchange cannot be

35


found, other comparable companies which have stocks actively traded in on the over-the- counter market also may be used.

The essential factor is that whether the stocks are sold on an exchange or over-the-counter there is evidence of an active,

free public market for the stock as of the valuation date. In selecting corporations for comparative purposes, care should be

taken to use only comparable companies. Although the only restrictive requirement as to comparable corporations specified

in the statute is that their lines of business be the same or similar, yet it is obvious that consideration must be given to other

relevant factors in order that the most valid comparison possible will be obtained. For illustration, a corporation having one or

more issues of preferred stock, bonds or debentures in addition to its common stock should not be considered to be direct-

ly comparable to one having only common stock outstanding. In like manner, a company with a declining business and decreas-

ing markets is not comparable to one with a record of current progress and market expansion.

Sec. 5. Weight To Be Accorded Various Factors.

The valuation of closely held corporate stock entails the consideration of all relevant factors as stated in section 4. Depending

upon the circumstances in each case, certain factors may carry more weight than others because of the nature of the com-

pany's business. To illustrate:

(a) Earnings may be the most important criterion of value in some cases whereas asset value will receive primary considera-

tion in others. In general, the appraiser will accord primary consideration to earnings when valuing stocks of companies which

sell products or services to the public; conversely, in the investment or holding type of company, the appraiser may accord the

greatest weight to the assets underlying the security to be valued.

(b) The value of the stock of a closely held investment or real estate holding company, whether or not family owned, is close-

ly related to the value of the assets underlying the stock. For companies of this type the appraiser should determine the fair

market values of the assets of the company. Operating expenses of such a company and the cost of liquidating it, if any, merit

consideration when appraising the relative values of the stock and the underlying assets. The market values of the underly-

ing assets give due weight to potential earnings and dividends of the particular items of property underlying the stock, capi-

talized at rates deemed proper by the investing public at the date of appraisal. A current appraisal by the investing public

should be superior to the retrospective opinion of an individual. For these reasons, adjusted net worth should be accorded

greater weight in valuing the stock of a closely held investment or real estate holding company, whether or not family owned,

than any of the other customary yardsticks of appraisal, such as earnings and dividend paying capacity.

Sec. 6. Capitalization Rates.

In the application of certain fundamental valuation factors, such as earnings and dividends, it is necessary to capitalize the

average or current results at some appropriate rate. A determination of the proper capitalization rate presents one of the most

difficult problems in valuation. That there is no ready or simple solution will become apparent by a cursory check of the rates

of return and dividend yields in terms of the selling prices of corporate shares listed on the major exchanges of the country.

Wide variations will be found even for companies in the same industry. Moreover, the ratio will fluctuate from year to year

depending upon economic conditions. Thus, no standard tables of capitalization rates applicable to closely held corporations

can be formulated. Among the more important factors to be taken into consideration in deciding upon a capitalization rate in

a particular case are: (1) the nature of the business; (2) the risk involved; and (3) the stability or irregularity of earnings.

Sec. 7. Average of Factors.

Because valuations cannot be made on the basis of a prescribed formula, there is no means whereby the various applicable

factors in a particular case can be assigned mathematical weights in deriving the fair market value. For this reason, no use-

ful purpose is served by taking an average of several factors (for example, book value, capitalized earnings and capitalized

dividends) and basing the valuation on the result. Such a process excludes active consideration of other pertinent factors,

and the end result cannot be supported by a realistic application of the significant facts in the case except by mere chance.

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Sec. 8. Restrictive Agreements.

Frequently, in the valuation of closely held stock for estate and gift tax purposes, it will be found that the stock is subject to

an agreement restricting its sale or transfer. Where shares of stock were acquired by a decedent subject to an option reserved

by the issuing corporation to repurchase at a certain price, the option price is usually accepted as the fair market value for

estate tax purposes. See Rev. Rul. 54-76, C.B. 1954-1, 194. However, in such case the option price is not determinative of

fair market value for gift tax purposes. Where the option, or buy and sell agreement, is the result of voluntary action by the

stockholders and is binding during the life as well as at the death of the stockholders, such agreement may or may not,

depending upon the circumstances of each case, fix the value for estate tax purposes. However, such agreement is a factor

to be considered, with other relevant factors, in determining fair market value. Where the stockholder is free to dispose of his

shares during life and the option is to become effective only upon his death, the fair market value is not limited to the option

price. It is always necessary to consider the relationship of the parties, the relative number of shares held by the decedent,

and other material facts, to determine whether the agreement represents a bonafide business arrangement or is a device to

pass the decedent's shares to the natural objects of his bounty for less than an adequate and full consideration in money or

money's worth. In this connection see Rev. Rul. 157 C.B. 1953-2, 255, and Rev. Rul. 189, C.B. 1953-2, 294.

Sec. 9. Effect on Other Documents.

Revenue Ruling 54-77, C.B. 1954-1, 187, is hereby superseded.

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