Statements on Management Accounting

BUSINESS PERFORMANCE MANAGEMENT

TITLE

Business Valuation

CREDITS

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

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Statements on Management Accounting

BUSINESS PERFORMANCE MANAGEMENT

Business Valuation

TA B L E O F C O N T E N T S
I. Introduction . . . . . . . . . . . . . . . . . . . . . 1 Discounted cash flow . . . . . . . . . . . .9
II. Reasons for the Valuation and Excess earnings . . . . . . . . . . . . . . .11
Premise . . . . . . . . . . . . . . . . . . . . . . . . .1 Market-Based Methods . . . . . . . . . . . .13
III. Standards of Value . . . . . . . . . . . . . . . . .2 Sale of stock in the same company .13
Fair Market Value . . . . . . . . . . . . . . . . . .2 Sale of similar companies . . . . . . . .13
Intrinsic Value . . . . . . . . . . . . . . . . . . . . .2 Guideline companies . . . . . . . . . . . .14
Investment Value . . . . . . . . . . . . . . . . . . .2 Asset-Based Methods . . . . . . . . . . . . .16
IV. Valuation Analysis . . . . . . . . . . . . . . . . .2 Operating asset value . . . . . . . . . . .16
General Economic Factors . . . . . . . . . . . .2 Liquidating value . . . . . . . . . . . . . . .18
Industry Economic Factors . . . . . . . . . . . .3 VI. Discounts and Premiums . . . . . . . . . . .18
Rivalry . . . . . . . . . . . . . . . . . . . . . . . . .3 Lack of Marketability Discount . . . . . . . .18
Threat of new entrants . . . . . . . . . . . . .3 IPO studies . . . . . . . . . . . . . . . . . . . .18
Threat of substitution . . . . . . . . . . . . . .3 Restricted stock studies . . . . . . . . . . .18
Bargaining power of customers . . . . . . .3 Controlling interest . . . . . . . . . . . . . . .19
Bargaining power of suppliers . . . . . . . .3 Lack of Control Discount . . . . . . . . . . . .20
Company Analysis . . . . . . . . . . . . . . . . . .4 Key Person Discount . . . . . . . . . . . . .20
SWOT analysis . . . . . . . . . . . . . . . . . . .4 Control Premium . . . . . . . . . . . . . . . . . .21
Historical financial analysis . . . . . . . . . .4 Trapped-in Capital Gains . . . . . . . . . . . .21
Normalization . . . . . . . . . . . . . . . . . . . .4 VII. Valuation Conclusions . . . . . . . . . . . . . .21
Related party transactions . . . . . . . . .4 VIII. Valuation Report . . . . . . . . . . . . . . . . . .21
Unusual transactions . . . . . . . . . . . .5 Detailed Report . . . . . . . . . . . . . . . . . .22
Non-operating activities . . . . . . . . . . .5 Introductory section . . . . . . . . . . . . . .22
Accounting applications . . . . . . . . . . .6 Sources of information . . . . . . . . . . . .22
Taxing the income stream . . . . . . . . .6 Economic analysis . . . . . . . . . . . . . . .22
V. Valuation Methods . . . . . . . . . . . . . . . . .6 Normalization . . . . . . . . . . . . . . . . . . .22
Earnings-Based Methods . . . . . . . . . . . . .6 Valuation approaches and methods
Determining discount rates using the considered . . . . . . . . . . . . . . . . . . . .22
buildup method . . . . . . . . . . . . . . . . . .6 Valuation approaches used . . . . . . . . .22
Determining the discount rate Other factors . . . . . . . . . . . . . . . . . . .22
using CAPM . . . . . . . . . . . . . . . . . . .8 Reconciliation of calculations . . . . . . .23
Using the rate in a weighted average Representations . . . . . . . . . . . . . . . . .23
cost of capital calculation . . . . . . . . .9 Assumptions and limiting conditions . .23
Earnings capitalization . . . . . . . . . . . .9 Background of the valuator . . . . . . . . .23

Statements on Management Accounting

BUSINESS PERFORMANCE MANAGEMENT

Business Valuation

TA B L E O F C O N T E N T S
Summary Report . . . . . . . . . . . . . . . . . .23 Tables
Calculation Report . . . . . . . . . . . . . . . .23 Table 1: S Corporation Benefit . . . . . . . . . .7
Oral Report . . . . . . . . . . . . . . . . . . . . . .24
Table 2: Buildup Determination of
IX. International Glossary of Business
Earnings Capitalization Rate . . . . .10
Valuation Terms . . . . . . . . . . . . . . . . . .24
Table 3: Discounted Cash flow . . . . . . . . . .12
Table 4: Excess Earnings . . . . . . . . . . . . .14
Exhibits
Table 5: Guideline Data . . . . . . . . . . . . . . .16
Exhibit 1: Revenue Ruling 59-60 . . . . . . .31
Table 6: Guideline Data . . . . . . . . . . . . . . .17

final- ly. employee stock ownership plan (ESOP) tion methodologies are considered. and initial a valuation of a closely held business is per. then a liq- consideration of items outside normal opera. The tion methodologies exist and their relevance to purpose of the valuation will dictate the standard the purpose of the valuation. 1 . Finally a reconciliation methodology is typically used. asset defi- The purpose of this Statement on Management ciencies. At this point dis- Valuators (CICBV) counts and premiums are considered and. the industry. The SMA explains what to expect in a valu- greatly matured over the years. The Accountants (AICPA) next step in the process is to normalize the American Society of Appraisers (ASA) financial data to make any adjustments to what The Institute of Business Appraisers (IBA) a new owner might experience. At professional standards. uidating value is determined and the asset tions that may be present. and the company. Valuations of closely held businesses are con- ducted for a multitude of purposes. Valuation stan. The first step is to describe the various sons that do not include an arm’s length trans- types of premises and standards (types) of value action. Then there is an analysis of will most likely have been prepared using some the economy. but may also include many rea- formed. The third valuations. the value may hinge that may be appropriate in different circum. The second step describes the initial analy. public offerings. of value used. The valuation report you will review dard of value to use. REASONS FOR THE enable the reader to per form valuation VA L U AT I O N A N D P R E M I S E calculations. stances depending on the reason for the valua. dards have been developed by various profes- sional organizations and there are a multitude of The valuation process starts with an understand- individuals performing valuations for closely held ing of the purpose for the valuation and the stan- businesses. actions—and equitable distribution actions. litigation—including stockholder step is a consideration of what common valua. Typically the premise used is that uation process is discussed next. and non-operating activities are made. on the persuasiveness of the valuation report. Appropriate dis- The National Association of Certified Valuation count and capitalization rates are developed and Analysts (NACVA) the various methodologies selected are applied The Canadian Institute of Chartered Business and a conclusion is reached. ation report. BUSINESS PERFORMANCE MANAGEMENT I. acquisitions. Accounting (SMA) is to familiarize the reader with the methodologies in a valuation report and to II. The valuations that do not result in an arm’s tion. length transaction include estate and gift tax val- sis that should be undertaken before any valua. and consequently. adjustments for excess assets. Fine tuning the val. If not. The following organiza. that point the various valuation methodologies tions provide professional standards: are considered to determine the most appropri- The American Institute of Certified Public ate approaches given the circumstances. The reasons This SMA provides a detailed description of how include actual mergers. uations. INTRODUCTION of results from the different methods is consid- The valuation of closely held businesses has ered. This includes the company is a going concern.

BUSINESS PERFORMANCE MANAGEMENT I I I . investor considers to be the true value based on Federal Reserve Bulletins. Also. the price. litigation and is defined in state laws. and the impact of economic conditions on the ple. when neither is under compulsion to buy or income stream and a rate of return. To determine the risk. at arm’s length in an open and unrestricted mar. This may result in Fair market value is the standard of value that the individual investor being willing to offer more typically comes to mind in business valuations. al and for the region in particular will have an For example. and U. Typically this Analysis. websites. the Fair value is the standard that is used in some impact of economic conditions of the industry. These include Business Valuation 2 . Yet in some states. and therefore have significant value. There are also commercial organiza- tions that provide information. the Economic Report of the President. For exam. acting defined as the present value of future benefits.S. which is provided at the end to that investor. in some states there is no lack of mar. sometimes for a fee. sensitivity to economic conditions. VA L U AT I O N A N A LY S I S between a hypothetical willing and able buyer The theoretical description of value can be and a hypothetical willing and able seller. fair the needs and situation of an individual investor. investor takes when purchasing the business. intrinsic value. ketability discount for minority shareholders in an oppressed minority shareholder action. They are: fair market value. through government sources such as the Census Bureau’s data on its website— Intrinsic Value Factfinder and Statistical Abstract of the United Intrinsic value is the value that an individual States. S TA N D A R D S O F VA L U E Investment Value There are four standards of value that relate to Investment value is the value that is based upon valuations. Bureau of Economic an evaluation of the available facts. the value may be the value in the hands of the sur. for an equitable distribution divorce action. This value may come into play in a merger or acquisition where the synergistic value to a par- Fair Market Value ticular investor is determined. impact on the valuation to varying degrees. The state of the economy can be researched geon. expressed in terms of cash equiva- lents. the valuator must know the Fair Value impact of economic conditions in general. value. specific company. The rate sell and when both have reasonable knowledge used in valuations is based upon the risk the of the relevant facts. at which property would change hands I V. than what all others would consider the fair mar- The profession has adopted a standard glossary ket value for a target company and is important of valuation terms. a single practitioner’s surgery prac. Department of Commerce is not used in an independent valuation. and investment value. To get a present value one must determine an ket. tice may not have any fair market value without depending on the nature of the business and its a covenant not to compete. But it is not the fair market value of the SMA. The definition of fair market value is of the target company. General Economic Factors in many cases the state describes the value in The economic outlook for the economy in gener- the hands of the owner just prior to the action.

nomic conditions are the most important. There are several factors to con. threat of substitution. that is not concentrated. patents. lates some industry concentration data. Threat of new entrants The size of the business. large number of small companies tends to icals that address economic issues. Inability to convert equipment to Moody’s. Rivalry Bargaining power of customers Rivalry consists of an analysis of the competition The bargaining power of the customers to drive in the industry. brand loy- more recognized structured approach. licens- any business valuation. bargaining power they are able to lower prices. approach that is well recognized is Michael Porter’s Five Forces. BUSINESS PERFORMANCE MANAGEMENT Resources. It tabulates the con. This assessment can be es. Slow market growth also tends to Bargaining power of suppliers 1 Michael Porter. the demand higher quality. the geographic range Threat of new entrants is also a factor to consid- of its customers. prices within the industry. and 50 firms. and period.1 This model describes an Threat of substitution industry as being influenced by five forces: rival. When there are barriers to entry the rivalry is and the source of its products all play a part. The concentration of firms within an sider. and the National Association of alternative uses may keep companies in the Certified Valuation Analysts. 1998). 8. 20. and bargaining alternatives provide a competitive ceiling for power of suppliers. Mercer Capital Management. demand more services. of customer market share or concentration of When there are a number of firms in an industry portion of output. special- done using one’s own approach or through a ized assets with little alternative uses. The Census Bureau tabu. and this company being valued. impact on the industry. the competition tends and the economic health of the customers. Competitive Strategy: Techniques for The suppliers of the company may also have an Analyzing Industries and Competitors (Free Press. When there are high The valuator must decide what economic facts fixed costs there is more of an inclination to have an impact on the risk associated with the spread these costs over more units. tends to increase rivalry. and access to distribution channels. products is also a risk to consider. threat of new entrants. to be more intense. most recent being 2002. Attributes to con- Industry Economic Factors sider include start-up costs and the amount of An assessment of the industry is important in capital needed for the business. newsletters. In some cases local eco. Prices for the bargaining power of customers. If the industry’s customers have a strong industry is important. Attributes to consider include the concentration centration in the top 4. The ability of customers to switch to alternative ry. increase rivalry. In addition there are industry and increase competition. the nature of its competitors. standardization of product. while in others the national picture is very important. less than when higher profits attract more com- petitors and profit margins drop. or get more services. One such alty. er. sider in weighing the intensity of the rivalry in an or demand higher quality is another factor to con- industry. Some of the attributes to 3 . increase rivalr y as does low differentiation between rivals’ products. territorial rights or other restrictions. down the selling price. Typically a numerous newspapers.

then a tax paid on the earnings. owner is the manager of the business there is an including forecasts and ratios. Five years is suggested in Revenue plies. and industry statistics. This may SWOT analysis include compensation. Typically at least five years of historical results are used. the owners will probably The historical financial information should go back far enough to capture the business cycle in the industry. The attributes Related party transactions that are considered are information obtained from In most closely held businesses where the financial statements and financial analysis. limited use. rarely are earnings retained in the company. This is often accomplished by transactions its to assess quality of management. Normalization Company Analysis Historical information is only useful if it is looked Regardless of whether a specific Por ter’s at in light of future operations. benefits. and loan terms. and non-operating the industry. pany is not doing well. The analysis is a method to evaluate the objectives of compensation of owners and related parties in a the company.B. Opportunities. the valuator can now apply those fac. A SWOT charitable contributions. travel and entertainment. 4 . payroll taxes. Other than the need for earn- assists in determining the risks in investing in the ings to be reinvested for the business’s capital company. 2 industry. and suppliers’ ability to integrate into the Ruling 59-60. historical centration of purchasers. Conversely. If there have been significant 2 Rev. If the com- with prior years. and Historical financial analysis then a dividend issued to the owner. quality of that are with related parties being at a monetary product. in addition to sation may be minimized in an effort to reduce being a tool to compare the company with com. which is provided in Exhibit 1. items. requirements. the industry normalization must be executed to accomplish risk needs to be understood. intercom- A SWOT analysis may be applied to focus on key pany transactions. the compen- determining trends of the business. areas of the company operations. and customer satisfaction. 59-60. Rul. cost to switch suppliers. 1959-1 C. con. non-recurring items. Historical financial information can be useful in if the company is an S corporation. changes in the company operations. rent. amount that does not represent what would be paid in non-related party transactions. After gaining an this. Thus it a non-related party. attempt to minimize the tax at the corporate quantitative information obtained through site vis. information prior to the change will probably have industry’s ability to integrate and produce sup. closely held business may be significantly differ- Weaknesses. BUSINESS PERFORMANCE MANAGEMENT consider include: concentration of suppliers. the payroll or a relative in college paid a lucrative cedures are often employed to compare results summer position to assist the family. along with non. Analytical review pro. and Threats the ent from what would be paid for similar work by company faces in meeting its objectives. tors to the target company along with specific risk factors inherent to the company. 237. Normalization considers related party trans- understanding of the economic conditions facing actions. A process called five-factor analysis is undertaken. forecasts. An elderly parent may be kept on petitor information available. level. It describes the Strengths.

S. U. If an appraisal is not the closely held business that has non-operating available. there Resource Institute. There is a famous tax case where related entity that rents the property to the busi. It is not unusual for a closely held company to be involved in different enterprises or in non-operating In many closely held corporations the real estate activities. Perhaps more common is market rents should be. This includes extraordi- owners in a manner that is unlikely to survive a nary items as defined in GAAP. This provides an opportunity to charge musical performances and raised Rock Cornish rent that is not at market rates and needs to be game hens. Frequently these tion data by location. then the consequences of the event may structure a retirement plan that favors the should be eliminated. it probably is a benefit that No business is worth anything because of what should be eliminated in the normalization it has done in the past. Trade associa. years of experi. Government Bureau of Labor Statistics site. may be a need to normalize. In occurred in the past that are not expected to some cases an owner of a closely held company recur. Therefore. SIC code. there is an expectation that it is a predictor of future results.S. Non-operating activities tions may also publish benefit data. They may also need to be eliminated if they are non-operating in nature or a form of invest- Benefits can also be skewed for the business ment that should be restructured into equity. owners and their related parties. Frequently the owner is pro- include industr y trade associations. The past is only useful if process. or related to the owner. Data on benefit the future. ed. or sales volume for most occupations. Travel and entertainment expenses are a common Sources for determining fair compensation area of normalization. An appraisal report will provide what mented to be valued. assets such as a beach house that is sometimes 5 . Victor Borge had a corporation that booked his ness. vided benefits in this area that would not be given Government Bureau of Labor Statistics annual to a non-owner employee in similar circumstances. such as the Economic If there are loans to or from related parties. but may also transition of ownership. which provides compensa. The business would have to be seg- adjusted. the value of the property may be inter. it is always important to ization rates. If this is the case. A real estate professional can pro- determine what a person would be paid for the vide the going rate of return for commercial prop- work performed if the person were not an owner erty in the area. BUSINESS PERFORMANCE MANAGEMENT pay themselves less than what would be paid to polated from property tax appraisals and equal- a third party. costs can be found on the U. and Internet sites that provide information. If a benefit only applies to a related party and not to others in Unusual transactions similar positions. the include other events that technically do not qual- benefit should be restructured to reflect a typical ify for extraordinary but are still not predictive of plan or possibly eliminated. loans are not at market rate and should be adjust- ence. The business may have to be segment- property occupied by the business is not owned ed into two different businesses and then the val- by the operating corporation but by a separate ues combined. If there are transactions that have Another consideration is retirement benefits. occupational handbook.

An example might be the understatement of inventory. that come under this category. along with other that comparisons can be made to other firms or professional standards.000 of annual earnings has the benefit of being able Re = Rf +ERP + Rs + Rc 6 . the future benefits.000 to shareholders. Sometimes GAAP. isons to publicly traded company betas are not deemed to be applicable or it is felt they should Table 1 illustrates the benefits of an S corpora. be supplemented. these methods calculate the present value of ates. Earnings-Based Methods The most common method of valuing a going Taxing the income stream closely held operating business is one based on When a normalized pre-tax operating income is earnings capitalization. Accounting applications The accounting methodology may also have to V. BUSINESS PERFORMANCE MANAGEMENT rented. The magnitude of the The buildup method is frequently used in small benefit depends upon the ability to distribute the and medium-size businesses where compar- earnings to the owners. C corporation would only be able to distribute These assets need to be separated and valued $103. and excess earnings. VA L U AT I O N M E T H O D S be adjusted. All of it can pass through the entire income it gener. Sometimes based method. There are a few methods determined. pricing model. and an asset- opment expenses is an example. This may be accomplished in total taxes between the corporate tax and the using the buildup method or the capital asset dividend tax in a C corporation and the share. assumed rate of 20% has a total value of $131.000. holders tax in an S corporation. while a not essential to the operation of the business. these methods ond layer of taxes on dividends. The magnitude require the determination of a discount rate and of the advantage is measured by the difference a capitalization rate. the next step is to consider taxes. earnings capitalization. states that the valuator industry averages. cash entities. If the company is of such a nature that flow capitalization. a market-based method. a personal aircraft. The full expensing of research and devel. a div- idend tax rate of 15%.500. tion assuming a corporate tax rate of 39%. They include dis- Here there is an issue regarding pass-through counted cash flow. This comparative benefit was reduced in 2003 when the dividend Determining discount rates using the and capital gain rate was reduced to 15% from buildup method ordinary income tax rates. departures from GAAP may have to be adjusted. in its effort should consider the three most common valua- to be conservative. a personal tax rate of The equation for this method can be written as 35%. or some other asset to distribute $130. 1. does not capture economic tion approaches: an earnings capitalization reality. there is an advantage in avoiding the sec. and a capitalization rate (CR) of 20%. This benefit capitalized at an apart from operations. One reason may be to use account- ing methods more common in the industry so AICPA Valuation Standard No. method. Therefore. The follows: table illustrates that a company with $200.

00 where The second component in the buildup method is the equity risk premium.00 –– –– Remainder $122.00 S corporation benefit $131. Bonds. currently published by ERP = Equity risk premium Morningstar. Therefore.00 Cash flow to shareholder $103.00 70. Roger Grabowski has chal- Rs = Size premium lenged this rate as being too high. S CORPORATION BENEFIT C Corporation S Corporation Earnings before $200.500.500.300. lenge the use of the equity risk premium at all.000. the 20-year Treasury rate at the date of the valuation is usually used There are some academic manuscripts that chal- as the risk-free rate. Some valuators continue The first component is the risk-free rate. The determination of Re = Expected rate of return of the company this factor has been a matter of controversy late- ly. His estimates are available through the Duff & Phelps. which is also avail- able from Morningstar.00 Shareholder tax (15%/35%) 18.000.00 taxes Corporate tax (39%) 78.00 $200. The to use SBBI.00 $200. LLC Rc = Specific company risk Risk Premium Report (D&P). BUSINESS PERFORMANCE MANAGEMENT TABLE 1.000.00 $130.00 Capitalized value (NCF/CR) $518.00 $200. the equity risk premium estimat- Rf = Risk-free rate of return ed annually in the book Stocks. while others are using D&P.000.00 Distribution to shareholders $122.000.700.000. going concern.000. Historically. 7 . The assumption for the valuation is that there is a rate differential is usually less than two points.000. Bills and Inflation (SBBI).000.000. has been used to appropriate the equity risk premium.00 $650.

It is unusual for an owner to own 30 different closely held Determining the discount rate companies. while others will assign plusses and size premium can also be found in SBBI. called non-systematic from the discount rate. numbers for investments and the risk will be diversified away. each specific risk. BUSINESS PERFORMANCE MANAGEMENT claiming the historic rates are not evident in the ● Political risk marketplace. ence. Table 2 provides an risk. At this point in the buildup method a discount rate can be determined. so it is heavily dependent pany volatility compared to the overall market on the valuation analyst’s judgment and experi. typically no opportunity to diversify. The evant item. usu- ● Distribution system ally represented by a market-wide index. This claim has not been accepted ● Global risk by valuators. The CAPM method measures the com- the unsystematic risk. place (beta). Ibbottson risk data. Typically the premium for the ninth and tenth deciles firms is used. there is of 3%. ● Location such as S&P 500 ● Technological risk ● Socio-cultural risk 8 . using CAPM Another way of determining the discount rate is There is currently no empirical data that can be by using the Capital Asset Pricing Model used to estimate the company specific risk or (CAPM). To obtain a capitaliza- In publicly traded firms there is no recognition of tion rate the estimated growth rate is subtracted specific company risk. The types of items usually considered include: The equation for CAPM is as follows: ● Management depth ● Management expertise Re = Rf +B (Rm-Rf) ● Access to capital ● Leverage where ● The five Porter threats ● Product diversification Re = Expected rate of return of the company ● Geographic distribution ● Demographics Rf = Risk-free rate of return ● Availability of labor ● Employee stability B = The company beta ● Economic factors ● Fixed asset age and condition Rm = Return for the market as a whole. minuses and just give a total number. The marketplace does not factor this risk in example of the buildup method using 20-year since a prudent investor will diversify his/her Treasuries. ● Size The size premium recognizes the higher risk in Some valuators will assign numbers to each rel- investing in smaller cap public companies. and an assumed growth rate But in closely held company investment.

of the Gordon model used to determine a stock es the owner may be very conservative and use value. It is then necessary to companies. 220. 9 . Using the rate in a weighted average cost of capital calculation Earnings capitalization In many cases the degree of leverage in a close. In some constant growth rate is estimated. with Alina Niculita. Typically an industry beta is used. BUSINESS PERFORMANCE MANAGEMENT Closely held companies do not have a public Wd = Percent of the capital structure that market and therefore do not have beta informa. When a perpetual income stream is used and a ly held company is not at optimal level. p. t = Tax rate The first step is to determine the net cash flow (free cash flow) for future years. often backed obtain a capitalization rate. If either is the case. Theoretically. 2007).3 reduce this value by interest bearing debt to determine the value of equity. Typically. York: McGraw Hill. is debt tion. while in other business. the growth businesses the owner may be very aggressive rate can be subtracted from the discount rate to and use a high degree of leverage. the discount rate would is common stock be used since growth is already factored in to each year’s forecast. Valuing a Business The Analysis and Appraisal of Closely Held Companies (New years is used. little or no debt financing. five 3 Shannon Pratt. a E weighted average cost of capital (WACC) should V= k . The formula for WACC is as follows: E= Next year’s earnings WACC = keWe + kd [1-t] Wd k = Required rate of return for equity investor where g = Growth rate (in perpetuity) ke = Cost of common equity (equity dis- count rate) Discounted cash flow If forecasts are used and specific values are We = Percent of the capital structure that determined each year. A group of publicly traded companies are identified and If WACC is used.g be considered in determining the value of the company. where This method estimates an appropriate percent- age of the capital structure coming from debt and V = Value of the company from equity. the kd = Pretax cost of debt (debt interest rate) Discounted Cash Flow (DCF) method is the most appropriate. interest expense is eliminated then their beta is calculated. the method should not be used. If the company is and the value determined is the market value of not large enough to have similar publicly traded invested capital (MVIC). This is an adaptation by personal guarantees.

0 Net capitalization rate 15.0 Total public small company 15. BUSINESS PERFORMANCE MANAGEMENT TABLE 2. bond 7. BUILDUP DETERMINATION OF EARNINGS CAPITALIZATION RATE Riskless rate: Long term government rates 4.2 Small company premium: Difference large and small company stock 4.4 Less: growth -3.5 Threats of new entrants 0.5 Net discount rate 18.7 Equity capital premium: Difference large company stock & govt.4 10 .5 Total specific risks 2.9 Specific risk factors: Lack of management depth 1.5 Threrat of negative legislation 0.

11 . . Similarly The formula for DCF is: in a less precise manner a best.6 percent is used assessments and rates. . There by tangible assets and one for earnings from are two ways of determining the terminal value. may be used. it requires = Net cash flow (Free Cash Flow) a sound set of forecasts. BUSINESS PERFORMANCE MANAGEMENT Net income some measure related to that. where In many small closely held businesses the pro- DCF= Value using discounted cash flow jections are not available and the method cannot be used. similar to the capitalization of earnings. Although this is ____________________________ the most theoretically sound method. This method capitalizes the company’s e = The capitalization rate earnings based on two rates. such as a P/E + Depreciation/Amortization multiple.Change in Working Capital overall capital. The probability for each outcome discounted back to the current period. number is not possible and a range of numbers ed. This is the method favored by most business valuators. Sensitivity analysis DCF = f c f 1 + f c f 2 +. The method is often described Table 3 provides an example of the discounted as a hybrid method because it takes into account cash flow method. is assessed and a probability distribution is used to determine the forecasted DCF. Five years of projected the company’s asset values.+ f c f n should be considered to determine the impact of (1 + r) (1 + r) (1 + r) changes in the assumptions on the estimated value. worse. A method used by investment bankers and used as a check by some valuators is the use of a market multiple. It takes the capital- income is used and then a terminal value is cal. one for earnings backed with a capitalization rate of 12. and most likely case scenario can be used with a 1 2 n weighted average result.6 percent. fcf = The free cash flow in a given year Excess earnings r = The discount rate Another earnings-based method is excess earn- ings. If the method is using +/. goodwill as illustrated in the following equation. one being a rate of return on tangible assets and the other based on n = The final terminal calculation a higher rate for earnings beyond the return on assets (goodwill). then a measure such as EBIT or – Capital Expenditure EBITDA related might be used. However. the value of mined. in some circumstances a single the future cash flows (terminal value) is calculat. and may be used. A discount rate of 16. If the discounting is a return on equity. The effects of uncer- tainty are a component of the risk factor deter- At the end of the forecast period. ization rate and separates it into different risk culated. The most common method is the capitalization of the ongoing cash flow.

016 $ 1.000 232. BUSINESS PERFORMANCE MANAGEMENT TABLE 3.000) (60.000) (200.000 232.055.000) (180.000) (220.941. DISCOUNTED CASH FLOW 2009 2010 2011 2012 2013 Terminal Projected net income $ 998.016 Depreciation 232.824.000 Capital needs (175.000 232.449 $ 770.909 marketability at 20% Estimated value $ 7.000) (100.60% Terminal value 11.205 $ 873.409.909 values) Less lack of 1.125 $ 1.386.947 Terminal value Capitalization rate 12.500.100.000 232.037 $ 705.327 $ 1.318.205.000) Projected cash flow $ 1.000 232.000) Working capital needs – – – (100.016 Present Value $ 977.124.257.200 $ 1.016 $ 1.110 $ 1.752 $ 856.497.000 12 .110 $ 1.125 $ 1.327 $ 1.449.497.519 Value (sum of present $ 9.000) (220.123 Present value $ 4.200 $ 1.300.048.000) (180.

and.255.431.058.4% was used. The earnings where with respect to assets of $14.607 of excess earnings to be capitalized at 27. Cg the sale may have been for a minority interest when one is trying to determine a value for the where whole company or a controlling interest. This can then be broken down into three categories: sales E g = The earnings in excess of those attributa. The sale may not have been at fair market value due to a forced sale. the value is calculat. BUSINESS PERFORMANCE MANAGEMENT Ea Eg An example of excess earnings is provided in V= + Table 4. sales of similar close- ble to a return on assets ly held companies. within the same company.595. Cg = The appropriate rate of capitalization for earnings attributable to goodwill Sale of stock in the same company The sale of stock in the same company sounds In its most common form. like a good approach.6% and a capitalization rate for goodwill of 27. Ra = The appropriate rate of capitalization for Sale of similar companies earnings attributable to net tangible Data regarding sales of similar closely held com- assets panies may be available. When available and Cg = The appropriate rate of capitalization of adequate data is provided. Ra = The appropriate rate of capitalization for Market-Based Methods earnings attributable to net tangible Another common approach to valuations can be assets classified as market-based methods. A sale that took place in a prior period may have been made A = The net tangible assets of the firm when economic conditions were different. however. Finally. The opposite might be true and one might be trying V = The value of the small business to value a minority interest when the sale was of a controlling interest. With actual earnings of V= The value of the business $4. or similar V = E – AR a + A reason that may distort the price. publicly traded guideline companies.189.829 this left $3. if the company is of suf- ficient size.602 was $1. There are also databas- es that can be obtained.176.456 and a total assets value of $26.593. this may not be ed as follows: the case. the proximity in E = The adjusted earnings of the firm time needs to be considered. In addition. In this example a return on assets was Ra Cg determined to be 8.222. the information can goodwill be helpful in determining the value of a compa- 13 . perhaps restricted by an internal agreement.4% to yield a Ea = The earnings attributable to a return on goodwill number of $11.

300 sales of closely held businesses in more than 14 . BUSINESS PERFORMANCE MANAGEMENT TABLE 4.donedeals. One type of business Guideline companies that has a better chance at comparability is fran.60% Expected Return $ 1.255. DoneDeals of operations in the past and the same risk fac- (www. Access to the database is free aspects of the transaction are disclosed.607 Capitalization rate 27. can be looked at in addition to companies in relat- ly 79% of the selling companies being privately ed industries that are subject to the same risks. and approximate. a from under $1 million to $16. similar company in a different market may face different economic factors. such as a fast food establish.595.org) is the the assembly of recreational vehicles may have largest database of guideline transactions for valuing mid-sized and smaller businesses. Pratt’s Stats® (www.829 Excess Earnings $ 3. The criterion in selecting companies ilar attributes. Although a match with compa- source of unique mid-market transaction data. In addition.176. Companies in the same industry lion and half over $15 million.456 Total value $ 26.602 Return on Assets 8.189.40% Goodwill $ 11. being valued. Finally there may be publicly traded companies chise operations. not necessary. there may be a consulting agreement data.222 Actual Earnings 4. the actual similarity of the from 1990 to the present. it is with approximately half of deals under $15 mil. that have similar risk factors as the company ment.bvmarket- example. The database includes information on over 30. The Institute of Business Appraisers Thus a company that manufactures parts used in (IBA) “Market Database” (www.593. For example.6 billion.431. owned. Professional practices also may have sim. EXCESS EARNINGS Net Assets $ 14.com) contains details on approximately at favorable terms that is not shown as part of 11. There are various databases for is to try to find companies with the same pattern private company comparables. ranging in deal price company can be problematic. It is very difficult to determine whether all 725 SIC Codes.058 ny.go-iba. nies that are close to identical is desirable.com) is a comprehensive tors in the future. For to IBA members.500 private and closely held business sales the sale.

and depreciation (EBITDA) ● Sales There are a variety of sources to find guideline ● Cash flow excluding debt companies. then a decision Thus. including equity investment appropriate when determining the value of a and debt investment. ● Net income after tax tors used are: ● Sales ● Earnings before interest and taxes (EBIT) ● Cash flow ● Earnings before interest. It is also value of the firm. Commercial sites such as Yahoo Finance can supplement the data. Some indica. the variable with the lowest coefficient of has to be made as to what the indicators of variation has the least dispersion. Because of the nature of minority interest where the interest would not be closely held companies. Factors to leverage used between the guideline companies consider when using MVE are: and the company being valued. the ance sheet numbers. If guideline companies are used. ● Net equity book value tion.S.000 U. Some valu. The income data ● Net income before tax used is before interest expense. BUSINESS PERFORMANCE MANAGEMENT more similar risks to the actual manufacturing of the vehicles than a company that manufactures Cv= d m parts for the assembly of automobiles. there may be dissimilar able to change the company leverage. Similar to the decision on company interest bearing debt must be subtract- whether to use WACC or not. then it may be appropriate MVIC is defined as the entire invested capital to determine the market value of equity. AMEX. such as Mergent Online. a decision has to ed to determine the value of the equity ownership be made as whether to use Market Value of interest. The SEC 10-k filings are accessible ● Book value of invested capital through the SEC website. value are. When a value is determined under MVIC. These indicators are typically various earnings figures and perhaps a couple of bal. amortiza. some of the where factors to consider include: ● Nature of the company Cv= Coefficient of variance ● Similarity of operations ● Geographic similarity d = standard deviation ● Demographic similarity ● Percentage of ownership transferred m = mean If guideline companies are used. and inactive) listed on the NYSE. and 15 . public companies (active the relationship. Invested Capital (MVIC) or Market Value of Equity (MVE). There are also a number of subscription sites lated with each other will be chosen. taxes. In these cases MVIC is the better measure. Typically the factors that are most closely corre. a fully searchable data- ators will use the coefficient of variance to judge base of 15. When the debt equity structure is similar to the guideline companies.

and If the company is a going concern.23 . Since publicly traded assets.63 NASDAQ exchanges.35 D . Because GAAP provides a mix- Based upon the above. in which case non-operating assets and liabilities need to be separated.26 . The multiples and coefficients of ating value of the assets is used. Since asset approaches do not measure stocks are minority shares. The issue of built-in gains 16 . BUSINESS PERFORMANCE MANAGEMENT TABLE 5.94 C 1.68 B .49 . no goodwill. if a controlling inter. The data results in the that the company will stay in business but has following calculations in Table 5.39 2.12 1. and 15% on net assets. or market approaches. EBITDA.24 11.55 Coefficient variation . In these cases the asset approach may act as a floor or the lowest the For example: value can be.91 Median . size.29 6. goodwill.90 9. lation of value is provided in Table 6. When the guideline company method is used it is Asset-Based Methods still appropriate to adjust for normalization. Four guideline companies are identified. A manufacturing company is being valued. the valuator decides to ture of fair values and historical costs. most of the time operating companies est is being valued a control premium should be are valued based on the earnings capitalization considered. The third category of valuation is based on the and unsystematic risk.79 10.32 2. MVIC is Operating asset value used. GUIDELINE DATA Guideline Company MVIC/Sales MVIC/EBITDA MVIC/Net assets A .84 10.43 Standard deviation .72 1. and Compustat provides increased risk of the company being valued and data on companies that can be sorted by SIC a 15% control premium is also used. This presumes variance are calculated. 25% on ments are needed to bring the values to fair sales. then the oper- net assets. adjust- base the determination 60% on EBITDA. The book value of the company is the starting point. The calcu- code. This method may also provide information discount is decided upon based on the needed for an excess earnings calculation. The factors utilized are sales. In addition a 20% value.02 2.04 4.

value and may need to be adjusted.000 Risk Discount 20% (504.300. there may need to be have been more receptive for C corporations.016.000) (875. held- and partnerships complicate the issue.000 135. with the IRS value number. when valuing minority shares. if elected.000 Weight 60% 25% 15% Value $ 2. property.376.000 Control Premium 302.000 $ 729.000 Value $4.000 $ 4.02 2. consideration of the built-in tax. the built-in gain is the Current assets are the easiest to adjust to fair tax that would have to be paid if the asset was value and in most cases GAAP provides a fair sold. this method is usually not used amount is not significant an adjusted deprecia- 17 . typically not at fair value and will need an Since they cannot cause the company to sell appraisal if the amounts are significant. If the their assets. That is. GUIDELINE DATA Factor MVIC/Sales MVIC/EBITDA MVIC/Net assets Total Multiple 0. adjustments for allowance for uncollectible Pass-through entities such as S corporations accounts among other items. Typically to-maturity securities may not be reflected at fair the built-in gain is recognized in an S corpora.000 15% MVIC $ 2.037.000) (225. method of inventory usually provides the best up basis. The value of plant.000 $ 450.000) Estimated value $ 3. they usually do not get a indicator of fair value for inventory.520.000) (146.43 Company $5.000 $ 4.000 $ 3.509. BUSINESS PERFORMANCE MANAGEMENT TABLE 6. Under GAAP.000 $ 583. But since partnerships can get a stepped.127.318.000. there is a potential for a tax that will There are various adjustments to consider.000 $ 1. This is a controversial issue.200.000 $ 4.000 524.84 10. For a C corporation.000 $ 670.025.501. be needed or a lack of a tax deduction for the asset. The FIFO tion.860.000 $ 2.000 87. If another comprehensive basis of reluctant to reduce the value while the tax courts accounting is in use.000.000 needs to be considered when using this method.000 $ 1.000 $ 4. and equipment is Minority interests are another consideration.000 Less company debt (725.000 $ 902. when the fair value is in excess of the book value.000) Net $ 2.

and trapped-in capital gain Zipp. 18 . 92-64. the Securities and Exchange Other assets may also need a separate apprais. “An Economist-Financial Analyst’s A series of studies known as the Emory studies Approach to Valuing Stock of a Closely-Held Company. Institutional and the other initial public offerings (IPO). 2007). June 1972. Government Printing Office Document No. Marketability and control are the most fre. 425. pp.2%. 353-354.” was conducted from 1980 through 2000.” Taxes. median discount of 33%. used. 381-385. It com. a key executive. Maher. but 33 transactions that took place primarily in may be appropriate if there is doubt regarding the 1983. p. similar results in the same time period.7 probability of the company staying in business. Commission published a study it made on al. 2444-2456. Trout. BUSINESS PERFORMANCE MANAGEMENT tion using reasonable useful lives and a non. DISCOUNTS AND PREMIUMS securities from 1969 to 1973. June IPO transactions over a period of many years and 1977. the IPO). and published by the American Institute taxes. But loans from related parties found a mean discount of 25.8%. 8 Michael J.4 accelerated depreciation method may result in an acceptable estimate of fair value. The median discount was 31.” Taxes. pp. the author states: “As a general rule of thumb. pp. IPO studies 6 Milton Gelman. depending on their nature. Discounts Involved in Purchase of Common Stock (1966 – 1969). JD. 7 Shannon Pratt. Valuing a Business: pared prices of stock transactions prior to an ini. Michael Maher conducted a study of restricted VI. mined a mean discount of 33%. One is based on restricted stock studies 5 Security and Exchange Commission. 562-571. Two methods using empirical data have been 4 http://www. Sept. He stud- ums are usually a factor in closely held compa. with Alina Niculita. Part 5. has published the results on their website. 9 Robert R. There is also a control premium. He determined a Regardless of what method was used to deter. Investor Study Report of the Security and Exchange Commission. Liabilities are usu. “Estimation of the Discount Associated Willamette Management Associates has studied with the Transfer of Restricted Securities. of Certified Public Accountants. Restricted stock studies In 1971. The median discount was 47%.9 quent issues encountered. discounts and premi.8 Robert Trout found mine an indicator of value. courts have Lack of Marketability Discount generally approved discounts for lack of There is no universally accepted method for determining the lack of marketability discount. It ally at fair value.willamette.com/. restricted stock values from 1966 to 1969. 1976.6 The mean Liquidating value and median in the above study was 33%.5 Four closed- may need to be adjusted to reflect their fair value end investment companies that had significant using market interest rates. Journal of Taxation. The Analysis and Appraisal of Closely Held Companies tial public offering (IPO) with the prices at which (New York: John Wiley. This Willamette Management Associates has studied method is not appropriate for a going concern. “Discounts for Lack of Marketability for the stock was initially offered to the public (at Closely Held Business Interests. pp. Another asset method is liquidating value. ied transactions from 1968 to1972 and deter- nies. Other factors that may be considered are discounts for the loss of In Business Valuation Methods written by Alan S. investment in restricted security investments were examined by Milton Gelman.

closely held corporation. Zipp. the sale is not possible the Congressional “Institutional Investor for a controlling interest in a closely held compa- Study Report of the Security Exchange ny. No. Part 5. 2444.. The median dis. These studies included three days. pp. there is also a marketabili- restricted stocks were considered identi. Obviously.”11 The Matrimonial Law Monthly. 1st Sess. with licly traded counterpart should average the mean in the vicinity of 35%.8% to 45%. The minority shareholder discount is count between 1980 and 1981 was 66% designed to reflect the decreased value and during 1985 and 1986 it was 43%. “There is consid. The results of ketability discounts for controlling interest. 6. which compared companies 3. and receive cash in of marketability. is designed to reflect the fact that that the marketability discount for a there is no ready market for shares in a closely held stock compared with a pub. The are: result of these studies reported the aver- age discount for lack of marketability 1.”12 in private stock transactions to those of subsequent public offerings of stock in The courts have also commented on lack of mar- the same companies. Premiums (New York: John Wiley & Sons. p. In the those studies reflected average discount Estate of Andrews they said: from 1980 to 1981 of 60% and between 1985 and 1986 of 43%. Baird & Co. No. on the other erable evidence. 64.” Zipp also between 35 percent and 50 percent. Publicly traded stock value The article cites two studies by Robert W. 15] several studies were sum. suggesting hand.. Control buyout value ranged from 25.10 2. Net asset value. however. Doc. Business Valuation Discounts and 1993). 168-169. of shares that do not convey control of a closely held corporation. 1971. marketability discount. 19 . 12 Shannon Pratt. Although there 10 Alan S. A truly mar- cal in all respects to freely traded stocks ketable stock is one where you can call your bro- of public companies. 12. Business Valuation Methods (AICPA. lack of marketability. pp. Shannon Pratt states: “The three bases most Commission” [H. often encountered from which a controlling inter- 92nd Cong. The lack of According to the article. est discount for lack of marketability is deducted 2456] and several private studies. except for their lack ker. Controlling interest marized which analyzed the average dis.R. in states: the absence of special circumstances that would tend to reduce the discount for In the June 1992 edition of Fairshare. BUSINESS PERFORMANCE MANAGEMENT marketability in the range of 15% to 50%. sell the stock instantly. 2001). [Vol. ty discount for a controlling interest. 11 Ibid. Although the marketability discount is usually count found between listed securities greater for a minority interest that cannot decide and their restricted counterparts. These to sell the company.

Executor. LEXIS 12. Petitioner v. A study publish by Shannon Pratt reduce marketability. Dougherty. Andrews. of publicly traded stock lacks control.” Real Estate Issues. Commissioner of 15 Shannon Pratt. A study that looked at stock price changes when senior management There are various factors to consider in deter. 59 T.C. 1988-429. tity of this type of discount.C. 17 Estate of Milton Feldmar v.C.S. Although a share the backup within the company. 20 . Commissioner of Internal Revenue.83%. Memo 1997-461.C. The courts have varied considerably on the mined that excludes a lack of control discount. Andrews. Memo memo LEXIS 292.M. changes were announced concluded that small- mining a lack of control discount. The valuator needs to con- control the activities of the company.C. (RIA) 90274. BUSINESS PERFORMANCE MANAGEMENT may be some overlap between these value. T. a fair value is deter.” 14 risk associated with the absence of this individ- ual can be accounted for in the determination of Lack of Control Discount the unsystematic risks or by applying a separate When the valuation is of an interest that cannot key person discount. 14 Estate of Albert L. Dougherty. The costs. T. example.C.65% the standard of value becomes important. the calculations were done on shares that two discounts in that lack of control may lack control.3%t to 25%. Respondent T. Respondent 79 T.16 the fact that flotation costs would have to be incurred if the corporation were to Key Person Discount publicly offer its stock. Patchin “Market Discounts for Undivided Dougherty and Charlotte K. 14-16. 58. there is the possibility In the Estate of Dougherty the court allowed a that the company would be at a serious disadvan- 35% discount on net asset value for a 100% tage if the owner. (CCH) 772..C. if there is an oppressed minority shareholder action. a lack of sider the difficulty in replacing the individual and control discount is appropriate.17 Yet another court 13 Estate of Woodbury G. Allen L. it should be borne used control premium data to determine a lack in mind that even controlling shares in a of control discount resulting in discounts from nonpublic corporation suffer from lack of 24. with Alina Niculita. Valuing a Business Internal Revenue. pp. in New York. 404. Commissioner. 1982 U. Estate of Paul Mitchell v. One court allowed 25% When the guideline method is used to determine while another allowed 10%. deceased. This may be caused by value. whose skills are relied upon. co-executors. 2007). Winter 1988. p. Petitioner v. Minority Interests in Real Estate. interest based on a valuation using net asset were not actively involved. Woodbury H. 1990 Tax Ct. 79 T.15 A study conducted on real marketability because of the absence of estate holding companies calculated a median a ready private placement market and discount of 34. amount of this discount. In some states er public companies had a decline of 8.13 In some smaller closely held companies or those that are highly technical. For while larger companies had a decline of 4.8%. Deceased. 938. T. Memo 1990-274.M. this issue is more serious in a closely held company where There have not been many studies on the quan- there is an interest that has control. No. 16 Peter J. Commissioner. The Analysis and Appraisal of Closely Held Companies Tax Ct. (New York: McGraw Hill. “Discounting this figure by 35 percent for exclusive technical knowledge or by the relation- nonmarketability and operating and liquidation ships between the owner and the customers.

capitalized operating assets. than others. p. 392. with Alina Niculita.7% to 33. Memo also possible and is called a summary report. A weighted average of the methods tors can also diminish the control premium. 2007). The relationship is as a tax basis. The valuator may decide that there is one method that is most persuasive and The amount of the premium can be diminished decide to use the value indicated by that by the need for super majorities that are legislat. Commissioner. This is 16. cal assumptions. used is employed. BUSINESS PERFORMANCE MANAGEMENT concluded that forecasts used already factored Trapped-in Capital Gains in the issue and did not allow a discount. This issue Control Premium also needs to be considered under other valua- There is more empirical information on control tion methods. T. The fact is that a buyer is not will- premiums than on lack of control discounts. The actual capital gain tax would be follows: the appropriate adjustment if there was antici- pated sale of the asset. For litigation and government 21 . where V I I . This will provide an estimate These may include how the board of directors is of the operating value of the company. tion of his conclusions on control premiums of The most common is the detailed report. Valuing a Business The Analysis and Appraisal of Closely Held Companies lations requested by a client and use hypotheti- (New York: McGraw Hill. Several types of valuation reports are available. The alternative is that the valuator ed or contractual if the interest being valued decides that multiple methods will be used and does not have a sufficient percentage to carry a decides on which methods are more persuasive super majority decision. A condensed version of this report is 18 Estate of James J. ( 1 +1 P) determine the present value of the tax benefit lost by not being able to take depreciation. not be depreciated using the fair market value as tionship between the two. VA L U AT I O N C O N C L U S I O N S At this point the various results obtained from M = Minority discount the different valuation methods utilized are sum- marized and the valuator will reconcile the differ- P = Control premium ent results. an alternative method might be to M = 1. method. VA L U AT I O N R E P O R T Shannon Pratt study was actually an interpola. or the state’s laws on ating assets and liabilities and excess or under- oppressed minority shareholders. Riener v. The data provided previously regarding a V I I I .19 full comprehensive report that has sufficient information for the reader to understand what the valuator did and how the conclusions were reached.18 Trapped-in capital gains were discussed under the net asset method of valuations. It 200-298.C. The valu- appointed. is also possible for a valuator to perform calcu- 19 Shannon Pratt. The ing to pay fair market value for assets that can- discount can be derived from the inverse rela. Even if a sale is not con- templated. Other contractual fac. shareholder agreements restricting ator may have to adjust this value for non-oper- the sale or gift of stocks.3%.

if it is a partial party transactions. products and services. This section will have the review. methodologies. marketability items. hypothetical assumptions used. plans of the company. calculated estimates of value under the various mation came from tax returns. has a deficiency in operating assets. whether it was an audit. and leverage ratios. owner leaves with cash or other assets. sidered are usually discussed in the fifth section. ond section. Other adjustments are discussed in the seventh tions. Next. or non-operating assets or lia- analysis are also found in this section. or compilation will be noted. customers and suppliers. technological risks. a summary report. If the infor. Typically multi-year financial statements are pre- Detailed Report sented with comments on sales and profit trends. The normalization will consider related uation and what is being valued. section. Economic analysis Other factors The third section reports on economic condi. profitability Introductory section ratios. analysis and the ownership interest being val- the purpose of the valuation. demographic infor. socio-cultural risks. including site visits and who was interviewed. BUSINESS PERFORMANCE MANAGEMENT proceedings the content of the report may vary. Valuation approaches and methods considered Sources of information Valuation approaches and methods that were con- Sources of information are detailed in the sec. Any applicable discounts or pre- pared the returns should be identified. and the calculation of operating value. threat of new value is reduced by the cost to replace. regulatory risks. then who pre. limitations. If the statements The sixth section discusses which valuation were looked at by a CPA. the degree of control. The detailed report may start with a letter of transmittal followed by an introductory section. It also describes what financial Valuation approaches used information was available. global risks. and any specialists used. methods were used. non-operating interest. An analysis of the overall economic condi. any scope tion of the basis of accounting used. The company based upon AICPA standards follows. and the value 22 . Sometime in a sale the including the background and history of the com. bilities. and a calculation report breakdown of ownership interest. unusual items. the mation. will also be described in quantitative terms. The com. Excess assets are treated as pany will be described in qualitative terms. non-operating assets. the date of the val. and tent. the fourth section will describe the normal- mation to enable the reader to understand the ization adjustments based upon the financial engagement and includes identifying the client. activity ratios. ued. miums will also be applied. If these pany. environmental operating assets and liabilities were not part of risks. need to be replaced for normal operations. excess pany. Non- entrants. along with liquidity ratios. workforce makeup. Normalization The introductory section includes sufficient infor. This may arise because the company tions is included if it has an impact on the com. and adjustments regarding the applica- information. The section may also have strategic A discussion of the comprehensive report con. the standard of value. The industry analysis and the company operating assets.

the Background of the valuator engagement does not include a conclusion of A summary of the background and qualifications value and is restricted to the client’s internal of the valuator should be provided. ● The standard of value being utilized It will also reflect on the persuasiveness of the ● Scope limitations various methods used. use. It will be ● Introduction less comprehensive than a detailed report and ● Who the client is may be restricted to the client. BUSINESS PERFORMANCE MANAGEMENT of the company as a whole will be adjusted to ● What time period include these items. culations for a client. Calculation Report cialists. Since the valuator does not decide what procedures should be executed. the fact that the fee is independent of the conclusions. This is similar to an agreed upon procedure under generally accepted auditing standards. ● Market approach ● Asset approach Assumptions and limiting conditions ● Representations of the valuator The assumptions and limiting conditions will ● Professional standards followed either be in a separate section of the report or ● Assumptions and limiting conditions they may appear in an appendix. ● Conclusion of value tion on use. and the fact that the valuator is not The valuator can agree to just do requested cal- responsible for updates to the report. It will also calculate the ● Specialists final opinion of value. ● Income approach where else in the report. ● Report date ● The intended users Reconciliation of calculations ● The degree of control The report typically will include commentary on ● The marketability of the interest the differences on value between the methods. ● Valuation approaches and methods used bility. ● Any hypothetical conditions sive report: ● Report date ● Introduction ● The intended users ● Who the client is ● Specialists ● The purpose of the valuation ● Summary of calculated value ● What is being valued ● Scope of work 23 . The assump. or this information will be found some. disclose the use of any spe. The report would ● The nature of the calculations include the following portions of a comprehen. ● Restricted use solely for the purpose tions and limiting conditions typically discuss the intended reliability of the source information. any restric. ● Sources of information ● Financial information Representations ● Economic data Either a section will be included that includes the ● Industry data representations and conclusions of the valuator ● Other empirical data and the signature of the person taking responsi. Summary Report The report may include the following: A summary report may also be issued.

the below identified societies and organizations have adopted the definitions for Adjusted Book Value Method—a method within the terms included in this glossary. conclusions. I N T E R N AT I O N A L G L O S S A R Y more particularly. and assump. one or more of these terms needs to It is permissible to give an oral report. analysis. body of knowledge that constitutes the compe- tent and careful determination of value and. from the enclosed definitions. its clientele. Analysts Appraisal Procedure—see Valuation Procedure. in the opinion of the business valuation pro- Oral Report fessional. or secu- manner that is clear and not misleading. ation practitioners by further memorializing the tions and limiting conditions. This rity using one or more methods based on the value of the assets net of liabilities. National Association of Certified Valuation Appraisal Method—see Valuation Method. intan- American Institute of Cer tified Public gible. business ownership interest. ● Any restricted use If. Appraisal Date—see Valuation Date. the asset approach whereby all assets and liabilities (including off-balance sheet. Valuators Appraisal Approach—see Valuation Approach. {NOTE: In Canada on a going concern basis} American Society of Appraisers Adjusted Net Asset Method—see Adjusted Book Value Method. of determining a value indication of a busi- cate the valuation process and conclusion in a ness. which incorporates several systematic risk The performance of business valuation services factors. This glossary has been should go over key areas of research. I X . developed to provide guidance to business valu- valuation methods. ed that the term be defined as used within that stood. Departure from this glos- TERMS sary is not intended to provide a basis for civil To enhance and sustain the quality of business liability and should not be presumed to create valuations for the benefit of the profession and evidence that any duty has been breached. BUSINESS PERFORMANCE MANAGEMENT ● Representations of the valuator duty is advanced through the use of terms ● Professional standards followed whose meanings are clearly established and ● Assumptions and limiting conditions consistently applied throughout the profession. it is recommend- ment because of the risk of being misunder. the communication of how that O F B U S I N E S S VA L U AT I O N value was determined. requires a high degree of skill and imposes upon Asset (Asset-Based) Approach—a general way the valuation professional a duty to communi. Canadian Institute of Chartered Business Appraisal—see Valuation. The presentation should be inclusive and valuation engagement. 24 . but the be used in a manner that materially departs valuator may be reluctant to accept the engage. Arbitrage Pricing Theory—a multivariate model The Institute of Business Appraisers for estimating the cost of equity capital. and contingent) are adjusted to their Accountants fair market values.

Business—see Business Enterprise. given valuation context. or investment entity (or a combina. centage deducted from the pro rata share of Capitalization Rate—any divisor (usually value of 100% of an equity interest in a busi- expressed as a percentage) used to convert ness to reflect the absence of some or all of anticipated economic benefits of a single the powers of control. period are converted to value through divi. Discount for Lack of Control—an amount or per- sion by a capitalization rate. the tendency of a stock’s price to correlate the mix of debt and equity financing. Control—the power to direct the management Business Valuation—the act or process of deter. cial leverage. the market requires in order to attract funds Capitalization of Earnings Method—a method to a particular investment. replace the future service capability of that Capitalization Factor—any multiple or divisor asset. ment. “discretionary” or ing volume. and policies of a business enterprise. industrial. percentage of the total. Capital Structure—the composition of the 25 . it should be supplemented by reasonable period of time given normal trad. invested capital of a business enterprise. ments in which each line is expressed as a service. See Financial Risk. nomic benefits for a representative single See Invested Capital. Cost of Capital—the expected rate of return that fits of a single period into value. or deducted from the current market price of a business enterprise. period into value. within the income approach whereby eco. each line item is shown as a percent- Business Risk—the degree of uncertainty of age of total assets. sheet. Debt-Free—we discourage the use of this term. with changes in a specific index. a qualifier (for example. and on the income state- realizing expected future returns of the busi. “operating”) and a specific definition in the Book Value—see Net Book Value. age of sales. mining the value of a business enterprise or Control Premium—an amount or a percentage ownership interest therein. by which the pro rata value of a controlling Capital Asset Pricing Model (CAPM)—a model interest exceeds the pro rata value of a non- in which the cost of capital for any stock or controlling interest in a business enterprise portfolio of stocks equals a risk-free rate to reflect the power of control. group of assets. each item is expressed as a percent- ness resulting from factors other than finan. It may be used in a publicly traded stock to reflect the decrease general sense to encompass various levels in the per-share value of a block of stock of specifically defined cash flows. BUSINESS PERFORMANCE MANAGEMENT Beta—a measure of systematic risk of a stock. used to convert anticipated economic bene. value indication of an individual asset by Capitalization—a conversion of a single period quantifying the amount of money required to of economic benefits into value. Common Size Statements—financial state- Business Enterprise—a commercial. When the that is of a size that could not be sold in a term is used. plus a risk premium that is proportionate to Cost Approach—a general way of determining a the systematic risk of the stock or portfolio. On the balance tion thereof) pursuing an economic activity. Cash Flow—cash that is generated over a peri- Blockage Discount—an amount or percentage od of time by an asset.

or security absence of marketability. an open and unrestricted market. See Excess Earnings. BUSINESS PERFORMANCE MANAGEMENT Discount for Lack of Marketability—an amount Excess Earnings Method—a specific way of or percentage deducted from the value of an determining a value indication of a business. Discount Rate—a rate of return used to convert Fair Market Value—the price. from a financial point of view. See Net Cash Flow. Fairness Opinion—an opinion as to whether or Economic Life—the period of time over which not the consideration in a transaction is fair property may generate economic benefits. Going Concern—an ongoing operating business Equity Risk Premium—a rate of return added to enterprise. net cash flows. 26 . such as at an auction. at which property Discounted Cash Flow Method—a method with. term. term “highest price. {NOTE: In Canada. Forced Liquidation Value—liquidation value. and increasing or decreas. systems. at able to pay out to equity holders (in the form which the asset or assets are sold as quick- of dividends) after funding operations of the ly as possible. factors such as having a trained work force. Business Risk.”} net income. Free Cash Flow—we discourage the use of this ital investments. business enterprise. when nei- Discounted Future Earnings Method—a method ther is under compulsion to buy or sell and within the income approach whereby the when both have reasonable knowledge of present value of future expected economic the relevant facts. ments of Going Concern Value result from Excess Earnings—that amount of anticipated eco. a risk-free rate to reflect the additional risk Going Concern Value—the value of a business of equity instruments over risk-free instru. and the necessary rate of return on the value of a selected asset licenses. making necessary cap. acting at arms length in calculated using a discount rate. nomic benefits that exceeds an appropriate an operational plant. would change hands between a hypothetical in the income approach whereby the present willing and able buyer and a hypothetical will- value of future expected net cash flows is ing and able seller. Financial Risk—the degree of uncertainty of Enterprise—see Business Enterprise. enterprise that is expected to continue to ments (a component of the cost of equity operate into the future. Effective Date—see Valuation Date. and procedures in place. expressed in a future monetary sum into present value. Equity Net Cash Flows—those cash flows avail. determined as the sum of a) the value of the Discount for Lack of Voting Rights—an amount assets derived by capitalizing excess earn- or percentage deducted from the per-share ings and b) the value of the selected asset value of a minority interest voting share to base. term “price” should be replaced with the Economic Benefits—inflows such as revenues. See deduction of all liabilities. realizing expected future returns of the busi- Equity—the owner’s interest in property after ness resulting from financial leverage. The intangible ele- capital or equity discount rate). base (often net tangible assets) used to gen- erate those anticipated economic benefits. ownership interest to reflect the relative business ownership interest. ing debt financing. etc. terms of cash equivalents. ble assets. Also frequently used to value intangi- reflect the absence of voting rights. the benefits is calculated using a discount rate.

stocks of companies that are engaged in the Investment Risk—the degree of uncertainty as same or similar lines of business and that to the realization of expected returns. business Internal Rate of Return—a discount rate at ownership interest. or intangible which the present value of the future cash asset with limitations in analyses. securities. customer loyalty. it is the Majority Control—the degree of control provided difference between the exercise price and by a majority position. Liquidation other investors reach the same conclusion. strike price of an option and the market Majority Interest—an ownership interest greater value of the underlying security. on the basis of an evaluation or avail. flows available to pay out to equity holders Goodwill Value—the value attributable to (in the form of dividends) and debt investors goodwill. security. (in the form of principal and interest) after Guideline Public Company Method—a method funding operations of the business enter- within the market approach whereby market prise and making necessar y capital multiples are derived from market prices of investments. When the term is business. than 50% of the voting interest in a business Invested Capital—the sum of equity and debt in enterprise. siders. equities. a business enterprise. ic definition in the given valuation context. investor based on individual investment Income (Income-Based) Approach—a general requirements and expectations.”} security. way of determining a value indication of a interest-bearing debt. location. 27 . products. mining the value of a business. goodwill. can be either “orderly” or “forced. to be the “true” or “real” value be realized if the business is terminated and that will become the market value when the assets are sold piecemeal. Levered Beta—the beta reflecting a capital and contracts (as distinguished from physi. or intangible asset using one or Key Person Discount—an amount or percentage more methods that convert anticipated eco. it should be supplemented by a specif- result of name. cal assets) that grant rights and privileges Limited Appraisal—the act or process of deter- and have value for the owner. patents. structure that includes debt. interest to reflect the reduction in value Intangible Assets—non-physical assets such as resulting from the actual or potential loss of franchises. or scope. copyrights. Investment Value—the value to a particular ket. to cash or pay a liability. a key person in a business enterprise. Liquidity—the ability to quickly convert property Intrinsic Value—the value that an investor con. mineral rights. reputation. BUSINESS PERFORMANCE MANAGEMENT Goodwill—that intangible asset arising as a used. the investment. the term used is “Value to the business. trademarks. {NOTE: in way of determining a value indication of a Canada. business ownership interest. and similar factors not Invested Capital Net Cash Flows—those cash separately identified. business ownership interest. proce- flows of the investment equals the cost of dures.” When the term applies to options. deducted from the value of an ownership nomic benefits into a present single amount. Owner. Debt is typically (a) Market (Market-Based) Approach—a general all interest-bearing debt or (b) long-term. are actively traded on a free and open mar. Liquidation Value—the net amount that would able facts.

or intangible asset by using one or (synonymous with Shareholder’s Equity). Net Present Value—the value. the term used is Merger and Acquisition Method—a method “Redundant Assets. Equity Net Cash Flows and Invested Capital Market Capitalization of Invested Capital—the Net Cash Flows. as of a specified ket value of the debt component of invested date. Premise of Value—an assumption regarding the Multiple—the inverse of the capitalization rate. as of a specified ties as they appear on the balance sheet date. which the asset or assets are sold over a Minority Interest—an ownership interest less reasonable period of time to maximize pro- than 50% of the voting interest in a business ceeds received. Present Value—the value. {NOTE: in Canada. account of the business enterprise. excess assets and non-operating assets) Marketability—the ability to quickly convert minus the value of its liabilities. or intangible assets depreciation as it appears on the books of that have been sold. more methods that compare the subject to With respect to a specific asset. Non-operating Assets—assets not necessary to Marketability Discount—see Discount for Lack ongoing operations of the business enter- of Marketability. comparisons. Minority Discount—a discount for lack of control Orderly Liquidation Value—liquidation value at applicable to a minority interest. liquidation. for example. business ownership ized cost less accumulated amortization or interests. or other unusual items nomic benefits being generated evenly to eliminate anomalies and/or facilitate throughout the year. non-economic. of future economic benefits and/or 28 . Market Capitalization of Equity—the share Net Cash Flows—when the term is used. market capitalization of equity plus the mar.”} within the market approach whereby pricing Normalized Earnings—economic benefits adjust- multiples are derived from transactions of ed for non-recurring. it price of a publicly traded stock multiplied by should be supplemented by a qualifier. prise. ness enterprise’s tangible assets (excluding fits. assets (net of accumulated depreciation. going concern. Mid-Year Discounting—a convention used in the Normalized Financial Statements—financial Discounted Future Earnings Method that statements adjusted for non-operating reflects economic benefits being generated assets and liabilities and/or for non-recur- at midyear. and amortization) and total liabili. depletion. See the number of shares outstanding. securities. enterprise. of future cash inflows less all cash out- capital. most likely set of transactional circum- Net Book Value—with respect to a business stances that may be applicable to the sub- enterprise. non-economic. and/or facilitate comparisons. ring. culated using an appropriate discount rate. or other significant interests in companies engaged unusual items to eliminate anomalies in the same or similar lines of business. BUSINESS PERFORMANCE MANAGEMENT security. property to cash at minimal cost. approximating the effect of eco. flows (including the cost of investment) cal- Market Multiple—the market value of a compa. the capital- similar businesses. the difference between total ject valuation. number of customers). ny’s stock or invested capital divided by a Net Tangible Asset Value—the value of the busi- company measure (such as economic bene.

fair market value. ment. net of the tax shield similar new property having the nearest available from such outlays. percentage. business ownership expressed as a percentage. The measure of sys- identical new property. or intangible asset. Standard of Value—the identification of the type ed on an investment. tematic risk in stocks is the beta coefficient. and/or change in value realized or anticipat. expressed as a per. fair Redundant Assets—see Non-operating Assets. given level of risk. asset using one or more valuation methods. Required Rate of Return—the minimum rate of Tangible Assets—physical assets (such as return acceptable by investors before they cash. for example. synergies. Valuation Approach—a general way of determin- Risk-Free Rate—the rate of return available in ing a value indication of a business. Systematic Risk—the risk that is common to all ued. business the market on an investment free of default ownership interest. Unsystematic Risk—the risk specific to an indi- mon equity for a given period. observation. security. plant and equipment. value. earned on a company’s com. advantages by combining the acquired busi- Rate of Return—an amount of income (loss) ness interest with their own. risky securities and cannot be eliminated Reproduction Cost New—the current cost of an through diversification. proper- will commit money to an investment at a ty. etc. or strategic stock divided by its earnings per share. or intangible risk. future earnings model. lar operations or assets that do not fit well Special Interest Purchasers—acquirers who together. investment value. Sustaining Capital Reinvestment—the periodic mitted to the client. BUSINESS PERFORMANCE MANAGEMENT proceeds from sale. hearsay. believe they can enjoy post-acquisition Price/Earnings Multiple—the price of a share of economies of scale. security. earned on a interest. expressed as a structure without debt. vidual security that can be avoided through Return on Investment—See Return on Invested diversification. accounts receivable. of value being utilized in a specific engage- centage of that investment. oped from the relationship between price Portfolio Discount—an amount or percentage and certain variables based on experience. value of a business. these. or a combination of prise to reflect the fact that it owns dissimi.). capital outlay required to maintain opera- Replacement Cost New—the current cost of a tions at existing levels. equivalent utility to the property being val. Risk Premium—a rate of return added to a risk. Terminal Value—See Residual Value. Valuation Date—the specific point in time as of free rate to reflect risk. calculated using an Rule of Thumb—a mathematical formula devel- appropriate discount rate. Report Date—the date conclusions are trans. which the valuator’s opinion of value applies 29 . Unlevered Beta—the beta reflecting a capital Return on Equity—the amount. company’s total capital for a given period. Capital and Return on Equity. Residual Value—the value as of the end of the Transaction Method—See Merger and discrete projection period in a discounted Acquisition Method. inventory. Valuation—the act or process of determining the Return on Invested Capital—the amount. usually industry specific. deducted from the value of a business enter.

BUSINESS PERFORMANCE MANAGEMENT (also referred to as “Effective Date” or Value to the Owner—see Investment Value. manner. operating. and cost of capital (discount rate) determined by technique of performing the steps of an the weighted average. ic way to determine value. at market value. Voting Control—de jure control of a business Valuation Method—within approaches. enterprise. the cost of all financing sources in the busi- Valuation Ratio—a fraction in which a value or ness enterprise’s capital structure. or physical data serve as the denominator. “Appraisal Date”). price serves as the numerator and financial. a specif. of appraisal method. Weighted Average Cost of Capital (WACC)—the Valuation Procedure—the act. 30 .

C.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.) (Also Part II. REVENUE RULING 59-60 Rev. No general formula may be given that is applicable to the many different valuation situations arising in the valuation of such stock. therefore. 2. and factors which must be considered in valuing such securities are outlined. . he should maintain a reasonable attitude in recognition of the fact that valuation is not an exact sci- ence. 1959-1 CB 237 -. . A sound valuation will be based upon all the relevant facts.2031-1(b) of the Estate Tax Regulations (section 81. in effect. an appraiser will find wide differences of opinion as to the fair market value of a particular stock. Often. However. Approach to Valuation. 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. 1954-1. Revenue Ruling 54-77. all other available financial data. but the elements of common sense. . 59-60. Sections 811(k). There is. .B.2512-1 of the Gift Tax Regulations (section 86. informed judgment and reasonableness must enter into the process of weighing those facts and determining their aggregate significance. 2031 Reg § 20. will depend upon the circumstances in each case. both parties having reasonable knowledge of relevant facts. being a question of fact. 3. 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 alternate date if so elected. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able.2031-2 In valuing the stock of closely held corporations.02 The fair market value of specific shares of stock will vary as general economic conditions change from “normal” to “boom” 31 . 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. or made the subject of a gift. BUSINESS PERFORMANCE MANAGEMENT EXHIBIT 1.03 Closely held corporations are those corporations the shares of which are owned by a relatively limited number of stock- holders.10. Rul. The result of this situation is that little. or the date of gift." Sec. Regulations 105. 1005. superseded. Background and Definitions. Purpose. Sec. shall be taxed on the basis of the value of the property at the time of death of the decedent. In resolv- ing such differences. to trade and to be well informed about the property and concerning the market for such property. Section 81. . Full Text: Section 1. 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. the general approach. The purpose of this Revenue Ruling is to outline and review in general the approach. Sections 2031(a).IRC Sec.01 A determination of fair market value. as well as all relevant factors affecting the fair market value must be considered for estate tax and gift tax purposes.02 Section 20. if any. or the stock of corporations where market quotations are not available.) Reference(s): Code Sec. as well as willing. 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. 2031 (Also Section 2512. Often the entire stock issue is held by one family. 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.19 of Gift Tax Regulations 108) define fair market value. 187.10 of the Estate Tax Regulations 105) and section 25. methods. trading in the shares takes place.

as well as all relevant factors affecting the fair market value. the diversity or lack of diversity of its operations. . in essence. (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. . 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. (b) The economic outlook in general and the condition and outlook of the specific industry in particular. 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. but a study of gross and net income. (g) Sales of the stock and the size of the block of stock to be valued. Events of the past that are unlikely to recur in the future should be discounted. its operating and investment assets. In many instances. It is important to know that the company is more or less successful than its competitors in the same industry. since recent events are of greatest help in predicting the future. BUSINESS PERFORMANCE MANAGEMENT or “depression. its growth or lack of growth. The appraiser must exercise his judgment as to the degree of risk attach- ing to the business of the corporation which issued the stock. both in the national economy and in the industry or industries with which the corporation is allied. the nature of the business. and other facts needed to form an opinion of the degree of risk involved in the business. and of dividends covering a long prior period. Equal or even greater significance may attach to the ability of the industry with which 32 . (e) The dividend-paying capacity. with due regard for recent significant changes. is traded infrequently. The detail to be considered should increase with approach to the required date of appraisal. sales records and management.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 of which should be considered as of the date of the appraisal.03 Valuation of securities is. (f) Whether or not the enterprise has goodwill or other intangible value. The following factors. capital struc- ture. For an enterprise which changed its form of organization but carried on the same or closely similar operations of its prede- cessor. some other measure of value must be used.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. should be considered. its products or services. according to the degree of optimism or pessimism with which the investing public regards the future at the required date of appraisal. The value of shares of stock of a company with very uncertain future prospects is highly speculative. although not all. is highly desirable. all available financial data. When a stock is closely held. since value has a close relation to future expectancy. but need not be limited to. or is traded in an erratic market. Factors To Consider.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. but that judgment must be related to all of the other factors affecting value. Sec. (d) The earning capacity of the company. either on an exchange or over-the-counter. The history to be studied should include. the history of the former enterprise should be considered.” that is. As a generalization. plant facilities. or that it is maintaining a sta- ble position with respect to competitors. (c) The book value of the stock and the financial condition of the business. (b) A sound appraisal of a closely held stock must consider current and prospective economic conditions as of the date of appraisal. 4. 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. a prophesy as to the future and must be based on facts available at the required date of appraisal.

(5) remaining amount carried to surplus. Consideration also should be given to any assets not essential to the operation of the business. For instance. (2) principal deductions from gross income including major prior items of operating expenses. (2) gross and net book value of principal classes of fixed assets. although in exceptional cases the reverse may be true. the nature of the business and of its assets may be such that they will not be impaired by the loss of the manager. real estate. including income and excess profits taxes. preferably in the form of comparative annual statements for two or more years imme- diately preceding the date of appraisal. and (6) net worth. 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. such as invest- ments in securities. such developments as the acquisition of additional production facilities or subsidiary companies. (3) net income available for dividends. The percentage of earnings retained for business expansion should be noted when 33 . high profits due to the novelty of its product and the lack of competition often lead to increasing competition. In valuing the stock of this type of business. Such statements should show (1) gross income by principal items. the loss may be adequate- ly covered by life insurance. particularly if there is a lack of trained personnel capable of succeeding to the management of the enterprise. interest and other expense on each item of long-term debt. Any balance sheet descriptions that are not self-explanatory. If the corporation has more than one class of stock outstanding. together with a balance sheet at the end of the month preceding that date. (4) rates and amounts of dividends paid on each class of stock. the loss of the manager's services. On the other hand. in total if they appear to be reasonable or in detail if they seem to be excessive. such nonoperating assets will command a lower rate of return than do the operating assets. These state- ments usually will disclose to the appraiser (1) liquid position (ratio of current assets to current liabilities). to distinguish between operating income and investment income. if found to exist. 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. (3) working capital. or other offsetting factors. and the absence of management-succession potentialities are pertinent factors to be taken into consideration. and taxes by principal items. the charter or certificate of incorporation should be examined to ascertain the explicit rights and privi- leges of the various stock issues including: (1) voting powers. Comparison of the company's balance sheets over several years may reveal. These. should be clarified in essential detail by supporting supplemental schedules. and (3) preference as to assets in the event of liquidation. (4) long-term indebtedness. Prospective competition which has not been a factor in prior years should be given careful attention. or competent management might be employed on the basis of the consideration paid for the for- mer manager's services. improvement in financial position. etc. (d) Detailed profit-and-loss statements should be obtained and considered for a representative period immediately prior to the required date of appraisal. BUSINESS PERFORMANCE MANAGEMENT the company is allied to compete with other industries. and reconciliation with. there may be factors which offset. For example. (5) capital structure. (2) preference as to dividends. should be carefully weighed against the loss of the manager's services in valuing the stock of the enterprise. officers' salaries. and details as to recapitalizations and other changes in the capital structure of the corporation. Furthermore. surplus as stated on the balance sheet. contributions (whether or not deductible for tax purposes) that the nature of its business and its community position require the corporation to make. In computing the book value per share of stock. therefore. With profit and loss statements of this character available. among other facts. and (6) adjustments to. assets of the investment type should be revalued on the basis of their market price and the book value adjusted according- ly. the effect of the loss of the manager on the future expectancy of the business. in whole or in part. the appraiser should be able to separate recur- rent from nonrecurrent items of income and expense. if corpo- rate accounting will permit. and balance sheet items compre- hending diverse assets or liabilities. 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. (c) Balance sheets should be obtained. preferably five or more years. depreciation and depletion if such deductions are made. In general.

Dividend-paying capacity is a factor that must be considered in an appraisal. An important consideration is that the corporations to be used for comparisons have capital stocks which are actively traded by the public. It follows. that dividends are less reliable criteria of fair market value than other applicable factors. Major categories of cost and expense to be so analyzed include the consumption of raw materials and supplies in the case of manufacturers. (f) In the final analysis. therefore. This is especially true in the valuation of a controlling interest in a cor- poration. stocks listed on an exchange are to be considered first. the dividend factor is not a material element. also may furnish support for the inclusion of intangible value. the cost of pur- chased merchandise in the case of merchants. no prevailing market prices are available. It will be helpful. may justify a higher value for a specific block of stock. taxes. and a record of successful operation over a prolonged period in a particular locality. 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. but resort to arbitrary five-or-ten-year averages without regard to current trends or future prospects will not produce a realistic valuation. therefore. therefore. such factors as the prestige and renown of the business. a record of progressively increas- ing or decreasing net income is found. 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. In some instances it may not be possible to make a separate appraisal of the tangible and intan- gible assets of the business. (e) Primary consideration should be given to the dividend-paying capacity of the company rather than to dividends actually paid in the past. It follows. processors and fabricators. in effect. Specifically. utility services. it is equally true that control of a corporation. and interest. The size of the block of stock itself is a relevant factor to be considered. but dividends actually paid in the past may not have any relation to dividend-paying capacity. Prior earnings records usually are the most reliable guide as to the future expectancy. While the element of goodwill may be based primarily on earnings. Since. depletion or depreciation. insurance. instead of by the ability of the company to pay dividends. Potential future income is a major factor in many valuations of closely-held stocks. then greater weight may be accorded the most recent years' profits in estimating earn- ing power. Although it is true that a minority interest in an unlisted corporation's stock is more difficult to sell than a similar block of listed stock. Where an actual or effective controlling interest in a corporation is to be valued. to consider deductions from income and net income in terms of percentage of sales. the ownership of a trade or brand name. rests upon the excess of net earnings over and above a fair return on the net tangible assets. may be measured by the amount by which the appraised value of the tangible assets exceeds the net book value of such assets. since the payment of such dividends is discretionary with the controlling stock- holders. Whatever intangible value there is. that such stocks should be valued upon a consideration of all the evidence affecting the fair market value. in the case of closely held stocks. if sufficient comparable companies whose stocks are listed on an exchange cannot be 34 . (h) Section 2031(b) of the Code states. in judging risk and the extent to which a business is a marginal operator. for instance. 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. either actual or in effect. BUSINESS PERFORMANCE MANAGEMENT dividend-paying capacity is considered. which is support- able by the facts. and all information concerning past income which will be helpful in predicting the future should be secured. The individual or group in control can substitute salaries and bonuses for dividends. The presence of goodwill and its value. (g) Sales of stock of a closely held corporation should be carefully investigated to determine whether they represent transac- tions at arm's length. representing as it does an added element of value. Recognition must be given to the necessity of retaining a reasonable portion of profits in a company to meet com- petition. The enterprise has a value as an entity. In accordance with section 2031(b) of the Code. goodwill is based upon earning capacity. there is no basis for making an adjustment for blockage. However. thus reducing net income and understating the dividend-paying capacity of the company. If.

To illustrate: (a) Earnings may be the most important criterion of value in some cases whereas asset value will receive primary consider- ation in others. In the application of certain fundamental valuation factors. Because valuations cannot be made on the basis of a prescribed formula. A current appraisal by the investing public should be superior to the retrospective opinion of an individual. the ratio will fluctuate from year to year depending upon economic conditions. it is necessary to capitalize the average or current results at some appropriate rate. Operating expenses of such a company and the cost of liquidating it. Thus. conversely. Such a process excludes active consideration of other pertinent factors. yet it is obvious that consideration must be given to other relevant factors in order that the most valid comparison possible will be obtained. the appraiser may accord the greatest weight to the assets underlying the security to be valued. and (3) the stability or irregularity of earnings. Weight To Be Accorded Various Factors. capitalized earnings and capitalized dividends) and basing the valuation on the result. is close- ly related to the value of the assets underlying the stock. such as earnings and dividend paying capacity. For illustration. In selecting corporations for comparative purposes. For these reasons. Sec. Sec. A determination of the proper capitalization rate presents one of the most difficult problems in valuation. BUSINESS PERFORMANCE MANAGEMENT found. For companies of this type the appraiser should determine the fair market values of the assets of the company. and the end result cannot be supported by a realistic application of the significant facts in the case except by mere chance. 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. such as earnings and dividends. capi- talized at rates deemed proper by the investing public at the date of appraisal. Moreover. than any of the other customary yardsticks of appraisal. In like manner. (b) The value of the stock of a closely held investment or real estate holding company. free public market for the stock as of the valuation date. The essential factor is that whether the stocks are sold on an exchange or over-the-counter there is evidence of an active. certain factors may carry more weight than others because of the nature of the com- pany's business. adjusted net worth should be accorded greater weight in valuing the stock of a closely held investment or real estate holding company. Although the only restrictive requirement as to comparable corporations specified in the statute is that their lines of business be the same or similar. no use- ful purpose is served by taking an average of several factors (for example. 5. For this reason. the appraiser will accord primary consideration to earnings when valuing stocks of companies which sell products or services to the public. 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. The valuation of closely held corporate stock entails the consideration of all relevant factors as stated in section 4. a company with a declining business and decreasing markets is not comparable to one with a record of current progress and market expansion. there is no means whereby the various applicable factors in a particular case can be assigned mathematical weights in deriving the fair market value. other comparable companies which have stocks actively traded in on the over-the. 7. whether or not family owned. if any. merit consideration when appraising the relative values of the stock and the underlying assets. Wide variations will be found even for companies in the same industry. Sec. 6. 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. a corporation having one or more issues of preferred stock. in the investment or holding type of company. whether or not family owned. book value. 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.counter market also may be used. Average of Factors. no standard tables of capitalization rates applicable to closely held corporations can be formulated. Capitalization Rates. 35 . (2) the risk involved. care should be taken to use only comparable companies. In general. Depending upon the circumstances in each case.

depending upon the circumstances of each case. fix the value for estate tax purposes. Where the option. 194. in determining fair market value. in such case the option price is not determinative of fair market value for gift tax purposes. 36 . in the valuation of closely held stock for estate and gift tax purposes. Effect on Other Documents. Sec. such agreement may or may not. 255. It is always necessary to consider the relationship of the parties. In this connection see Rev. the relative number of shares held by the dece- dent. 1954-1.B. 54-76. with other relevant factors. is hereby superseded. 1954-1. 187. BUSINESS PERFORMANCE MANAGEMENT Sec. 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. and other material facts.B. Where the stockholder is free to dispose of his shares during life and the option is to become effective only upon his death. 294. Revenue Ruling 54-77. the option price is usually accepted as the fair market value for estate tax purposes. 1953-2. is the result of voluntary action by the stockholders and is binding during the life as well as at the death of the stockholders. However. 157 C. C.B. such agreement is a factor to be considered. Where shares of stock were acquired by a decedent subject to an option reserved by the issuing corporation to repurchase at a certain price. 189. Restrictive Agreements. 9. Rul. Rul. However.B. 1953-2. C. See Rev. it will be found that the stock is subject to an agreement restricting its sale or transfer. the fair market value is not limited to the option price. or buy and sell agreement. C. 8. Rul. Frequently. and Rev.

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