In general, a company whose securities are traded in volume by informed persons in a free and active market has its fair market value determined continuously. The prices at which the securities of such a company trade are a reflection of the collective opinion of the investing public as to what the future prospects of the company are at that point of time.
However, when a stock is traded infrequently, or is traded in an erratic market, or is closely held, such as in the case of ABC, some other measure of value must be found in the prices at which the stock of companies engaged in the same or a similar line of business are selling in a free and active market. Several publicly traded companies were found to be comparable to ABC. Industry composite data was considered relevant and was utilized where appropriate.
This valuation was conducted under the guidelines established by the Treasury Department and the Internal Revenue Service in its determination of fair market values of closely held business enterprises for income tax, estate tax, gift tax, and other related purposes. Fair market value has been defined by the Internal Revenue Service as:
“… the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. Court decisions frequently state, in addition, that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and be well informed about the property and concerning the market for such property.”
The Internal Revenue Code, Section 223(b), specifies that the value of stocks and securities of corporations not listed on an exchange or freely traded “…shall be determined by taking into consideration, in addition to all other factors, the value of stock or securities of corporations engaged in the same or a similar line of business which are listed on an exchange.” By Revenue Ruling 65-193 the Treasury Department extended the use of Revenue Ruling 59-60 to include the determination of fair market value of closely held businesses for income and other tax purposes. The primary authority for determination of fair market value of a business enterprise, therefore, has been established as Revenue Ruling 59-60. This Revenue Ruling lists eight factors which are fundamental to any appraisal “…in addition to all other factors…” as follows:
History of the Company and Nature of Its Business
Determination of degree of risk of a company in relation to other companies in its industry requires a review of past trends and the subject company’s stability or instability in the marketplABC. Depth and longevity of management, secondary management strength, and turnover of the labor force are important. The condition of the company’s facility, trends in its industry, etc. also help to determine the degree of risk. More weight is given to recent events, and past nonrecurring financial effects should be reviewed for diminution and elimination if appropriate.
Economic Outlook in General and Condition and Outlook of the Industry in Particular
Economic conditions in the trading arena in which the company operates are of primary importance, but nationwide economic trends, and in some instances international economics, may have favorable or adverse effects on an industry or a company. The intermediate and long term future of the industry and the company’s competitive position in the industry has an important effect on the value of the company. A valuation would be incomplete without a careful analysis of the economic climate in which the company must perform.
Book Value of the Stock and Financial Condition of the Business
Any company must be financially structured to respond to the opportunities available to it or meet with failure. Inadequate capitalization, overpowering debt, inefficient operations, inadequate expense
control, and many other negative factors can defeat the effectiveness of the company in its industry. A study of capital and operating ratios and their relationship to comparable companies is a necessary part of the valuation process. Although “Book Net Worth” or “Book Value” in current inflationary times has little effect upon the determination of fair market value, since many assets are often worth more than stated book value, book value does establish a base from which adjusted values can be calculated.
Earnings Capacity of the Company
Simplified, “the value of a company to any acquirer is the future stream of earnings which he may expect to receive from the company.” A review of the past is a foundation for future expectations. Further, the Appraiser must review the past to search for extraordinary events which give rise to over and understatement of past earnings. Primary emphasis should be given to the most recently experienced earnings.
Dividend Paying Capacity
The ability to pay dividends must be examined; whether dividends are paid by closely held companies
is not important. Tax laws discourage dividend payments by private companies, but dividend capacity is evidenced by excess liquidity, relatively high levels of executive salaries, bonuses to
shareholder-employees and other generous employee benefits.
Whether or Not the Enterprise Has Goodwill or Other Intangible Assets
Reference is not made to the accounting definition of goodwill. A record of profitable operations in a trading arena, the reputation of the enterprise, the ownership of patents or trademarks, and the prestige of the firm better define goodwill. In the selection of Capitalization Rates, Discount Rates and Price/Earnings Ratios, the Appraiser should assign fractional points for the existence of good-will and should subtract points for “negative goodwill” or other intangibles.
Sales of Stock and Size of the Block of Stock to be Valued
The relationship of the parties to a transaction may be more important than the price at which the shares are traded. Arm’s length sales to knowledgeable, unrelated third parties in the recent past would be a basis for valuation. The Appraiser should discount private transactions, and transactions controlled by restrictions such as those contained in buy-sell agreements, unless there is evidence of independent third party negotiations. Discounts for minority blocks and premiums for control blocks of stock should be applied depending on the size of the block involved.
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 or Over the Counter
Revenue Ruling 59-60 emphasizes “…volume in a free and active market by informed persons.” Therefore, the Appraiser should look for comparable companies first on the New York Stock Exchange, second on the American Exchange, and, finally, on the Over-the-Counter Market. Basis for comparability would be provided by product mix, similarity of market, sales trends, and operating and financial ratios. Industry statistics, where applicable, are also helpful to the Appraiser.
In addition to the eight factors above, there are other factors which the Appraiser must consider in performing his valuation. Specifically, an Appraiser must consider comparability of accounting methods and discounts to fair market value determinants. Our views on these subjects are summarized below:
Comparability in Accounting Methods
The accounting profession allows a number of alternative accounting treatments in areas such as inventory and depreciation accounting. Depending upon the particular accounting method utilized, reported earnings may differ materially within a given year. These accounting treatments, which are permitted under Generally Accepted Accounting Principles (GAAP), are usually one-time decisions. Once a company has opted for a particular accounting treatment it cannot change without good cause. That is to say, a company cannot flip-flop between various accounting alternatives year after year just to suit its desire to affect reported earnings. Because of these rules, accounting statements for a particular company are generally comparable from year to year. This comparability, however, may not exist from company to company even if they are in the same industry. This is especially true if one is comparing a “public” company with a “closely held” company.
In general, it is the goal of public companies to maximize reported earnings. This is because the value of a public company’s stock tends to reflect the trend in reported earnings. Obviously, the degree of sensitivity of stock values to reported earnings is tempered by economic conditions, market conditions, and other variables. Public companies tend to utilize straight line depreciation for reporting purposes and accelerated depreciation for tax purposes. This accounting treatment gives rise to higher reported earnings and “deferred income taxes payable” on the balance sheets of these companies. In addition, many public companies still use FIFO inventory accounting, which generally leads to higher reported profits.
On the other hand, “closely held” companies do not often concern themselves with reported earnings. Their major concern is maximizing cash flows and minimizing taxes. It is not unusual to find private companies utilizing accelerated depreciation, LIFO inventory methods, and aggressive reserve accounting, which tend to minimize earnings and taxes while maximizing cash flows.
Maximization of cash flows is very important to lending institutions, which are more concerned with a company’s ability to service debt than they are in a company’s ability to report earnings, since reported earnings, in and of themselves, do not necessarily reflect the ability of a company to repay its obligations. As a consequence, a company that is able to maximize its cash flows is normally in a better position to plan for its working capital needs, its capital expenditure requirements, and its future long term capital.
Accounts to Fair Market Value
The marketability of the company’s stock and the control position of majority shareholders, and the relationship of these factors to the block of stock being valued, can also affect the concluded value. Closely held stock, which lacks marketability, is far less attractive than a similar stock with ready access to the public marketplABC. A minority stock interest in a closed corporation is usually worth much less than a proportionate share of the assets to which it is attached. Correspondingly, a control position is usually worth much more than a proportionate share of the assets to which it is attached. In valuing a block of stock, Revenue Rulings and court decisions provide a basis for concluding that a discount is
valid for an absence of marketability and for a minority interest if the value base does not already
reflect the lack of marketability on a minority interest. Similarly, control premiums are often applied to controlling blocks of stock because of the ability of those control blocks to control the management and operations of the Company.
Accordingly, discounts, if applied, can range from 5% to 50% of determined value for lack of marketability. Premiums for control have normally ranged from 10% to 40% or more above minority interest values in recent years with 25% usually the norm.