Valuing Closely Held Businesses
Chapter 15
Valuation Principles
• Recall Ch. 15: Economic models that value
financial assets are based on concept of value
as discounted present value of future cash
flows.
• Valuing real assets (e.g. real estate, closely
held businesses) is based on same general
principles as valuing financial assets.
– “Closely held” refers to business that is privately
owned and does not issue publicly traded stocks
or bonds.
Revenue Ruling 59-60
• IRS’s Revenue Ruling 59-60
– Commonly used source of conceptual guidance for
valuing closely held companies
– Fair market (classic definition): price at which
property would change hands between willing buyer
and willing seller when former is seller under no
compulsion to sell, with both parties having
reasonable knowledge of facts
– In valuation of closely held corporations or valuation
of stock of corporations for which market quotations
are unknown or unreliable, all available financial data
and all relevant factors affecting fair market value
should be considered.
Revenue Ruling 59-60
• 8 fundamental factors that require careful analysis:
1. Nature and history of business
2. Company and industry economic outlook
3. Financial condition of business including book value of
stock
4. Earning capacity
5. Dividend payment capacity
6. Whether company has goodwill or other intangible
assets
7. Prior sales of stocks in company and size of block to be
offered
8. Market prices of stocks of corporations engaged in same
or similar businesses that have stocks actively traded in
free and open markets
Revenue Ruling 59-60
• Most basic approach to valuing company:
Calculate book value of company (assets minus
liabilities)
• Assets on balance sheet are based on historical
cost (less depreciation for fixed assets)
• Calculation of liquidation value overcomes
problems of relying on historical cost.
– Liquidation value: estimated current market value of
all assets minus all liabilities
• Indicates amount that could be obtained by selling off all
company’s assets and paying off all liabilities
Revenue Ruling 59-60
• Using rules of thumb or benchmarks to determine
value at which business is sold
– Examples
• Management training companies sell for 1-1½ times
current year’s revenue
• Small investment advisory practices sell for 3-4 times
current year’s revenue
• Broad rules of thumb, such as 10-15 times earnings
– Rules of thumb are based on many years of
experience in particular industry and are related
to what is considered reasonable rate of return on
invested capital in that industry
Revenue Ruling 59-60
• Use some variation of capitalization of income
method
– Capitalization of income requires calculation of discounted
present value of some future income stream
– Present value of constant income stream
expected to be paid in perpetuity equals dollar
amount of income divided by discount rate
• Ex. Present value of dollar per year paid in perpetuity at
20% discount rate is $5.00 since $1/.20 = $5.00.
• 20% discount rate translates into 5 times income
stream.
Revenue Ruling 59-60
• Difficulty of any discounted cash flow approach is
selection of appropriate discount rate.
– Closely held businesses usually select discount rates as
function of perceived riskiness of business.
– Common guideline: Select discount rate in terms of
percentage rate added to current ninety-day Treasury bill
interest rate, assuming T-bill rate reflects current cost of
money for short-term, risk-free loan
– No hard-and-fast rule!
Revenue Ruling 59-60
• Valuation for growing income stream is
complicated.
– Common example of valuing growing income
stream is that of valuing share of common stock
using dividend discount valuation model (recall
Ch. 14) .
Case Analysis: Valuing Home
Medical Care, Inc.
• Home Medical Care, Inc.: closely held home medical
services company
• See Exhibit 15.1: HMC’s income statement
– Approximately 60% of revenue comes from oxygen
equipment rental and oxygen sales
– Approximately 40% of revenue comes from product sales
• See Exhibit 15.2: HMC’s balance sheet
• See Exhibit 15.3: HMC’s key financial ratios and
industry standards
Case Analysis: Valuing Home
Medical Care, Inc.
• Exhibits 15.1-15.3 provide information about nature
of business, book value of stock, financial conditions
of business, earning and dividend paying capacity of
company
• See Exhibit 15.4: HMC’s 5-year pro-forma
income statement
– Provides information to help judge future financial
condition of business
Case Analysis: Valuing Home
Medical Care, Inc.
Profitability
• Based on all three measures of profitability, HMC is
significantly more profitable than average company
of comparable size in industry. In 2008:
– ROS of 6.4% is 1.8% above industry median of 4.6%.
– ROI of 11.6% is more than 3% above industry median of
8.4%.
– ROE of 23.8% is more than 3% above industry median of
20.6%.
Case Analysis: Valuing Home
Medical Care, Inc.
Liquidity
• Current ratio of 2.2 and quick ratio of 1.8 are
adequate and in line with industry medians of
2.4 and 1.9, respectively.
• Days sales in receivables at 83 days is in line
with industry median of 87 days.
• Days sales in inventory at 62 days is in line
with industry average of 55 days.
Case Analysis: Valuing Home
Medical Care, Inc.
Operating Efficiency
• Sales to total assets of 1.8 compared to industry
average of 1.9 (HMC is in line with industry)
• Industry is capital-intensive
– Additional investment of $1.00 in assets is needed to
support each additional $1.80 of sales that HMC generates
as company grows
– Compared to sales to assets ratio of 3.8 for retail
drugstores, which indicates that $1.00 in additional assets
supports sales growth of $3.80
Case Analysis: Valuing Home
Medical Care, Inc.
Leverage
• HMC’s leverage position is relatively high, but in line
with industry
– HMC’s total debt as percent of total assets is 51.4%
compared to industry figure of 51.7%
– Median value of debt as percent of total assets across 21
broad industry groups is 31.2%
• HMC’s long-term debt as percent of total assets is 22.9%
compared to industry median of 15.6%.
– Despite heavy debt use, HMC’s times interest earned is a
healthy 6.5 compared to industry ratio of 6.8.
Case Analysis: Valuing Home
Medical Care, Inc.
Overall Evaluation
• Despite high leverage (characteristic of industry), HMC is
an efficiently managed, profitable, and solvent company.
• Above-average profitability and normal debt use of
industry  rate of return on equity capital exceeds
common rule of thumb of “about 20% return on equity
capital”
• Return to capital is very good, but company is riskier than
average closely held corporation due to heavy debt use.
Case Analysis: Valuing Home
Medical Care, Inc.
Applications of Valuation Model to Home Medical Care
• Exhibit 15 shows forecast of expected future sales
growth and profitability
– Revenues and earnings are expected to grow at 20% per
year for next 5 years
• Suppose we expect earnings to grow at 10% per year
for all years after 2008. What is reasonable value for
HMC based on its future income stream?
Case Analysis: Valuing Home
Medical Care, Inc.
Applications of Valuation Model to Home Medical Care
• Selecting appropriate capitalization rate
– 90-day T-bill rate: approximately 5.5%
– HMC is a small company with much uncertainty as
to whether its high growth expectations can be
achieved  rate of at least 16% above risk-free
rate is appropriate
– Discount rate: 21.5% (= 5.5% + 16%)
– What is future value of HMC’s income stream at
22% discount rate?
Case Analysis: Valuing Home
Medical Care, Inc.
Applications of Valuation Model to Home Medical Care
• Base value on discounted present value of expected
future earnings
– Apply dividend discount model as of end of 2008
– Value of HMC equals sum of present value of earnings
from 2009 through 2013, plus present value of company
at end of 2013 as determined by value of all future
earnings growing at 10% per year indefinitely
Case Analysis: Valuing Home
Medical Care, Inc.
Application of Valuation Method to Home Medical Care
• Present value of next 5 years’ earnings using 22%
discount rate:
PV of 5 years’ earnings = $277,000/1.22 + $332,400/1.222 +
$398,800/1.223 + $478,600/1.224 + $574,300/1.225
• At end of year 5 (calendar year 2013), value of
company should be present value of all future
earnings growing at 10% per year:
V5 = ($574,300 × 1.10)/(0.22 − 0.10)
V5 = $5,264,417
Case Analysis: Valuing Home
Medical Care, Inc.
Application of Valuation Method to Home Medical Care
• Present value of V5 discounted back to year
one at 22% discount rate:
PV of V5 in year 1 = $5,264,417/1.225
PV of V5 in year 1 = $1,947,830
• Total value of HMC is sum of present value of
next 5 years’ earnings plus present value of
V5:
Value of HMC = $1,098,529 + $1,947,830 = $3,046,359
Case Analysis: Valuing Home
Medical Care, Inc.
Application of Valuation Method to Home Medical Care
• This valuation approach gives HMC fairly high value:
–
–
–
–
HMC is assuming company will grow at rate of 20% for next 5 years.
At end of 5-year period, V5 of $5,264,417 is approximately 9.2 times
earnings in 2008 (capitalization rate of 10.9%).
Unless growth prospects documented, it is unlikely that potential
buyer would pay as much as $3.1 million for HMC
Value of $3.1 million is approximately 13.4 times 2008 earnings of
$230,800 (well above common rule of thumb of 10 times earnings
for small businesses)
Case Analysis: Valuing Home
Medical Care, Inc.
Application of Valuation Method to Home Medical Care
• Substantial value added can be achieved by
successfully implementing high-growth strategy
– Optimal “exit strategy” for HMC:
•
•
Do whatever possible to meet 20% growth targets
over next 5 years
Position company for sale at reasonable multiple of
earnings in 2013 or 2014