By Nestor Cruz
A common bone of contention between the Internal Revenue Service (IRS) and tax payers in the context of estate taxation is the valuation of closely-held businesses. There are generally two methods used. In this part we discuss the guideline company method. In the second part and third parts, which will be published in future issues, we discuss the discounted cash flow method and compare the results achieved using as an illustration the recent Tax Court valuation case Estate of Gallagher v. Commissioner of Internal Revenue, TCM 2011 – 148 (2011). After the value of the company is ascertained, any applicable marketability discounts must be applied. In a future article we will discuss discounts, again using Gallagher as illustration.
The “guideline company” method is a market-based valuation approach which estimates the value of the subject company by comparing it to similar public companies and is a generally-accepted method for valuing stock of a closely-held business. Since the method determines fair market value using market data from similar public companies (guideline companies), the selection of appropriate comparable companies is of paramount importance. To identify guideline companies, courts compile a list of publicly-held companies from public records such as 10-K reports, screening out those not operating primarily in the same business as the company under analysis.
In Gallagher thirteen such companies were originally identified by an expert witness. The list was subsequently winnowed down to four similar in size to the company under analysis. It was believed those companies were most comparable because their underlying price multiples generally reflected an investor’s assessment of both current and future earnings prospects of subject company, as well as the business and financial risks inherent in subject company’s business as of the valuation date. Alert readers will immediately notice the great degree of subjectivity insinuated into the process by the selection of four out of thirteen potential comparables. This subjectivity is inevitable and readers have probably encountered it in the context of residential real estate. Nevertheless, because we are dealing with numbers attached to dollar signs the whole process appears to be very exact, which is not the case.
The next step in the process is to examine the so-called MVIC to EBITDA price multiples or ratios. “MVIC” stands for “market value of invested capital,” which is generally the total market capitalization of the common stock of a company, with adjustments discussed below. “EBITDA” is “earnings before interest, income taxes, depreciation, and amortization.” A very simplistic approach would be to compare market valuation to net earnings after tax, that is, the traditional P/E ratio found in the financial pages of the newspaper; but, the companies would not be truly comparable because of different capital structures (which affect interest paid), tax management (which affects interest accrued), year in which equipment was bought and choice of accounting methods (which affect depreciation expense), and intangible assets being amortized (which affect amortization expense). Moreover, EBITDA is a good measure of the cash thrown off by a business since it adds back non-cash expenses such as depreciation and amortization.
In other words, to the net income after tax figure the courts add back interest expense, income tax, depreciation and amortization to reach a figure which will make companies truly comparable. In Gallagher the four comparable companies had MVIC to EBITDA multiples of 11.1, 12.4, 10.9, and 12.6 for an average multiple of 11.8. When applying the found multiple to the company under discussion, adjustments might be made. For example, if subject company is growing at a slower pace than the comparables, a lower multiple might be used; or, if subject company has better future growth or profit prospects than the comparables a higher multiple might be called for. Again, adjusting the calculated market multiple introduces subjective consideration into the appraisal, which, to a certain extent, vitiates this procedure, which is based on the premise that financial markets are the best indication of enterprise value.
There are other adjustments of a technical nature which should be made in the pursuit of finance theory purity. For example, since interest expense has been added back to the denominator, then either the book or market value of company debt should be added to the numerator market value; that is, MVIC is equal to the market capitalization of the common stock plus debt outstanding. In any event, one should always be conscious that valuations are only estimates since for closely-held companies, by definition, there is no market price for shares. Nevertheless, the guideline company method is backed by sound reasons of finance and accounting theory. Furthermore, it incorporates the price-discovery function of the stock market which gives the value at which willing buyers and sellers are exchanging cash for shares.