Business valuation factors

• What the company owns, which is reflected on the balance sheet, and
• What the company earns, which is reflected in the income statement.

In valuing a business for tax purposes, the IRS is guided by the factors listed in Revenue Ruling 59-60.¹

The nature and history of the business

Consideration is given to factors such as:

• Size and consistency of the growth rate.
• Stability of the business or lack thereof.
• Products, services and company assets.
• Record of sales.
• Management - especially recent changes.
• Diversity of operations.

Economic outlook

The general economic outlook and condition of the particular industry in which the business operates will affect how a business is valued. Common questions to be considered include the following:

• Is it a growth industry?
• How competitive is this company within the industry?
• What would be the economic effect of the loss of a key employee?

The book value of the stock

• Based on assets minus liabilities - to show liquidity position.
• Believed to be unreliable in valuing most businesses.

The earning capacity of the company

This is perhaps the most significant factor:

• Earning capacity is average earnings over a five-year period multiplied by a capitalization rate.
• There is no standard table of capitalization rates.
• Capitalization rates are usually based on price-earnings ratios of similar, publicly traded companies.

The dividend paying capacity

This is considered to be a primary factor:

• This does not mean dividends actually paid, but the capacity to pay.
• The IRS recognizes the need to retain a reasonable portion of the profits for expansion needs.

Goodwill and other intangible values

• Goodwill is based on earning capacity. It represents an excess of net earnings over and above a fair return on the net tangible assets of the business.
• Other intangibles include the following:
  • Ownership of a trade or brand name.
  • Prestige and renown of the business.
  • Prolonged successful operation in a particular locality.

Prior sales and size of block

• Prior sales may be meaningful if they were arms-length transactions.
• Small isolated sales or distress sales are not significant.
• Valuation of a controlling interest may carry a premium value.
• Valuation of a minority interest should include a discount.

Similar companies

How the business performs in comparison to its competitors is another consideration. For example, the valuation may consider the market price of stocks of similar, publicly traded corporations.

• Companies must be sufficiently comparable.
• The comparative appraisal method examines price-earnings, price-book value and price-dividend ratios of each corporation.

Weight to be given to each factor

Some factors will carry more weight than others. There is no exact mathematical formula.

A study by Standard Research Consultants² showed that in 74 tax cases, the most frequently used factors were:

• Sale price, in 33 cases;
• Book value, in 24 cases; and
• Earning power, in 17 cases.

Earnings will typically have more importance in companies selling products and services, whereas net worth will be more important in real estate holding companies.

¹ See also Revenue Ruling 65-193, Revenue Ruling 77-287, Revenue Ruling 68-609, Revenue Ruling 80-213, and Revenue Ruling 83-120.
² Study by Standard Research Consultants, as quoted in the CLU Journal, Vol. 34, No. 2, April 1980, pp. 61-70.