WFU Law School
Law & Valuation
5.6 Business Valuation in Legal Contexts

5.6.1 Business valuation for estate tax purposes

Use of DCF method.

Estimating cash flows. How do courts make predictions about future earnings? Not surprisingly, the courts often hew to the seemingly safe ground of history—generally relying heavily or exclusively on a company’s past performance when predicting future results. After all, when undertaking an enterprise already fraught with as much uncertainty as valuation, a set of historical accounting records can seem like a warm safety blanket. Consider the court’s approach in the case of Central Trust Company v. United States, revered as a classic among legal valuators.

Financial analysts—who do not live solely in the past—balk at such heavy reliance on historical earnings to extrapolate future results. They also find peculiar the courts’ contentedness to engage valuators only on a superficial level—choosing arbitrary conventions such as “splitting the difference” between competing valuation reports or applying simple, mechanical “formulas” as in Central Trust rather than mix it up on the playing field of financial theory. Few would argue that this brand of judicial decision-making has any significant relationship to reality. Some suggest it may be jurisprudence undertaken in the spirit compromise and expediency rather than pursuit of justice or truth. Bolder critics have argued that the judiciary is devolving into a state-run mediation program when valuation issues arise—a program in which all the participants know at the outset that the endgame is a middle ground where questions of right and wrong are of secondary importance.

Should we, as lawyers and managers, demand that judges dive deeper than historical accounting records and compromise solutions?Consider the following cases in which the court looked beyond the financial statements to make judgments about future earnings.

Hooper v. Commissioner
41 B.T.A. 114 (1940)

In this estate tax case, the decedent’s estate included a minority interest in the family business, a corporation engaged in the business of manufacturing and selling cotton fabric.The company, however, was not in good shape. At the time of valuation, the country was emerging from depression. In the preceding years, the company had been consistently losing money. There was a definite trend toward diminishing value.

In projecting the company’s future earnings, however, the Board of Tax Appeals chose to ignore the history of negative earnings and look to immediate economic conditions which would indicate a rosier going concern value.The Board opined that:

The evidence discloses that the company had a poor earnings record. In 1932 it operated at a loss of $165,404, and its total net loss for the period 1926 to 1932 (including the profit and loss of its selling agent prior to January 1, 1932, the effective date of the merger) was $59,683, or a loss of $5.77 per share. In March 1933, after the bank holiday, its business increased; and on August 3, 1933, it could reasonably have been anticipated that it would realize, and it did realize, a substantial profit for the year. The testimony of petitioner's witnesses convinces us, however, that the increase in business and profits following the bank holiday in 1933 was largely due to fear of a violent sudden inflation, and to the rise in the prices of raw materials when the country went off the gold standard. It therefore was not a true indication of what might be expected in the future.

Had the lawyers and Board of Tax Appeals not looked beyond the pure “numbers,” a vastly different result would have been had.

Diefenthal v. United States
343 F. Supp. 1208 (1972)

Also a tax case, the court in Diefenthal was attempting to value plaintiff’s scrap iron business. The court in this case was presented with financial statements that gave the impression that the company had relatively low earnings considering the amount of business it was doing. In looking beyond the financial statements, the court noted that the company had close business relationships with several other companies that happened to be owned by a family member. It appeared that a portion of the earnings of the related companies should have been imputed to the scrap iron business—in essence finding that some of the company’s income had been “siphoned off” by the other businesses. The court added this “collateral income” to the company’s earnings and used the adjusted figures as the basis for projecting future income.

Hooper and Diefenthal are simple, straightforward examples of judicial scrutiny extending beyond historical accounting data and deceptively simplistic “weighting” procedures. Who bears the responsibility for ensuring that courts ground their decisions on sound financial theory rather than short-cut compromise measures? Most judges—burdened by an overextended docket—will say the lawyers do.


James Heekin began business as a coffee roaster in Cincinnati, Ohio in 1864.Business was good, and he began selling other dry goods such as baking powder, spices, and tea. As business expanded, he also began making his own tins to package the goods.Ninety years later, the Heekin Can Company was a $17 million business with five plants throughout the Midwest.

Since its founding, the company remained under tight family control.In 1955, two of James’ sons—both of whom had served as president of the company—died, and their ownership interests in Heekin passed to their children. These gifts of amounted to over 70,000 shares of company stock (about 25% of the outstanding shares). At the time of distribution, the executors of both estates filed estate and gift tax returns declaring the stocks’ value to be $10 per share.The executors later amended these declarations to $7.50 per share.

The IRS had a different idea about the value of Heekin shares: $24 per share. Of course, litigation promptly ensued. Central Trust Company v. United States, 158 Ct. Cl. 504, 305 F.2d 393 (1962).

The claims court embarked upon a valuation of Heekin using the DCF methodology. It started out on a standard tack: focusing on the historical accounting data from the previous five years. These data would then be used to forecast future earnings—making estimates in accord with the historical trend. Not so easy, however.The earnings over the previous five years had been irregular. The Korean War had created a temporary surge in the need for cans, resulting in increased revenues. Also, several large charges were made against earnings for one-time losses. The court analyzed these abnormalities and adjusted Heekin’s earnings to normalize the financial statements. Even still, a clear trend in earnings was hard to discern. The adjusted earnings figures were as follows:

Adjusted earnings
12 months ending Sept. 30, 1954

How should the court use this information to predict future earnings? Business is improving, but only in fits and starts. You could average the earnings for the period. But this might give undue weight to the low earnings of the first year. The court’s solution: give more relative weight to recent earnings. How much weight? Very simple: Beginning with the most recent year, the court multiplied the earnings by 5, 4, 3, 2, and 1 respectively. The average is then taken by dividing the sum by the total of the multipliers (15).

The difference is not tremendous, but also not insignificant. A straight average of the five-year earnings is $421,892.99. Using the court’s weighted method, the average is $454,492.83.

Conceptually, this approach seems a little more satisfying than arbitrarily calculating an average—especially if you are a firm believer that more recent earnings are a better indication of future results. The court gives effect to a general trend in earnings. But no connection is articulated between the method and the conditions of the company. Maybe 1953 is a better indication of future earnings—maybe not.

link to Mercer articles

5.6 Business Valuation in Legal Contexts

©2003 Professor Alan R. Palmiter

This page was last updated on: April 5, 2004