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Business valuation factors

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A man is working on a ski board in his shop.

The value of a business interest is generally based on two things:

  • 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.

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The information in this article was obtained from various sources not associated with State Farm® (including State Farm Mutual Automobile Insurance Company and its subsidiaries and affiliates). While we believe it to be reliable and accurate, we do not warrant the accuracy or reliability of the information. State Farm is not responsible for, and does not endorse or approve, either implicitly or explicitly, the content of any third party sites that might be hyperlinked from this page. The information is not intended to replace manuals, instructions or information provided by a manufacturer or the advice of a qualified professional, or to affect coverage under any applicable insurance policy. These suggestions are not a complete list of every loss control measure. State Farm makes no guarantees of results from use of this information.

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