CHAPTER 8
Business Valuations

In lawsuits where the business has been interrupted so significantly that it ceases to exist or where its value has changed significantly, the appropriate method to measure the loss may be to do a business valuation. The field of business valuations has grown dramatically over the past two decades. Numerous books have been written on the methodology of business valuation. In addition, many articles and periodic newsletters are available to keep experts aware of the latest developments in the field.1 Therefore, this chapter provides only an overview of the methods involved; references in which readers can find a more expanded treatment of the topic are also included. The additional focus of this chapter is to show how business valuation methods can be applied in cases of business interruption.

Legal Standard for Business Valuations in Business Interruption and Business Failure Lawsuits

When a defendant damages a plaintiff to such an extent that the plaintiff’s business fails, the question arises: How should damages be valued? Given that the plaintiff has lost profits, should estimated past and projected future profits be the manner in which damages are measured? Abundant case law clearly states that the proper measure of damages is the value of the business, not projected profits. When this is the case, then the methodological approach to measure damages is different from in a typical business interruption case.

Numerous cases reiterate the court’s position on how losses should be measured when a plaintiff’s business is so interrupted that it goes out of business. One example is Indu Craft, Inc. v. Bank of Baroda, a case in which a manufacturer lost its access to credit at a bank because the plaintiff would not invest in a business of a bank manager’s relative. The plaintiff’s access to goods from its foreign suppliers was cut off, and it went out of business. The plaintiff presented two alternative measures of damages: lost profits, which it did not correctly measure in that it did not parcel out fixed versus variable costs, and the lost value of its business. In reviewing the case, the U.S. Court of Appeals for the Second Circuit stated:

The magistrate judge determined Indu Craft presented sufficient evidence to prove the loss of its value as an ongoing business. It also determined that plaintiff’s evidence of lost profits failed to take into account variable and fixed costs and was therefore insufficient as a matter of law. Faced with adequate proof of the lost value of the business and inadequate proof of lost profits, the trial court nonetheless granted judgment as a matter of law in favor of the Bank. While we agree with the magistrate judge’s conclusions regarding the sufficiency of the proof regarding loss of value and the insufficiency of the lost profits evidence, we are unable to adopt the trial court’s view that the evidence, as a whole, failed to support the jury’s damages award.

The court then went on to say:

In fact, when the breach of contract results in the complete destruction of a business enterprise and the business is susceptible to valuation methods, such an approach provides the best method of calculating damages.2

A U.S. Supreme Court decision reinforced the court’s consistent view on this issue. The case, Coastal Fuels of Puerto Rico, Inc. v. Caribbean Petroleum Corporation,3 arose out of an antitrust lawsuit. In this case, Coastal Fuels of Puerto Rico had won a price discrimination decision at a lower court level against Caribbean Petroleum Corporation (CAPECO) but had failed to win a Section One Sherman Act claim of monopolization. The Supreme Court had earlier vacated a jury verdict on damages; the court thought that the total damages might have been too high, as the antitrust verdict had included damages for monopolization. The price discrimination claim was retired, and, ironically, the verdict on this second trial was three times higher than the original damages value.

The total damages verdict in the second proceeding, $4.5 million before trebling, included $2 million for “going concern damages.” The issue of going concern damages, the value of the business, became a main focus of the court in its review of the analysis that had been presented. In reaching its decision, the court relied on Farmington Dowel Products Co. v. Forster Manufacturing Co.4 In citing the Farmington court, the court established that if lost value is to be a measure of damages for a company that went out of business due to the defendant’s actions, the value should be measured as of the date that the company went out of business – not its value as of the trial date. In explaining why the value as of the trial date is inappropriate, the Farmington court stated that a valuation:

would have required an estimate of profits for a period of some ten years during which the company neither existed nor made, plus an estimate of the going concern value … of a company which had ceased being a going concern over ten years before, which estimate would have involved a further estimate of profits for a more remote future period.

The court in Coastal Fuels concluded that it faced the same situation. The only meaningful difference was that the period of time between the trial date and the date when the plaintiff went out of business was four years instead of ten. The court agreed with the Farmington Dowel court when it concluded that valuing a company long after it had gone out of business relied “too heavily on speculation and conjecture.” The court was very clear in its opinion:

We conclude that the Farmington Dowel framework – that going concern value should be evaluated as of the time the plaintiff goes out of business and actual lost profits awarded only up to that date – is and should be the norm. It may be that in some situations the difference between the date the company went out of business and the date of trial is not great and the issue does not arise in any significant sense. But here, more than four years had passed. We do not adopt a per se rule that four years is inherently too great a gap, but we think it raises such risks of speculative evidence that the Farmington Dowel framework presumptively applies.5

Lost Profits Versus Lost Business Value

The court in Coastal went on to clarify the circumstances in which lost profits are appropriate and in which the value of the business is the relevant measure. It did so by once again adopting the court’s reasoning from the Farmington Dowel case. In Farmington Dowel, that court allowed lost profits to be the appropriate measure until the date the plaintiff went out of business. The appropriate measure of damages was then the value of the business. The court in Farmington was clear that a plaintiff could not claim both posttrial future profits as well as the lost value of the business. It said:

To do so would result in a clear duplication [the plaintiff] would get its present value as a going concern plus its future profits, but the latter figure would be a major element in determining the former figure.

While it may be an obvious point, a plaintiff may not recover both the value of the business as well as projected lost profits. The quote from Farmington Dowel reinforced the court’s position that the proper measure of damages is the value of the business as opposed to projected lost profits. If, however, the plaintiff is unable to present a reliable measure of the value of its business but is able to present projected lost profits that are nonspeculative, then the court may accept the latter as its second choice. This was articulated by the Eighth Circuit in Albrecht v. Herald Co. In such instances, one issue that would have to be established is whether a plaintiff could reliably project lost future profits but yet be unable to use such projected profits in a reliable business valuation.

A review of part of the Albrecht’s court’s opinion on this issue is useful. First, the court reaffirmed again that awarding both future lost profits and the value of the business would be duplication:

It is our opinion that the plaintiff has received all permissible damages under items one and two, damages occasioned prior to the sale and the full market value on the sale of his route as a going concern, free of the restrictive practices. This value is figured on the basis of his reconstituted route with all 1200 customers. Fair market value would be that price a willing seller could secure from a willing buyer, and the evidence establishes $24,000 as the maximum price obtainable. Plaintiff has thus been made whole on his actual damages and further compensated as a matter of congressional policy by receiving treble damages. He is not entitled to sell the route, receive full compensation therefore, and still receive the profits the route might have made over his reasonable work‐life expectancy. The trial judge did cut these damages down to future losses occurring after the sale for a period of three years. We feel this also is duplicitous.

The prospect of future earnings is considered in arriving at the fair market value of a given business. Here undoubtedly the value of the route rested not in its tangible assets of an old truck and paper wrapper (valued $600) but in the exclusive contract for distribution of a well‐regarded newspaper in a given area. Whatever that fair market value might be, plaintiff has received it. Capitalizing and discounting future profits is one method of figuring present value, but this does not mean that a person is entitled to present value plus future profits. Certainly the antitrust laws in dealing with damages are not intended to give a person a life annuity in addition to whatever actual damage a party might have suffered in his business property. The injury is to the business and not to the person. The statutory penalty of trebling actual damages and allowing substantial attorney fees satisfies the purpose and policy of the antitrust statutes.6

Having explained why duplication cannot be allowed, the court did open the door to the use of projected lost profits when the value of the business cannot be reliably established. In explaining its reasoning, the court in Albrecht rejected plaintiff arguments and the case he relied on, which allowed such projections. The next quotation explains that in the cases that it found not to be relevant, it was not possible to place a value on a business; thus projected earnings were an acceptable substitute:

To summarize then the cases relied on by the plaintiff, we think it can be fairly said that none of these cases allowed a plaintiff damaged by an antitrust violation to recover both the value of the business as a going concern at the time of the damage and future profits of that business after the time of the damage. The future profits, which were allowed in those cases, were used as a method of calculating the damage to the value of the businesses involved because no other reliable method of valuing the business was presented. However, in the instant case we have clear proof in the record of the value of plaintiff’s business as a going concern, and that value must necessarily take into consideration its future profit earning potential. Thus, we think that the cases relied on by the defendant, which allow the plaintiff to recover the going‐concern value of his business, but not future profits in addition, are applicable to the instant case.7

Business Valuation Framework

Exhibit 8.1 provides a basic framework for the valuation process. It shows that this process can be conceptually broken down into stages. In the initial stages, shown at the top of the chart, the expert does his preliminary investigation into the nature of the business and the purpose of the assignment. The expert then selects the appropriate techniques to be used to value the business. These are shown in the middle of the chart. By employing these methods, the expert is able to arrive at a value for the equity of the business. This equity value may then be subject to certain adjustments such as those shown at the bottom of Exhibit 8.1. The remaining part of this chapter takes the reader through the steps in the valuation process.

Theoretical Value of a Business

The value of a business should be a function of the future benefits that will accrue to the owners of the business. For publicly held businesses, these benefits may come from future dividends and increases in the price of the stock. For closely held businesses, these benefits can be derived in different ways from publicly held firms. Whichever the case, the valuation exercise involves defining the benefits and projecting them into the future. The higher the value of such benefits, the greater the value of the business. The identification and analysis of such benefits is the subject of the valuation process.

Image described by caption and surrounding text.

EXHIBIT 8.1 Pathway to valuation.

Source: Robert Trout, “Business Valuations,” in Measuring Commercial Damages (New York: John Wiley & Sons, 2000), p. 237. This material is used by permission of John Wiley & Sons, Inc.

Methods of Business Valuation

In a business valuation, an analyst assigns a value to a financial asset for which there is often either no market or only a limited one available to value it. Businesses whose equity or debt securities are actively traded on securities exchanges are regularly valued on a daily basis. Such companies are known as publicly held companies based on the “public” ownership of their equity. For bigger companies, the ownership is usually held by a large number of stockholders. Issuing companies have to adhere to Securities and Exchange Commission (SEC) filing and disclosure requirements as well as other state regulations.

Public Versus Private Companies

There are significant differences in the valuation process for public and private companies. The shares of public companies are traded in securities markets where they get regularly revalued. For large Fortune 500 companies that trade on the New York Stock Exchange, the values of their shares can greatly assist the analyst in determining the value of the company. For other public companies that trade infrequently on the over‐the‐counter (OTC) market, the quoted value of the shares contains less information content on the value of the company. Private companies, however, do not have organized markets for their shares. The expert has to do other analysis, such as trying to find comparable companies that are public and using information about their stock prices to ascertain how the market would value the private company. This method, called comparable multiples, is discussed later in this chapter.

Another way in which public and private companies differ is in their financial statements. As part of the securities registration process required by national securities laws, public companies must have audited financial statements. Private companies, however, can have compiled or reviewed statements. Compilations are restatements of the financial data provided by the company without any meaningful verification. Reviewed statements feature more verification than compiled statements. Under a review process, the accountants investigate certain aspects of the statements but employ significantly fewer verifications than they do in an audit. The fact that these statements are not audited does not mean that they are unreliable or cannot serve as the basis for an accurate valuation. However, the evaluator must understand that audited and reviewed statements differ in the degree to which the data they contain have been verified for accuracy.

Business Valuation Parameters

At the start of a business valuation, two parameters need to be established. These are:

  1. Purpose of the valuation. It is assumed that the business is being valued as a result of an interruption in the operations of the plaintiff. This interruption has either caused the company to go out of business or resulted in a decline in its value. The expert’s task is to compute the value prior to the business interruption and compare it to the value at some other date.
  2. Valuation date. A business’s value changes over time. Therefore, it is important to stipulate the date as of which the value is to be computed. This date often is selected based on legal assumptions that would be provided to the expert. The Coastal Fuels court indicated that this date should not be beyond the date that the company went out of business.

Factors to Be Considered When Doing a Business Valuation

Several factors need to be analyzed when conducting a business valuation. These include firm‐specific factors as well as external variables, such as the state of the economy and the condition of the industry. These external factors define the environment within which the firm operates. Firm‐specific factors reflect the unique aspects of the firm as it operates in this economic environment.

Revenue Ruling 59–60 and Factors to Consider in Valuation

A number of revenue rulings clarify the factors that tax courts consider when evaluating valuation analyses. Perhaps the most frequently cited of these rulings is Revenue Ruling 59‐60. It is particularly relevant in the valuation of closely held businesses. It lists some of the factors that evaluators of closely held businesses should consider as part of the valuation process. Although some experts may disagree as to how these are presented and what other factors should be considered in a valuation, it is helpful to consider these factors – particularly when certain courts place significant weight on them.

Firm‐Specific Factors

One of the first steps in the valuation process is to conduct research into the background of the company. This involves an investigation into its history. Often this includes a site visit. The expert identifies the senior management, their backgrounds, and compensation levels. In addition, the company’s principal products and services are identified. Often various lists are prepared that delineate the company’s main facilities and other details relevant to a valuation of the company. In doing such an investigation, the expert tries to identify those aspects of the company that contribute to the overall value of the company. For example, a company might have a well‐established brand name for some of its products, and this may create the expectations that it may have dependable cash flows in the future. Another company might find great value in its experienced workforce, which its competitors may lack. The identification of these value drivers can play an important role in the overall valuation process.

Having done a review of the company’s history and products, the expert needs to review the company’s finances, including its sources of capital and how it has financed its assets. A review of the company’s current and historical capital structure then leads to a consideration of its expected future financing needs. Questions need to be answered, such as: Will the company have sufficient access to capital to be able to grow at the rates that are incorporated in the valuation process?

Each valuation presents its own set of firm‐specific factors that the expert must consider and analyze. Normally these factors would include the company’s customer base as well the makeup of its suppliers and the relationships it has with each group. For example, the expert may do an analysis of the company’s sales by customer to see what percent of total sales is accounted for by each customer. The expert may go on to analyze how sales by customer have varied over time. A similar analysis could be conducted for the company’s suppliers. It is not possible to give one all‐inclusive list of all firm‐specific factors that fits all valuations. Each valuation is different. After an initial review, the expert compiles a list of unique factors that have to be considered.

Economic Factors

An evaluator of a business needs to understand the overall economic environment within which the business operates. More precisely, this is the macroeconomic environment. Various economic aggregates, such as those discussed in Chapter 3, are useful when assessing the state of the macroeconomy. The interrelationship among the business, its sales, and the performance of the economy needs to be assessed when valuing a business, just as it does when measuring lost profits from a business interruption.

Depending on the nature of the business, and the extent to which it derives its demand from a specific region of the country, a regional economic analysis may be needed. This type of analysis is also discussed in Chapter 3, which explores the sources of macroeconomic data available to the expert. In doing an analysis of these data, the expert can evaluate the extent to which the firm’s net earnings and cash flows are influenced by business fluctuations.

Industry Factors

The state of the industry needs to be analyzed when doing an evaluation of a specific business within an industry. This component of the overall analysis is similar to what is covered in Chapter 4. It involves an analysis of the condition of the industry, including a consideration of the level of competition and the profitability of the industry over time. The evaluator should be able to determine whether profitability has been stable or was increasing or decreasing as of the evaluation date. All other things constant, businesses that operate in highly competitive environments are exposed to greater degrees of competitive pressure, which may result in lower profit margins. If the level of competition has recently changed, or is expected to change, such as through a process of deregulation of the industry, the value of the business may change. If deregulation results in lower margins and profits, the value may fall correspondingly.

Many other potential industry factors can be considered. Among them is the life cycle of the industry and the plaintiff’s product line relative to its competition in the industry. Once again, each case brings its own specific factors that need to be addressed on a case‐to‐case basis.

Financial Analysis

Following an analysis of the overall economy and the industry, the expert may want to conduct a financial analysis of the company. This often includes a financial ratio analysis.8 These ratios consider five main characteristics of a company: liquidity, assets activity, financial leverage, performance, and profitability. A list of the standard financial ratios is presented in Table 8.1.

TABLE 8.1 Financial Ratios

Ratio Ratio Formula
Liquidity
 Current Ratio Current Assets / Current Liabilities
 Acid Test Ratio Current Assets ‐ Inventories / Current Liabilities
Asset Management
 Inventory Turnover (Days) Average Inventories / Cost Goods Sold / 360
 Inventory Turnover (Days) (Alternative Calculation) Average Inventories / Sales / 360
 Receivable Turnover (Days) Average Receivables / Sales / 360
 Fixed Assets Turnover Sales / Net Fixed Assets
 Total Assets Turnover Sales / Total Assets
Debt Management
 Total Debt to Total Assets Total Debt / Total Assets
 Times Interest Earned Earnings before Interest & Taxes / Interest Charges
EBITDA Coverage EBITDA + Lease Payments / Interest + Principal Pay + Lease Pay
Profitability
 Net Profit Margin Net Income ‐ Preferred Dividends / Sales
 Basic Earning Power Earnings before Interest & Taxes / Total Assets
 Return on Total Assets (ROA) Net Income ‐ Preferred Dividends / Total Assets
 Return on Equity (ROE) Net Income ‐ Preferred Dividends / Average Common Equity
Market Value
 Price/Earnings Ratio Price per Share / Earnings Per Share
 Price to Cash Flow Price Per Share / Operational Cash Flow Per Share
 Market to Book Market Price per Share / Book Value Per Share

Liquidity ratios provide information on the ability of the company to meet its short‐term obligations. Activity ratios indicate how quickly the company turns over or converts certain assets into sales, such as inventories or accounts receivable. Financial leverage ratios consider a company’s capital structure and how much debt versus equity it utilizes to finance its assets. Profitability ratios measure the company’s ability to generate profits, such as gross and net profits, from its sales. Market ratios reflect how the market values the company. Financial ratios provide more information content when they are compared to industry norms,9 referred to as cross‐sectional comparisons. In addition, the expert also reviews the trends in the ratios over time to see if there is an improvement or a deterioration in a particular aspect of the company’s condition.

Valuation Concepts

Several different valuation concepts are used in the field of business valuation. Some have more relevance than others. These are:

  • Liquidation value
  • Book value
  • Enterprise value
  • Fair market value
  • Fair value

Liquidation Value

Liquidation value is the value that would be realized if the assets of the firm were sold and the proceeds used to satisfy outstanding liabilities. This value is influenced by the manner in which the assets are sold. In many liquidations, assets are sold at “fire sale” prices that are well below the values that would be realized in a more orderly sale. Commission costs for the services of intermediaries who facilitate the sale may also have to be considered. Higher value can be realized with a more orderly liquidation, for the seller may be more selective in the prices that it accepts.

Liquidation value sometimes is used as a floor value for a company. That is, it is considered a value that is below or, at worst, equal to the value that the expert would put forward in the valuation.

Book Value

Book value, which is also called net asset value, is the difference between the value of the company’s assets and its liabilities. The value of the assets is the value that those assets carry on the company books. This value may be less than the market value due to the cumulative impact of depreciation. In some valuations, the expert can adjust this value to reflect more accurate market values, but the relevant data may not be available to do such an adjustment.

For some asset‐oriented businesses, such as ones in the financial services industry, net asset value may be higher – the asset may be kept on the books at more accurate values. For other businesses, the asset side of the balance sheet may include various intangibles that are difficult to value. Accounting rules have recently changed regarding the valuation of goodwill. Goodwill must now be regularly reexamined and written down if its value is reduced.10

It is usually assumed that the liabilities are carried at accurate values on the company’s balance sheet. However, certain categories of liabilities may be too uncertain to be valued and thus are included on the balance sheet. Potential litigation liabilities are an example. It may be that the market is aware that such liabilities are significant, but because accountants cannot construct a reliable estimate of their value, they are not included. When this happens, the expert needs to try to address this issue explicitly prior to issuing a total value for the company.

Enterprise Value

“Enterprise value” is a term that is used differently in different contexts. It reflects the value of the entire business rather than the value of the equity. If earnings‐oriented methods are used to value a business, the resulting value does not necessarily reflect how the business was capitalized. An enterprise value approach is able to reflect the relevant components of debt and equity in the company’s capital mix. Once the value of the liabilities is deducted from the total value, the value of equity can be distinguished from the enterprise value. Enterprise value reflects the market value of the invested capital. Some users, however, are so concerned about the ambiguity of the usage of this term that they recommend avoiding its use in the valuation process.11 However, enterprise value is a concept that is very actively used in valuation for public financial markets; users can feel confident that its usage is very well accepted.

Fair Market Value

The term “fair market value” is defined as the value that would be realized in a transaction between a buyer and seller, each being fully informed of the relevant facts, and neither under a compulsion to pursue the transaction. In most contexts, having a willing buyer and seller means that the transaction is an arm’s‐length transaction. This rules out values that are derived from situations where the buyer or seller is unduly influenced to complete the transaction. Sometimes the term “fair market value” is used interchangeably with “cash value” or “market value.”

Fair Value

In some cases, an alternative to the term “fair market value” must be used according to the laws of the relevant jurisdictions. This value may be different from the market value, as the latter could be subject to various discounts, which are discussed later in this chapter.

“Fair value” is usually understood to mean a legal standard that applies to certain types of valuations. It is commonly used in valuations for oppressed minority shareholder lawsuits. In such suits, this usually means the value that would prevail “but for” the actions of the oppressor. It is also used in lawsuits brought by dissenting shareholders who are pursuing their shareholder appraisal rights. Often the term “fair value” is discussed in state statutes that relate to such suits.

Most Commonly Used Valuation Methods

Several techniques are commonly used to value closely held businesses. Some of these methods are more appropriate than others, depending on the particular circumstances surrounding the business being valued.

  • Discounted future cash flows. This method requires a projection of future cash flows and the selection of a discount rate to bring the future projected amounts to present value.
  • Capitalization of earnings. Capitalization of future earnings treats the income stream as a perpetuity and values it by dividing a representative earnings base by the appropriate capitalization rate.
  • Comparable multiples. This is a very common approach to valuing businesses. It involves the selection of certain comparable multiples and applying them to the target business to derive a value.
  • Asset‐oriented approaches. There are several asset‐oriented approaches. Some are relevant to the valuation of both public and private businesses; others are applied more frequently to privately held businesses. They simply focus on the value of the assets in relation to the firm’s liabilities with explicitly taking into account the future earnings of the business.

Discounted Future Cash Flows or Net Present Value Approach

The discounted future cash flows approach to valuing a business involves three main analytical steps:

  1. Projecting future cash flows
  2. Measuring the length of the projection period
  3. Selecting the appropriate discount rate

The value of a business using discounted cash flows can be expressed as follows:

(8.1)equation

where:

  • CFi = the ith period’s cash flows
  • n = the number of periods
  • r = the risk‐adjusted discount rate

We have already discussed the discounting process in Chapter 7. One of the key decisions in using the discounted cash flow approach is to select the proper discount rate. This rate must be one that reflects the perceived level of risk in the target company.

One of the steps in the valuation process is determining the length of the projection period. The cash flows are scheduled to grow at a rate g. Often this rate is derived from a consideration of the historical growth of the company’s cash flows. Many experts project the cash flows for a five‐year period and then capitalize the cash flows that are projected for the sixth year and thereafter. This is expressed in Equation 8.2.

While many valuations that use discounted cash flows employ a five‐year period for the first part of Equation 8.2, this is not a hard and fast rule. Other lengths, such as seven years, are also acceptable. One of the factors that determine the length of the future projection period is the length of time that the expert feels confident that he can accurately forecast.

The value in year 5, V5, is the capitalized value of the cash flows that the business would derive after the fifth year. These cash flows are treated as a perpetuity and are capitalized by dividing the cash flow value for the sixth year by the growth adjusted discount rate (r – g). That is, the sixth year’s cash flows are computed by multiplying the fifth year’s cash flows, FCF5, by (1 + g). This is then divided by the capitalization rate, which is the difference between the discount rate, r, and the growth rate, g. The value V5 is a year 5 value, and it must be brought to year 0 terms by dividing it by (1 + r)5. This discounted value of the cash flows after year 5 is sometimes referred to as the residual.

Discount Rate and Risk

Our discussion would be conspicuously incomplete if we did not briefly discuss the selection of the discount rate and the risk‐adjustment process that was covered in great detail in Chapter 7. The greater the risk associated with the projected cash flow stream, the higher the discount rate that is used. If the projected cash flow stream is considered highly likely, then a lower discount rate is used. For high‐risk cash flow streams, a risk premium is added that increases the discount rate. The use of a higher discount rate lowers the present value of each annual projected income amount.

The discount rate is often set as the sum of a risk‐free rate plus an appropriate risk premium. Experts often look to the variability of securities that are traded in the marketplace and the risk premium that they include. This risk premium is then added to the risk‐free rate to arrive at the risk‐adjusted discount rate.

Capitalization of Earnings

The capitalization process allows the expert to determine the present value of a business’s future income by treating it as a perpetuity. A perpetuity has no specific ending period. The capitalization process requires the expert to select an earnings base. The capitalization rate is then divided into that base to determine the present value of the earnings stream.

Some naive critics disparage the capitalization of earnings technique because, in their view, the process assumes that the business will be in existence for an infinite time period. Each case is different, but in many instances, this may not be a valid criticism, because monies that would be received an infinite number of years from now would be worth nothing, given the time value of money. Moreover, the present value of income that is received further into the future is worth less and less. The more distant the income that is received, the less valuable it is.

When using capitalization of earnings to value a lost profits claim, experts need to be aware that the resulting analysis implies that the defendant is obligated to pay to the plaintiff damages that extend for an indefinite period. If such a loss period is inconsistent with the facts and the legal obligations of the defendant, then capitalization may not be the appropriate way to value the plaintiff’s lost profits.

Capitalization Rates Versus Discount Rates

The terms “capitalization rate” and “discount rate” sometimes are used interchangeably. When a specific projection of income has been developed for a certain time period, then the term “discount rate” is used. When the task is to value a business that is capable of generating an income stream for an indefinite period of time, then the term “capitalization rate” is used. The relationship between the capitalization rate and the discount rate is depicted in Equation 8.3.

where:

  • ke = the capitalization rate
  • r = discount rate
  • g = the growth rate of the income stream being valued

Comparable Multiples

Comparable multiples are used to value a comparable business by deriving multiples that have been used to value companies, such as in acquisitions, and applying them to the business in question. The first step in the process is to determine comparable companies. These are sometimes referred to as proxy firms or guideline companies. The process of selecting comparable companies is similar to what the expert does when using the yardstick method to value lost profits in a business interruption. In this process, the expert seeks to find companies that market a similar product or service as the business in question. This is often done by searching databases that have historical acquisition/transactions data by NAICS or Standard Industrial Classification (SIC) code and then selecting a set of comparable transactions. Several such databases exist, and they vary in their attention to companies of different sizes.12 The expert can search these databases, get several transactions, and then research the target companies more carefully to determine if they really are comparable. Sometimes some of the companies are eliminated from consideration due to certain differences between them. Perhaps one of the potential comparable companies is much larger than the company in question. Another possible reason for a rejection is if the company is in more than one line of business, and these other areas are significantly different from the business that is being valued. Still another reason could be that the comparable value for one of the deals was so different from the others that it is considered an outlier or an anomaly. In this step of the valuation process, the expert makes a judgment call to eliminate certain companies.

Several possible multiples can be used to value businesses. Two of the most frequently cited are earnings before interest, taxes, depreciation, and amortization (EBITDA) and price/earnings (P/E) multiples. Data of such multiples are readily available. EBITDA multiples are often used in valuing acquisition targets.

Other multiples, such as revenues multiples, may be more relevant for certain types of businesses, such as some closely held companies. Revenues, as opposed to earnings‐oriented multiples, are used when there are concerns about the quality of the earnings data.

Users of this method may have to make additional adjustments after a value is determined by applying the multiple. Since the comparable multiples method is an earnings‐oriented approach to business valuation, the expert may possibly choose to add in the value of nonoperating assets, as they were not necessary to the generation of the earnings base to which the multiple was applied. Whether adjustments such as these are done depends on the particular circumstances of the valuation.

Asset‐Oriented Approaches

Asset‐oriented methods consider the value of a company’s assets in relation to its liabilities. The simplest application of this is the determination of net asset value – also called shareholder equity. This is the difference between assets and liabilities on the company’s balance sheet. It does not explicitly consider the earning power of the assets except what is explained by their values.

It is important to note that the value of a company’s assets on its balance sheet is purchase price less accumulated depreciation. This value may be very different from an asset’s market value. If there is reason to believe that the market value of a company’s assets is very different from its book value, then asset‐oriented approaches may be less helpful (unless adjustments to the asset values can be made). Most damages experts are not in a position to make such adjustments, although they may bring in other experts to help with such adjustments.

Intangible assets may present particular challenges to the valuation expert seeking to do an asset‐oriented valuation. While recent changes in accounting rules require a regular examination of goodwill, this may not be sufficient for the expert who is valuing the entire business.13

The discussion of asset‐oriented approaches assumes that the liabilities carried on the company’s books are accurate values. If a liability is knowable and capable of being measured, accounting rules require it to be noted. However, certain liabilities may not be on the balance sheet because they are uncertain and not measurable. This does not mean, however, that they are not significant and potentially sizable. The huge litigation liabilities of tobacco and asbestos manufacturers are cases in point.

Adjustments and Discounts

The expert may need to make various adjustments to the values he derived from the application of some of the methods already discussed. Two of the more common adjustments are marketability and minority adjustments.

Marketability Discounts

Stock investments in some companies are more liquid than others. One major difference is in the liquidity of stock in closely held and public companies. The stock of closely held companies is distinctly different from that of public firms in that a market already exists for public stocks; the stock of private companies, however, has only limited marketability. Depending on where a public stock is traded, this investment can be quite liquid. “Liquidity” refers to the speed with which an asset can be sold without incurring a significant loss of value. Under normal conditions, the stocks of major companies that are traded on the larger exchanges such as the New York Stock Exchange/Euronext are liquid investments. Stocks of companies infrequently traded on the OTC market are not as liquid. However, even these stocks have a market maker who will endeavor to buy and sell the shares. This is not the case for shares of closely held companies. Therefore, if the stock values of comparable public companies are used to value closely held shares, these derived values need to be reduced to reflect the relatively lower marketability of closely held shares.

Restricted Stock

There has been abundant research on marketability discounts. One body of research examined the prices of letter stock. These types of shares are also referred to as restricted stock or unregistered stock. Letter stocks are shares of public companies that are identical to the company’s shares that are actively traded, except that the stock is restricted and cannot be traded for a specific time period. Public sales of restricted shares are regulated by SEC Rule 144, which was adopted in 1972. Companies issue restricted shares for a variety of reasons, including general capital raising, financing of mergers or for the compensation of management. Rule 144 requires that unregistered shares acquired in a private offering by a public company be held for a specific time period. After that time period there are limitations on the number of such shares that can be sold during a specific time period. Over the years since its implementation in 1972, Rule 144 has been amended several times, with the most recent being 2008. The effect of these amendments was to shorten the holding period.

Because the lettered stock may not be traded in public markets, it lacks the marketability of the unrestricted shares. The price difference between these two categories of stock can be used as a guide to the value of this one attribute – marketability. Whatever discount that is derived from this research, however, underestimates the true marketability discount. This is because letter shares are usually restricted for a period of one to two years, at which point they become registered with the SEC and can be publicly traded. Therefore, this research measures only the discount due to the temporary lack of marketability and the indefinite lack of marketability of closely held stock.

Marketability Discount Research

A number of studies have tried to measure the value of the discount that the market puts on a lack of marketability. In the context of business valuations, “marketability” refers to the ability of an investor in a business to sell his investment without significant loss of value. Various studies that attempt to measure the discount that the market itself applies to less marketable investments are categorized according to the methodology that has been employed.

RESTRICTED STOCK STUDIES

One of the early studies on restricted stock discounts was the Securities and Exchange Commission’s Institutional Investors Study.14 The SEC’s researchers examined companies that were traded on the New York and American Stock Exchanges, as well as OTC companies. They considered shares that were restricted and compared their values to the unrestricted shares of the same companies. They found an average discount of 25.8%. Shortly after the SEC study, Milton German examined 89 restricted stock transactions and found that the restricted shares sold at discounts equal to 33% of the unrestricted stock.15 Similar results were obtained by Robert Moroney, who found a mean discount of 35.6% for 146 restricted stock transactions.16 Robert Trout used a multiple regression model to estimate the marketability discount for 60 restricted stock purchases. He found an average discount of 33.45%.17 Still another study, done by J. Michael Maher, found a similar mean discount of 35.43%.18 In the 1980s, using data from 28 restricted stock private placements from 1978 to 1982, Standard Research Consultants found an average discount of 45%. Williamette Management Associates, using data on 33 restricted stock private placements from 1981 to 1984, found an average discount of 33%. The results of these studies are summarized in Table 8.5.

A review of Table 8.5 shows a clear declining trend on minority discounts. This is due to the various regulatory changes, some of which we have already discussed previously. In 1990 the SEC allowed institutional investors to trade unregistered among themselves. This gave such shares some greater liquidity. In February 1997 the SEC reduced the required holding period for these securities from two years to one year. This also increased the liquidity of these securities. We can see from Table 8.5 that the only study that focuses on a post‐1997 time period is the second Columbia Financial Advisors study. It is interesting to note that this study showed the lowest discount (13%).

TABLE 8.5 Summary of Restricted Stock Studies

Source: Adapted from Shannon Pratt, Valuing a Business, 5th ed. (New York: McGraw‐Hill, 2008), p. 431.

Study Years Covered Sample Size Average Discount (%)
SEC 1966–1969 398 25.8
Gelman 1968–1970 89 33.0
Trout 1968–1972 60 33.5
Moroney NA 146 35.6
Standard Research Consultants 1978–1982 28 45.0
Silber 1981–1988 69 33.8
FMV Opinions, Inc. 1979–1992 100 23.0
Williamette Management 1981–1984 33 31.2
Johnson 1991–1995 76 20.2
Columbia Financial Advisors 1996–1997 23 23.0
Columbia Financial Advisors 1997–1998 15 13.0
Stout 1980–2016 750 15.8

Depending on the issues in the valuation, the expert may want to access the Stout Restricted Stock database, which features many restricted stock transactions with 60 data fields that the expert can review and use to derive some empirical support for a specific discount.19 This database is commercially available.

Tax Court Decisions Regarding Use of Average Discounts Derived from Research Studies

The term “benchmarking” has been used in this area to refer to the practice of determining the relevant marketability discount by applying averages from the various studies such as this shown in Table 8.5. One of the problems with using average discounts from research studies is determining whether or not there are unique circumstances related to the company’s shares being valued that would cause it to have a different marketability study. In Mandelbaum v. Commissioner, the court advocated the use of 8 factors for experts to consider as shown in Table 8.6.20 The expert could then determine if any of these factors implied a below or above average discount. The consideration of such factors does not eliminate subjectivity on the part of the expert. Rather, experts can differ in how they access each factor.

TABLE 8.6 Mandelbaum Factors

1. Financial statement analysis
2. Dividend policy
3. Background on the company, its history, products, or other relevant factors
4. Management
5. Amount of control associated with shares in question
6. Any limitations on the transfer of the shares
7. Corporate share redemption policy
8. Potential costs of doing an initial public offering

Other decisions also supported the use of more case‐specific analysis rather than just using benchmarking.21 Commercial databases are now available that can facilitate the inputting of company‐specific information, which can narrow down the transactions considered to those companies that are financially most similar to the company whose equity is being valued. One is the Stout database.22 Another is the LiquiStat database, which contains data on secondary market transactions for illiquid securities.23

Research on Private Transactions Before Initial Public Offerings

An alternative methodology for deriving the marketability discount is to examine the difference between the prices of private securities transactions prior to initial public offerings (IPOs) and the IPO prices. A total of eight studies have been conducted by John Emory of Baird & Company and another by Williamette Management Associates. Emory examined various offerings at different points in time from 1980 to 2000. Each study would cover a two‐ or three‐year period. The number of offerings in each study ranged from 97 during the period 1980 to 1981 and 1,847 during the period 1997 to 2000.24 Emory found a range of different discounts for all eight studies that yielded a mean of 46% and a median of 47%. Williamette Management Associates did similar studies covering parts of the period from 1975 to 2002.25 They also examined the difference between the prices of shares in closely held companies and the prices of the shares after the companies had gone public. The results of the Williamette studies tended to be lower than the Emory research values. For example, the Williamette studies over the period 1975 to1997 yielded mean discounts that ranged from 28.9% (1991) to 56.8% (1979).26 The 1999 and 2000 Williamette studies generated even lower discounts. For example, their 2000 study shows a mean discount of 18% and a median value of 31.9%. The researchers surmised that these lower values were a function of the unusual market conditions that prevailed during this time period. When a longer time period, such as the entire period studied by John Emory, was considered, the mean discount was 46% and the median was 47%.27

Conclusion of Restricted Stock and Pre‐IPO

Research in this field shows that when public prices are used as a guide for the value of the stock of private companies, a marketability discount of at least one‐third is appropriate. The studies in this area support such a discount, if not an even higher one, from the public price.

Minority Discounts

A second discount might also be needed, depending on the percentage of ownership the privately held stock position constitutes. This is because control is an additional valuable characteristic that a majority position possesses that a minority holding does not. A minority shareholder is often at the mercy of majority shareholders. The holder of a minority position can only elect a minority of the directors, and possibly none of the directors, depending on whether the corporation is incorporated in a state that allows cumulative voting. Majority and minority shareholders each possess proportionate rights to dividend distributions, but a majority shareholder possesses the right to control the actions of the corporations in addition to these dividend decisions. This is an additional characteristic and commands an additional premium that must be paid. Looking at it from the minority shareholder’s viewpoint, the minority position is valuable and will trade at a discount to account for the lack of control.

A guide to the appropriate minority discount is the magnitude of the average control premium. Table 8.7 shows that the average control premium between 1980 and 2018 was 43.3%. This premium can be used to compute the appropriate minority discount using Equation 8.4:

Using the average control premium of 42.5%, we get an implied minority discount of 32%.

Applying Marketability and Minority Discounts

Let us assume that a value of $40 per share has been computed for a 20% ownership position in a closely held firm. For the purpose of demonstrating the use of discounts, let us assume 33% marketability and minority discounts. The value of this stock position equals:

Unadjusted value $40/share
Less 20% marketability discount 32.00
Less 33% minority discount 22.40

The $17.96 per‐share value is the value of a nonmarketable minority position in this closely held business.

Summary

In cases where the plaintiff has been so injured that it has gone out of business, the measure of damages may be the value of the business as of a date that is the one determined to be most relevant. This measure of damages has been consistently endorsed by the courts. The courts have also tended not to support year‐by‐year lost profits projections to value the damages of a defunct corporation. In addition, combining both could involve double counting.

Several different standards of value exist, one of which is fair market value. This is the value that a willing buyer would pay and a willing seller would accept, each being under no compulsion to sell and both being fully informed of the relevant facts. Another standard, fair value, may be relevant. This measure does not necessarily rely on the values that would prevail in a market.

There are various approaches to valuing a business. These methods have been discussed at length in the business valuation literature. The main methods are discounted cash flow (DCF), comparable multiples, and asset‐oriented approaches such as net asset value. DCF involves projecting cash flows, such as free cash flows, for a finite time period, such as five years, and then computing a terminal value through the process of capitalization. Capitalization itself is another income‐oriented approach that can be used by itself without forecasting out specific cash flows or earnings levels. In addition, businesses can be valued by finding certain comparable multiples from proxy firms that can be applied to financial measures for the target firm to value it. Price/earnings multiples are one potential example among many. Various transactions databases exist, which the expert can search to determine the relevant comparables. One key decision of an expert is which transactions are truly comparable and which are not.

TABLE 8.7 Control Premiums and Implied Minority Discounts

Source: Mergerstat Review, 2019.

Year Control Premium Offer (%) Implied Minority Discount (%)
1980 49.9 33.3
1981 48.0 32.4
1982 47.4 32.2
1983 37.7 27.4
1984 37.9 27.5
1985 37.1 27.1
1986 38.2 27.6
1987 38.3 27.7
1988 41.9 29.5
1989 41.0 29.1
1990 42.0 29.6
1991 35.1 26.0
1992 41.0 29.1
1993 38.7 38.3
1994 40.7 54.5
1995 44.1 61.7
1996 37.1 29.4
1997 35.9 22.4
1998 40.7 39.5
1999 43.5 33.0
2000 49.1 53.8
2001 58.0 35.2
2002 59.8 39.9
2003 63.0 21.1
2004 30.9 27.2
2005 33.6 17.6
2006 31.9 18.9
2007 31.6 26.0
2008 57.3 31.9
2009 52.4 44.6
2010 52.5 18.6
2011 54.3 50.7
2012 46.3 44.7
2013 44.2 40.8
2014 44.7 26.0
2015 40.0 35.7
2016 48.0 40.0
2017 37.1 22.1
2018 38.1 21.0
Average 43.3 32.6

Still another method to value a business is to focus on the value of its assets less its liabilities. These values can be derived from the balance sheet, or the values can be adjusted to try to reflect market values as opposed to values at which assets are carried on the balance sheet. Depending on the nature of the business, the services of other experts may be needed to complete the valuation.

In computing fair market value, the expert may have to apply certain discounts, such as a discount to account for lack of marketability. For example, this discount could apply to a closely held company but likely would not apply to a larger publicly held business. Other discounts may be relevant for minority interests. Various research studies have attempted to quantify both discounts.

References

  1. Albrecht v. Herald Co ., 452 F. 2d 124 (8th Cir. 1971).
  2. RMA Annual Statement Studies. www.rmaq.org.
  3. Brigham, Eugene F., and Philip R. Davies. Intermediate Financial Management, 13th ed. Boston: Cenage, 2020, pp 279–306.
  4. Coastal Fuels of Puerto Rico, Inc. v. Caribbean Petroleum Corp ., 990 F.2d 25, 26 (1st Cir. 1993).
  5. Dengel, F.R., Emory, John Sr., and Emory, John Jr. “Discounts for Lack of Marketability: Emory Pre‐IPO Discount Studies 1980–2000 as Adjusted October 10, 2002,” www.emoryco.com.
  6. Emory, John D. “The Value of Marketability as Illustrated in Initial Public Offerings of Common Stock.” Business Valuation News (September 1985): 21–24.
  7. Emory, John D. “The Value of Marketability as Illustrated in Initial Public Offerings of Common Stock.” Business Valuation Review (December 1986).
  8. Farmington Dowel Products Co. v. Forster Manufacturing Co ., 421 F2d 61 (1st Cir. 1970).
  9. German, Milton. “An Economist‐Financial Analysts Approach to Valuing Stock of a Closely Held Company.” Journal of Taxation (June 1972): 354.
  10. Indu Craft, Inc. v. Bank of Baroda, 47 F. 3d 490 (2nd Cir. Circuit, 1995).
  11. “Institutional Investor Study Report of the Securities and Exchange Commission.” Washington, DC: U.S. Government Printing Office, Document 93–64, March 10, 1971.
  12. LiquiStat™ Database. www.plurisvaluation.com.
  13. Maher, J. Michael. “Discounts for Lack of Marketability for Closely Held Business Interests.” Taxes (September 1976): 562–571.
  14. Mandelbaum v. Commissioner, LAR 34.1a (T.C. 1996).
  15. Moroney, Robert E. “Most Courts Overvalue Closely Held Stocks.” Taxes (March 1973): 144–154.
  16. Pratt, Shannon P. “Discounts and Premia,” in Valuation of Closely Held Companies and Inactively Traded Securities. Charlottesville, VA: Institute of Chartered Financial Analysts, 1990.
  17. Pratt, Shannon P. Valuing a Business, 5th ed. New York: McGraw‐Hill, 2008.
  18. Pratt, Shannon. Valuing Business and Professional Practices, 5th ed. (Homewood, IL: Dow Jones‐Irwin, 2008), pp. 436–438.
  19. Pratt, Shannon P. Valuing Small Businesses and Professional Practices. Homewood, IL: Dow Jones‐Irwin, 1986.
  20. Statement of Financial Accounting Standards 142. FASB.
  21. Stout Database. www.stoutadvisory.com.
  22. Temple v. U.S ., No. 9:03. CV 165. (D.C. 2006).
  23. Trout, Robert R. “Business Valuations” in Measuring Commercial Damages. New York: John Wiley & Sons, 2000.
  24. Trout, Robert R. “Estimation of the Discount Associated with the Transfer of Restricted Securities.” Taxes (June 1977): 381–385.
  25. Van Horne, James C., and John M. Wachowicz. Financial Management and Policy. Upper Saddle River, NJ: Prentice Hall, 1996.
  1. 1 Business Valuation Review.
  2. 2 Indu Craft, Inc. v. Bank of Baroda, 47 F. 3d 490 (2nd Cir. Circuit, 1995).
  3. 3 Coastal Fuels of Puerto Rico, Inc. v. Caribbean Petroleum Corp., 990 F.2d 25, 26 (1st Cir. 1993).
  4. 4 Farmington Dowel Products Co. v. Forster Manufacturing Co., 421 F2d 61 (1st Cir. 1970).
  5. 5 Indu Craft, Inc. v. Bank of Baroda, 47 F. 3d 490 (2nd Cir. Circuit, 1995).
  6. 6 Albrecht v. Herald Co., 452 F. 2d 124 (8th Cir. 1971).
  7. 7 Ibid.
  8. 8 For a good review of financial ratio analysis, see Eugene F. Brigham and Philip R. Davies, Intermediate Financial Management, 13th ed. (Boston: Cenage, 2020), pp. 279–306.
  9. 9 See RMA Annual Statement Studies, www.rmaq.org.
  10. 10 Statement of Financial Accounting Standards 142. FASB.
  11. 11 Shannon Pratt, Valuing a Business, 5th ed. (New York: McGraw-Hill, 2008), p. 37.
  12. 12 See, for example, Pratt's Stats and Biz Comps.
  13. 13 SFAS 142.
  14. 14 “Institutional Investor Study Report of the Securities and Exchange Commission,” Document 93–64, Washington, DC: U.S. Government Printing Office, March 10, 1971.
  15. 15 Milton German, “An Economist-Financial Analysts Approach to Valuing Stock of a Closely Held Company,” Journal of Taxation (June 1972): 354.
  16. 16 Robert E. Moroney, “Most Courts Overvalue Closely Held Stocks,” Taxes (March 1973): 144–154.
  17. 17 Robert R. Trout, “Estimation of the Discount Associated with the Transfer of Restricted Securities,” Taxes (June 1977): 381–385.
  18. 18 J. Michael Maher, “Discounts for Lack of Marketability for Closely Held Business Interests,” Taxes (September 1976): 562–571.
  19. 19 www.bvresources.com.
  20. 20 Mandelbaum v. Commissioner, LAR 34.1a (T.C. 1996).
  21. 21 Temple v. U.S., No. 9:03. CV 165. (D.C. 2006).
  22. 22 Stout Database, www.stoutadvisory.com.
  23. 23 LiquiStat™ Database, www.plurisvaluation.com.
  24. 24 See, for example, John D. Emory, “The Value of Marketability as Illustrated in Initial Public Offerings of Common Stock,” Business Valuation News (September 1985): 21–24; John D. Emory, “The Value of Marketability as Illustrated in Initial Public Offerings of Common Stock,” Business Valuation Review (December 1986); and John D. Emory, Sr., John D. Emory, Jr., and F. R. Dengel, Business Valuation Review (December 2002).
  25. 25 Shannon Pratt, Valuing Business and Professional Practices, 5th ed. (Homewood, IL: Dow Jones-Irwin, 2008), pp. 436–438.
  26. 26 Ibid., p. 437.
  27. 27 F.R. Dengel, John Emory Sr., and John Emory JR., “Discounts for Lack of Marketability: Emory Pre-IPO Discount Studies 1980–2000 as Adjusted October 10, 2002,” www.emoryco.com.
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