Look Forward to Find the Value of Your Business
Business valuation is a forward-looking exercise; this is a basic premise of the valuation process for any ownership interest. The income approach to valuation fully embraces this belief because the income approach determines the value of an ownership interest by looking at the future benefits that flow to ownership and discounting those benefits to present value. The discount rate used to determine the present value should recognize the risks associated with their receipt.
The Value of Ownership Interest
The value of an ownership interest in a company should be thought of as an investment, that is, a commitment of dollars today in exchange for future payments which compensate the investor for the time the funds are invested and provide a return on the investment. Not only do the benefits to be received need to be based on future expectations, the investor’s required rate of return (or cost of capital) should also reflect future expectations. Investors will not pay for past performance. One needs to look no further than the public companies that operate in high-growth markets, such as artificial intelligence or software, that trade at triple-digit trailing price/earnings multiples. Pricing in this market reflects forward-looking expectations, not historical pricing.
Pierce v. Commissioner
Pierce v. Commissioner T.C. Memo. 2025-29 (Pierce) is a case which includes the rise of a business making knock off products, marital infidelity, and blackmail, but is generally known for the Tax Court affirming tax-effecting pass-through entities. The case also focuses on the forward-looking nature of the benefits of ownership and addresses the determination of the discount rate used in the valuation of the company. The case involves gifts of stock made by the owners to trusts. The gift tax returns were selected for audit, and a 30-day letter was issued by the IRS noting a deficiency and proposed adjustments to tax. The case went to court to determine the value of the interests for federal gift tax purposes. The tax court stated:
In valuing stock of a closely held corporation, we first consider actual sales of the stock at arm’s length in the normal course of business at or around the time of valuation. In the absence of actual sales of the company’s stock, courts typically consider one or more of three approaches to determine the stock’s fair market value: (1) the market approach, (2) the income approach, and (3) the asset-based approach… The income approach capitalizes income and discounts cashflow to determine the value of stock. This method is premised on the assumption that the value of the company should be determined based on the basis of the present value of the future distributed earnings.
The court reaffirmed the forward-looking premise and use of the income approach, referencing the Estate of True v. Commissioner, T.C. Memo. 2001-167 in support of its opinion. In Pierce the court went on to further state:
Thus, to determine the value of the business, we must determine (1) the projected future cashflows for a discrete period, (2) the discount rate that will be applied to these future distributions to determine the present value, (3) the terminal value of the company, and (4) the non-operating assets.
Case Findings
The court’s opinion discussed factors to consider in the projected future cash flows of the company (including tax affecting pass-through entity earnings) and the inclusion of factors only known and knowable at the date of valuation. The court’s opinion also discussed the development of the discount rate used in the discounted cash flow analysis. There were two primary experts involved in this case which arrived at different discount rates. Looking more closely at the discount rates, the experts were close on how the equity risk premium (ERP) should be determined. The ERP is a component of the discount rate and is the premium that investors must receive to entice them to invest in the public market instead of risk-free long-term government securities. The court stated that the ERP includes a market risk premium and a size premium.
An additional company-specific risk (CSR) premium can be added to account for risks unique to the company and its cash flow. The two experts were within 1% of each other in their development of the ERP but differed in their treatment of the CSR premium; one added a 5% premium, and the other did not add a CSR premium. The court expected an analysis showing that the CSR premium accounted for risks specific to the company that were not accounted for in the ERP. The explanation at trial was not satisfactory to the court and it rejected the CSR premium.
Case Relevance for Business Valuation
In the ruling, the court confirmed two important points. First, business valuation, like any investment, is forward-looking in nature. Investors will not pay for past performance and are concerned with future performance. Using an income approach, the value of a business is derived from forward-looking cash flow. The second point is that the required rate of return of an investment and the discount rate used in the valuation of a company need to account for the specific risks associated with receiving the benefits (cash flows). Both points should be considered in a business valuation.
Should you have any questions concerning this article or the value of your business or of Business Valuation services in general, please contact T. Eric Blocher CPA, ASA, CVA.