The most widely-used method to
compute the value of a business looks at the present
value of anticipated future income or
cash flow generated by the business. In effect,
the valuator capitalizes the company's current
earnings. Like other methods for valuing financial
instruments, this method relies on the discounted
cash flow (DCF) model. Earnings projections, extrapolated
from the company's accounting statements, are
discounted using a capitalization rate (or multiplier)
that takes into account the buyer's required risk-based
rate of return and a factor for future growth.
The DCF method, or the capitalization of
earnings method, is well-suited for valuing
a company whose earnings can be reasonably predicted—constant
earnings, growing earnings, or intermediate term
growth followed by constant earnings. The key
is thoughtful forecasting, supported by articulated
and reasonable assumptions. Often DCF valuations
will be based on "best," "worst"
and "most-likely" case scenarios.
Estate and gift tax. The IRS
has provided guidelines for valuing closely held
corporations. Revenue
Ruling 59-60 (1959-1, C.B. 237) and Section
2031 of the Internal Revenue Code. These guidelines,
used by the IRS in estate and gift tax cases,
have been used by courts in equitable distribution
cases.
Section 1 states: "The purpose of this
Revenue Ruling is to outline and review in general
the approach, methods and factors to be considered
in valuing shares of the capital stock of closely
held corporations for estate tax and gift tax
purposes." (More>>)
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Example
Dr. and Mrs. Nehorayoff divorced.
He owned a half-interest in a closely held medical
practice, which interest earned at least $50,000
annually, over and above a reasonable salary.
In an equitable distribution proceeding, how
would the court determine the value of the business
by capitalizing earnings?
Answer: The court considered,
among other things, the earnings record and
the risk involved -- each reflecting an assessment
of the business -- to "capitalize"
the earnings figure. Rev. Rul. 59-60 §
6. In making these judgments, expert testimony
was essential, and the court considered the
expert's reason for adopting a particular
earnings stream and choosing the multiplier.
Based upon the nature of this enterprise,
its history and prospects and "all the
facts and circumstances of this case"
-- judges fudge, too -- the court looked at
actual earnings to impute future earnings
and then said the appropriate capitalization
factor would be in the range of 3 to 4 (a
discount rate of 25% - 33%). From this the
court concluded the value of Dr. Nehorayoff's
interest in the business using capitalization
of net earnings to be $200,000.
For an excellent discussion of
this method, see Nehorayoff
v. Nehorayoff, 108 Misc. 2d 311, 437 N.Y.S.
2d 584 (1981).
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5.2 Business Valuation - Income Methods