Valuation Assumptions

By David H. Goodman CPA

Business appraisals are prepared for many purposes: divorce settlements, determining the value of a gift of an interest in a family owned business, or in shareholder actions. A valuation may be performed to value stock options of a closely held business or the purpose may be to determine what the value of the business would be if it had not entered bankruptcy. Whatever the purpose of the appraisal there are key underlying assumptions that need to be understood to grasp what a business appraisal does tell you and what it does not. This understanding is key to defending or attacking a business appraisal.

Assumption 1: All appraisals are a forecast of future income. Whether it is an appraisal of jewelry, real estate, or a business, the value determined is a forecast of future income. The income may be the proceeds received in a sale, the value of an income stream, or both. If I own a diamond ring, the value is whatever it will sell for. The appraiser bases the value on what comparable rings are currently selling for. On the other hand, if I own rental real estate I receive both an income stream (rent) and the potential for future appreciation of the property. The combination of the two determines the value of the property.

Assumption 2: The sooner an investor receives his or her money the more value it has. This is known as the time value of money - $100 today is worth more than $100 in 5 years. From the perspective of investors, the longer it takes for them to recover their money from an investment the higher the return on investment they expect. The reason for this is that there are a number of risk factors impacting their ability to recover their investment: inflation, bankruptcy, natural catastrophes, and so forth, that could cause investors to lose all of their investment. This is why the stock market fell after September 11^th, 2001 and why it continued to fall in light of the overstatement of income by major corporations -- the risk has become substantially greater and market stock prices reflect this increased risk.

Assumption 3: Investors will purchase investments of equal value interchangeably. This is known as substitution. This assumption is critical to the valuation of a privately owned business, debt or stock options. Implied by substitution is that there is some price at which an investor will purchase an investment with income potential. Substitution is based on one of the assumptions of the efficient market theory[1] -- that investors have access to timely and accurate information about a particular investment. That the largest publicly traded companies have knowingly reported false earnings or withheld information for shareholders undermines this assumption.

Investments are equalized by their rate of return. The riskier the investment the greater the rate of return an investor will require. Privately or closely held businesses are generally considered riskier than publicly traded companies. The size of the business is important as well. An investment in US Treasury bonds is certainly less risky than an investment in Pete's Used Cars.

In addition to these assumptions, there are fundamental principles to understand about business appraisals in general.

Principle 1: All appraisals are an opinion of value. No matter how much empirical data is used or how scientific or precise the appraiser tries to make their appraisal look, in the end, they have to use subjective opinion to determine the value. Areas in an appraisal that are subjective include the determination of the discount or capitalization rate and discounts. The two most common discounts are for lack of marketability and lack of control when valuing a minority interest in a business. Appraisers who use more than one method to value a business may weight these values depending on their confidence. This value looked very precise, but each weighting is subjective. Finding the hidden assumptions in a business valuation report requires expertise. You will best serve yourself or your client by having a qualified business appraiser review the report.

Principle 2: The Valuation date determines what information can be used when appraising a company. The valuation date, also known as the "as of" date, is the specific point in time as of which the valuator's opinion of value applies. Often this applies to the business' most recently completed fiscal year; however in the case of an appraisal for estate tax purposes, the value will be either the date of death or the alternative date. It is not unusual for judges and inexperienced business appraisers to misunderstand the implications of the valuation date. When appraising a business as of a particular date only the facts knowable as of that date may be referenced. For example, a business is appraised as of December 31, 2000 with a value of $500,000. In June of 2001, the business receives an unsolicited offer and the owner sells her business for $700,000. As of December 31, 2001, the appraiser cannot foresee the future and predict the sale of the business after receiving an unsolicited offer. If the appraiser's report is dated after June 2001, it is appropriate for the appraiser to reference the sale and the impact on value this has.

The Internal Revenue Service and the Tax Courts on certain cases have taken the position that a sale months after the appraisal date is a factor to be considered when reaching an opinion of value. When doing appraisals for gift or estate taxes it is important to know what positions the IRS and Tax Court have taken.