WFU Law School
Law & Valuation
5.5.1 Normalize Financials

5.5.2 Method Chosen

  • Asset method
  • Income method
  • Market method
  • Weighting factors

Exclusive use of book value

Use of book value, or adjusted book value only, does not take into account intangibles such as goodwill, customer lists, trademarks, patents, reputation, and on forth. Accordingly, many cases reject this method. Estate of Poley, T.C. Memo 3/7/47, affirmed (1948), CA(3) Fed2d 434(e): Estate of Patton, T.C. Memo 10/30/51(i); Estate of Tebb, (1957), 27 T.C. 671(A)(i) and (e).

Depreciation

True depreciation is obviously more accurate than tax depreciation, and therefore, an appraisal of tangible assets as to current and fair market value may be useful. Furthermore, the straight method as opposed to the accelerated depreciation method may be more appropriate when using a depreciation schedule to value tangible personal property.

Weighting of earnings

If the expert simply averages the last five years' earnings, and the earnings have increased each year, then it would be more accurate to weight the earnings on a 5/4/3/2/1 basis with the 5 weight applied to the most recent year in order to accurately project future income.

Risk factors

In determining the capitalization rates, the expert should consider a variety of risk factors including, but no limited to, small size, small market share, intensity of competition, cyclical businesses, products that are faddish, depend on style or fashion trends, limited capitalization or limited access to capital, lack of management depth, strong demanding customers, industry over capacity and deteriorating locational factors. Failure to properly consider these factors may result in a lower than appropriate capitalization rate.

In Smith v. Smith, supra, depreciation, as well as interest, was added back in to operating expenses.

Use of comparable

It is essential that a comparable be truly comparable if it is to be given any credibility. Using the Internal Revenue SIC Code may reveal similar industry statistics, but the P/E ratio for a multi-million dollar company with publicly traded stock might be terribly misleading when used to value a small business in a similar industry. Furthermore, the P/E ratio for public companies is based on after-tax earnings. Therefore, adjustments should be made before comparing these P/E ratios to (1) pre-tax earnings, (2) net operating income (EBIT), (3) operating cash flow (EDIT+D), (4) seller's discretionary cash (operating cash flow before compensation).

Factor averaging

The averaging of several factors, for example, book value, capitalization, earnings and capitalized dividends, serves no useful purpose according to Revenue Ruling 59-60, Section (7). However, this was specifically rejected in Sharp v. Sharp, supra.

Excess earnings method

Misuse of Revenue Ruling 68-609

First of all, this Ruling states that a formula approach may be used for determining the fair market value of intangible assets of a business only if there is no better basis therefor available. Since you cannot sell a law practice, then the "formula" method might be appropriate to value a law practice, whereas it might be inappropriate to value a medical practice since medical practices are bought and sold and you can look at comparables to support your valuation. Secondly, the gross misuse of the rates of return and capitalization rates can result in terribly distorted valuations. It should be remembered that the suggested rate of return (8%-10%) and capitalization rate (15%-20%), were based on economic conditions for 1968 and the percentages are only set forth in the Ruling as examples, not as requirements. A more reasonable return on tangible assets might be 12%-15%, depending upon comparables acquired from publications such as Robert Morris Associates, Annual Statement Studies, and Ibbotson Associates, Stocks, Bonds, Bills and Inflation Yearbook.

Even if the use of Revenue Ruling 68-609 is appropriate, common errors in the use of this methodology include: (1) failure to deduct a reasonable owner's salary, (2) failure to normalize earnings, (3) failure to adjust book value, (4) use of inappropriate rate of return or capitalization rate as discussed earlier.
5.5.1 Normalize Financials

©2003 Professor Alan R. Palmiter

This page was last updated on: August 4, 2003