§ 31.06 VALUATION METHODS
This section summarizes valuation methods commonly used by appraisers.
[1] Closely Held Corporations
Revenue Ruling 59-60 provides as follows:
Closely held corporations are those corporations the shares of which are owned by a relatively limited number of stockholders. Often, the entire stock issue is held by one family. The result of this situation is that little, if any, trading takes place. There is, therefore, no established market for the stock and such sales as occur at irregular intervals seldom reflect all of the elements of a representative transaction as defined by the term "fair market value."
Rev. Rul. 59-60, 1959-1 C.B. 237.
Because the valuation of an interest in a closely held corporation is an attempt to place a fair market value on something that, by definition, is not normally bought and sold, the valuation of the stock of a closely held corporation requires an entirely different approach than the valuation of any other asset. The valuation process has been described as a "matter of judgment and opinion rather than mathematics." Suther v. Suther, 28 Wn. App. 838, 843, 627 P.2d 110, review denied, 95 Wn.2d 1029 (1981) (citations omitted).
Despite the apparent mystery surrounding the valuation of closely held corporations, a few points seem beyond dispute. First, one valuation method does not fit all types of companies. For example, liquidation value might be an appropriate method to value an interest in a real estate holding company but is usually not an appropriate method to value an interest in a service company, particularly a profitable one.
Second, if the valuation method the expert uses does not make sense, the court will probably reject the expert's opinion. For example, if the expert values a company by multiplying the prior year's sales by one-and-a-half, but the expert cannot explain why the hypothetical purchaser would pay one-and-a-half times the sales for the company, the court will probably disregard the expert's opinion.
Third, while an appraiser's "judgment calls" (e.g., setting a capitalization rate, making balance sheet adjustments, etc.), play a large part in establishing the value of a closely held corporation, the appraiser's mathematical calculations must be accurate and his or her valuation method must be internally consistent.
Perhaps the most common method for valuing a closely held business that is a profitable "going concern" is the "return on investment" method. The return on investment method attempts to quantify the amount that a hypothetical prospective purchaser would pay to obtain the anticipated future income stream of the business.
The primary task of the appraiser in the return on investment method is to determine the anticipated future earnings of the company. The appraiser generally looks at historical earnings to determine the anticipated earnings of the company. The appraiser will typically "adjust" the historical earnings, by subtracting any nonrecurring income and adding back any nonrecurring expense. The appraiser may also adjust historical earnings by the amount of any overcompensation or undercompensation of owner/employees. The appraiser will then calculate the average adjusted earnings over a period of time (usually three to five years). Frequently, the appraiser will use "weighted" average earnings, which give greater weight to the company's income in the more recent years.
Of course, a company's historical earnings are not always representative of what the company will earn in the future. A company's earnings during a start-up or research and development period are normally less than the earnings of a fully productive company. Conversely, any number of changes can reduce the earnings of a previously profitable company: changes in the general economy; product obsolescence; loss of key personnel; increases in the price of raw materials; government regulation; etc.
After the appraiser determines the company's anticipated future earnings, those earnings are discounted to present value using a risk-adjusted discount rate. This determination of the "capitalization rate" is the area in which the appraiser has the greatest discretion. The exercise of this discretion invariably has a significant impact on the appraiser's opinion of value.
In theory, a capitalization rate for a specific appraisal may be "constructed" by taking the current rate of return on a risk-free investment and adding to this rate a premium for risk and anticipated future inflation. The most important of the three factors is the risk premium. Simply stated, the riskier the business, the less a prospective investor will pay for the business...
