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"I Have Only Come Here Seeking Knowledge..." But What Knowledge is Allowed to Affect a Valuation?

I have always cringed when Sting followed up the title line with "Things they would not teach me of in college". On the other hand, he was able to include in the same song (Wrapped Around Your Finger) the one and only rock reference to "Scylla and Charybdis", so the guy's got chutzpah and I think I've forgiven him!

 

This month's tenuous link to the lyric allows me to air the question of what information an analyst is allowed to consider in performing a valuation.  I am going to return one last time to the case of Estate of Louise Paxton Gallagher v. Commissioner (T.C. Memo. 2011-148). You may recall that I have already reviewed the Tax Court's comments in this case on the use of the market method of valuation and how to value an S Corp.

 

Mrs. Gallagher died on July 5, 2004. The case revolved around the valuation of her 15% interest in Paxton Media Group (PMG).


Going back to basics - Revenue Ruling 59-60 states fair market value is "the price at which the property would change hands between a willing buyer and a willing seller.... both parties having reasonable knowledge of relevant facts".  The question here is what "relevant facts" would a willing buyer have had access to as of the valuation date.

 

Both the experts for the estate and the IRS considered the guideline public company method. This approach takes publicly available information from comparable companies' financial statements (often revenue and EBITDA measures for a trailing 12-month period) and calculates a valuation multiple by comparing these to the market cap for the company based on stock price as of the valuation date. This multiple is then applied to the relevant measures of the subject company to determine a value.

 

The valuator for the estate based his valuation analysis, in part, on data from comparable public companies reports for the quarter ended March 28, 2004 whereas the valuator for the IRS used information as of June 30, 2004.

 

The argument that the estate's valuator made was that the June information would not have been publicly available as of July 5. There is always a lag between the end of a quarter and the release of a company's 10-Q so a willing buyer would not have had access to the second quarter's information and therefore would not have taken it into account in determining value.

 

The court disagreed: "our hypothetical actors could...make inquiries of...  the guideline companies (or of financial analysts), which would have elicited non-publicly available information as to end-of-June conditions.

 

With respect, I disagree. I think it unlikely that the guideline companies would have responded to this type of inquiry from a willing buyer with any relevant information - surely the provisions designed to prevent insider trading would have restricted the availability of this data. While I agree that the opinions of financial analysts could have been sought, they generally only provide earnings estimates that give a broad indication of how the guideline companies would actually have performed.

 

This may appear to be a small point, but the multiples suggested by the public company data can vary materially based on the data that goes into the calculation and the Court's position appears to go against the fair market definition in 59-60.