Guest editorial: Where Revenue Ruling 59-60 Got it Wrong
by Rick Warner, ASA, AVA, Principal, Great Lakes Valuations and Sr. Contributing Editor, Business Valuation Update
Most of us as appraisers are familiar with Revenue Ruling 59-60 and its prescription for factors to be considered as part of the valuation of the stock of closely held companies (N-E-B-E-D-I-S-M anyone?). And while I agree with most of what 59-60 has to say, I do have a bone to pick (Ok, a little bone…) with at least one of the eight factors.
Section 4 of the ruling introduces eight factors to be considered by appraisers as we go about our business of valuing the stock of closely held companies. The second factor introduced in particular requires that we complete a careful analysis of “the economic outlook in general and the condition and outlook of the specific industry in particular.”
Now before anyone runs off and reports me to the local IRS examining agent responsible for the Atlanta area (well fine, I am in Chicago, but a little mis-direction never hurt anyone…) I’m not saying that an analysis of the economy and the industry is unimportant. In fact I think an analysis of the industry is critically important. With regard to an analysis of macro-economic conditions however, I’m not so sure. Oh sure, I understand the need to look at what’s going on in the national economy, much like I need to be aware that asteroid 2012 DA14 is slated to pass very close to Earth on February 15, 2013, but it doesn’t mean that I shouldn’t take food out of the freezer for dinner that night.
As most appraisers I was fortunate to be busy during the final quarter of 2012, completing appraisals in support of transfers of stock and interests in closely held companies and partnerships prior to us all flying off the “fiscal cliff” (I knew I couldn’t get through this article without referring to the “cliff”). Anyway, every appraisal that I completed during this busy period included a section describing the national, regional, and local economies as appropriate as of the date of valuation. But here’s the question – does my analysis of macro-economic conditions really add anything to the credibility of my opinion of value for the stock of a privately owned company doing business here in northern IL? (cat’s out of the bag, I really am in the Chicago area).
Let’s assume for a moment that one particular company that I was engaged to value was a $15 million (revenues) plastic injection molder. Pretty typical engagement for most of us. The “economic section” of my appraisal reports is generally built around information gleaned from the Federal Reserve’s “beige book”, the Business Roundtable’s quarterly “CEO Survey, the Institute of Supply Management’s Report on Business®, the Conference Board’s report on leading economic indicators, and other similar sources. So while I find it interesting, and helpful, and possibly even somewhat relevant that housing markets around the U.S. and in Chicago’s own 7th Federal Reserve District are enjoying a bit of a comeback is this macro-economic focus where I should be really spending my time?
I don’t think so.
What is important however is the fact that my hypothetical plastic injection molder has several “major” customers in the greater health-care industry, to whom it supplies in-mold-labeled hazardous waste containers. So while I might not be all that interested in the state of the housing market in Peoria, I’m really interested in what’s going on in the health-care industry in the upper-Midwest, and in particular with regional hospitals, who are the customers for my hypothetical injection molder.
So what’s my argument with 59-60? It’s the degree of emphasis between macro-economic and micro-economic issues. In my opinion, as appraisers we serve our clients better by focusing on micro-economic issues. Am I saying that macro-economic trends regarding the cost of energy, and natural gas prices are not important to my injection molder? Not really.
But, again in my opinion, the analysis of micro-economic issues is where we as appraisers earn our fees. We should be looking at the income statements for the companies that we are appraising and based on our analysis of what the company does, and who it sells to, and what’s going on in the industry, make judgments as to what that income statement will look like in the future. Insofar as macro-economic conditions translate into some impact on the company’s income statement should we pay attention? Sure, but most of the time the issues that are likely to impact the earnings of a company are much more “micro-economic” in origin.
So dig out that micro-economic college text (the good news is that not a lot has changed on that front in oh, thirty years or so) and spend more of your analytical time on issues like supply and demand, elasticity of demand and pricing, uncertainty and risk. The appraisals that you produce for your clients will be the better for it.