Two definitions of fair market value were provided in Appraisal Review #4. Interestingly, the concept of hypothetical willing buyers and sellers is not found in the statutory definition quoted in Revenue Ruling 59-60. Rather, hypothetical investors are indicated as found in court decisions. The hypothetical willing investors found in the second definition, from International Valuation Glossary — Business Valuation and formerly in the ASA Business Valuation Standards, were clarified and amplified in judicial interpretations of fair market value and adopted by the appraisal profession. Thank you, Paul Hood, for this observation.
Having defined fair market value, we can begin to analyze the basic factors used to describe the standard of value. Again, we do so with the idea of appraisal review, broadly speaking, in mind.
The “Basic Eight” Factors
Revenue Ruling 59-60 provides eight factors for consideration in fair market value determinations in its Section 4 . I refer to these as the “basic eight” factors of the ruling. These factors are important, and we will discuss each of them. They appear in most appraisal reports as follows with little or no discussion:
- The nature of the business and the history of the enterprise since its inception.
- The economic outlook in general and the condition of the specific industry in particular.
- The book value of the stock and the financial condition of the business.
- The earnings capacity of the company.
- The dividend-paying capacity of the company and the company’s history of, and prospects for, paying dividends.
- Whether or not the enterprise has goodwill or other intangible value.
- Sales of stock and the size of the block of stock to be valued.
- The market price of stocks of corporations engaged in the same or similar lines of business having their stocks actively traded in a free and open market, either in an exchange or over the counter.
The ruling then provides a more detailed discussion of each of the eight factors. In this post, we will address each of the factors briefly. Before doing so, however, note that in the preceding Section 3, Revenue Ruling 59-60 also states that a sound valuation will be based upon the relevant facts, but the elements of common sense, informed judgment, and reasonableness must enter the process of weighing those facts and determining their aggregate significance. I refer to these as the “critical three” factors of the ruling. We will make mention of these three critical elements on multiple occasions.
Some Color on the Eight Factors
The relevant factors to be considered according to RR 59-60 include the following in italics with brief comments following: (emphasis added). I have covered these basic eight factors in considerable detail in a separate document, “Fair Market Value: What Revenue Ruling 59-60 Says and Does Not Say.” In that document, the text of the ruling is broken into short sections and I comment on each section in some depth. It will be available to all subscribers of this blog shortly. In the meantime, the basic eight include:
- The nature of the business and the history of the enterprise since its inception. It is important to understand the business in which a company to be valued operates the relevant implications for value. For example, in determining the fair market value of a bank or a healthcare company, an understanding of their regulatory environments is necessary. The guidance suggests developing a “history of the enterprise since inception.” In practice, this means developing an overview of ancient history and focusing on the more recent history. In practice, this usually leads to a focus on the last five years (or so) of performance. This focus period might be shorter for newer companies and longer for cyclical companies.
- The economic outlook in general and the condition of the specific industry in particular. Companies operate in the context of the national, regional and/or local economies. The appraiser must place a company being valued in appropriate context given the appropriate economic influences on the business. Appraisers should also understand the conditions in a company’s particular industry. Is the industry in favor? Is it growing? Is it declining? Are there particular aspects of the industry that should be considered in the appraisal? These are questions that appraisers must address.
- The book value of the stock and the financial condition of the business. The book value of a company’s stock is its shareholders’ equity, or total assets minus total liabilities. This is a number. However, the “book value” referenced in RR 59-60 is an adjusted book value where assets, and by implication, liabilities, are marked to their current market values. This would be another number. The ruling recognizes that goodwill is a function of earning power and that it may not be practical to value this intangible asset separately. Nevertheless, goodwill per the ruling is the excess (or deficit, if “badwill”) of value over the book value of a company’s stock. In the alternative, goodwill could be measured by the excess of capitalized value over adjusted book value. Then, the ruling calls for a focus on the financial condition of the business. While looking at the balance sheet, it is always appropriate to evaluate the financial condition of the business. Is it highly leveraged? Overcapitalized? Are there excess assets like cash or beach homes on the balance sheet? Is the company borrowing funds from a bank or other lender? What is the relationship with the lender, and are all loan covenants being met? A solid analysis of the current and historical balance sheets is necessary to determine not only financial condition at the valuation date, but trends leading to the current position, which may be positive or adverse. The analysis of the financial condition of a business should identify any particular risks flowing from the balance sheet for consideration in hypothetical negotiations. While providing little guidance regarding the assessment of risk, the ruling mentions on several occasions that appraisers must make judgments about the risks associated with earnings and the balance sheet.
- The earnings capacity of the company. This aspect of analysis is generally assumed to call for a historical analysis of revenues and earnings, including an examination of trends in terms of dollars and margins. Since valuation is expectational, this means that an appraiser’s analysis should lead to a reasonable outlook for expected earnings in the future, either for a single period income capitalization method or for a longer period with a financial forecast for the discounted cash flow method. This factor, combined with the dividend capacity element, suggests that the drafters of RR 59-60 were focused on expected cash flow. In any event, appraisers are charged with evaluating the earnings and expected cash flow of a company as of the valuation date. In evaluating expectations for cash flow and its growth, appraisers must also evaluate the risks associated with achieving those cash flows. For example, a company with two customers providing 50% each of sales is riskier than a company with 50 customers, each providing 2% of sales.
- The dividend-paying capacity of the company and the company’s history of, and prospects for, paying dividends. The dividend-paying capacity of any company is a function of its current and expected earnings and the demands on those earnings for working capital, capital expenditures for growth, or debt retirement. The drafters of RR 59-60 were suspicious of actual dividends paid since they can be manipulated by controlling owners. Prior to the 1980s, the capitalization of dividends was a frequently used valuation method. In all likelihood, the focus on dividend paying capacity was based on suspicions that business owners would tend to minimize dividends actually paid. Nevertheless, the “history of, and prospects for, paying dividends” is particularly important for the valuation of minority interests. Expected dividends have value to hypothetical and real investors. And the value of expected or prospective dividends cannot be addressed in qualitative terms.
- Whether or not the enterprise has goodwill or other intangible value. This element of goodwill is a byproduct of the valuation process. Goodwill is normally defined as value in excess of shareholder’s equity or book value. To the extent that the capitalization of earnings yields value indications of value in excess of book value, goodwill will be reflected in the appraisal. As noted above, another measure of goodwill would be the difference between capitalized value and adjusted (marked to market values) book value. RR 59-60 states: “Whatever intangible value there is, which is supportable by the facts, may be measured by the amount by which the appraised value of the tangible assets exceeds the net book value of such assets.”
- Sales of stock and the size of the block of stock to be valued. RR 59-60 suggests that information about current value may be gleaned from previous sales in the stock of a subject company or prior transactions involving the company itself. The size of the block of stock being valued also matters. For example, if the block represents a controlling 60% interest, a determination of fair market value would likely be required at the financial control level of value. Alternatively, if the block is a 10% interest, it is a nonmarketable minority interest, and would be valued at the nonmarketable minority level of value on the levels of value chart above. Interestingly, there is virtually no guidance in RR 59-60 regarding the valuation of minority interests. There is no mention of the minority interest discount and no mention of the marketability discount in the entire ruling. While the concepts can be inferred from a careful reading of the ruling, the absence of focus on minority interest valuation was likely the result of an unclear understanding of the levels of value, which we discussed in the previous post. The levels of value chart was not published prior to 1990, even though the concepts underlying it were beginning to be understood.
- The market price of stocks of corporations engaged in the same or similar lines of business having their stocks actively traded in a free and open market, either in an exchange or over the counter. This element of RR 59-60 suggests examining the public securities markets for valuation evidence relevant to the value of particular companies. It says to look at the market prices, but we look at prices relative to net income, EBITDA, or revenue, for example, to see what the implied valuation multiples are for potential application to a subject company. The admonishment suggests examining stocks that are “actively traded.” In 1959, there were many small, legally public companies that had inactive markets. There are some today. The standard is companies engaged in the same or similar businesses with active markets for their shares. Valuations developed in this fashion employ what we now call the guideline public company method and yield value indications at the marketable minority level of value on the levels of value chart.
The focus of Revenue Ruling for developing values was on public companies. Section 6 of the ruling consists of a single paragraph titled “Capitalization Rates” with mention of capitalizing earnings or dividends. The entire guidance regarding income methods consisted of the following sentence:
“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.”
In fairness to the drafters, the first published description for using the Capital Asset Pricing Model to develop capitalization rates was not published until 1989. (See Mercer, Z. Christopher, “The Adjusted Capital Asset Pricing Model for Developing Capitalization Rates: An Extension of Previous ‘Build-Up’ Methodologies Based Upon the Capital Asset Pricing Model,” Business Valuation Review, December 1989). Email me if you would like a copy of this early article.
The Critical Three Factors
The definition of fair market value and the basic eight factors are listed in nearly every business valuation report. However, not every business valuation report reflects a solid understanding of this important standard of value. Often, one or more of the critical three factors of common sense, informed judgment and reasonableness are missing. I am hopeful that this series will provide an important resource for appraisers, attorneys, and courts as we all deal with fair market value from our various perspectives.
Common sense is defined as:
Sound and prudent judgment based on a simple perception of the situation or facts.
One can understand why the drafters of RR 59-60 would want common sense applied in fair market value determinations. Common sense just makes sense. Common sense when applied considers all relevant information about the situation or the facts. Unfortunately, common sense is not universally applied by valuation professionals. The lack of common sense is often seen in appraisals in adversarial matters where one or more appraisers lean toward the side of advocacy. When reading and reviewing appraisals, it is incumbent on the reviewer to apply his or her own common sense, whether it has been applied in the appraisal under review or not. It has been said (anonymous):
There is nothing so uncommon as common sense.
If common sense were universally applied, this quote would not have gained traction. In appraisal and appraisal review, we need to apply regular doses of common sense. A “simple perception of the situation or facts” clearly suggests that all relevant information should be considered in any fair market value determination. A good question to ask when reviewing an appraisal would be, “Does this make sense on its face?”
Law Insider defines informed judgment as:
a choice made by a person who has the ability to make such a choice, and who makes it voluntarily after all relevant information necessary to making the decision has been provided, and who understands that he is free to choose or refuse any alternative available and who clearly indicates or expresses the outcome of his choice. (emphasis added)
Informed judgment in the context of appraisal or appraisal review means considering “all relevant information,” which is the same as guidance in RR 59-60 (on three occasions) to consider “all relevant factors.” The appraiser or review appraiser must, of course, make informed judgments while also applying common sense. Judgments made in appraisals that do not follow from a consideration of “all relevant factors” would not be informed judgments. The informed judgment also implies the absence of bias, since one is “free to choose or refuse any alternative” based on consideration of all relevant information. An informed judgment is also one that is clearly indicated or expressed. A good question to ask when reviewing an appraisal would be, “Does this assumption or conclusion flow logically from the facts as presented and does it appear to be based on all relevant information?”
Reasonableness is defined as:
The fact of being based on or using good judgment and therefore being fair and practical.
This definition of reasonableness invokes the making of judgments that are “fair and practical.” How do we determine whether something is reasonable or not? Often by comparisons with other things. In appraisal, for example, if an appraiser concludes that the fair market value of a company reflects a multiple of 4 times normalized EBITDA and “the market” for similar companies suggests pricing in the range of 8 times EBITDA, that conclusion might appear to be unreasonable.
I figured out the concept of reasonableness early in my valuation career. One of my first publications in the American Society of Appraisers Business Valuation Review was in 1988 (unbelievably, that was going on 34 years ago!) when I wrote a short piece on “Issues in Recurring Valuations.” By then, we at Mercer Capital had institutionalized certain tests of reasonableness for recurring clients. The short piece discussed the concept of comparisons of both year-to-year methodologies and conclusions and reaching conclusions regarding reasonableness. The graphic used in the article was as follows. The text in the report discussed each element of the appraisal, explaining what changed and why. We concluded that the then current appraisal was reasonable in light of all the comparisons.
We still see recurring appraisals from firms that do not make such simple comparisons to test reasonableness. This can be done by appraisers and if not, then certainly such comparisons should be made by a review appraiser if applicable.
In this ongoing series of posts, we have begun a discussion of appraisal review that is broader than the normal consideration of the topic. We are digging into the definitions and implications of the standard of value known as fair market value in some depth. We cannot develop fair market value opinions or review them without a core understanding of the standard.
In the first post in the series, we introduced appraisal review, broadly speaking, as a new focus for ChrisMercer.net. The next post addressed fair market value before the definitions. Then we looked at the conceptual levels of value before arriving at the definitions of fair market value. In this post, we looked at the “basic eight” factors of RR 59-60 and the “critical three” factors.
In the next post, the sixth in the series, we will examine fair market value and the integrated theory of business valuation.
As always, please feel free to comment on these posts. The dialogue will be good for all.
 For a more in-depth consideration of these eight factors and the entirety of Revenue Ruling 59-60, see: Mercer, Z. Christopher, “Fair Market Value: What Revenue Ruling 59-60 Says and Does Not Say,” available to subscribers of my blog, www.ChrisMercer.net. I will email the article to each subscriber. It will then be available to new subscribers to the blog at the time of signing up.