In the recent article published in the Business Valuation Update, “A Veteran Valuer Looks at the BV Profession,” valuation expert Robert E. Kleeman discusses four rules he believes are the major drivers of professional valuation services today. Below, we provide an excerpt from the article in which Kleeman makes the case that, if business valuation is to successfully sustain itself as a profession and not a provider of a commodity service, practitioners need to review and dissect these four rules and make sure they are using them correctly today.
“A determination of fair market value, being a question of fact, will depend on the circumstance in each case. No formula can be devised that will be generally applicable to the multitude of different valuation issues arising in estate and gift cases. Often, an appraiser will find wide differences of opinion as to the fair market value of a particular stock. In resolving such differences, he should maintain a reasonable attitude in recognition of the fact that valuation is not an exact science. A sound valuation will be based upon all the relevant facts, but the elements of common sense, informed judgment and reasonableness must enter into the process of weighing those facts and determining their aggregate significance.” [Rev. Rul. 59-60, Sec. 4]
Let’s deconstruct this discussion and see how it is still vital today and why we need to make sure we are following the instruction the rule provides.
‘[F]air market value, being a question of fact, will depend on the circumstances in each case.’ Since fair market value is a question of fact, and depends on the circumstance in each case, by definition, each valuation is unique. In all the years I have been practicing valuation, I have never come across two valuations where the facts and circumstances were exactly the same. This is true even though I have valued individual McDonald’s, Burger King, and Pizza Hut franchises. No two stores had the same facts and circumstances involved. Issues such as demographics, location, and local competition are important. So are issues such as some multistore operations versus a single-store operation. There are certainly similarities in the operations of a McDonald’s franchise, but the value of Franchise A may be quite different than Franchise B. What about the Pizza Hut franchise that only sells pizza versus the store that has a beer and wine license as well? Could this have an impact on value? Of course!
‘Valuation is not an exact science.’ Why not? What is a science? Webster’s defines a science as “the intellectual and practical activity encompassing the systematic study of the structure and behavior of the physical and natural world through observation and experiment.” Chemistry is a science. Every time you mix the elements properly, you get a predetermined result. Every time you formulate H2SO4, you get sulfuric acid. The salt on your table is NaCl, or sodium chloride. These formulas just don’t change. That certainly is not the case with the valuation of a closely held entity.
How can valuation be a science? Two very competent appraisers can look at the same business and arrive at different conclusions as to the value. Why is that possible? Because valuation is not a science. It encompasses judgmental issues. What is the risk involved with the specific entity? What is the real growth potential of both the market and the specific company? Can the specific company actually exceed the growth rate of the industry? Does the specific company have the financial strength to grow at the industry rate? These and a myriad of other questions are not scientific; they are based on the experience and judgment of the appraiser.
Why does the Rev. Ruling specifically state that “[n]o general formula may be given that is applicable to the many different valuation situations arising in the valuation of such stock”? The answer is crystal clear; no formula captures the many nuances found in a closely held company. From product to management to financial stability to competition, each of these factors must be analyzed and considered before reaching a conclusion of value.
“It is advisable to emphasize that in the valuation of the stock of closely held corporations or the stock of corporations where market quotations are either lacking or too scarce to be recognized, all available financial data, as well as all relevant factors affecting the fair market value, should be considered." [Rev. Rul. 59-60, Sec. 4]
The revenue ruling provides us with eight factors “to be considered.” (emphasis added) There are no absolutes in this list. So what are we considering? History, current and expected economic conditions, financial analysis, dividend capacity, goodwill, and comparable sales. No formulas are listed. Sure, we can use math for financial ratio analysis, but the consideration of the various factors again is a judgmental and common-sense issue.
We, as valuation professionals, are required to acquire as much data as possible to then examine and analyze that data and apply that data to the facts and circumstances that are part of our valuation engagement. True valuation professionals are “data junkies,” and never have all the data they might desire. As Colin Powell once commented, if the general waits until he has 100% of the data, the war will be over before a decision is made. Since we will never have all the data we might desire, we must go with what we have, using judgment, reasonableness, and common sense to guide us toward the conclusion of value.
“In the application of certain fundamental valuation factors, such as earnings and dividends, it is necessary to capitalize the average or current results at some appropriate rate. A determination of the proper capitalization rate presents one of the most difficult problems in valuation. That there is no ready or simple solution will become apparent by a cursory check of the rates of return and dividend yields in terms of the selling prices of corporate shares listed on the major exchanges of the country. Wide variations will be found even for companies in the same industry. Moreover, the ratio will fluctuate from year to year depending upon economic conditions. Thus, no standard tables of capitalization rates applicable to closely held corporations can be formulated. Among the more important factors to be taken into consideration in deciding upon a capitalization rate in a particular case are: (1) the nature of the business; (2) the risk involved; and (3) the stability or irregularity of earnings." [Rev. Rul. 59-60, Sec. 6]
What do Ford, General Motors, Toyota, and Honda have in common? They all are in the business of manufacturing automobiles. Yet let’s look at their respective market valuations. At the time this article was written, GM stock was selling at a P/E ratio of 6.99, with a dividend payout of 4.22%. Ford had a dividend yield of 5.54% yet was selling for a P/E ratio of 6.01. Toyota had a dividend payout of 2.96% with a P/E ratio of 10.3, and Honda had a dividend yield of 2.63% and a P/E ratio of 6.04. What does this tell us? Ford had the highest dividend yield yet the lowest P/E ratio. Why? The public’s perception of growth, future success, market, and product adaptability. Public perception cannot be measured with a formula. This is even more relevant to a closely held entity. No “public perception” is available. We don’t have analysts following the company. We don’t have the CFO of the company giving us guidance as to future earnings. Yet we must factor those same issues into our valuation conclusion. What is the risk involved? How do we measure the very items discussed in Rev. Ruling 59-60?
As contemplated in the revenue ruling, things can and do change. History may be a guide, but it is not an answer. Projections may be a guide, but are they reliable? Can a technological change impact the subject company? If yes, how do you measure the impact and factor that into your valuation conclusion?
“Because valuations cannot be made based on a prescribed formula, there is no means whereby the various applicable factors in a particular case can be assigned mathematical weights in deriving the fair market value. For this reason, no useful purpose is served by taking an average of several factors … and basing the valuation on the result. Such a process excludes active consideration of other pertinent factors and the end result cannot be supported by a realistic application of the significant facts in the case except by mere chance.” [Rev. Rul. 59-60, Sec. 7]
Again, we have the specific reference to the fact that there cannot be prescribed formulas. In over 40 years of business valuation, the one truth I truly understand is that no two businesses are exactly the same. I don’t care whether they are car dealers, hamburger stands, or widget manufacturing entities. Each business has unique characteristics that need to be understood and applied to the information prior to reaching the conclusion of value.
I believe that this is true with statistical analysis. When we apply the statistical analysis to the data, what are we really achieving? An idea that the data are meaningful? That we have outliers? That, statistically, our answer should fall somewhere within the “range” that the statistics provide? While helpful, all the statistics in the world only provide us with additional information to be considered. They don’t provide us with the answer; they are but just one tool available to the valuation professional.
How do these four rules impact the current business valuation climate?
For further thoughts from the author on this topic, access the complete article, “A Veteran Valuer Looks at the BV Profession," originally published in the August 2018 issue of the Business Valuation Update.