2004 Monthly Newsletters
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Hyde Valuations, Inc ®  www.NamasteGraphicDesigns.com
December 2004 - Appraising the Appraisal

An appraisal is an appraiser’s opinion of the value of something, and as such, there is some leeway in the final number determined. There are literally hundreds of decisions an appraiser has to make that can affect the appraised value either up or down. This is why any two competent appraisers rarely arrive at the exact same number. They can both be correct, unless one of them has made an actual mistake in the application of his or her methodology.  

Almost all appraisals use, or at least consider, three basic approaches to determining what something is worth. The Asset Approach focuses on what you can see and touch, the Market Approach compares transactions that have occurred in similar properties or entities with the subject, and the Income Approach bases the value on the income or return on investment that the property is expected to generate. Each approach has several different methods, some of which do not necessarily apply to certain assignments.  

The methods under the Asset Approach typically only take into consideration those assets that are tracked on a balance sheet. Any intangible value an entity has, such as Copyrights, Patents, Below Market Leases, or Proprietary Processes are usually not considered at all. The Asset Approach usually involves an analysis of the cost to reproduce or replace the subject. Sometimes additional appraisals might be required.  

The Market Approach is probably the most easily understood, but often is one of the hardest to apply correctly. In a nutshell, if something just like what you are appraising sold today for $100,000 then your appraisal will likely come in at $100,000. However, things are never that easy. Finding a documented transaction involving something that closely approximates the subject of the appraisal usually entails some objectivity. Is it really comparable with the subject and was the transaction representative of the market? This is a question that appraisers should ask themselves every time they work on an assignment. Since identical transactions can rarely be found, supportable adjustments must often be made to apply this approach.  

The Income Approach is based on the idea that the value of something is based on the amount of money it generates for the owner, taking into consideration the risk of that income stream continuing. Oftentimes, the Income Approach carries the most weight in an appraisal, and unfortunately, it also carries the most opportunities for appraiser error. When forecasting future earnings, an appraiser must take into consideration what is expected to occur in the future. This is according to the IRS’ Revenue Ruling 59-60 “Valuation … is a prophecy as to the future.” An average of historical returns is not a forecast, neither is any analysis of historical performance. Once a forecast has been determined the income stream is converted into a value either by discounting future income streams back to the present or by capitalization of a single income stream.  

There are many different methods that can be used to determine a discount rate. Each has its benefits, however, the nature of the assignment should determine which method is used. The Build Up Method is applicable for most appraisals of small businesses. The Factor Rating Method is used by many business brokers. The Capital Asset Pricing Model (CAPM) is applicable for larger privately held companies. Real estate appraisals typically either extract their rate from the market and/or use a Band of Investment analysis. In a real estate appraisal, if the rate is taken from the market, both the Income Approach and Market Approach will determine similar values, as they become in effect, the same approach. Care must be taken in the application of the determined discount or capitalization rate because certain methods generate rates that are applicable with certain income streams. If an appraiser generates a discount rate applicable to an after tax income stream and applies it to a pretax stream, it will result in an over valuation of the subject.  

Discounts and Premiums are another animal with many sharp teeth that can bite an unsuspecting client if not used correctly. Certain methods generate a certain level of value that, depending on the assignment, may or may not require a discount or premium to move the value determined to the level of value desired. For example, if an assignment is to value a minority interest in a small company, and the appraiser has used a method based on sales of controlling interests in small companies, discounts for lack of control and lack of marketability may be required. Any Discounts or Premiums that are used in an appraisal need to be well supported and explained. 

The purpose behind any appraisal is to come up with a number; to reconcile all the various methods used into one value for the subject. This can be done a number of different ways, but they all should be explained so the reader can follow the logic. If the final number is not explained, the balance of the report really has no meaning. Also, an appraiser should review the appraised value to make sure that it makes sense. For income producing properties, a simple Purchase Justification Test (PJT) is often useful. The premise behind a PJT is that a potential buyer of the subject should be able to make the payments on his purchase and obtain a return on his investment if the subject were purchased using the appraised value.  

There are many possible pitfalls in any valuation assignment. As professionals, you are trusted to know what is a good appraisal and what isn’t. Be skeptical of appraisals that consist of only numbers and any report that is not well written and thought out. Should you or your firm be interested, we have a number of presentations prepared that explain in further detail any of these topics that we would be happy to put on free of charge for any size firm. For details, please give us a call.

November 2004 - Business and Commercial Damages

Business and Commercial Damages, specifically in the area of lost profits and loss of business value, result in claims which need expert skills to evaluate the business interests in order to determine the measure of liability and the amount of compensatory damages. Business Appraisers are more qualified in many instances than either economists or accountants who often do not have the same diverse skill sets. Our firm has another advantage – we are able to appraise both businesses and real estate in these types of cases.  

There are three well established methods for determining damages. They are:  
1.The Before and After Method  
2.The Yardstick Method  
3.The But For Method

The Before and After Method compares the revenues and profits before and after an event. The purpose of this method is to demonstrate that “but for” the event, the business would have earned the profit it had earned in the past. This method is appropriate when a business has an established profit record and it can be reasonably demonstrated that the primary cause of the loss of profits was the defendant’s activity. The analyst may compare plaintiff’s revenue and earnings before and after the alleged act, the loss of specific customers or sales, plaintiff’s expenses before and after or plaintiff’s debts before and after the alleged act. Often, however, the loss may be due to a combination of causes and the expert must be prepared to identify and quantify the effect of those other causes.  

The Yardstick Method is typically used when a new business without much of a history of sales or profits is damaged. This method involves the use of comparable businesses or the industry history to see if there is a difference in the level of plaintiff’s business after an event. The use of this method is very similar to the market approach in business valuation using guideline companies. Appropriate yardsticks include the company’s own history, history of similar companies or divisions, or in some instances industry history.  

The But For Method is commonly used when a claim is made that plaintiff’s profits were diverted to the defendant and would have gone to the plaintiff but for the event. Typical examples are cases of unfair competition, breach of an employment contract or non-compete agreement, or misappropriation of trade secrets.  

Some cases require the use of more than one of these methods or combinations of them. For example, in patent infringement cases, the minimum damage is typically the reasonable royalty that the plaintiff would be entitled to, regardless of profits. Damages may also be measured in terms of costs incurred as a result of the damaging act or event. In some cases, the appropriate damage may be the cost to unwind the transaction and put the plaintiff in the same position as he or she was prior to the transaction. Other alternatives may be the calculation of increased sales at plaintiff’s margin or possible decreased proportionate expenses because of increased production.  

Services typically needed in this area include preliminary evaluation, reviewing opposing expert work product, identifying other experts, aiding in discovery, identifying and evaluating alternatives for settlement, preliminary calculations, reviewing case law for economic impact and providing demonstrative exhibits. In taking on additional assignments, the expert must be careful to do these in such as way as to not compromise the case or the expert’s independence.  

There are differing opinions as to the correct rate of return to be used to apply to historical damages to bring them to the appropriate value as of the trial date. At a minimum, it is well established that a risk-free rate such as the rate on U.S. Treasury obligations should be used. Some maintain that the defendant’s debt rate should be used and others still use the plaintiff’s cost of capital, the expected rate of return that the market requires in order to attract funds to a particular investment.  

The amount of past losses must be estimated as they cannot be known with certainty. There must be some risk adjustment process employed in the estimation of past losses. This may be accomplished by applying some discount rate to account for the risk or by using risk adjusted data in the analysis. According to Patrick A. Gaughan, author of Measuring Commercial Damages, “If the expert explicitly attempted to do this in the estimation process, then no further risk adjustment of past estimated losses may be necessary.”  

The estimates of future profits require the determination of a discount rate to account for the riskiness of the projected income stream. The discount rate is used to convert the estimates of future profits to a present value as of the trial date. There are differing opinions as to the magnitude of the discount rate that should be used, however, generally in commercial damage cases, the discount rate is often the cost of capital of the corporation. 
October 2004 - Coordinating Business & Asset Appraisals

A thorny problem in business valuation crops up when the appraiser needs to know the values of assets that he or she is not qualified to appraise. This happens most often when a business owns significant fixed (real estate, plant and equipment) or intangible (goodwill, customer lists, etc.) assets which have specialized uses. We appraise both businesses, tangible and intangible assets, and real estate, however, we are not qualified to appraise some types of specialized plant and equipment. 

In our experience, the need for a business appraiser to obtain additional fixed asset appraisals arises most frequently in three situations:

1. With holding companies, family partnerships and limited liability companies: These are the most obvious cases in which such appraisals are necessary. Shame on the business appraiser who does not recognize this up front. When we do both the required real estate appraisals and the business appraisal, we are able to get them done in a timely manner and make sure that they are coordinated properly – a benefit to your clients.

2. With marginally profitable or unprofitable companies: If a company is losing money and has no credible plan to restore profitability, it will likely have no value based on its earnings or cash flow. If so, it will be valued based on liquidation (what it owns less what it owes). That is a relatively easy determination, but the same situation arises with companies that do not earn satisfactory (compared to normal market rates) returns on investment. This may be difficult to ascertain, particularly if a business is in transition because of internal or external factors such as management turmoil or marketplace trends that affect its future earning power. In such cases, it may not become apparent that the asset-based value exceeds the earnings-based value until the engagement is well underway. The best insurance an appraiser can take out against this is to attempt as early as possible to develop rough earnings and asset-based values. The appraiser can then determine if the assets will need to be appraised (particularly if it is suspected that their carrying values on the financial statements, which reflect depreciated historical costs, are below their fair market values). 

3. When a business owns non-operating assets: Non-operating assets are unnecessary for the conduct of business. They might include excess cash or inventory, notes and loans receivable, idle equipment, investments in other companies (which are usually reflected at cost, not fair market value, on the financial statements) and the classic “Florida condominium” and other perquisites. If an asset can be sold off without impact on the company’s normal operations, it is non-operating and should be valued at fair market value.

Most business appraisal assignments involve “going concerns” – businesses that are expected to keep operating because their highest value (“highest and best use”) is based on the benefits expected to be generated for their shareholders (usually earnings and / or cash flow).

When the going concern premise is in question (when a company is unprofitable, earning very low profits, or faces major threats), or when it owns “excess” assets (those which are not necessary to the normal conduct of business), it is often necessary to engage real estate, machinery and equipment, or other fixed asset appraisers. We are one of the very few business appraisers that are certified to appraise both businesses and real estate. We also appraise some other types of fixed assets including equipment.  

When working with both business and real estate or other such specialists, it is imperative that both be on the same page. Two of the most important consistencies are:

1. The premise of value: if liquidation is assumed, is it forced (implying inadequate or no exposure time on the market) or orderly (implying adequate exposure time)? Are the assets in question to be sold piecemeal or together? There are other variations, as well.

2. Income and expense assumptions: this is primarily relevant to real estate appraisals. Depending on case facts and circumstances, if a business leases its facilities from an affiliated entity, the rent paid by the business (part of the business valuation analysis) must be the same as that assumed by the real estate appraiser (valuing the facilities).

September 2004 - Fourth and Long for Minority Stock?

We have long advocated that every business with multiple owners spend a few bucks and have their attorney draw up an appropriate buy-sell agreement or some type of stock redemption plan. We are equally insistent that family businesses go a step further and develop ownership and management succession plans. Similar rules apply to family owned real estate properties.

Many family business owners transfer minority or noncontrolling stock (or non-voting stock, which is by definition a minority interest due to its lack of control) to their children. This lets them maintain control and reduce their estates’ values. Because the transferred stock is minority, it is typically entitled to a valuation discount for lack of control. It also is typically entitled to a discount for lack of marketability, depending on what liquidity mechanisms are provided by the buy-sell agreement or stock redemption plan. Minority stock transfers can efficiently achieve succession and estate planning goals. (Touchdown!).

But such transfers are not perfect. (There’s a flag on the field!) They have two drawbacks owing to the fact that control ownership remains with the senior generation. They punt on:

1. Management succession: the decision as to which family member, if any, will be the control shareholder (quarterback). If not addressed while the senior members (veterans) are around and competent (on the roster), this may lead to nasty family scrimmages. This is a threshold issue for the family to confront and resolve based on what is best for the business and the people. It is tough and emotional to determine who makes the cut.

2. Estate tax cost: When a control owner dies, their interest is valued at a premium compared to the value of minority interests. A few years ago, there was a hugely controversial Tax Court case involving the Simplot estate. Simplot had an extraordinary capital structure, with 1,848 non-voting shares for each voting share. A massive control premium (holding penalty) was assigned to the decedent’s voting shares. The case was appealed successfully, but at great cost.

Simplot situations may also create shareholder oppression cases, which are murky because state statutes which govern them are relatively new, inconsistent and untested. In oppression cases, dissenters may be able to sue to dissolve the business and receive their pro rata shares of the proceeds, or they may be entitled to the “fair value” of their shares, which may or may not reflect valuation discounts.

The key to resolving these issues is for the family to develop and implement a plan that addresses management succession. If successful (Touchdown!), the senior generation will transfer enough shares to their heirs during their lifetimes to eliminate their control position, leaving them with a minority interest which would be valued with discounts at their death. If the shares are transferred in minority blocks over the years, all such transfers (except the one that eliminates the control position) will be valued with such discounts (extra point!).

August 2004 - Public Comparables for Private Companies?

Revenue Ruling 59-60, the foundation of “fair market value”, requires that appraisers consider “market prices of interests in entities engaged in the same or a similar line of business having their interests actively traded in a free and open market, either on an exchange or over-the-counter”. 

Many appraisers blindly use large public companies as benchmarks to value small and even some very small private companies. I strongly disagree with this for seven reasons:

1. The identification of “similar businesses” is difficult. Public companies are usually more mature, larger and more diversified than private businesses. They have more management depth and financial resources, less concentrated product lines and customer bases, and larger market shares. In short, they are less risky than private companies in terms of fundamentals like cash flow stability.

2. Public and private company investors and equity markets differ fundamentally. Public investors are typically large financial institutions, pension plans, and wealthy individuals with financial sophistication and diversified portfolios. Private company investors’ major investment by far is the stock in their companies. Public investors have shorter time horizons and enjoy deeper markets and greater liquidity. They focus almost exclusively on earnings, cash flow, dividends and appreciation, while private company investors also consider asset values and many other intangible factors. Private company owners can maximize their benefits through salaries and other perquisites almost without regard for earnings. For very small businesses, buyers’ motivations are often to obtain jobs, not to maximize earnings or equity values. Public investors have the ability to protect themselves with put and call options, stop loss and limit orders. Private investors cannot do so—in fact it may take them a long time to sell, which makes their investments far riskier. Their investment liquidity is seriously impaired and highly uncertain.

3. Most public investors own small portions of large businesses. They do not control them. They benefit only from stock performance (dividends and price appreciation). They are also at risk for far greater price volatility. Private investors typically purchase substantial or complete interests, manage them actively and benefit directly from performance in the form of higher compensation.

4. The quantity and quality of information available from public companies (which are required to follow Securities and Exchange Commission disclosure requirements) usually exceeds that available from private companies.

5. Public companies generally tend to sell at higher valuation multiples than do private companies. As a result, appraisers using large public companies as comparables must make large reductions and other adjustments to public company multiples in order to arrive at reasonable private company values. It is difficult to substantiate them, which sometimes weakens their credibility.

6. Revenue Ruling 59-60 was written over 40 years ago. At that time, there was virtually no data available on “private comparables”; that is, sale prices of private companies. Today, there are many databases with such information that appraisers can use. The information is a much better fit with the reality of many small and very small private company valuations.

7. Comparables are part of the Market Approach, one of three basic valuation approaches. The others - Income and Asset – are equally valid and may supersede Market Approach results.

The bottom line: because public companies are not always comparable to private companies, other data and approaches must be considered.

There is an important conceptual difference concerning the ways in which appraisers use private and public comparables. The premise of public guidelines is that a few comparables are sufficient because the large number of daily transactions (thousands of shares traded) provides statistical confidence in the result. By contrast, the premise of private comparables is that there are enough (more than five) transactions which are sufficiently similar. The large number of transactions offsets the fact that the descriptive data are not perfect. (Few private sale reports name the company and provide detailed disclosure of the transaction terms). In contrast, when appraising real estate, we often use a few comparables because we know a lot about them and how they relate to the Subject Property. When using private company databases, we typically know very little about the source data and must rely on larger numbers to obtain reliability.

In theory, then, it is all right to use a few public comparables that closely fit the subject business in a similar fashion to using a few good real estate comparables, but the more private business guidelines one has, the better.

July 2004 - Economic and Industry Analysis

Often, when reviewing another appraiser’s work product for some reason, we encounter a detailed description of the world economy and the national economy and a generic report dealing with some industry category. The appraiser then proceeds to the discussion of the subject company and the various valuation methods without ever referencing the economic or industry section. In these instances, we cannot help wondering what the appraiser was thinking when he or she wrote these sections and included them in the report. We wonder if perhaps the appraiser simply purchased these sections from one of a number of vendors and tossed them into the report.  

The major reason that we believe appraisers include economic and industry sections in appraisal reports is to comply with the requirements of Revenue Ruling 59-60 which tells us to consider “the economic outlook in general and the condition and outlook of the specific industry in particular.”[1] USPAP also tells us to include “financial and economic conditions affecting the business enterprise, its industry, and the general economy.”[2] Some appraisers fail to understand that Revenue Ruling 59-60 states just prior to listing its often quoted eight factors, “The following factors, although not all-inclusive, are fundamental and require careful analysis in each case.”[3] USPAP tells us to “…study it [the subject business] in terms of the economic and industry environment within which it operates.”[4]  

We believe that appraisers must explain how what is going on in the economy affects the industry and the subject business and how the economic outlook affects the risk of the subject company achieving its forecasted net cash flow. Simply including an economic section without using it and explaining its impact is insufficient. Also, the industry section including the industry outlook must be explained and used to illustrate how it affects the subject company. In order to do this, the economic section of the report must include specific references to the industry in which the company operates and explain its impact on the value of the subject company. Both the economic analysis and the industry analysis must fit and be appropriate for the subject company. The type and degree of analysis should change depending on the size and the nature of the business being appraised.  

When we read an appraisal of a local hot dog stand and it includes a detailed description of the world economic status and nothing about the local economy, we cannot help but wonder what the appraiser was thinking. Certainly, what is happening in the worldwide economy appears to be much less relevant to the local hot dog stand than what is happening in the state, city or town, and neighborhood in which the local hot dog stand is located. Also, trends in the fast food sector of the restaurant industry are relevant but again, what is happening in the local area of the hot dog stand is the most important.  

Commercial real estate appraisers are trained to determine how the economy directly affects the value of the property they are appraising. Our training as both commercial real estate appraisers and business appraisers allows us to do a better job of analyzing and explaining, where needed, just how the economic and industry outlook affects both the businesses and the real estate we appraise.  

Valuations play a part in all strategic transactions. For additional information or advice on a current situation, please do not hesitate to call. We value both businesses and commercial real estate. 
June 2004- Market Data

One of the most informative statements ever made about good appraisal practice was by Ray Miles, MCBA, ASA, FIBA the founder of The Institute of Business Appraisers, who said that:

“The best data on the market comes from the market.”

This may seem obvious, but it is profound. The essence of an appraiser’s job is to replicate the behavior of hypothetical willing buyers and sellers to develop an indication of the value they would negotiate. We must look to the market for this kind of behavioral evidence. An appraisal without market data is like a legal argument without precedent or a financial statement without footnotes: it has little or no basis.

Some appraisal methods have little or no basis in market evidence. This makes them risky and open to challenge and refutation:

1. The “Excess Earnings” or “Formula” Method, which, although originally promulgated by the IRS, was also discredited in Revenue Ruling 68-609 as being a method of last resort. It relies upon arbitrary capitalization rates that have no direct market substantiation. This method should never be used as a stand alone method – when used, it needs support from other methods.
 2. “Rules of Thumb” or other anecdotal formulas (such as “a service business is worth one times revenue”) that also have little or no supporting market data. Rules of Thumb are often useful as a sanity check but they rarely, if ever, qualify as an appraisal method.
 3. Reference to prior transactions in a company’s securities, which cannot be shown to be at arms’ length and may therefore not be indicative of market conditions. Prior transactions must be examined very carefully before using them as an appraisal method indication of value.
 4. Any method that relies solely on the appraiser’s judgment, usually accompanied by the phrase “in my professional opinion.” These “methods” are very dangerous – experienced and qualified appraisers always support the methods they use.
 5. Any method for which there is not enough market data to create statistical confidence. If we are valuing a company with reference to comparable private sales, there should be at least five of them. If insufficient data points exist to reliably determine a value, the method in question should be relegated to a sanity check at best or not used in the final reconciliation of value.

Data must also be taken from the appropriate market:

1. It is inaccurate to value small private companies using large public comparables. The value of Home Depot stock has no relationship whatsoever to the value of the local hardware and lumber store.
 2. In a fair market value appraisal, it may be incorrect to use “strategic” sales as comparables. Strategic transactions are based on Investment Value or the value to a specific entity. Examples of strategic purchases often include acquisitions by public companies of other public companies or very large private companies. Many of these transactions are based on motivations other than those that qualify as fair market value transactions such as purchasing market share, a specific product line, executive hubris, or some other strategic reason.
 3. Discounts and premiums for control and liquidity characteristics must be applied to provide appropriate levels of value, but they should reflect both market data and case-specific facts and circumstances. The use of averages or “standard” discounts is inappropriate. 

May 2004 - The Method Behind the Madness: Why Discounts Exist

Valuation discounts and premiums are often confusing and misunderstood. They are also an area fraught with error and often the subject of litigation. Perhaps the following example will lessen the confusion.

Let’s consider discounts applicable to a 1% limited interest in a partnership owning vacant non-income producing land with an independently appraised value of $1,000,000 and an equal basis (zero embedded capital gains tax liability).

Question: “I don’t think valuation discounts are relevant here. You can value the interest two ways – using an income approach or an asset approach. The income approach would use the expected cash flow distributions to the 1% interest based largely on an analysis of the historical distributions. Since there has been no cash distributions and none are expected until the land is sold (which could be a very long time), there is no value to the interest under the income approach. The asset approach uses the value of the underlying assets to value the 1% interest. Based on asset value, the land is worth $1,000,000, so if it is sold, the limited partner will end up with 1% times $1,000,000 or $10,000. That is cash, so no discounts should apply to it. So the interest is worth either $10,000 based on the asset approach or $0 based on the income approach. No discounts are warranted!”

Comment: That is a superb statement of the dilemma! To resolve it, we have to consider two assumptions: the difference between direct and indirect ownership of the land and the premise of value.

There is a big difference between owning the land directly and owning a limited interest in a partnership (or some other entity) which owns the land. The limited interest’s owner does not have the legal power to force sale of the land. They must wait until the eventual sale to realize any economic benefit. We have no idea if or when that will occur. The decision to sell is the prerogative of the general partner (according to the limited partnership agreement). The limited partner lacks control, which is one source of valuation discount, and the limited interest lacks a ready market, which is a source of the other discount. Who would buy a limited interest for $10,000 without knowing when or even if the land will be sold, and without the power to control that?  

There is also the question of the premise of value, and to what it applies. In this case, for the limited partner to get their $10,000, there have to be TWO liquidity events: sale of the land and distribution of the proceeds (or winding up of the partnership, which amounts to the same thing). When we value the land at $1,000,000, we are assuming it is sold today (a liquidation premise of value for the underlying asset). However, to jump to assuming that this implies a distribution or winding up is a second liquidation premise of value, a liquidation now, for the partnership, not the asset – which is not warranted, again because the limited partner cannot force either liquidating event to occur. 

If you assume that sale of the land leads by itself to distribution of the proceeds or winding up, you are ignoring the existence of the partnership (and the constraints it creates for its limited partners). The IRS often questions whether or not family limited partnerships or related entities have a real business purpose, however, those issues are the responsibility of the attorneys, not the appraiser. The appraiser must assume the partnership or other entity is legally valid. That being the case, there must be two separate liquidity events for the limited partner to realize value. Again, first the sale of the land (the underlying asset or assets), and second, the complete distribution of the proceeds of the sale of the underlying asset to the partners must occur. The partner’s inability to control the occurrence and timing of these events leads to the discounts for lack of control and lack of marketability.

In this case, we are in effect overvaluing the partnership by starting with the $1,000,000 appraised value of the underlying asset, because we are assuming both a liquidating sale and a full distribution. For sure, the value has to be less than that because the sale is not going to occur now, but we have no idea when it might, if ever, happen. The discounts for lack of control and lack of marketability compensate for that initial overvaluation. Similarly, we could start with a zero value (based on lack of income and cash flow distributions) and speculate on the timing of the eventual sale (and the resultant value), but this is vastly more uncertain than the preferred approach of starting with liquidation value and discounting it.

The bottom line is that the question stated the limits of the value correctly. By considering the premise of value applicable to the asset and the limited partnership interest, and the fact that the partnership creates the need for a second liquidity event, we create the basis for the two discounts that lead us to a value greater than zero and less than $10,000.

Valuations play a part in all strategic transactions. For additional information or advice on a current situation, please do not hesitate to call. We value both businesses and commercial real estate. 

April 2004 - When Should the Public Guideline Company Method Be Used?

This article is included in the Spring 2004 issue of Business Appraisal Practice – the professional journal published by The Institute of Business Appraisers. The Public Guideline Company Method uses the price of public company stocks as of the effective date of the valuation to assist in determining value for a private company. The selected public companies are analyzed and comparisons to the private company being valued made. Various relationships between the stock price and the public company data are determined and compared to the private company to determine an estimate of value.

The purpose of this article is to propose some guidelines that will assist business appraisers to determine when it is appropriate to use the guideline public company method and when it is appropriate to reject this method. In my opinion, the guideline public company method is used by some business appraisers in many instances when it should not have been used or when at least some of the guideline companies selected should have been excluded as not being comparable.  

Revenue Ruling 59-60  

Revenue Ruling 59-60, the business appraiser’s “Bible,” supports the use of the guideline public company method. According to number eight of the factors to consider, “The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange of over-the-counter” should be considered.[i] The revenue ruling goes on to expand on this topic as follows:  

Section 2031(b) of the Code states, in effect, that in valuing unlisted securities the value of stock or securities of corporations engaged in the same or a similar line of business which are listed on an exchange should be taken into consideration along with all other factors. An important consideration is that the corporations to be used for comparisons have capital stocks which are actively traded by the public. In accordance with section 2031(b) of the Code, stocks listed on an exchange are to be considered first. However, if sufficient comparable companies whose stocks are listed on an exchange cannot be found, other comparable companies which have stocks actively traded on the over-the-counter market also may be used. The essential factor is that whether the stocks are sold on an exchange of over-the-counter there is evidence of an active, free public market for the stock as of the valuation date. In selecting corporations for comparative purposes, care should be taken to use only comparable companies. Although the only restrictive requirement as to comparable corporations specified in the statute is that their lines of business be the same or similar, yet it is obvious that consideration must be given to other relevant factors in order that the most valid comparison possible will be obtained. For illustration, a corporation having one or more issues of preferred stock, bonds, or debentures in addition to its common stock should not be considered to be directly comparable to one having only common stock outstanding. In like manner, a company with a declining business and decreasing markets is not comparable to one with a record of current progress and market expansion.[ii] (Items highlighted and italicized by author).  

An Example  

An example of what in my opinion was an inappropriate use of the guideline public company method is summarized below:  

Company Being Appraised Chart

It was obvious that the appraiser did not investigate any of the guideline companies. Instead, apparently he took some numbers from a secondary source and used them to force a value for the subject company.  

Some Proposed Guidelines  

In the initial review to determine whether or not the guideline public company method should be pursued, I believe business appraisers could save a lot of time and energy if the following guidelines were adopted:  

Finding Potential Guideline Companies:

Prior to a discussion of the application of various market methods, the relationship between the size of the subject company and the size of companies in the various market comparison data needs to be explored.  

Size of the Company:  

The size of the company matters in business valuation issues. According to Shannon Pratt, “smaller companies in most industries tend to sell at lower multiples of most financial variables than larger companies in the same industry. This conclusion, reached from analysis of market data, is consistent with income approach (cost of capital) research, which shows that smaller companies have higher costs of capital (higher discount rates) than larger companies. Higher discount rates in the income approach should mean lower multiples in the market approach, and this relationship does, indeed, hold true.”[iii]  

Pratt goes on to give some examples to support his position: Middle Market companies with $2 to $3 million of earnings before interest, taxes, depreciation and amortization (EBITDA) are easier to sell and command higher pricing multiples on average than companies with $1 to 1.5 million in EBITDA.[iv]  

The following table illustrates data from a study of private company sales showing the relationship between some common sales multiples and size of the company[v]:  

Size of Company  

Sales Price/Ask Price  

Sales Price/Company Sales  

Sales Price / Seller’s Discretionary Cash Flow  

Businesses sold for under $100,000  




Businesses sold for over $500,000  




This relationship between multiples and size of the company also holds true for public companies. Companies under $50 million typically sell for considerably lower price to earnings multiples than companies from $50 to $500 million, and companies over $500 million typically sell for higher multiples than those from $50 to $500 million.[vi]  

According to Pratt, “Larger companies are less risky, and therefore, are priced in the market reflecting lower discount rates and higher market multiples.”[vii] Pratt continues to state, “Size does matter. The smaller the company, the higher the average cost of capital and the lower the average market valuation multiple.”[viii]  

Since size matters, using market data for much larger or much smaller companies than the subject company can result in erroneous conclusions.  


According to Gary Trugman in his second edition of Understanding Business Valuation, a size restriction of 10 to 25 times the sales volume of the appraisal subject is appropriate. He also mentions that Shannon Pratt in an earlier edition of Valuing a Business, had indicated that 10 times revenue is a good upper limit. According to Trugman, “…common sense must be applied. If the guideline companies are too big, they lose relevance to the appraisal subject.”[ix]  

I feel that revenue multiples should be low for small companies and larger for bigger privately held companies. The following is my suggestion as a guideline to be used for this method (obviously some exceptions will occur):  

Private Companies:  

Revenue -- Under $5 Million (Method Not Applicable)  
 Revenue -- $5 million to $20 million (comparables limited to 5 times revenue)  
 Revenue -- $20 million to $50 million (comparables limited to 10 times revenue)
 Revenue -- over $50 million (comparables limited to 25 times revenue)  

Active Trading and Penny Stocks  

Gary Trugman also mentions that guideline companies must be actively traded and not be penny stocks. He defines actively traded as at least 5 percent of the company’s outstanding stock trades over the six-month period prior to the valuation date. He refers to penny stocks as stocks with a selling price of $5 or less (but indicates sometimes a $3 and less price is used by his firm -- rarely less than $3 per share). The restriction on the price limit is designed to get rid of speculators that often trade in penny stocks.[x]  


Caution and common sense must be employed when using the Guideline Public Company Method. As Trugman often states, “using Home Depot to value the local hardware store” just does not work. The relevance is missing. Also, using penny stocks or inactively traded stocks is simply inappropriate.  

The Guideline Public Company Method is very useful and a valid method when used both appropriately and properly.  

Valuations play a part in all strategic transactions. For additional information or advice on a current situation, please do not hesitate to call. We value businesses and commercial real estate. 

[i] Internal Revenue Service, Revenue Ruling 59-60, Sec. 4. Factors to Consider, .01, h.
[ii] Internal Revenue Service, Revenue Ruling 59-60, Sec. 4. Factors to Consider, .02, h.
[iii] Shannon P. Pratt, The Market Approach to Valuing Businesses. (New York: John Wiley & Sons, Inc., 2000), p. 242.
[iv] Shannon P. Pratt, The Market Approach to Valuing Businesses. (New York: John Wiley & Sons, Inc., 2000), p. 242.
[v] Shannon P. Pratt, The Market Approach to Valuing Businesses. (New York: John Wiley & Sons, Inc., 2000), p. 243.
[vi] Shannon P. Pratt, The Market Approach to Valuing Businesses. (New York: John Wiley & Sons, Inc., 2000), p. 243.
[vii] Shannon P. Pratt, The Market Approach to Valuing Businesses. (New York: John Wiley & Sons, Inc., 2000), p. 243.
[viii] Shannon P. Pratt, The Market Approach to Valuing Businesses. (New York: John Wiley & Sons, Inc., 2000), p. 251.
[ix] Gary R. Trugman, Understanding Business Valuation: A Practical Guide to Valuing Small to Medium-Sized Businesses. Second Edition. (New York: American Institute of Certified Public Accountants, Inc., 2002), p. 173.
[x] Gary R. Trugman, Understanding Business Valuation: A Practical Guide to Valuing Small to Medium-Sized Businesses. Second Edition. (New York: American Institute of Certified Public Accountants, Inc., 2002), p. 173.

March 2004 - Ball Park Estimates Strike Out

You have a terrific headache and are rushed to the emergency room. The attending physician takes a quick look, does no examination or testing, and says “Take this patient immediately to the operating room and prepare him for brain surgery!”

How does THAT make you feel? Are you relieved and dazzled by the doctor’s efficiency? Or are you even more terrified?

This vignette is analogous, albeit with higher stakes and risks, to requests appraisers often receive to furnish “quick and dirty”, “formula” or “ballpark” valuation opinions. Like snap medical decisions, such opinions are fraught with grave risks for all parties concerned. No qualified professional should honor them. (In keeping with the title of this letter, the appraiser should take a walk). Those who do so violate the fundamental requirements of the Uniform Professional Standards of Professional Appraisal Practice as well as those of every professional appraisal society. By doing so, they expose themselves to legal, financial, professional and reputation problems. Appraisers have a fiduciary responsibility – a relationship based on trust - to their clients. Anything other than well-researched, complete opinions violates that trust.

Of course, appraisers want to help solve clients’ problems. How can we do so while fulfilling our professional obligations?

There is a middle ground. We can provide, among other options, “limited calculations”, “summary reports”, “consulting services”, “restricted (as to user) reports”, “oral reports”, “preliminary reports”, and “hypothetical reports”, each of which has major stated limitations and all of which are less than a full, formal written opinion of value. (A full opinion concludes a specific numerical value, is based on a full investigation and analysis, and is completely documented.) For real estate appraisals (commercial properties, land, office, retail, restaurants, hotels, etc.), limited appraisals and restricted use or limited reports are available in lieu of a complete, self-contained report depending on the specific client need.  

Limited calculations are just that – computations of value with less than full investigation and possibly documentation, although the limitations must be disclosed. This type of report might be based on just a few years of historical financial results and can be used as a basis for establishing an asking price for a possible sale. It is useful for things like planning life insurance coverage for buy-sell agreements. They can also be used to rebut others’ unreasonable value conclusions.

Not all of these options are suitable for any given situation. In many jurisdictions, for example, rules of evidence require that full written valuation reports be submitted well in advance of trial. Similarly, tax valuations almost always require full reports. Generally, if there is going to be a “real deal” – an actual transaction where buyer and seller negotiate a price - these less-than-full valuation services might be appropriate.  

We Appraise both Business Interests and Commercial Real Estate

February 2004 - Return on Investment: Risk vs. Reward

Occasionally, I am asked a very tough question: “What is a good return on an investment?” What makes this a tough question is its total open endedness. The answer can only be the appraisal standard answer of “it depends!” An answer that is unsatisfactory but honest – in fact the only answer possible until some parameters are known about the potential investment.

We have all heard the expression: Risk versus Reward. The concept is simple, but critically important in the world of investments. Generally, the higher the risk an investor is willing to assume, the higher the potential reward from the investment – however, the higher the risk, the higher the probability that the invested capital will be lost as well.

Of course, there are many different types of risk that must be considered – the major concerns being: purchasing power risk (inflation), illiquidity risk (difficulty in converting the investment to cash), as well as business risk (risk of losing the principal).

One of the highest risk “investments” is the purchase of a lottery ticket. Many individuals are enticed by the possibility of great reward – the receipt of perhaps millions of dollars. They rarely consider the possibility of achieving that huge potential reward – typically one in several million. The likelihood of the total loss of the principal invested is extremely high.

Near the other end of the spectrum is a deposit in a typical insured savings account in a financial institution. As long as the deposit is within the size limits of the government backed insurance, the likelihood of the return of the principal is extremely high, however the potential return on the investment is also very low – currently about 1%.

The chart below is provided for illustration purposes only. The rates shown are simply shown as an example to illustrate differences between rates based on investor’s perceptions of risk:  

Investment / Discount Rate Chart
Appraisers use what are called Discount Rates or Capitalization Rates to convert expected future income streams, which may or may not include the return of the principal invested, into a present value. Present value is a financial concept based on the idea that there is a difference in value between a dollar received today and a dollar that will not be received for a year or more.  

Discount rates and thus capitalization rates come from the market and are based on such things as general economic conditions, industry risks, and risks applicable to the specific company or other investment being appraised. According to IRS Revenue Ruling 59-60, “determination of the proper capitalization rate presents one of the most difficult problems in valuation.”[1] It goes on to state that there is no one formula or system that will work for all companies or other investments. Things must be taken into consideration such as: “1) the nature of the business; 2) the risk involved; and 3) the stability or irregularity of earnings.”[2]  

Selecting the appropriate discount or capitalization rate to be used to value a business or a commercial property is the most difficult part of virtually any appraisal – it requires experience, judgment and skill. A small difference in the rate can make a large difference in the resulting estimate of value as is shown in the simple example below assuming an annual income stream of $100,000:  

If the anticipated income stream varies over time or has a limited life or the likelihood of the return of the initial investment is included, the calculation of value becomes more complex. Appraisers are in the business of assessing risk and developing anticipated returns. 

January 2004 - Company Owns Real Estate? Be Careful! 

Valuing an operating company that owns real estate presents some problems and choices to the appraiser. Some instances are pretty cut and dry. For example, typically on a controlling-interest basis, if an operating company owns real estate not used or needed in the operations (a non-operating asset), few appraisers, if any, would disagree with the method of valuing the property separately, removing it and all related revenue and expenses from the operating company, and adding the net value of the property to the value of the operating company to determine the value of the stock. Some other instances are not quite so simple.  

The following are the typical configurations for real estate actually used in the operations as commonly seen with operating companies:  

  • Real estate is leased from an independent, arms-length third party
  • Real estate is leased from a related entity or individual  
  • Real estate is owned by the operating company  
  • Some combination of the above  

The following is a discussion of the wrinkles that need to be considered when valuing a control interest with each of these configurations.

Real estate is leased from an independent, arms-length third party  

This is the easiest of all configurations. When real estate used in the company operations is leased from an independent, arms-length third party, the lease rate represents what a potential buyer of the company would also pay. No adjustments to the lease rate are typically made in a control valuation.  

There are a few things, however, that should be considered and perhaps investigated. The following list is not exhaustive—it is an example of the kind of things that could impact the value of the company.

First, when does the lease expire and does it have any renewal options? A company with an attractive, below market lease rate may be worth more than a similar company with a “market” lease rate. However, if the below market lease rate comes to an end in a short time, i.e. a year or two, what will likely occur upon the expiration of the lease is very pertinent. Are the lease options at fixed determinable amounts or are they at “market”? These questions must be answered. A below market lease that is not transferable; (i.e. the rate goes to market in the event of a sale), may or may not result in a benefit to the company in a valuation depending on the purpose and use of the appraisal.  

Second, capacity issues must be addressed. Has the company outgrown the space? Or is it likely to do so in a relatively short period of time? If capacity is an issue, how this will be resolved and the associated costs should be built into the appraiser’s forecast.  

Third, depending on the nature of the business, things like anticipated traffic pattern changes, road construction work, road widening plans, etc. may be important. I have recently appraised several businesses that had huge impacts from extended road construction work which made access to their business locations very difficult for a year or more. Several retail businesses have recently gone out of business in Eastern Oregon as a direct result of the highway department installing a concrete median in the center of the main road in town prohibiting left turns into businesses that had been accessed this way for over twenty years.  

Real estate is leased from a related entity or individual  

This configuration is quite commonly found in the appraisal of closely held interests. Often, the rental rate is considerably above or below “market” rental rates. When valuing a control interest, many business appraisers adjust the actual rent paid to a rate representative of what an outside, independent landlord would charge, i.e. a “market rental rate.” While this is appropriate, the additional issues discussed above may need to be considered as well.  

The estimate of a market rental rate is obtained from a variety of sources. The best source, in my opinion, is from a current real estate appraisal of the property. Included in most commercial real estate appraisals is the market rate used by the appraiser in his or her income method. As a practical matter, many companies cannot afford or are unwilling to spend the amount necessary to obtain a real estate appraisal. In these cases, I typically call several real estate appraisers that I often work with on other matters and ask them their opinion of a reasonable rental rate for the type and location of the property in question. If both of these first two methods are not an option, the business appraiser could check with commercial real estate brokers (those firms that commonly lease property are best) for estimates or as a last resort, they could do their own rental survey.  

Real estate is owned by the operating company  

This configuration may be more challenging. Some business appraisers consider real estate owned by the company as an operating asset and make no adjustments to the income stream. This is certainly an option. However, I find this option troublesome. There are some businesses where real estate is an integral part of the business, for example, motels and hotels, storage rental units, etc. However, for the most part, businesses that could be operated from another location are better treated as if they are separate from the real estate.  

When appraising a controlling interest, I typically remove the real estate owned by the operating company and make adjustments necessary to reflect the property as if it were leased from an independent third party at market rates. I then value the company based on an adjusted income stream as if the property were leased and add the value of the property to the value of the company to obtain the value of the business entity. This means that if the property is covered by a mortgage, I remove the loan and add back the associated interest expense before subtracting a “market” lease rate for the property. Depreciation allocated to the real estate should also be adjusted and separated from depreciation for the operating assets.  

Not making this adjustment may significantly undervalue the company’s stock. Consider the following example:  

The company owns real estate used in the business with a book value of $750,000 but with a current fair market value of $2,000,000. If the real estate were leased from an independent, third party, the real estate appraiser has indicated that the market triple net lease rate would be $200,000. A $250,000 loan is owed against the property.  

Capitalization Value  

Rates Estimate

As this chart illustrates, there is a significant difference in the value of the company’s stock based on which approach is used.  

The key question to ask is: Would a hypothetical willing buyer and a hypothetical willing seller consider the current fair market value of the real estate or would they simply consider it an operating asset and not make any adjustments?  

Based on my twenty-three years experience as a business broker, I believe that both buyers and sellers will and do consider the value of the real estate owned and used by the business separately from the value of the business itself.

Business, Real Estate, and Machinery & Equipment Appraisals
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