Previous
| Previous |
Table of Contents | Next |
PART 2--COURSE READING
THE VALUATION OF A CLOSELY HELD BUSINESS
Ted Kurlowicz
The value that an owner derives from a closely held business interest comes
from one or more of three sources. First, there are the rights that an owner
holds in the business assets. Recall that a sole proprietor owns any property
used by the business. The owners of a partnership or corporation have no
direct individual rights to specific business property but have a legal
interest known as liquidation rights against business property should the
business be dissolved. Another source of value to the business owner is
the right to receive income from business operations. This right will usually
be significant only if the business is being valued as a going concern.
Finally, the right to control the business by the majority owner, or majority
group, is a source of value. Therefore ownership units representing controlling
blocks can be worth relatively more than ownership units in the minority
group.
This chapter focuses on some basic techniques of business valuation. The
valuation technique selected by the financial services professional depends
on the purpose for the valuation. As we will see below, the valuation technique
chosen will differ depending on whether the business is being valued for
liquidation purposes or for sale as a going concern. Furthermore, a valuation
being performed for tax purposes must fall within the acceptable guidelines
of the IRS.
Although these factors must all be considered in determining fair market
value, the weights accorded to each factor will depend on the circumstances
of the specific business. Generally speaking, the earning capacity of the
company is primary. Other factors will be weighted depending on the circumstances
of the business being valued and the purposes for which the valuation is
being performed. For example, goodwill may be an important intangible asset
for a business operating as a going concern. However, the goodwill value
of a business may be a attributable to the skills and services of its owner.
If the business is being valued for liquidation purposes or at the death
of the owner, goodwill may no longer be significant. In any event the remainder
of this chapter will focus on various valuation methods and their appropriateness
to specific situations.
| TABLE 1 Hypo Enterprises Balance Sheet |
|||
|
Assets
|
Liabilities
|
||
|
Real property |
$440,000
50,000 140,000 150,000 25,000 $805,000 |
Mortgages Current indebtedness Accounts payable Other Owners' equity (or capital account) |
$357,000
50,000 25,000 30,000 343,000 $805,000 |
In valuing closely held corporate stock book value per share is the total
book value divided by the number of shares outstanding at the end of the
accounting period. The value of a block of stock is simply the number
of shares in the block multiplied by book value per share.
Is the book value the "real" value of the corporation, that is, the fair
market value? For a number of reasons it generally is not. The value of
the assets on the books is usually not their fair market value. Rather,
book value of an asset is usually equal to its initial cost less accumulated
depreciation. The fair market value of any asset may be more or less than
its book value. Some assets, such as real estate, eventually appreciate
over time and have a fair market value that is considerably higher than
their book value. On the other hand, there may be assets whose values
on the books are in excess of their actual fair market value. For example,
some accounts receivable are typically uncollectible. If no adjustment
is made on the books for these accounts, book value will be in excess
of actual value. Furthermore, obsolescent equipment may be on the books,
and its depreciated cost figure will be higher than its market value.
The values of liabilities as shown on the books are likely to be more
realistic. It is unlikely that a liability will decline in value because
the obligation to pay will generally remain legally enforceable as long
as the debtor and the liability continue to exist.
| TABLE
2 Hypo Enterprises Adjusted Book Value (not including intangibles) |
|||
|
Assets
|
Liabilities
|
||
| Cash Accounts receivable Inventory Equipment and fixtures Real property |
$ 25,000
125,000 110,000 40,000 600,000 $900,000 |
Accounts
payable Current indebtedness Other Mortgages |
$ 25,000
50,000 30,000 357,000 $462,000 |
| Assets
as adjusted: $900,000 Less total liabilities: $462,000 Adjusted book value (not including intangibles): $438,000 |
|||
One problem that exists in the process of adjusting book value for
intangibles is the difficulty in valuing goodwill. The IRS has changed
its opinion over the years and currently allows a formula valuation
of goodwill only when better evidence if its value is unavailable.
Theoretically goodwill represents the earning power of a business
in excess of a fair return on its tangible assets. A formula technique
may be used to estimate this theoretical value.
Example: Assume Hypo's earnings have aver-aged $100,000 annually over the previous 5 years. If a fair rate of return on tangible assets in Hypo's industry is 10 percent and Hypo is considered an average risk, Hypo could expect to earn $90,000 per year based on its tangible assets (10 percent of $900,000--see table 2). The additional $10,000 of annual income ($100,000 less $90,000) may be attributed to goodwill. The annual earnings attributable to goodwill are capitalized, as discussed in the section "Capitalization of Earnings," to reach the total value of goodwill.
Although the IRS has taken the position that formula valuation
of goodwill should be used only as a last resort, it is often used
by appraisers and generally accepted by the courts.
Some other facts about goodwill should be mentioned. First, goodwill
can often be attributed to identifiable factors such as effective
management. If these factors will not be present in the future,
then the value of the goodwill should be reduced or eliminated.
Second, goodwill can generally be claimed as an element of value
only when the business is sold as a unit. If a business is sold
in a piecemeal fashion, the value of goodwill is usually lost. It
may be possible to sell know-how or the license to use a particular
trade name, or in some cases it may be possible to recoup the value
of a certain location for a particular business. Usually, however,
the full amount of goodwill can be obtained only if the business
is sold as a unit.
| TABLE 3 Hypo Enterprises Adjusted Earn-ings |
|
| 1985
1986 1987 1988 1989 |
$
80,000 85,000 90,000 95,00 100,000 |
| total earnings $450,000 | ||||||||||||||||||
| Average earnings (unweighted): $90,000 ($450,000 ¸ 5 years)Most recent year's earnings: $100,000 | ||||||||||||||||||
|
||||||||||||||||||
| TABLE
4 Projected Future Earnings for Hypo Enterprises |
|
| Year | Projected Earnings |
| 1 2 3 4 5 6 and subsequent years |
$100,000
120,000 130,000 140,000 150,000 150,000 |
| TABLE
5 Discounted-Future-Earn-ings Value of Hypo Enter-prises |
|||
| Year | Projected Earnings |
Discount Factor (15%) |
Present Value |
| 1 2 3 4 5 6 and sub-sequent years Current value |
$ 100,000
120,000 130,000 140,000 150,000 1,000,000* |
0.870 0.756 0.658 0.572 0.497 0.497† |
$ 87,000
90,720 85,540 80,080 74,550 497,000 $914,890 |
| *This is the value of a constant annual income stream of $150,000 at 15% (that is, $150,000 multiplied by the capital-ization factor 6.67). †$1,000,000 is the value of the income stream of $150,000 per year at the end of the 5th year, so a discount factor is used for 5 years. |
| 60 percent of $300,000 | $500,000 |
| 40 percent of $400,000 | 160,000 |
| Total | $460,000 |
| TABLE
6 Hybrid Valuation of Hypo Enterprises |
||
| Adjusted book
value (average) 5-year average earnings 12 percent return on adjusted book value Excess attributable to goodwill $24,000 capitalized at 20 percent rate Total value of corporation |
$60,000
36,000 $24,000 |
$300,000 120,000 $420,000 |
| TABLE
7 Price and Earnings Data for Company Compara-ble to Hypo |
|||
| Year | Earnings | Average price | P/E |
| Year
1 Year 2 Year 3 |
$250,000 300,000 325,000 | $550,000 750,000 700,000 |
2.20
2.50 2.15 Average P/E 2.28 |
Example: LIFO, Inc., has two owners. The majority owner holds 90 percent of the stock outstanding and the minority owner the remainder. The degree of control lost by the minority owner is substantial, and the minority interest is worth far less than 10 percent of the total value of LIFO. Now suppose FIFO, Inc., has four equal shareholders. Each shareholder owns a minority interest, but no discount for lack of control is probably appropri-ate under these circumstances.The IRS has accepted the validity of minority interest discounts in many cases, especially in valuing minority interests held by estates for estate tax purposes. As always, minority interests should be valued for this purpose at fair market value (including applicable discounts). Suppose the business is worth $1 million and the decedent's interest is 10 percent. It is highly unlikely that the decedent could have sold the interest for $100,000 on the date of death because this interest did not possess the benefits of control. In this case it would be unfair to assess federal estate taxes as if the value of the interest was really 10 percent of the value of the business. Both the IRS and the courts have allowed discounts for minority interests, but the facts and circumstances surrounding the valuation are generally closely scrutinized to make sure the discount is appropriate. Some recent studies have revealed that the average discount is approximately 30 percent and can be much higher in appropriate circumstances.
| TABLE
8 Hypo Enterprises |
||
| Assets | Fair Market Value | Forced-Sale Value |
| Real property Equipment and fixtures Inventory Accounts receivable Cash Less liabilities |
$600,000 40,000 110,000 125,000 25,000 $900,000 (462,000) $438,000 |
$540,000
10,000 55,000 93,750 25,000 $723,750 (462,000) $261,750 |
| Previous |
Top |
Next |