Business Valuation Upon Divorce: How Theory and Practice Can Lead To Problems in Court

Business Valuation Upon Divorce: How Theory
and Practice Can Lead to Problems In Court

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Richard R. Orsinger
[email protected]
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Orsinger, Nelson, Downing & Anderson, LLP
San Antonio Office:
1717 Tower Life Building
San Antonio, Texas 78205
(210) 225-5567
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and
Dallas Office:
5950 Sherry Lane, Suite 800
Dallas, Texas 75225
(214) 273-2400
http://www.ondafamilylaw.com
AICPA/AAML Conference on Divorce

May 10-12, 2012
Aria Resort & Casino
Las Vegas, NV
2012
Richard R. Orsinger
All Rights Reserved
CURRICULUM VITAE OF RICHARD R. ORSINGER

Education:
Washington & Lee University, Lexington, Virginia (1968-70)

University of Texas (B.A., with Honors, 1972)
University of Texas School of Law (J.D., 1975)
Licensed:
Texas Supreme Court (1975); U.S. District Court, Western District of Texas (1977-1992; 2000-present); U.S.
District Court, Southern District of Texas (1979); U.S. Court of Appeals, Fifth Circuit (1979); U.S. Supreme
Court (1981)
Certified:
Board Certified by the Texas Board of Legal Specialization Family Law (1980), Civil Appellate Law (1987)
Organizations and Committees:

Chair, Family Law Section, State Bar of Texas (1999-2000)
Chair, Appellate Practice & Advocacy Section, State Bar of Texas (1996-97)
Chair, Continuing Legal Education Committee, State Bar of Texas (2000-02)
Vice-Chair, Continuing Legal Education Committee, State Bar of Texas (2002-03)
Member, Supreme Court Advisory Committee on Rules of Civil Procedure (1994-present);
Chair, Subcommittee on Rules 16-165a
Member, Pattern Jury Charge Committee (Family Law), State Bar of Texas (1987-2000)
Supreme Court Liaison, Texas Judicial Committee on Information Technology (2001-present)
Tx. Bd. of Legal Specialization, Civil Appellate Law Advisory Commission (Member and Civil Appellate Law
Exam Committee (1990-2006; Chair 1991-1995); Family Law Advisory Commission (1987-1993)
Member, Supreme Court Task Force on Jury Charges (1992-93)
Member, Supreme Court Advisory Committee on Child Support and Visitation Guidelines
(1989, 1991; Co-Chair 1992-93; Chair 1994-98)
Member, Board of Directors, Texas Legal Resource Center on Child Abuse & Neglect, Inc. (1991-93)
President, Texas Academy of Family Law Specialists (1990-91)
President, San Antonio Family Lawyers Association (1989-90)
Associate, American Board of Trial Advocates
Fellow, American Academy of Matrimonial Lawyers
Director, San Antonio Bar Association (1997-1998)
Member, San Antonio, Dallas and Houston Bar Associations
Professional Activities and Honors:
One of Texas Top Ten Lawyers in all fields, Texas Monthly Super Lawyers Survey (2010 - 3rd Top Point Getter)
Listed as one of Texas Top Ten Lawyers in all fields, Texas Monthly Super Lawyers Survey (2009)
Recipient of the Franklin Jones, Jr. CLE Article Award for Outstanding Achievement in CLE (2009)
Listed as Texas Top Family Lawyer, Texas Lawyers Go-To-Guide (2007)
Listed as one of Texas Top 100 Lawyers, and Top 50 Lawyers in South Texas, Texas Monthly Super Lawyers
Survey(2003-2010)
Texas Academy of Family Law Specialists Sam Emison Award (2003)
State Bar of Texas Presidential Citation for innovative leadership and relentless pursuit of excellence for continuing legal
education (June, 2001)
State Bar of Texas Family Law Sections Dan R. Price Award for outstanding contributions to family law (2001)
State Bar of Texas Gene Cavin Award for Excellence in Continuing Legal Education (1996)
State Bar of Texas Certificate of Merit, June 1995, June 1996, June 1997 & June 2004
Listed in the BEST LAWYERS IN AMERICA: Family Law (1987-2011); Appellate Law (2007-2011)
Continuing Legal Education and Administration:
Course Director, State Bar of Texas:
Practice Before the Supreme Court of Texas Course (2002 - 2005, 2007, 2009 & 2011)
Enron, The Legal Issues (Co-director, March, 2002) [Won national ACLEA Award]
Advanced Expert Witness Course (2001, 2002, 2003, 2004)
1999 Impact of the New Rules of Discovery
1998 Advanced Civil Appellate Practice Course
1991 Advanced Evidence and Discovery
Computer Workshop at Advanced Family Law (1990-94) and Advanced Civil Trial (1990-91) courses
1987 Advanced Family Law Course. Course Director, Texas Academy of Family Law Specialists First Annual Trial Institute,
Las Vegas, Nevada (1987)
Books and Journal Articles:
Editor-in-Chief of the State Bar of Texas TEXAS SUPREME COURT PRACTICE MANUAL (2005)
Chief Editor of the State Bar of Texas Family Law Section's EXPERT WITNESS MANUAL (Vols. II & III) (1999)
Author of Vol. 6 of McDonald Texas Civil Practice, on Texas Civil Appellate Practice, published by Bancroft-Whitney Co.
(1992) (900 + pages)
A Guide to Proceedings Under the Texas Parent Notification Statute and Rules, SOUTH TEXAS LAW REVIEW (2000) (coauthored)
Obligations of the Trial Lawyer Under Texas Law Toward the Client Relating to an Appeal, 41 SOUTH TEXAS LAW REVIEW
111 (1999)
Asserting Claims for Intentionally or Recklessly Causing Severe Emotional Distress, in Connection With a Divorce, 25 ST.
MARY'S L.J. 1253 (1994), republished in the AMERICAN JOURNAL OF FAMILY LAW (Fall 1994) and Texas Family Law Service
NewsAlert (Oct. & Dec., 1994 and Feb., 1995)
Chapter 21 on Business Interests in Bancroft-Whitney's TEXAS FAMILY LAW SERVICE (Speer's 6th ed.)
Characterization of Marital Property, 39 BAY. L. REV. 909 (1988) (co-authored)
Fitting a Round Peg Into A Square Hole: Section 3.63, Texas Family Code, and the Marriage That Crosses States Lines, 13
ST. MARY'S L.J. 477 (1982)
SELECTED CLE SPEECHES AND ARTICLES
State Bar of Texas' [SBOT] Advanced Family Law Course: Intra and Inter Family
Transactions (1983); Handling the Appeal: Procedures and Pitfalls (1984); Methods and
Tools of Discovery (1985); Characterization and Reimbursement (1986); Trusts and
Family Law (1986); The Family Law Case in the Appellate Court (1987); Post-Divorce
Division of Property (1988); Marital Agreements: Enforcement and Defense (1989);
Marital Liabilities (1990); Rules of Procedure (1991); Valuation Overview (1992);
Deposition Use in Trial: Cassette Tapes, Video, Audio, Reading and Editing (1993); The
Great Debate: Dividing Goodwill on Divorce (1994); Characterization (1995); Ordinary
Reimbursement and Creative Theories of Reimbursement (1996); Qualifying and
Rejecting Expert Witnesses (1997); New Developments in Civil Procedure and Evidence
(1998); The Expert Witness Manual (1999); Reimbursement in the 21st Century (2000);
Personal Goodwill vs. Commercial Goodwill: A Case Study (2000); What Representing
the Judge or Contributing to Her Campaign Can Mean to Your Client: Proposed New
Disqualification and Recusal Rules (2001); Tax Workshop: The Fundamentals (2001);
Blue Sky or Book Value? Complex Issues in Business Valuation (2001); Private Justice:
Arbitration as an Alternative to the Courthouse (2002); International & Cross Border
Issues (2002); Premarital and Marital Agreements: Representing the Non-Monied Spouse
(2003); Those Other Texas Codes: Things the Family Lawyer Needs to Know About
Codifications Outside the Family Code (2004); Pearls of Wisdom From Thirty Years of
Practicing Family Law (2005); The Road Ahead: Long-Term Financial Planning in
Connection With Divorce (2006); A New Approach to Distinguishing Enterprise
Goodwill From Personal Goodwill (2007); The Law of Interpreting Contracts: How to
Draft Contracts to Avoid or Win Litigation (2008); Effect of Choice of Entities: How
Organizational Law, Accounting, and Tax Law for Entities Affect Marital Property Law
(2008); Practicing Family Law in a Depressed Economy, Parts I & II (2009); Property
Puzzles: 30 Characterization Rules, Explanations & Examples (2009); Troubling Issues
of Characterization, Reimbursement, Valuation, and Division Upon Divorce (2010);
Separate & Community Property: 30 Rules With Explanations & Examples (2010); The
Role of Reasoning in Constructing a Persuasive Argument (2011)
UT School of Law: Trusts in Texas Law: What Are the Community Rights in
Separately Created Trusts? (1985); Partnerships and Family Law (1986); Proving Up
Separate and Community Property Claims Through Tracing (1987); Appealing Non-Jury
Cases in State Court (1991); The New (Proposed) Texas Rules of Appellate Procedure
(1995); The Effective Motion for Rehearing (1996); Intellectual Property (1997);
Preservation of Error Update (1997); TRAPs Under the New T.R.A.P. (1998); Judicial
Perspectives on Appellate Practice (2000)
SBOT's Advanced Evidence & Discovery Course: Successful Mandamus Approaches
in Discovery (1988); Mandamus (1989); Preservation of Privileges, Exemptions and
Objections (1990); Business and Public Records (1993); Grab Bag: Evidence &
Discovery (1993); Common Evidence Problems (1994); Managing Documents--The
Technology (1996); Evidence Grab Bag (1997); Evidence Grab Bag (1998); Making and
Meeting Objections (1998-99); Evidentiary Issues Surrounding Expert Witnesses (1999);
Predicates and Objections (2000); Predicates and Objections (2001); Building Blocks of
Evidence (2002); Strategies in Making a Daubert Attack (2002); Predicates and
Objections (2002); Building Blocks of Evidence (2003); Predicates & Objections (High
Tech Emphasis) (2003)
SBOT's Advanced Civil Appellate Practice Course: Handling the Appeal from a
Bench Trial in a Civil Case (1989); Appeal of Non-Jury Trials (1990); Successful
Challenges to Legal/Factual Sufficiency (1991); In the Sup. Ct.: Reversing the Court of
Appeals (1992); Brief Writing: Creatively Crafting for the Reader (1993); Interlocutory
and Accelerated Appeals (1994); Non-Jury Appeals (1995); Technology and the
Courtroom of the Future (1996); Are Non-Jury Trials Ever "Appealing"? (1998);
Enforcing the Judgment, Including While on Appeal (1998); Judges vs. Juries: A Debate
(2000); Appellate Squares (2000); Texas Supreme Court Trends (2002); New Appellate
Rules and New Trial Rules (2003); Supreme Court Trends (2004); Recent Developments in the Daubert Swamp (2005); Hot Topics in Litigation: Restitution/Unjust
Enrichment (2006); The Law of Interpreting Contracts (2007); Judicial Review of
Arbitration Rulings: Problems and Possible Alternatives (2008); The Role of Reasoning
and Persuasion in the Legal Process (2010)
Various CLE Providers: SBOT Advanced Civil Trial Course: Judgment Enforcement,
Turnover and Contempt (1990-1991), Offering and Excluding Evidence (1995), New
Appellate Rules (1997), The Communications Revolution: Portability, The Internet and
the Practice of Law (1998), Daubert With Emphasis on Commercial Litigation,
Damages, and the NonScientific Expert (2000), Rules/Legislation Preview (State
Perspective) (2002); College of Advanced Judicial Studies: Evidentiary Issues (2001);
El Paso Family Law Bar Assn: Foreign Law and Foreign Evidence (2001); American
Institute of Certified Public Accounts: Admissibility of Lay and Expert Testimony;
General Acceptance Versus Daubert (2002); Texas and Louisiana Associations of
Defense Counsel: Use of Fact Witnesses, Lay Opinion, and Expert Testimony; When and
How to Raise a Daubert Challenge (2002); SBOT In-House Counsel Course: Marital
Property Rights in Corporate Benefits for High-Level Employees (2002); SBOT 19th
Annual Litigation Update Institute: Distinguishing Fact Testimony, Lay Opinion &
Expert Testimony; Raising a Daubert Challenge (2003); State Bar College Spring
Training: Current Events in Family Law (2003); SBOT Practice Before the Supreme
Court: Texas Supreme Court Trends (2003); SBOT 26th Annual Advanced Civil Trial:
Distinguishing Fact Testimony, Lay Opinion & Expert Testimony; Challenging
Qualifications, Reliability, and Underlying Data (2003); SBOT New Frontiers in Marital
Property: Busting Trusts Upon Divorce (2003); American Academy of Psychiatry and the
Law: Daubert, Kumho Tire and the Forensic Child Expert (2003); AICPA-AAML
National Conference on Divorce: Cutting Edge IssuesNew Alimony Theories;
Measuring Personal Goodwill (2006); New Frontiers` - Distinguishing Enterprise
Goodwill from Personal Goodwill; Judicial Conference (2006); SBOT New Frontiers in
Marital Property Law: Tracing, Reimbursement and Economic Contribution Claims In
Brokerage Accounts (2007); SBOT In-House Counsel Course: When an Officer
Divorces: How a Company can be Affected by an Officers Divorce (2009); SBOT
Handling Your First Civil Appeal The Role of Reasoning and Persuasion in Appeals
(2011); New Frontiers in Marital Property Law: A New Approach to Determining
Enterprise and Personal Goodwill Upon Divorce (2011)
TABLE OF CONTENTS
I. INTRODUCTION.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
II. STANDARDS OF VALUE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
A. FAIR MARKET VALUE... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1. Definitions of Fair Market Value.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
2. Inputs in Determining Fair Market Value.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
3. Rev. Ruling 59-60's Fair Market Value of a Privately-Owned Business.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
B. FAIR VALUE (ACCOUNTING)... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1. Definition of Fair Value (Accounting).. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
2. Inputs for Determining Fair Value (Accounting)... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
C. FAIR VALUE (DISSENTERS RIGHTS)... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1. Colorado.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2. California.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
3. Colorado.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
4. Delaware.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
5. Illinois.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
6. Iowa.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
7. Kansas.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
8. Kentucky.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
9. Maine.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
10. New Jersey.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
11. New York.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
12. Texas... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
13. Vermont.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
14. Wyoming... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
15. Whats Fair?.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
D. ANALOGY TO DIVORCE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
E. INTRINSIC VALUE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
1. What is Intrinsic Value?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
F. INVESTMENT VALUE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
G. LIQUIDATION VALUE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
H. BOOK VALUE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
I. GOING CONCERN VALUE... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
J. SENTIMENTAL VALUE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
K. STANDARD OF VALUE FOR DIVORCE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Alabama... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Arizona.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Arkansas.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
California... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Colorado.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Connecticut.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Delaware.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Florida.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Hawaii.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Idaho.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Illinois.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Indiana.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Iowa.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Kansas.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Mississippi... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Missouri... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
New York.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
New Jersey... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
New Mexico.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
North Carolina.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
North Dakota.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Ohio... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Oklahoma.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Pennsylvania.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
South Carolina.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Tennessee.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Texas.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Vermont... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Virginia.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
West Virginia... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Wisconsin.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
17
17
17
17
17
17
17
17
17
17
18
18
18
18
19
19
III. STANDARDS OF LEGAL ADMISSIBILITY... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

A. GENERAL ACCEPTANCE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
B. DAUBERT RELIABILITY.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
C. WHERE THE STATES FALL... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
D. HOW MIGHT THESE STANDARDS APPLY TO BUSINESS VALUATION?. . . . . . . . . . . . . . . . . . . . . . .
19
19
19
20
22
IV. THE INCOME APPROACH (EARNINGS AND CASH FLOW)... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

A. PROJECTING FUTURE CASH FLOWS.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
B. NORMALIZING HISTORICAL EARNINGS OR CASH FLOW.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1. Adjustments to the Income Statement.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
a. Normalizing Adjustments.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
b. Control Adjustments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
c. Fundamental Adjustments... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
d. Determining Reasonable Compensation.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2. Applicable to the Market Approach as Well.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
C. DETERMINING AN EXPECTED GROWTH RATE... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
D. DETERMINING TERMINAL VALUE... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
23
24
25
25
25
26
26
26
26
26
26
V. THE INCOME APPROACH (DEVELOPING A CAP RATE/DISCOUNT RATE).. . . . . . . . . . . . . . . . . . . .

A. MODERN PORTFOLIO THEORY... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
B. CAPM... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
C. THE RISK FREE RATE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
D. THE EQUITY RISK PREMIUM.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1. Surveys.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2. Ex Post Analysis.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3. Ex Ante Analysis.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
E. MODERN APPLICATIONS OF MPT AND THE CAPM.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1. Beta.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2. The CAPM Formula.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3. Size Premium... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4. What Constitutes Diversification.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5. Using the CAPM to Value Private Businesses... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6. Alternative Asset Pricing Models.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
F. BUILD UP METHOD.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1. The Risk Free Rate.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2. The Equity Risk Premium.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
27
27
27
28
29
30
31
31
33
33
33
34
34
35
35
35
36
36
ii
3. The Size Premium.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4. The Industry Risk Premium.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5. The Specific Company Risk Premium.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6. The Build-Up Method as an Extension of the CAPM.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
G. PROBLEMS WITH THE RISK FREE RATE... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1. Nominal vs. Real Yields.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2. Risk Free You Say?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3. Negative Yields.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4. The Flip Side of Fear.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5. Government Manipulation.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6. Selecting the Right Security... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
7. Matching Horizons.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
8. Compounding.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
9. Historical vs. Current.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
H. PROBLEMS WITH THE EQUITY RISK PREMIUM.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1. The Equity Premium Puzzle.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2. Different Windows Into the Data.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3. Is Older Data Relevant?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4. Geometric Versus Arithmetic Mean.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5. Matching Maturities... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6. Mismatched Time Frames.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
7. Survivor Bias.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
8. The ERP is Cyclical.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
9. Ex Post Is Not Ex Ante.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
10. Increased Systemic Risk.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
11. Other Problems.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
12. Recap of Problems with Estimating the ERP.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
13. What Would Warren Buffett Do?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
14. Is the Game Worth the Candle?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
I. PROBLEMS WITH BETA.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1. Differing Market Indexes... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2. Estimation Period... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3. Return Interval.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4. Adjustments to Beta... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5. Unrelated Market Pricing... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6. High Betas Can Be Good... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
7. Conservatism.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
8. Comparability to Privately-Owned Businesses.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
9. Admissibility in Court.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
J. PROBLEMS WITH THE CAPM... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1. Statistical.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2. The Need to Adjust Inputs.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3. The CAPM Assumes Stable Inputs.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4. What Market Proxy to Use... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5. Admissibility in Court.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6. Uncharacteristic Market Behavior.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
K. PROBLEMS WITH THE SIZE PREMIUM.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1. Using Market Cap to Measure Size.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2. The Smallest Public Companies are not Comparable.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3. Beta Reversal.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4. Small Caps in Financial Trouble.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6. Excess Returns are Cyclical.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
7. The January Effect.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
iii
36
36
37
37
38
38
38
38
38
38
39
39
40
40
40
40
41
42
43
44
44
44
44
45
45
45
45
46
46
47
47
47
47
47
47
48
48
48
48
48
48
50
50
50
51
52
53
53
53
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53
53
8. Circularity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
9. The Breakpoints Between Deciles.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
10. Size Premia are Historical.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
11. Size Versus Liquidity Premium?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
12. Are There Better Measures of Risk Than Size?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
L. PROBLEMS WITH THE INDUSTRY RISK PREMIUM.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
M. SHOULD THERE BE A LIQUIDITY PREMIUM?.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
N. PROBLEMS WITH THE SPECIFIC COMPANY RISK PREMIUM... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
53
54
54
54
54
54
54
55
VI. THE MARKET APPROACH... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

A. THE GUIDELINE PUBLIC COMPANY METHOD.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
B. THE MERGED-AND-ACQUIRED COMPANY METHOD.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
C. COMPARABLE PRIVATELY-OWNED COMPANIES.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
D. PRIOR TRANSACTIONS INVOLVING THE SUBJECT COMPANY.. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
E. CHALLENGES IN USING THE MARKET APPROACH.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
F. PROBLEMS WITH THE MARKET APPROACH... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
56
56
57
58
58
58
58
VII. NET ASSET APPROACH.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

1. Adjustments to the Balance Sheet.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
VIII. DISCOUNT FOR LACK OF MARKETABILITY, ADJUSTMENT FOR CONTROL, AND CONTROL
PREMIUM/MINORITY DISCOUNT.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
A. DISCOUNT FOR LACK OF MARKETABILITY.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
1. Benchmark Studies.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
a. Restricted Stock Studies.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
b. Pre-IPO Pricing.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
c. Comparing Acquisitions.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
2. Survey-Based Approaches.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
3. Does the Marketability Discount Apply to a Controlling Interest?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
4. Double-Counting With Size Premium.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
5. Is Cost of Later Sale Properly Considered?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
B. DISCOUNT FOR LACK OF CONTROL (MINORITY DISCOUNT).. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
1. Comparability to a Marketable Minority Interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
2. What Constitutes Control?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
3. Is a 50% Interest a Minority Interest?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
4. What if There is No Controlling Interest?.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
5. Where Should Lack of Control be ReflectedIn Projected Revenues, the Discount Rate, or an Ending Adjustment?
.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
C. CONTROL PREMIUM.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
D. IMPLIED MINORITY DISCOUNT; CONTROL ADJUSTMENT.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
E. APPLICABILITY OF DISCOUNTS TO DIVORCE VALUATIONS.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
IX. BUY-SELL AGREEMENTS AND TRANSFER RESTRICTIONS.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Arizona.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Arkansas.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
California... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Florida.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Georgia.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Indiana.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Iowa.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Minnesota.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Missouri... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Montana... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
iv
72
72
72
72
73
73
73
73
73
74
74
New Hampshire.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
New Mexico.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
New Jersey... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
New York.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Oklahoma.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Oregon.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Pennsylvania.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
South Dakota.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Tennessee.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Texas.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Utah.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Virginia.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Washington.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
West Virginia... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
74
74
74
75
75
75
75
75
75
75
76
76
76
76
X. ENTERPRISE VS. PERSONAL GOODWILL.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77

XI. COVENANTS NOT TO COMPETE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
XII. TAX-EFFECTING THE VALUE OF THE BUSINESS... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
A. TAX-EFFECTING DIVORCE VALUATIONS.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
B. TAX-EFFECTING S-CORPORATIONS.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
C. CONSIDERING TAX ON THE LIFO RESERVE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
D. CONSIDERING CAPITAL GAINS.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1. Future Capital Gains on Sale of Ownership Interest.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2. Embedded Capital Gains.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
77
78
78
80
80
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Business Valuation Upon Divorce: How Theory and Practice Can Lead to Problems In Court
Business Valuation Upon Divorce: How Theory and

Practice Can Lead to Problems In Court
by
Richard R. Orsinger
Board Certified in Family Law
& Civil Appellate Law by the
Texas Board of Legal Specialization
I. INTRODUCTION. There is no objectively valid way
to value a business interest that is not freely traded in a
marketplace. There are theories, models, and methods,
developed in connection with publicly-traded stocks and
bonds, that have been adapted for use in valuing
privately-owned business interests. Even in their original field, however, these theories, and models, and
methods, are attended by controversy. Using these
theories, models and methods to value privately-owned
businesses further compounds the problems.
NOTE: In the pdf version of this article, you can click

on the superscripted endnote numbers and jump to the
endnote. The URLs in the endnotes are web enabled and
link to the underlying cited material. You can download
the pdf file from this URL:
<http://www.orsinger.com/PDFFiles/BusinessValuati
onUponDivorce.pdf>
II. STANDARDS OF VALUE. The standard of value
is the type of value being used in a specific valuation
engagement. In Shannon P. Pratt, VALUING A BUSINESS:
THE ANALYSIS AND APPRAISAL OF CLOSELY HELD
COMPANIES 22-30 (3d ed. 2008), Pratt recognizes seven
standards of value: (i) fair market value, (ii) fair value,
(iii) investment value, (vi) intrinsic or fundamental
value, (iv) going-concern value, (vi) liquidation value,
(vii) book value. See also James R. Hitchner, FINANCIAL
VALUATION: APPLICATIONS AND MODELS (2d ed. Wiley
2006) pp. 3-6. To these can be added one more standard, (viii) sentimental value.
Business valuators apply indicators of value derived

from stock sales in liquid markets to the task of valuing
illiquid privately-owned business interests. These
indicators of value have poor predictive ability when
applied to the future stock prices of the very companies
from whom the measures are taken. There is reason to
suspect that these indicators of value work no better in
determining the value of a privately-owned business
interest.
When a business valuation is done incident to divorce,
ascertaining the value is complicated by the fact that
standards of value vary from state to state. These
complications are further compounded by differing rules
regarding the use of marketability and minority discounts, and how enterprise goodwill and personal
goodwill are treated in the divorce.
A. FAIR MARKET VALUE. In the business valuation field, the idea of value is dominated by the definition that the U.S. Government requires for tax purposes:
fair market value.
1. Definitions of Fair Market Value. Treasury
Regulation 20.2031-1(b) defines "fair market value" in
this way:
Under the Frye case, the test for admissibility of an

expert opinion was whether the experts methodology
had been generally accepted. Since the U.S. Supreme
Court decided the Daubert case in 1993, trial judges and
lawyers have become more inclined to question the
reliability of the methods and data used by experts,
including those who testify to business values. However,
approximately one-fourth of the states still use a general acceptance standard for admissibility of expert
testimony, further confounding business valuation
practice.
The fair market value is the price at which the

property would change hands between a willing
buyer and a willing seller, neither being under any
compulsion to buy or to sell and both having
reasonable knowledge of relevant facts.
See Treasury Reg. 25-2512-1 (fair market value defined
for gift tax purposes). Treasury Reg. 20.2031-1(b) goes
on to say:
The fair market value of a particular item of property includible in the decedent's gross estate is not
to be determined by a forced sale price. Nor is the
fair market value of an item of property to be
determined by the sale price of the item in a market other than that in which such item is most
commonly sold to the public, taking into account
the location of the item wherever appropriate.
the applicable valuation date.

(b) Based on selling prices. (1) In general, if
there is a market for stocks or bonds, on a stock
exchange, in an over-the-counter market, or otherwise, the mean between the highest and lowest
quoted selling prices on the valuation date is the
fair market value per share or bond. [Note: the
closing price is not used to fix value for tax purposes.] If there were no sales on the valuation date
but there were sales on dates within a reasonable
period both before and after the valuation date, the
fair market value is determined by taking a
weighted average of the means between the highest and lowest sales on the nearest date before and
the nearest date after the valuation date. The
average is to be weighted inversely by the respective numbers of trading days between the selling
dates and the valuation date. If the stocks or bonds
are listed on more than one exchange, the records
of the exchange where the stocks or bonds are
principally dealt in should be employed if such
records are available in a generally available
listing or publication of general circulation. In the
event that such records are not so available and
such stocks or bonds are listed on a composite
listing of combined exchanges available in a
generally available listing or publication of general
circulation, the records of such combined exchanges should be employed. In valuing listed
securities, the executor should be careful to consult
accurate records to obtain values as of the applicable valuation date. If quotations of unlisted securities are obtained from brokers, or evidence as to
their sale is obtained from officers of the issuing
companies, copies of the letters furnishing such
quotations or evidence of sale should be attached
to the return.
*
*
*
(c) Based on bid and asked prices. If the
provisions of paragraph (b) of this section are
inapplicable because actual sales are not available
during a reasonable period beginning before and
ending after the valuation date, the fair market
value may be determined by taking the mean
between the bona fide bid and asked prices on the
valuation date, or if none, by taking a weighted
average of the means between the bona fide bid
and asked prices on the nearest trading date before
and the nearest trading date after the valuation
date, if both such nearest dates are within a reason-
Id.
In United States v. Cartwright, 411 U.S. 546, 550-51
(1973), the U.S. Supreme Court said:
In implementing 26 U.S.C. 2031, the general
principle of the Treasury Regulations is that the
value of property is to be determined by its fair
market value at the time of the decedent's death.
The fair market value is the price at which the
property would change hands between a willing
buyer and a willing seller, neither being under any
compulsion to buy or to sell and both having
reasonable knowledge of relevant facts. Treas.
Reg. 20.2031-1(b). The willing buyer-willing
seller test of fair market value is nearly as old as
the federal income, estate, and gifts taxes themselves, and is not challenged here.FN7 Under this
test, it is clear that if the decedent had owned
ordinary corporate stock listed on an exchange, its
value' for estate tax purposes would be the price
the estate could have obtained if it had sold the
stock on the valuation date, that price being, under
Treas. Reg. 20.2031-2(b), the mean between the
highest and lowest quoted selling prices on that
day.
2. Inputs in Determining Fair Market Value. The
IRS Regulations set out a hierarchy of information to be
considered in estimating fair market value for estate and
gift tax purposes. The more reliable indicators of value
must be used if they are available; if none are available,
then the next highest level of indicator should be used,
and so on, in descending order. Subdivision (f) covers
closely-held business interests that has had no recent
arms length sales.
IRS Regulation 20.2031-2 Valuation of stocks
and bonds.
(a) In general. The value of stocks and
bonds is the fair market value per share or bond on
able period. The average is to be determined in the

manner described in paragraph (b) of this section.
cable because actual sale prices and bona fide bid

and asked prices are lacking, then the fair market
value is to be determined by taking the following
factors into consideration:
(d) Based on incomplete selling prices or

bid and asked prices. If the provisions of paragraphs (b) and (c) of this section are inapplicable
because no actual sale prices or bona fide bid and
asked prices are available on a date within a
reasonable period before the valuation date, but
such prices are available on a date within a reasonable period after the valuation date, or vice versa,
then the mean between the highest and lowest
available sale prices or bid and asked prices may
be taken as the value.
(1) In the case of corporate or other

bonds, the soundness of the security, the interest
yield, the date of maturity, and other relevant
factors; and
(2) In the case of shares of stock, the
company's net worth, prospective earning power
and dividend-paying capacity, and other relevant
factors.
Some of the "other relevant factors" referred
to in subparagraphs (1) and (2) of this paragraph
are: The good will of the business; the economic
outlook in the particular industry; the company's
position in the industry and its management; the
degree of control of the business represented by
the block of stock to be valued; and the values of
securities of corporations engaged in the same or
similar lines of business which are listed on a stock
exchange. However, the weight to be accorded
such comparisons or any other evidentiary factors
considered in the determination of a value depends
upon the facts of each case. In addition to the
relevant factors described above, consideration
shall also be given to nonoperating assets, including proceeds of life insurance policies payable to
or for the benefit of the company, to the extent
such nonoperating assets have not been taken into
account in the determination of net worth, prospective earning power and dividend-earning capacity.
Complete financial and other data upon which the
valuation is based should be submitted with the
return, including copies of reports of any examinations of the company made by accountants, engineers, or any technical experts as of or near the
applicable valuation date.
(e) Where selling prices or bid and asked

prices do not reflect fair market value. If it is
established that the value of any bond or share of
stock determined on the basis of selling or bid and
asked prices as provided under paragraphs (b), (c),
and (d) of this section does not reflect the fair
market value thereof, then some reasonable modification of that basis or other relevant facts and
elements of value are considered in determining
the fair market value. Where sales at or near the
date of death are few or of a sporadic nature, such
sales alone may not indicate fair market value. In
certain exceptional cases, the size of the block of
stock to be valued in relation to the number of
shares changing hands in sales may be relevant in
determining whether selling prices reflect the fair
market value of the block of stock to be valued. If
the executor can show that the block of stock to be
valued is so large in relation to the actual sales on
the existing market that it could not be liquidated
in a reasonable time without depressing the market, the price at which the block could be sold as
such outside the usual market, as through an
underwriter, may be a more accurate indication of
value than market quotations. Complete data in
support of any allowance claimed due to the size
of the block of stock being valued shall be submitted with the return. On the other hand, if the block
of stock to be valued represents a controlling
interest, either actual or effective, in a going
business, the price at which other lots change
hands may have little relation to its true value.
(g) Pledged securities. . . .

(h) Securities subject to an option or
contract to purchase. Another person may hold
an option or a contract to purchase securities
owned by a decedent at the time of his death. The
effect, if any, that is given to the option or contract
price in determining the value of the securities for
estate tax purposes depends upon the circum-
(f) Where selling prices or bid and asked

prices are unavailable. If the provisions of paragraphs (b), (c), and (d) of this section are inappli-
Id. If comparable companies whose shares are traded on

an exchange cannot be found, then sales of comparable
companies whose stock is sold "over the counter" should
be used. Id. 4.02 (g).
stances of the particular case. Little weight will be

accorded a price contained in an option or contract
under which the decedent is free to dispose of the
underlying securities at any price he chooses
during his lifetime. Such is the effect, for example,
of an agreement on the part of a shareholder to
purchase whatever shares of stock the decedent
may own at the time of his death. Even if the
decedent is not free to dispose of the underlying
securities at other than the option or contract price,
such price will be disregarded in determining the
value of the securities unless it is determined under
the circumstances of the particular case that the
agreement represents a bona fide business arrangement and not a device to pass the decedent's shares
to the natural objects of his bounty for less than an
adequate and full consideration in money or
money's worth. See section 2703 and the regulations at 25.2703 of this chapter for special rules
involving options and agreements (including
contracts to purchase) entered into (or substantially
modified after) October 8, 1990.
Although Revenue Ruling 59-60 gives the market

approach to business valuation first priority, it ultimately settles on an income approach using marketderived multipliers. Earning capacity and dividend
paying capacity are both listed as factors to consider in
valuing a company. Id. 4.01. In Section 5, Rev. Rule
59-60 says: "Earnings may be the most important
criterion of value in some cases . . . . In general, the
appraiser will accord primary consideration to earnings
when valuing stocks of companies which sell products
or services to the public. . . ." Id. 5(a). Section 6
discusses capitalization rates, saying that "[a] determination of the proper capitalization rate presents one of the
most difficult problems in valuation." Id. 6.
The United States Tax Court said: [W]e note that each
factor listed in Rev.Rul. 5960 does not necessarily
have a bearing on value and need not be given weight in
every case. Estate of Ford v. C.I.R., T.C. Memo.
1993-580, 1993 WL 501917, *11 (U.S. Tax Court
1993).
It is interesting to note that the Treasury Regs description of factors to consider, when there is no market data
from which to draw value inferences, is very much like
Intrinsic Value. See Section II.D.
Revenue Ruling 59-60 has endured remarkably well,

considering the level of understanding of business
valuation principles in 1959. Its durability is largely
attributable to the generality of the principles put forth
in the Ruling, and the enduring nature of its insights that
predate and really transcend the quantitative revolution
that has come to dominate business valuation in recent
years. Nowadays business valuators primarily use some
version of the Capital Asset Pricing Model (CAPM) and
the Build Up Method to arrive at a defensible capitalization or discount rate to reply to projected earnings or
cash flows. Both methods are examined in detail later in
this Article.
3. Rev. Ruling 59-60's Fair Market Value of a

Privately-Owned Business. Modern business valuation
theory found an early expression in Revenue Ruling
59-60,1 where the IRS grappled with the difficulty of
determining the fair market value of stock in a corporation where there is no ready market price reflecting
investors consensus on what the stock is worth. Revenue Ruling 59-60 uses the familiar definition of fair
market value required by federal law for tax reporting.
The IRS eschewed any specific instructions on how to
value such a business: "No formula can be devised that
will be generally applicable to the multitude of different
valuation issues arising in estate and gift tax cases."
Rev. Rul. 59-60 3.01.
B.
Revenue Ruling 59-60 3.03 asserts that the best

indicator of value is the price at which stock in a company trades in a free and active market. But where the
stock is closely held, or traded infrequently, or traded in
an erratic market, some other measure must be used. Id.
3.03. Revenue Ruling 59-60 suggests that the next best
measure may be the price of stock in comparable
companies that are trading in a "free and open market."
FAIR VALUE (ACCOUNTING).
1. Definition of Fair Value (Accounting). The

accounting profession has adopted the term "fair value"
as the equivalent to the legal "fair market value." The
current definition and description of "fair value" is set
out by the Financial Accounting Standards Board, in
Accounting Standards Codification, Glossary:
Fair value is the price that would be received
to sell an asset or paid to transfer a liability in an

orderly transaction between market participants at
the measurement date.
FASB ASC Topic 820 Implementation Guidance, p. 5

(10-20-2009).
Transaction costs should be excluded from
all fair value measurements.
See FASB ASC Topic 820 Glossary.

Additional considerations have been established by the
FASB regarding determining fair value:
FASB ASC Topic 820 Implementation Guidance, p. 5

(10-20-2009).
A fair value measurement assumes that the

asset or liability is exchanged in an orderly transaction between market participants to sell the asset
or transfer the liability at the measurement date.
The transaction to sell the asset or transfer the
liability is a hypothetical transaction at the measurement date, considered from the perspective of
a market participant that holds the asset or owes
the liability (FASB ASC 820-10-35). The exit
price objective applies for all assets and liabilities
measured at fair value.
2. Inputs for Determining Fair Value (Accounting). The accounting profession has developed its own
hierarchy of indicators of fair market value to be used by
accountants when they are valuing assets (and liabilities)
to be listed on a financial statement (like a balance sheet
or statement of assets and liabilities). Take care to note
that the accounting profession uses the term "fair value"
to mean what lawyers mean when lawyers say "fair
market value."
In the USA, the ultimate authority on Generally Accepted Accounting Principles (GAAP) is the Financial
Accounting Standards Board (FASB). In September
2006, FASB promulgated Financial Accounting Standard 157 ("FAS 157"). The document can be found at
<http://www.fasb.org/pdf/fas157.pdf>. FAS 157 established a hierarchy of information to use in determining
the "fair value" of assets or liabilities under Generally
Accepted Accounting Practices (GAAP).
Fair value measurements of assets assumes

the highest and best use by market participants,
considering the use of the asset that is physically
possible, legally permissible, and financially
feasible at the measurement date. FASB ASC
Topic 820 Implementation Guidance, p. 5
(10-20-2009).
Fair value is a market-based measurement,
not an entity-specific measurement. For some
assets and liabilities, observable market transactions or market information might be available.
For other assets and liabilities, observable market
transactions and market information might not be
available. However, the objective of a fair value
measurement in both cases is the same--to estimate
the price at which an orderly transaction to sell the
asset or to transfer the liability would take place
between market participants at the measurement
date under current market conditions (that is, an
exit price at the measurement date from the perspective of a market participant that holds the asset
or owes the liability).
Here is the Federal Reserve Bank of New York's summary of FAS 157:
FASB Statement No. 157, Fair Value Measurements (FAS 157), issued in September 2006,
defines fair value, establishes a framework for
measuring the fair value of assets and liabilities
based on a three level hierarchy, and expands
disclosures about fair value measurements. The
FASB's three-level fair value hierarchy gives the
highest priority to quoted prices in active markets
for identical assets or liabilities (Level 1) and the
lowest priority to unobservable inputs (Level 3).
Level 1 inputs are quoted prices in active markets
for identical assets or liabilities that the reporting
branch or agency has the ability to access at the
measurement date (e.g., the FFIEC 002 reporting
date). Level 2 inputs are inputs other than quoted
prices included within Level 1 that are observable
for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable inputs for
the asset or liability. 3
FASB ASC 820-20-05-1B (as amended May 2011).2

Fair value measures should consider the
utility of the asset or liability being measured and
specific attributes to the asset or liability.
Here is what FAS 157 itself says about the hierarchy of

inputs for estimating fair value:
25. If the reporting entity holds a large

number of similar assets or liabilities (for example,
debt securities) that are required to be measured at
fair value, a quoted price in an active market might
be available but not readily accessible for each of
those assets or liabilities individually. In that case,
fair value may be measured using an alternative
pricing method that does not rely exclusively on
quoted prices (for example, matrix pricing) as a
practical expedient. However, the use of an alternative pricing method renders the fair value measurement a lower level measurement.
Fair Value Hierarchy

22. To increase consistency and comparability in fair value measurements and related disclosures, the fair value hierarchy prioritizes the inputs
to valuation techniques used to measure fair value
into three broad levels. The fair value hierarchy
gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or
liabilities (Level 1) and the lowest priority to
unobservable inputs (Level 3). In some cases, the
inputs used to measure fair value might fall in
different levels of the fair value hierarchy. The
level in the fair value hierarchy within which the
fair value measurement in its entirety falls shall be
determined based on the lowest level input that is
significant to the fair value measurement in its
entirety. Assessing the significance of a particular
input to the fair value measurement in its entirety
requires judgment, considering factors specific to
the asset or liability.
26. In some situations, a quoted price in an

active market might not represent fair value at the
measurement date. That might be the case if, for
example, significant events (principal-to-principal
transactions, brokered trades, or announcements)
occur after the close of a market but before the
measurement date. The reporting entity should
establish and consistently apply a policy for identifying those events that might affect fair value
measurements. However, if the quoted price is
adjusted for new information, the adjustment
renders the fair value measurement a lower level
measurement.
23. The availability of inputs relevant to the

asset or liability and the relative reliability of the
inputs might affect the selection of appropriate
valuation techniques. However, the fair value
hierarchy prioritizes the inputs to valuation techniques, not the valuation techniques. For example,
a fair value measurement using a present value
technique might fall within Level 2 or Level 3,
depending on the inputs that are significant to the
measurement in its entirety and the level in the fair
value hierarchy within which those inputs fall.
27. If the reporting entity holds a position in

a single financial instrument (including a block)
and the instrument is traded in an active market,
the fair value of the position shall be measured
within Level 1 as the product of the quoted price
for the individual instrument times the quantity
held. The quoted price shall not be adjusted because of the size of the position relative to trading
volume (blockage factor). The use of a blockage
factor is prohibited, even if a market's normal daily
trading volume is not sufficient to absorb the
quantity held and placing orders to sell the position
in a single transaction might affect the quoted
price.11
Level 1 inputs
24. Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or
liabilities that the reporting entity has the ability to
access at the measurement date. An active market
for the asset or liability is a market in which
transactions for the asset or liability occur with
sufficient frequency and volume to provide pricing
information on an ongoing basis. A quoted price in
an active market provides the most reliable evidence of fair value and shall be used to measure
fair value whenever available, except as discussed
in paragraphs 25 and 26.
[FN11] The guidance in this Statement

applies for positions in financial instruments
(including blocks) held by all entities, including
broker-dealers and investment companies within
the scope of the AICPA Audit and Accounting
Guides for those industries.
Level 2 inputs
28. Level 2 inputs are inputs other than

quoted prices included within Level 1 that are
observable for the asset or liability, either directly
or indirectly. If the asset or liability has a specified
(contractual) term, a Level 2 input must be observable for substantially the full term of the asset or
liability. Level 2 inputs include the following:
Level 3 inputs
30. Level 3 inputs are unobservable inputs
for the asset or liability. Unobservable inputs shall
be used to measure fair value to the extent that
observable inputs are not available, thereby allowing for situations in which there is little, if any,
market activity for the asset or liability at the
measurement date. However, the fair value measurement objective remains the same, that is, an
exit price from the perspective of a market participant that holds the asset or owes the liability.
Therefore, un-observable inputs shall reflect the
reporting entity's own assumptions about the
assumptions that market participants would use in
pricing the asset or liability (including assumptions
about risk). Unobservable inputs shall be developed based on the best information available in the
circumstances, which might include the reporting
entity's own data. In developing unobservable
inputs, the reporting entity need not undertake all
possible efforts to obtain information about market
participant assumptions. However, the reporting
entity shall not ignore information about market
participant assumptions that is reasonably available without undue cost and effort. Therefore, the
reporting entity's own data used to develop
unobservable inputs shall be adjusted if information is reasonably available without undue cost and
effort that indicates that market participants would
use different assumptions.
a. Quoted prices for similar assets or

liabilities in active markets
b. Quoted prices for identical or
similar assets or liabilities in markets that are not
active, that is, markets in which there are few
transactions for the asset or liability, the prices are
not current, or price quotations vary substantially
either over time or among market makers (for
example, some brokered markets), or in which
little information is released publicly (for example,
a principal-to-principal market)
c. Inputs other than quoted prices
that are observable for the asset or liability (for
example, interest rates and yield curves observable
at commonly quoted intervals, volatilities, prepayment speeds, loss severities, credit risks, and
default rates)
d. Inputs that are derived principally
from or corroborated by observable market data by
correlation or other means (market corroborated
inputs).
It is evident that a valuation of a closely-held business

interest is likely to rely on Level 3 inputs.
29. Adjustments to Level 2 inputs will vary

depending on factors specific to the asset or liability. Those factors include the condition and/or
location of the asset or liability, the extent to
which the inputs relate to items that are comparable to the asset or liability, and the volume and
level of activity in the markets within which the
inputs are observed. An adjustment that is significant to the fair value measurement in its entirety
might render the measurement a Level 3 measurement, depending on the level in the fair value
hierarchy within which the inputs used to determine the adjustment fall.11 The guidance in this
Statement applies for positions in financial instruments (including blocks) held by all entities,
including broker-dealers and investment companies within the scope of the AICPA Audit and
Accounting Guides for those industries.
C. FAIR VALUE (DISSENTERS RIGHTS). Many

states have, through statute or case law, provided that,
when a minority owner dissents from a merger or sale of
the business, the dissenting minority owner is entitled to
be paid the value of his proportionate interest in the
company, without a minority discount or marketability
discount. Examples of state law on this question are set
out below. It is important to recognize that the hypothetical sale construct of fair market value forces the valuator and the court into considering minority and marketability discounts that a hypothetical buyer would take
into account in determining how much to pay to take a
stake in the company. In a dissenting minority liquidation, the public policy in most states is to avoid imposing these detriments of sale on the dissenting minority
owner, since they would have the practical effect of
unfairly transferring value from the minority dissenter to

the controlling owners of the company.
stantially devoted to the mere possession of assets,

such as real estate. See Brown v. Hedahl'sQ B &
R, Inc., 185 N.W.2d 249 (N.D.1971). Net asset
value becomes especially important when, as here,
the corporate change in question contemplates a
complete liquidation of the assets and the corporation is dissolved.
1. Colorado. In Pueblo Bancorporation v. Lindoe,

Inc., 63 P.3d 353, 360 (Colo. 2003), the Colorado
Supreme Court ruled that the proper interpretation of
fair value is the shareholder's proportionate interest in
the value of the corporation. Therefore, a marketability
discount should not be applied at the shareholder level
to determine the fair value of the dissenter's shares.
The applicability of a minority discount was not raised
in the case. In Walter S. Cheesman Realty Co. v. Moore,
770 P.2d 1308, 1311 (Colo. App. 1988), the court of
appeals wrote:
2. California. California Corporations Code 2000

provides:
2000. Avoidance of dissolution by purchase of
plaintiffs' shares; valuation; vote required; stay of
dissolution proceedings; appraisal under court
order; confirmation by court; appeal
Moore contends that the term fair value, as used

in 74124, C.R.S. (1986 Repl.Vol. 3A), is not
synonymous with fair market value and, thus, the
trial court erred in applying a fair market value
method of valuing his stock. We agree that the
term fair value as used in the dissenters' rights
statute imports a broader approach to valuation
than does the term fair market value. However,
we conclude that the method of valuation employed by the trial court was, in fact, a fair value
standard.
(a) Subject to any contrary provision in the articles, in any suit for involuntary dissolution, or in
any proceeding for voluntary dissolution initiated
by the vote of shareholders representing only 50
percent of the voting power, the corporation or, if
it does not elect to purchase, the holders of 50
percent or more of the voting power of the corporation (the purchasing parties) may avoid the
dissolution of the corporation and the appointment
of any receiver by purchasing for cash the shares
owned by the plaintiffs or by the shareholders so
initiating the proceeding (the moving parties) at
their fair value. The fair value shall be determined
on the basis of the liquidation value as of the
valuation date but taking into account the possibility, if any, of sale of the entire business as a going
concern in a liquidation. . . .
The trial judge had used a net asset value approach to

valuing the company, because the company held real
estate and the proposed action was to sell the assets and
distribute the proceeds to the shareholders. The court of
appeals approved this method of determining fair value,
even though the net asset value approach is a recognized
method of determining fair market value. The appellate
court said:
The Court of Appeals in Mart v. Severson, 95

Cal.App.4th 521, 531-32, 115 Cal.Rptr.2d 717, 725-26
(Cal. App. 2002), said:
Here, Cheesman is a close corporation whose

business is to own real estate. The major portion of
its assets is real estate. Cheesman's stock has not
been publicly traded and no market can accurately
be constructed. The event which precipitated
Moore's dissent was the corporate decision to
terminate Cheesman's existence and liquidate the
assets. Under these circumstances, any market
value attributable to the dissenter's stock would not
be reliable. See Metrmont Materials Corp. v.
Pennell, 270 S.C. 9, 239 S.E.2d 753 (1977).
California case law construing section 2000 approves the use of a hypothetical sale model, like
the one employed by the appraisers in this case, to
calculate the fair value of a corporation that can be
sold as a going concern in liquidation. (Abrams,
supra, 114 Cal.App.3d at pp., 248249, 170
Cal.Rptr. 656 (Abrams).) In Abrams, the court held
that appraisers who conducted a section 2000 fair
value determination acted properly by assuming
that the owners of the corporation would have
agreed not to compete with the corporation after it
was sold as a going concern in liquidation. (Abrams, supra, 114 Cal.App.3d 240, 170 Cal.Rptr.
Net asset value, on the other hand, is relevant and

entitled to greater weight than other factors if, as in
this case, the business of the corporation is sub-
656.) The court reasoned that [s]ection 2000

states that the appraisers should consider the possibility of a sale as a going concern in a liquidation.
Under the statute, the appraisers are not only
entitled, but are required, to consider the manner in
which the parties to such a hypothetical sale are
most likely to maximize their return. (Id. at p.
249, 170 Cal.Rptr. 656.)
[W]e hold that in determining the fair value of a

dissenter's shares in a closely held corporation, the
trial court must first determine the value of the
corporation and the pro rata value of each outstanding share of common or equity participating
stock. In the case of a going concern, no minority
discount is to be applied; and, except under extraordinary circumstances, no marketability
discount is to be applied.
Case law also confirms that the potential threat of

future competition by the current shareholders
should not affect the fair value analysis. (Brown v.
Allied Corrugated Box. Co. (1979) 91 Cal.App.3d
477, 154 Cal.Rptr. 170 (Brown)). Brown involved
a fair value determination conducted pursuant to
former section 4659, the predecessor statute to
section 2000. (Brown, supra, 91 Cal.App.3d at p.
480, fn. 2, 154 Cal.Rptr. 170.) The Brown court
found that the appraisers who conducted that
determination erred by considering the negative
impact of the fact that the shareholder who was
primarily responsible for developing the corporation's goodwill had not entered into a non-compete
agreement with the corporation. (Id. at pp.
487488, 154 Cal.Rptr. 170.) The Brown court
reasoned that the goodwill of a business is the
indivisible property of the corporation and the
value of that asset must be reflected in the fair
value determination. In other words, discounting
the value of the corporation because of the threat
of future competition by one of its shareholders
unfairly deprives the moving party of the true
value of his stock.
4. Delaware. In the hallmark case of Cavalier Oil

Corp. v. Harnett, 564 A.2d 1137, 1144 (Del. 1989), the
Delaware Supreme Court held that minority dissenters
were entitled to be paid their proportionate interest in
the company, without minority and marketability
discounts:
A proceeding under Delaware's appraisal statute,
8 Del.C. 262, requires that the Court of Chancery
determine the fair value of the dissenting stockholders' shares. The fairness concept has been said
to implicate two considerations: fair dealing and
fair price. Weinberger v. UOP, Inc., 457 A.2d at
711. Since the fairness of the merger process is not
in dispute, the Court of Chancery's task here was
to value what has been taken from the shareholder:
viz. his proportionate interest in a going concern.
TriContinental Corp. v. Battye, Del. Supr., 74
A.2d 71, 72 (1950). To this end the company must
be first valued as an operating entity by application
of traditional value factors, weighted as required,
but without regard to post-merger events or other
possible business combinations. See Bell v. Kirby
Lumber Corp., Del. Supr., 413 A.2d 137 (1980).
The dissenting shareholder's proportionate interest
is determined only after the company as an entity
has been valued. In that determination the Court of
Chancery is not required to apply further weighting factors at the shareholder level, such as discounts to minority shares for asserted lack of
marketability.
The Court of Appeals, in Brown v. Allied Corrugated

Box Co., 91 Cal.App.3d 477, 487, 154 Cal.Rptr. 170,
176 (Cal. App. 1979), said:
[T]he statutes suggest that a minority shareholder
who brings an action for the involuntary dissolution of a corporation should not, by virtue of the
controlling shareholder's invocation of the buy-out
remedy, receive less than he would have received
had the dissolution been allowed to proceed. The
majority commissioners' decision here to devalue
plaintiffs' shares for their lack of control was in
direct conflict with this principle.
The Court in Cavalier made this important point regarding the fact that a hypothetical sale is not the paradigm
for dissenters rights:
The application of a discount to a minority shareholder is contrary to the requirement that the
company be viewed as a going concern. Cavalier's argument, that the only way Harnett would
have received value for his 1.5% stock interest was
3. Colorado. In Pueblo Bancorporation v. Lindoe,

Inc., 37 P.3d 492, 499 (Colo. App. 2001), the court said:
to sell his stock, subject to market treatment of its

minority status, misperceives the nature of the
appraisal remedy. Where there is no objective
market data available, the appraisal process is not
intended to reconstruct a pro forma sale but to
assume that the shareholder was willing to maintain his investment position, however slight, had
the merger not occurred. Discounting individual
share holdings injects into the appraisal process
speculation on the various factors which may
dictate the marketability of minority shareholdings. More important, to fail to accord to a minority shareholder the full proportionate value of his
shares imposes a penalty for lack of control, and
unfairly enriches the majority shareholders who
may reap a windfall from the appraisal process by
cashing out a dissenting shareholder, a clearly
undesirable result. [Emphasis added.]
anticipation of the corporate action unless

exclusion would be inequitable.
Id. 490.1301(4). We have consistently said there
is no predominant, perfect formula for arriving at
fair value. Sieg, 512 N.W.2d at 278. Similarly, no
one factor dominates the determination of fair
value. Id. Nevertheless, in interpreting this statute
and its predecessors, we have recognized three
standard approaches to stock valuation: (1) market
value of the stock; (2) net asset value of the corporation; and (3) investment value. Id.; Woodward v.
Quigley, 257 Iowa 1077, 1081, 133 N.W.2d 38, 40
(1965). Within the framework of these methods of
valuation are innumerable factors that bear on the
value of the stock. See DavisEisenhart, 539
N.W.2d at 142; Sieg, 512 N.W.2d at 278. The
most useful methods of valuation and the most
relevant factors vary, depending upon the circumstances of each case. 12B Charles R.P. Keating &
Jim PerkowitzSolheim, Fletcher Cyclopedia of
the Law of Private Corporations 5906.120, at
433 (perm. ed. rev.vol.1993) [hereinafter Fletcher].
In In re Shell Oil Co., 607 A.2d 1213, 1218 (Del. Supr.

1992), the court said: Once a shareholder perfects his
right to appraisal under 8 Del.C. 262(d), the Court of
Chancery is required to determine the fair value of his
shares, exclusive of any element of value arising from
the accomplishment or expectation of the merger . . . .
The Court went on to note that it had previously rejected

applying a minority discount in a dissenters rights case,
and in this case it was rejecting the use of a marketability discount, as well. Id. at 889.
5. Illinois. The Illinois Supreme Court has ruled that

trial judges maybut are not required toapply minority
and marketability discounts in minority dissent cases.
See Stanton v. Republic Bank of South Chicago, 581
N.E.2d 678, 681 (Ill. 1991) which held:
7. Kansas. In the dissenters rights case of Arnaud v.

Stockgrowers State Bank of Ashland, Kansas, 992 P.2d
216, 220 (1999), the Court said:
With respect to the Bank's argument that the

minority and illiquidity discounts were arbitrary
and lacked foundation, we find that the trial court
acted within its discretion to apply such discounts,
even though not required to do so . . . .
To allow a discount under the facts of this case

would discourage investments in corporations by
persons who would acquire a minority interest
because it would enable the majority shareholders
to seize the minority shareholders' interest in the
corporation to the extent a minority or marketability discount is allowed. Investments should be
encouraged, not discouraged.
6. Iowa. In Security State Bank v. Ziegeldorf, 554

N.W.2d 884, 888-89 (Iowa), the Iowa Supreme Court
said:
Given the statutory nature of this action, the
starting point in determining fair value is the
definition of that term provided in chapter 490:
8. Kentucky. Kentucky Revised Statutes

271B.13-010, Definitions for subtitle, provides:
Fair value, with respect to a dissenter's shares,
means the value of the shares immediately before
the effectuation of the corporate action to which
the dissenter objects, excluding any appreciation or
depreciation in anticipation of the corporate action
unless exclusion would be inequitable.
Fair value, with respect to a dissenter's

shares, means the value of the shares immediately before the effectuation of the corporate action to which the dissenter objects,
excluding any appreciation or depreciation in
10
must be given to the value of the domestic entity as

a going concern without including in the computation of value any control premium, any minority
ownership discount, or any discount for lack of
marketability. If the domestic entity has different
classes or series of ownership interests, the relative
rights and preferences of and limitations placed on
the class or series of ownership interests, other
than relative voting rights, held by the dissenting
owner must be taken into account in the computation of value. [Emphasis added]
9. Maine. In the case of In re Valuation of Common

Stock of McLoon Oil Co., 565 A.2d 997, 1005 (Me.
1989), the Court said:
Any rule of law that gave the shareholders less
than their proportionate share of the whole firm's
fair value would produce a transfer of wealth from
the minority shareholders to the shareholders in
control. Such a rule would inevitably encourage
corporate squeeze-outs.
10. New Jersey. In Lawson Mardon Wheaton, Inc. v.
Smith, 734 A.2d 738, 748 (1999), the New Jersey
Supreme Court said:
(c) The determination of the fair value of an

ownership interest made for purposes of this
subchapter may not be used for purposes of making a determination of the fair value of that ownership interest for another purpose or of the fair
value of another ownership interest, including for
purposes of determining any minority or liquidity
discount that might apply to a sale of an ownership
interest.
The history and policies behind dissenters' rights

and appraisal statutes lead us to conclude that
marketability discounts generally should not be
applied when determining the fair value of
dissenters' shares in a statutory appraisal action. Of
course, there may be situations where equity
compels another result. Those situations are best
resolved by resort to the extraordinary circumstances exception in 2 ALI Principles, 7.22(a).
13. Vermont. In In re 75,629 Shares of Common Stock

of Trapp Family Lodge, Inc., 725 A.2d 927, 930-31 (Vt.
1999), the Court said:
11. New York. In Friedman v. Beway Realty Corp.,

661 N.E.2d 972, 977-78 (N.Y. 1995), the New York
high court ruled that it was impermissible to take a
minority discount in a minority dissentors case, but that
a marketability discount was allowed.
The basic concept of fair value under a dissenters'

rights statute is that the stockholder is entitled to
be paid for his or her proportionate interest in a
going concern. Weinberger v. UOP, Inc., 457
A.2d 701, 713 (Del.1983); accord In re Valuation
of Common Stock of McLoon Oil Co., 565 A.2d
997, 1004 (Me.1989); Friedman v. Beway Realty
Corp., 87 N.Y.2d 161, 638 N.Y.S.2d 399, 661
N.E.2d 972, 976 (1995). The focus of the valuation
is not the stock as a commodity, but rather the
stock only as it represents a proportionate part of
the enterprise as a whole. McLoon Oil, 565 A.2d
at 1004. Thus, to find fair value, the trial court
must determine the best price a single buyer could
reasonably be expected to pay for the corporation
as an entirety and prorate this value equally among
all shares of its common stock. See id. Under this
method, all shares of the corporation have the
same fair value. See id.
12. Texas. Texas Business Organizations Code

10.362, "Procedure for Dissent by Shareholders as to
Said Corporate Actions," provides:
10.362. Computation and Determination of
Fair Value of Ownership Interest
(a) For purposes of this subchapter, the fair
value of an ownership interest of a domestic entity
subject to dissenters' rights is the value of the
ownership interest on the date preceding the date
of the action that is the subject of the appraisal.
Any appreciation or depreciation in the value of
the ownership interest occurring in anticipation of
the proposed action or as a result of the action
must be specifically excluded from the computation of the fair value of the ownership interest.
A dissenting shareholder is not in the position of a

willing seller, however, and thus, courts have held
that fair value cannot be equated with fair market
value. See, e.g., McLoon Oil, 565 A.2d at 1005;
Hansen, 957 P.2d at 41. Accordingly, methods of
(b) In computing the fair value of an ownership interest under this subchapter, consideration
11
stock valuation used in tax, probate or divorce

cases to determine fair market value are inapposite
to the determination of fair value under the
dissenters' rights statute. See McLoon Oil, 565
A.2d at 1004 (stock valuation method used in tax
and probate cases not applicable); Hansen, 957
P.2d at 40 (fair market valuation for purposes of
property distribution in marriage distinguishable
from fair value for purposes of dissenters' rights).
A shareholder who disapproves of a proposed
merger gives up the right of veto in exchange for
the right to be bought out at fair value, not at
market value. See Hansen, 957 P.2d at 41.
673, 687 (Wyo. 2006), the Wyoming Supreme Court

said:
We join the majority of courts in holding, as a
matter of law, that a minority discount may not be
applied in determining the fair value of a dissenting shareholder's interest. . . . . In a dissenters'
rights appraisal, the focus of the valuation is not
the stock as a commodity, but rather the stock only
as it represents a proportionate part of the enterprise as a whole.
The Court also rejected a 5% reduction for trapped-in
capital gains as violating the standard of fair value. Id.
at 687-88.
The court also rejected the argument that minority

dissenters should be charged with the tax liability
arising when the corporation had to sell assets to raise
the money to pay the minority dissenter, on the ground
that the dissenters' rights statute requires the court to
value the corporation as a going concern. Id. at 934.
The court also refused to apply the formula in a buy-sell
agreement which did not expressly say that the formula
would apply to a buy-out of a dissenters rights. Id. at
933-35. The court also upheld the trial judge decision to
apply a control premium in valuing the entity as a
whole: Under the circumstances presented here, there
was no legal error in applying a control premium to
adjust a valuation that reflected publicly traded minority
interests. Id. at 934-35. This adjustment, more accurately called a control adjustment, is discussed in
Section VII.B below.
15. Whats Fair? A Mercer Capital article4 poses the

question of Whats Fair? in the minority dissent and
appraisal cases. To explore that topic, the article poses
three questions. Number 1should a dissenting minority
shareholder receive its proportional share as if the entire
company were to be sold? If so, the minority owner is
participating in part of the control value, which is a right
it did not have before the transaction triggering dissent
rights. Id. p. 2. Number 2should a dissenting minority
shareholder receive a value that presumes that the
minority interest was as marketable as a controlling
interest? That, too is an attribute the minority interest
did not have prior to the triggering event. Number
3Should the dissenting minority shareholder receive
only what could have been realized by the sale of the
minority interest to a buyer who would discount the
price to reflect a lack of control and a lack of liquidity?
That would prematurely force a discount on the dissenting shareholders interest that would not have been
effectuated but for the controlling owners desire to
force the sale. Mercer Capital, Fair Value is Redefined
by the Mississippi Legislature (2008).5
14. Wyoming. Wyoming Statutes Annotated

17161301(a)(iv), Definitions, provides:
(iv) Fair value means the value of the corporation's shares determined:
(A) Immediately before the effectuation of
the corporate action to which the shareholder
objects;
(B) Using customary and current valuation
concepts and techniques generally employed
for similar businesses in the context of the
transaction requiring appraisal; and
(C) Without discounting for lack of marketability or minority status except, if appropriate, for amendments to the articles pursuant
to W.S 17-16-1302(a)(v).
D. ANALOGY TO DIVORCE. Some people argue

that the same policy that applies to dissenters rights
should apply to a spouse who is forced, by the divorce
process, to sell his or her marital interest in a going
business. In the case of In re Marriage of Thornhill,
232 P.3d 782 (Colo. 2010), the Colorado Supreme Court
rejected a spouses request to extend a prior ruling that
a marketability discount could not be applied in dissenting minority, because the earlier case involved statutory
interpretation. The court said: [W]e decline to adopt a
per se rule against marketability discounts and instead
hold that trial courts may, in their discretion, choose to
In Brown v. Arp and Hammond Hardware Co., 141 P.3d
12
apply such discounts when valuing an ownership

interest in a closely held corporation in a divorce proceeding. The Arizona Court of Appeals rejected a
spouses effort to extend the Fair Value rule to a
closely-held business in a divorce, in Mazzocco v.
Mazzocco, 2009 WL 151566, *2 (Ariz. App. 2009). The
Washington Court of Appeals accepted the analogy
between a divorcing spouse and dissenting shareholder,
in Baltrusis v. Baltrusis, 113 Wash. App. 1037, 2002
WL 31058365 (Wash. App. 2002) (unpublished opinion), and rejected discounts where the trial court ordered
the wife to buy out the husbands minority interest in a
company controlled by the wifes family.
E.
estimates of intrinsic value. What our annual

reports do supply, though, are the facts that we
ourselves use to calculate this value.
Warren E. Buffett, An Owners Manual sent to Berkshires Class A and Class B shareholders (undated).6
From an investment perspective regarding publicly-traded stock, Intrinsic Value is the underlying
value of a company divorced from its market value or
share price. It is based on both quantitative factors
(capital, earnings, revenue) and qualitative factors
(management quality, intellectual capital, past record).
The Intrinsic Value of a company may be lower (or
higher) than its present market value on an exchange,
indicating that the market has undervalued (or overvalued) the company. Intrinsic Value is most often determined using what is called "Fundamental Analysis." The
theory of Fundamental Analysis holds that an individual
security has an Intrinsic Value (equilibrium price) that
depends on the security's earning potential. Eugene F.
Fama, Random Walks in Stock-Market Prices 3 (1965).7
This earning potential depends on fundamental factors
such as the quality of management, outlook for the
industry, outlook for the economy, etc. Id. p. 3. Fundamental Analysis proceeds through the study of an
investment by looking at the firm's (1) competitive
advantage, (2) earnings growth, (3) sales revenue
growth, (4) market share, (6) financial reserves, and (6)
quality of management, all as reflected in its financial
statements.8 Through this form of analysis the investor
can determine whether the current market price of the
security is above or below its Intrinsic Value. Because
the actual price tends to move toward Intrinsic Value
over time, the investment can be made so as to profit
when the market price eventually moves to Intrinsic
Value. Id. at 3. Revenue Ruling 59-60 describes the way
to arrive at Fair Market Value for privately-owned
company stock that amounts to Fundamental Analysis.
If you stop short of envisioning a sale to a third party,
the Rev. Rule 59-60 approach leads to Intrinsic Value.
INTRINSIC VALUE.
1. What is Intrinsic Value? Ibbotson defines "Intrinsic Value" as "the value that an investor considers, on
the basis of an evaluation or available facts, to be the
true' or real' value that will become the market value
when other investors reach the same conclusion."
IBBOTSON SBBI 2011 VALUATION YEARBOOK p. 12.
The Intrinsic Value of a company is the value of a
company determined from an analysis of its true value,
as distinguished from the value that is recognized by
others, as reflected in the marketplace. Intrinsic Value
involves all aspects of the business, tangible and intangible. Intrinsic Value may or may not equate to Fair
Market Value, since Fair Market Value represents the
prevailing view of value of the business, or its value in
exchange and not its actual value.
Warren Buffett described Intrinsic Value in this way:
Intrinsic value is an all-important concept that
offers the only logical approach to evaluating the
relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is
the discounted value of the cash that can be taken
out of a business during its remaining life.
*
*
*
The calculation of intrinsic value, though, is not so
simple. As our definition suggests, intrinsic value
is an estimate rather than a precise figure, and it is
additionally an estimate that must be changed if
interest rates move or forecasts of future cash
flows are revised. Two people looking at the same
set of facts, moreover and this would apply even
to Charlie and me will almost inevitably come up
with at least slightly different intrinsic value
figures. That is one reason we never give you our
F. INVESTMENT VALUE. Investment Value is

the value of an asset to a particular investor, based on
that investor's investment requirements. Investment
Value can also be seen as the value of a business to a
specific buyer, as distinguished from a hypothetical
buyer. Under prevailing conceptions, a Fair Market
Value determination cannot be based on Investment
Value because Fair Market Value assumes a hypothetical investor, not a particular investor.
13
Many readers will no doubt have experienced the

frustration of being forced, by the hypothetical buyer
construct of the Fair Market Value concept, to ignore a
possible or even likely sale of the company to a strategic
buyer, in a divorce-related valuation.
Accountants have developed the term adjusted book

value, to reflect a balance sheet with values that are
marked to market, meaning that the individual asset
values have been adjusted to their fair market values.
While a marked-to-market balance sheet is more accurate than a balance sheet based on historical cost, even
a marked-to-market balance sheet omits unidentified
intangible assets that are self-generated (and are therefore expensed, not purchased, and are neither listed at
their purchase price nor at market value).
G. LIQUIDATION VALUE. Liquidation Value

describes the total value that could be realized if all of a
company's physical assets were sold and the debts paid
off and the business terminated. Liquidation value is
determined by the likely proceeds from the sale of assets
such as the real estate, fixtures, equipment, and inventory, less the expenses of selling the assets and closing
the business, less the outstanding debt. Residual intangible assets (including goodwill) are not included in a
company's liquidation value. 9 Shannon Pratt distinguishes "value as an orderly disposition" from "value as
a forced liquidation." Shannon Pratt, VALUING A BUSINESS 47-48 (5th ed. 2008). Liquidation destroys any
going concern value or enterprise goodwill that may
exist. However, it always represents the minimum value
for the company. See Pablo Fernndez, Company
Valuation Methods: The Most Common Errors in
Valuation (2007).10
In Bendalin v. Delgado, 406 S.W.2d 897, 900-01 (Tex.

1966), the Texas Supreme Court said: "Book value is
entitled to little, if any, weight in determining the value
of corporate stock, and many other factors must be taken
into consideration." However, in distinguishing a
number Texas cases disparaging book value, the court of
appeals in Sears Roebuck & Co. v. Dallas Cent. Appraisal Dist., 53 S.W.3d 382, 390 (Tex. App.--Dallas
2000 pet denied), noted that"[n]one of these cases
involve the valuation of merchandise inventory and
there is no indication that the book value at issue in any
of these cases was calculated in accordance with
GAAP." The Dallas Court of Appeals rejected a blanket
assertion that Book Value was no evidence of market
value. The Court said:
H. BOOK VALUE. Book Value is the value of a

shareholders equity as reflected on a companys
balance sheet. It is also the difference between assets
and liabilities, again on the balance sheet. Book Value
is constructed from the historical purchase price of the
companys assets, less depreciation. Depreciation is a
creature of tax law, and does not necessarily match the
economic or functional obsolescence of the improvements or equipment that are being depreciated. Book
Value can vary from actual value when assets have
appreciated in value since being purchased, or when
depreciable assets have declined in value more or less
than the tax law assumes. Book Value includes some
intangible assets, if they are separately identifiable, but
almost never reflects enterprise goodwill, except for the
enterprise goodwill of businesses that have been purchased for more than the value of their identifiable
tangible and intangible assets. Book Value also omits
self-created intangible value, which accounting principles require to be expensed rather than booked as an
asset. It is possible that Book Value could reflect the fair
market value of a business, but that would usually occur
only when the business is a passive vehicle for holding
saleable assets, and even then the assets need to be
adjusted to market value from their balance sheet values.
In some circumstances, book value of inventory may be probative of market value by either
serving as some indication of market value or by
being equivalent to market value. . . . In other
circumstances, the two values may be entirely
unrelated. . . . Whether the book value of inventory
is in fact indicative of or equivalent to its market
value is an issue to be determined by the trier of
fact on a case by case basis. We decline Sears's
invitation to hold that, as a matter of law, inventory book value derived according to generally
accepted accounting principles is not equal to
market value. [Citations omitted.]
I.
GOING CONCERN VALUE. Going Concern
Value is the value of a company viewed as an operating
enterprise. A profitable, functioning business is made up
of individual assets, but the assets taken as a whole are
worth more when they are assembled into a functioning
business than if each asset were to be valued separately.
Going Concern Value at a minimum reflects the cost and
time it would take for someone to assemble a going
concern from replacement assets. But if the business is
profitable, the Going Concern Value reflects not only
14
the cost of duplicating the business, but also the proven

ability of the business to make a profit for its owners.
The.Free.Dictionary.com defines Going Concern Value
as: "the value of a business in operation, taking into
account the goodwill and the value of the income, in
addition to hard assets, such as real estate and equipment."11 The Pennsylvania Supreme Court contrasted
going concern value and goodwill in this way: Going-concern value refers generally to the ability of a
business to generate income without interruption, even
where there has been a change in ownership, whereas
goodwill represents a preexisting relationship arising
from a continuous course of business which is expected
to continue indefinitely. Butler v. Butler
663 A.2d 148, 151 n. 9 (Pa. 1995).
reasonably compensated requires the allowance of damages in compensation for the

reasonable special value of such articles to
their owner taking into consideration the
feelings of the owner for such property.
K. STANDARD OF VALUE FOR DIVORCE.
With 51+ different sets of divorce laws in America and
its territories and protectorates, it should come as no
surprise that a variety of approaches exist to valuing a
closely-held business interest in a divorce. A great
number of states ascribe to a fair market value standard,
but in practice they give trial judges great freedom to
arrive at any value that finds support in the evidence. In
a number of cases, where a court most probably arrived
at an intrinsic value and not a value upon sale, the
courts decision was upheld as being within its discretion.
J. SENTIMENTAL VALUE. The Texas Supreme

Court has recognized the right of persons to recover for
the loss of the sentimental value of personal property. In
City of Tyler v. Likes, 962 S.W.2d 489, 496-97 (Tex.
1997), the Supreme Court said:
Alabama. Alabama is not a Fair Market Value state. In

Grelier v. Grelier, 44 So.3d 1092, 1097 (Ala. App.
2009), the court said:
While few persons suffering serious bodily

injury would feel made whole by the mere recovery of medical expenses and lost wages, many
whose property has been damaged or destroyed
will be entirely satisfied by recovery of its value.
As a rule, this is measured by the property's market
value or the cost of repairing it. See Pasadena
State Bank v. Isaac, 149 Tex. 47, 228 S.W.2d 127,
12829 (1950). In some cases, however, the
damaged property consists of "articles of small
market value" that "have their primary value in
sentiment." Brown v. Frontier Theatres, Inc., 369
S.W.2d 299, 30405 (Tex. 1963). Such property
can only be adequately valued subjectively; yet,
the owner should still be compensated. As the
Court discussed in Brown, special rules apply in a
suit to recover for the loss of property that is
primarily of sentimental value:
Alabama law has not adopted a fair market value

standard for assessing marital property. Rather,
under Alabama law, a trial court must determine
the value of property with the only limitation being
that the value must be equitable under the circumstances of the particular case. See generally Yohey
v. Yohey, 890 So.2d 160 (Ala. Civ. App. 2004).
That standard implies that the valuation must be
fair to all parties concerned. See generally Black's
Law Dictionary 578 (8th ed.2004) (defining
equitable distribution as the fair ... allocation
of marital property). In cases in which a divorce
court does not contemplate the sale of a business in
which one of the spouses holds a minority interest
but, instead, intends that the business shall remain
a going concern, it makes little sense to determine
fair value by the measuring stick of a hypothetical
sales price. That methodology would artificially
reduce the value of the marital asset in almost
every case, which would be unfair, i.e., inequitable, to the party receiving only a portion of the
reduced value or the property equivalent to that
reduced value but would be advantageous to the
party retaining the business interest, including its
actual value to him or her as the holder.
It is a matter of common knowledge that

items such as these generally have no market
value which would adequately compensate
their owner for their loss or destruction. Such
property is not susceptible of supply and
reproduction in kind, and their greater value
is in sentiment and not in the market place. In
such cases the most fundamental rule of
damages that every wrongful injury or loss to
persons or property should be adequately and
Arizona. Arizona uses fair market value in divorces. In

Mazzocco v. Mazzocco, 2009 WL 151566, *2 (Ariz.
15
App. 2009), the Arizona Court of Appeals held that it

was not error for a trial court to value a closely-held
business at fair market value (with a marketability
discount) as opposed to fair value (i.e., without a
marketability discount).
lated by determining the fair market value of the business, which is the amount a willing buyer and a willing
seller would exchange assets absent duress. . . . Typically, fair market value measures the value of the assets
of the business plus the value of goodwill.
Arkansas. Arkansas has a statute that requires, in a

divorce, that the court determine the fair market value of
stocks, bonds, or other securities issued by a corporation, association, or government.A.C.A. 9-12-315.
The court of appeals in Cole v. Cole, 82 Ark. App. 47,
110 S.W.3d 310, 313 (Ark. App. 2003), said: Arkansas
law requires the use of the fair market value standard
for valuing businesses in a marital property context.
For this reason, courts in Arkansas divorces apply
marketability and minority discounts. Winn v. Winn
Enters., Ltd. P'ship, 265 S.W3d 125, 128-29 (2007)
(contrasting divorce value from value of dissenting
minority shareholders).
Hawaii. Antolik v. Harvey, 761 P.2d 305, 318-19 (Haw.

App. 1988): When dividing and distributing the value
of the property of the parties in a divorce case, the
relevant value is, as a general rule, the fair market value
(FMV) of the parties' interest therein on the relevant
date. We define the FMV as being the amount at which
an item would change hands from a willing seller to a
willing buyer, neither being under any compulsion to
buy or sell and both having reasonable knowledge of the
relevant facts. . . . We disagree with the position advanced by Wife, and In re Marriage of Fleege, 91
Wash.2d 324, 588 P.2d 1136 (1979), that the relevant
value of a sole professional business is its value to the
professional who operates it. Other assets are, as a
general rule, valued at their FMV. We know of no valid
reason why sole professional businesses should not be
valued at their FMVs.
California. California does not require its divorce judges

to use the Fair Market Value standard in valuing a
closely held business interest upon divorce. Investment
value is an acceptable measure of value. In re Marriage
of Hewitson, 142 Cal.App.3d 874, 886-87, 191 Cal.Rptr.
392, 400-01 (Cal. App. 2nd Dist. 1983) (We hold,
therefore, that the determination of the value of Ronan
by its investment value, as distinguished from its market
value, will satisfy the mandate of Civil Code section
4800, subdivision (a)).
Idaho. In McAfee v. McAffee, 971 P.2d 734, 739 (Idaho

App. 1994), the court of appeals affirmed a trial courts
valuation based on net fair market value when the
closely-held business had no profits to capitalize and
was not a going business.
Illinois. In the case of In re Marriage of Melnick, 468
N.E.2d 490, 495 (Ill. App. 1984), the court said:
Colorado. In In re Marriage of Thornhill, 232 P.3d 782,

783 (Colo. 2010), the Colorado Supreme Court said it
was within the discretion of the court to apply a marketability discount to an ownership interest in a privatelyowned company, thus suggesting a fair market value
standard.
The worth of a corporation's stock is usually its

market value, which is defined as the price which
a willing purchaser will pay to a willing seller in a
voluntary transaction . . . . Valuation based upon
market value should, of course, be determined as
accurately as is professionally possible using such
business and accounting expertise as may be
available. Although there may be no established
market for the stock of a closed corporation,
courts have recognized an ascertainable value
for such shares. In re Marriage of Reib (1983), 114
Ill.App.3d 993, 1000, 70 Ill.Dec. 572, 578, 449
N.E. 919, 925.
Connecticut. In Turgeon v. Turgeon, 460 A.2d 1260,

1265 (Conn. 1983), the Supreme Court indicated that a
privately-owned company would be valued at fair
market value for purposes of divorce.
Delaware. In E.E.C. v. E.J.C., 457 A.2d 688, 694 (Del.
1983), the Delaware Supreme Court held it would not be
proper to value husbands solo law practice by reference
to future income. Instead, the business should be valued
based on net assets.
In In re Marriage of Mitchell (1981), 103 Ill.App.3d

242, 248, 58 Ill.Dec. 684, 688, 430 N.E.2d 716, 720, the
court held that precise rules for determining the value
of closely held stock cannot be laid down but that every
Florida. Christians v. Christians, 732 So.2d 47, 47-48

(Fla. App. 1999): The valuation of a business is calcu-
16
relevant evidential fact entering into the value of the

corporate property reflecting itself in the worth of the
corporate stock should be considered, including past
sales if relevant.
privately-owned business in a divorce.

New Mexico. In Trego v. Scott, 961 P.2d 168, 172-73
(N.M. App. 1998), fair market value was used in a
divorce calculation. In Smith v. Smith, 837 P.2d 869,
874 (N.M. App. 1992), the court affirmed the valuation
of a business at fair market value.
In In re Marriage of Grunsten, 709 N.E.2d 500, 601 (Ill.

App. 1999), the Illinois court of appeals held that a
closely-held business should be valued based on fair
market value.
North Carolina. Walter v. Walter, 561 S.E.2d 571, 577

(2002) (In an equitable distribution proceeding, the
trial court is to determine the net fair market value of the
property based on the evidence offered by the parties).
Indiana. In Trost-Steffen v. Steffen, 772 N.E.2d 597, 508

(Ind. App. 2002), the appellate court affirmed a fair
market value found for a closely-held business.
North Dakota. In Nuveen v. Nuveen, 795 N.W.2d 308,

313 (N.D. 2011), the Supreme Court of North Dakota
said: The fair market value of a business is ordinarily
the proper method for valuing property in a divorce. . .
. Fair market value is the price a buyer is willing to pay
and the seller is willing to accept under circumstances
that do not amount to coercion. [Citations omitted.]
Iowa. In In re Marriage of Hogeland, 448 N.W.2d 678,

681 (Iowa App. 1989), the court of appeals said:
Generally, stock should be valued at market value if the
market value can be ascertained.
Kansas. In Bohl v. Bohl, 657 P.2d 1106, 1108-09 (Kan.
1983), the appellate court affirmed a fair market value
determination of a closely-held business.
Ohio. Cronin v. Cronin, 2005 WL 188191, *2 (Ohio

App. 2005): [T]he trial court is not bound to any
particular valuation method. James, supra. Moreover,
income methods have been used by courts to value
businesses. . . . The trial court has broad discretion in
determining which expert to believe in assigning a value
of marital property. [Citation omitted.]
Mississippi. Fair Market Value was used to value a

business in Broome v. Broome, 75 So.3d 1132, 1142
(Miss. App. 2011).
Missouri. In Wood v. Wood, 2011 WL 5926162, *1-2
(Mo. App. 2011), the Missouri Court of Appeals held
that a closely-held business should be value for divorce
based on fair market value.
Oklahoma. In Mocnik v. Mocnik, 838 P.2d 500, 505

(Okl. 1992), the Supreme Court said that goodwill of a
business must be valued based on a contract or based on
fair market value.
New York. In Bricker v. Bricker, 893 N.Y.S.2d 128, 130

(N.Y. App. Div., 2010), the court said: There is no
uniform rule for fixing the value of a going business and
the valuation of a business for equitable distribution
purposes is an exercise properly with the fact-finding
power of the trial court, guided by expert testimony.In
Sieger v. Sieger, 859 N.Y.S.2d 240, 242 (N.Y. App.
Div. 2008), the court said: It is well-established that the
determination of the value of business interests is a
function properly within the fact-finding power of the
court . . . . Where the determination as to the value of a
business is within the range of the testimony presented,
it will not be disturbed on appeal if it rests primarily on
the credibility of expert witnesses and their valuation
techniques . . . .
Pennsylvania. Verholek v. Verholek, 741 A.2d 792, 79596 (Pa. Super.1999): Husband's second and third
arguments relate to the trial court's valuation of the 310
shares of Cattron stock. The Divorce Code does not
contain a specific method for valuing assets. The trial
court must exercise its discretion and rely on the estimates, inventories, records of purchase prices, and
appraisals submitted by the parties. . . . The court is free
to accept all, none, or portions of the testimony regarding the true and correct value of property. . . . Additionally, the court may reject evidence offered by both
parties in favor of its own valuation method. [Citations
omitted.]
New Jersey. In Brown v. Brown, 792 A.2d 463, 470-91

(N.J. App. 2002), the court of appeals used a Fair
Market Value standard of value in connection with a
South Carolina. In Browder v. Browder, 675 S.E.2d 820,

825 (S.C. App. 2009), the court said: In making an
equitable distribution of marital property, the court must
17
. . . . determine the fair market value of the property . .

. . Accord, Perry v. Estate of Perry, 473 S.E.2d 860,
863 (S.C. App. 1996) (In dividing marital property, the
family court must identify both real and personal
property and determine the fair market value of the
identified property).
valuation.
Virginia. The Supreme Court of Virginia has rejected a
willing buyer/willing seller standard of value for
divorce. In Owens v. Owens, 589 S.E.2d 488, 493 (Va.
2003), the Court stated:
Tennessee. The court in Kerce v. Kerce, 2003 WL

22037526, *3-4 (Tenn. App. 2003), recognized the
Delaware Block Method and Rev. Ruling 59-60 as
valid ways to value a privately-owned business. In
Roberts v. Roberts, 2010 WL 4865441, *5 (Tenn. App.
2010), the court did not expressly endorse a standard of
value for a privately-owned business; the court said:
The value of a marital asset is determined by considering all relevant evidence regarding value. The burden is
on the parties to produce competent evidence of value,
and the parties are bound by the evidence they present.
Thus the trial court, in its discretion, is free to place a
value on a marital asset that is within the range of the
evidence submitted.
Virginia's equitable distribution law employs the

concept of intrinsic value when determining the
worth of certain types of marital assets. See Howell
v. Howell, 31 Va.App. 332, 339, 523 S.E.2d 514,
517 (2000). Intrinsic value is a very subjective
concept that looks to the worth of the property to
the parties. Id. It cannot be limited by objective
criteria commonly used in open market transactions:
The item may have no established market
value, and neither party may contemplate
selling the item; indeed, sale may be
restricted or forbidden. Commonly, one party
will continue to enjoy the benefits of the
property while the other must relinquish all
future benefits. Still, its intrinsic value must
be translated into a monetary amount. The
parties must rely on accepted methods of
valuation, but the particular method of valuing and the precise application of that method to the singular facts of the case must
vary with the myriad situations that exist
among married couples.
Texas. It is unclear from Texas appellate opinions

whether a Texas court must use the Fair Market Value
standard in valuing a business upon divorce. The case of
R.V.K. v. L.L.K., 103 S.W.3d 612, 618 (Tex. App.--San
Antonio 2003, no pet.), explicitly said that the value to
be accorded a business that is to be divided in a divorce
proceeding is "market value. However, that language is
in a plurality opinion, not a majority opinion, and as
such is not binding legal precedent. Other Texas cases
say that closely-held business interests have no market
value, and that the court must use some other measure of
value. See Mandell v. Mandell, 310 S.W.3d 531, 536-37
(Tex. App.--Fort Worth 2010, pet. denied) (When the
sale of stock is restricted by a requirement that the
shares be offered first to the corporation or to other
shareholders, then essentially the fair market value of
the stock is zero. . . . In this situation, the parties may
show the actual value of the property interest to the
owner.); Elliott v. Whitten, 2004 WL 2115420 at *12
(Tex. App.--Houston [1st Dist.] 2004, pet. denied)
(memorandum opinion) (There can be no cash market
value of corporate stock where it has not been sold in
sufficient quantities to establish a prevailing sales
price).
Id. at 339, 523 S.E.2d at 51718; Bosserman v.

Bosserman, 9 Va.App. 1, 6, 384 S.E.2d 104, 107
(1989) (observing that Virginia courts must
determine from the evidence that value which
represents the property's intrinsic worth to the
parties).
In Hoebelheinrich v. Hoebelheinrich, 600 S.E.2d 152,
154-55 (Va. App. 2004), the court said:
In Virginia, the courts look to the intrinsic value
of the property to the parties to measure value for
equitable distribution purposes. . . . Intrinsic
value is a very subjective concept that looks to the
worth of the property to the parties and their marriage. . . . As a consequence of the subjective
nature of intrinsic value, the particular method of
valuing and the precise application of that method
to the singular facts of the case . . . must vary with
Vermont. In Goodrich v. Goodrich, 613 A.2d 203, 20406 (Vt. 1992), the Supreme Court affirmed a valuation
of a privately-held company based on fair market value,
and endorsed the Revenue Ruling 59-60 approach to
18
the myriad situations that exist among married

couples. [Citations omitted.]
judgment upon it, for the reason that the

subject-matter so far partakes of a science,
art, or trade as to require a previous habit or
experience or study in it, in order to acquire
a knowledge of it. When the question involved does not lie within the range of common experience or common knowledge, but
requires special experience or special knowledge, then the opinions of witnesses skilled
in that particular science, art, or trade to
which the question relates are admissible in
evidence.
West Virginia. In Tankersley v. Tankersley, 390 S.E.2d

826, 828 (1990), the Supreme Court of West Virginia
said: The concept of net value is rather simple when
a court is valuing a single asset which has a valid lien or
encumbrance. In these situations, the net value equals
the fair market value of the property less the amount of
any lien or encumbrance. In Durnell v. Durnell, 460
S.E. 710, 717 (W. Va. 1995), the Supreme Court affirmed a net asset approach to valuing a medical practice.
Numerous cases are cited in support of this rule.

Just when a scientific principle or discovery
crosses the line between the experimental and
demonstrable stages is difficult to define. Somewhere in this twilight zone the evidential force of
the principle must be recognized, and while courts
will go a long way in admitting expert testimony
deduced from a well-recognized scientific principle or discovery, the thing from which the deduction is made must be sufficiently established to
have gained general acceptance in the particular
field in which it belongs.
Wisconsin. In McReath v. McReath, 335 Wis.2d 643,

800 N.W.2d 399, 408 (Wis. 2011), the Supreme Court
of Wisconsin said:
Property valued for the purpose of dividing the
marital estate should be valued at its fair market
value. . . . Fair market value is the price that
property will bring when offered for sale by one
who desires but is not obligated to sell and bought
by one who is willing but not obligated to buy.
[Citations omitted.]
We think the systolic blood pressure deception test

has not yet gained such standing and scientific
recognition among physiological and psychological authorities as would justify the courts in admitting expert testimony deduced from the discovery,
development, and experiments thus far made.
III. STANDARDS OF LEGAL ADMISSIBILITY.

The state court standards for admissibility of expert
witness testimony generally fall into two camps: general
acceptance (Frye) and scientific reliability (Daubert).
A. GENERAL ACCEPTANCE. In 1923, the Court
of Appeals for the District of Columbia decided Frye v.
United States, 293 F. 1013 (D.C. Cir. 1923). In Frye, the
defendant sought exoneration based on passing a blood
pressure deception test, conducted on a precursor to the
polygraph. Id. 1014. In a two-page opinion, the appellate court disposed of the case in this way:
Id. at 1014. Frye was taken to establish the general

acceptance test, that scientific expert testimony was
admissible only if it relied on principles that had been
generally accepted. After Frye, some courts struggled
against this popularity-based litmus test, and instead
looked past general acceptance to the more fundamental
question of the reliability of the underlying principles
relied upon by the expert. Black, A Unified Theory of
Scientific Evidence, 56 FORDHAM L.REV. 595, 644 n.
268 & 269 (1988).
Counsel for defendant, in their able presentation of

the novel question involved, correctly state in their
brief that no cases directly in point have been
found. The broad ground, however, upon which
they plant their case, is succinctly stated in their
brief as follows:
B. DAUBERT RELIABILITY. In Daubert v.

Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579, 113
S. Ct. 2786, 125 L.Ed.2d 469 (1993), the U.S. Supreme
Court held that Federal Rule of Evidence 702 overturned earlier case law requiring that expert scientific
testimony must be based upon principles which have
"general acceptance" in the field to which they belong.
The rule is that the opinions of experts or

skilled witnesses are admissible in evidence
in those cases in which the matter of inquiry
is such that inexperienced persons are unlikely to prove capable of forming a correct
19
See Frye v. U.S., 293 F. 1013 (D.C. Cir. 1923) (establishing the "general acceptance" test for scientific expert
testimony). Under Rule 702, the expert's opinion must
be based on "scientific knowledge," which requires that
it be derived by the scientific method, meaning the
formulation of hypotheses which are verified by experimentation or observation. The Court used the word
"reliability" to describe this necessary quality. The U.S.
Supreme Court's opinion in Daubert applies in all
federal court proceedings.
case, based on scientific techniques. Business valuation

is not a science at all, so Kuhmo Tire would seem to be
the more relevant approach to determining the admissibility of business valuation expert testimony. Kuhmo
Tire utilizes as the standard of admissibility the knowledge and experiences of [the relevant] discipline.
So in a business valuation case the trial judge must
evaluate the admissibility of expert opinion on business
valuation in light of the knowledge and experience of
the discipline. That draws the judges into business
valuation theory and business valuation practices. Thus,
professional standards in the business valuation community in essence become legal standards.
In Daubert, the Supreme Court gave a non-exclusive list

of factors to consider on the admissibility of expert
testimony in the scientific realm: (1) whether the
expert's technique or theory can be or has been tested;
(2) whether the technique or theory has been subject to
peer review and publication; (3) the known or potential
rate of error of the technique or theory when applied; (4)
the existence and maintenance of standards and controls;
and (5) whether the technique or theory has been
generally accepted in the scientific community.
An application of these evidentiary principles to accounting is reflected in Garnac Grain Co., Inc. v.
Blackley, 932 F.2d 1563 (8th Cir. 1991). There a
corporate client sued its auditors for negligently failing
to conduct audits in accordance with Generally Accepted Auditing Standards (GAAS). The corporation
hired a new auditing firm to review the old auditing
firm's work, and the new auditing firm concluded that
the old auditors failed to adhere to GAAS during the
fiscal year ending 1-1-82. At trial, plaintiff offered the
testimony of an accounting professor who opined that
the auditors violated GAAS for a period of six years, not
just one year. Although the second auditing firm spent
600 hours in arriving at its conclusion as compared to
the 20 hours spent by the professor, and although the
second auditors looked at the first auditors' work papers
while the professor looked only at the second auditors'
report before arriving at his opinion, the appellate court
ruled that the professor's opinion was admissible under
Fed. R. Evid. 702 and 703. The appellate court noted
that the professor later reviewed the first auditors' work
papers and reaffirmed his earlier conclusion. Note that
in Garnac Grain Co., the legal standard of care was
taken to be GAAS; the issue was whether the plaintiff's
experts had the qualifications and used the proper
methodology in determining whether the defendant
breached that standard of care.
In Kuhmo Tire Co. v. Carmichael, 526 U.S.137, 11 S.

Ct. 1167, 143 L.Ed.2d 238 (1999), the Supreme Court
said that the reliability and relevancy principles of
Daubert apply to all experts, not just scientists, and
where objection is made the court must determine
whether the evidence has "a reliable basis in the knowledge and experience of [the relevant] discipline." The
trial court has broad discretion in determining how to
test the expert's reliability. Id. Kuhmo Tire acknowledged that the list of factors in Daubert did not apply
well to certain types of expertise, and that other factors
would have to be considered by the court in such
instances. The admissibility criteria for non-scientific
fields might be summarized: (1) the opinion must be
based on sufficient facts or data; (2) the testimony must
be the product of reliable principles and (3) the expert
must reliably apply these principles and methods to the
facts of the case. Carl Lloyd Sheeler, Business Valuation, p. 70.12
Thus, under the Federal Rules of Evidence, the court
must determine the appropriate criteria of reliability and
relevancy for all experts who testify, and as a preliminary matter must determine that those criteria are met
before the expert is permitted to testify. Many states
have adopted the Federal Rules of Evidence as their
states rules. Many states have therefore adopted Daubert
as the standard for admissibility of expert testimony in
their courts. Daubert, however was a hard science
C. WHERE THE STATES FALL. While many

states have rules of evidence that are identical to the
Federal Rules of Evidence, and have endorsed the
Daubert reliability standard for the admissibility of
expert testimony, a number of states have rejected
Daubert. For example, the Alabama Supreme Court, in
Vesta Fire Ins. Corp. v. Milam & Co. Const., Inc., 901
So.2d 84, 106 (Ala. 2004), said: This Court has not yet
20
explicitly adopted the Daubert test. . . . Further, we

decline to adopt Daubert under the circumstances of this
case. In Logerquist v. McVey, 1 P.3d 113, 132 (Ariz.
2000), the Arizona Supreme Court rejected Daubert,
saying: We thus conclude that we should not and
cannot adopt the Joiner and Kumho interpretation of
Daubert but will continue to apply Ariz. R. Evid. 702 as
written. In People v. Leahy, 882 P.2d 321, 332 (Cal.
1994), the California Supreme Court held that the
People v. Kelly formulation survived Daubert in this
state, and that none of the above described authorities
critical of that formulation persuades us to reconsider or
modify it at this time. The Florida Supreme Court
rejected Daubert and reaffirmed Florida's reliance on the
Frye standard in Brim v. State, 695 So. 2d 268 (Fla.
1997). The Georgia Court of Appeals, in Dailey v.
State, 271 Ga.App. 492, 610 S.E.2d 126, 129 (Ga. App.
2005), said: This court is not, of course, bound by
Daubert. Indeed, we have been consistent in declining
to apply the Daubert standard. In Weeks v. Eastern
Idaho Health Services, 153 P.3d 1180, 1183 (Idaho
2007), the Idaho Supreme Court said that Idaho has
not adopted the Daubert standard for admissibility of an
expert's testimony but has used some of Daubert's
standards in assessing whether the basis of an expert's
opinion is scientifically valid.. In People v. Basler, 710
N.E.2d 431, 434 (Ill. App. 5 Dist. 1999), an Illinois
Court of Appeals said: the use of the Frye standard in
federal courts was overruled by Daubert . . . , but Frye
remains the law in Illinois. The Indiana court of
appeals, in Turner v. State, 953 N.E.2d 1039, 1050 (Ind.
Ct. App. 2011), said that, in light of the differences
between Indiana Rule 702 and Federal Rule 702, we
have previously declined to follow Kumho Tire in
applying the Daubert reliability analysis to non-scientific expert testimony. In Clemons v. State, 392 Md. 339,
896 A.2d 1059, 1065 (Md. 2006), the Maryland
Supreme Court said: Maryland has continued to adhere
to the Frye test rather than the Daubert standard.
Although Missouri has adopted evidence rules similar
to the Federal rules, the Missouri Court of Appeals, in
Bailey v. Cameron Mut. Ins. Co., 122 S.W.3d 599, 603
(Mo. App. E.D. 2003), said: Missouri, however, has
not adopted Daubert. The Nevada Supreme Court, in
Higgs v. State, 222 P.3d 648, 650 (Nev. 2010), said:
While Nevada's statute of admissibility tracks the
language of its federal counterpart, Federal Rule of
Evidence (FRE) 702, we see no reason to part with our
existing legal standard. In so deciding, we decline
Higgs' invitation to adopt the standard of admissibility
set forth in Daubert v. Merrell Dow Pharmaceuticals,
Inc. . . . An intermediate New Jersey appellate court,

in State v. Calleia, 997 A.2d 1051, 1060 (N.J. Super. A.
D. 2010), said: Although in 1993 the United States
Supreme Court abandoned the general acceptability
standard in Frye v. United States, . . . in favor of a more
relaxed scientific reliability standard, Daubert v. Merrell
Dow Pharmaceuticals, Inc., . . . the test in New Jersey
continues to be whether the scientific community
generally accepts the reliability of the proffered evidence. The North Carolina Supreme Court rejected
Daubert in Howerton v. Arai Helmet, Ltd., 597 S.E.2d
674, 692 (N.C. 2004), where it said: [W]e are concerned that trial courts asserting sweeping pre-trial
gatekeeping authority under Daubert may unnecessarily encroach upon the constitutionally-mandated function of the jury to decide issues of fact and to assess the
weight of the evidence. The North Dakota Supreme
Court rejected Daubert in State v. Hernandez, 707
N.W.2d 449, 453 (N.D. 2005) (This Court has a formal
process for adopting procedural rules after appropriate
study and recommendation by the Joint Procedure
Committee, and we decline Hernandez's invitation to
adopt Daubert by judicial decision). The South Carolina Supreme Court, in State v. Council, 515 S.E.2d 508,
518 (S.C. 1999), said: While this Court does not adopt
Daubert, we find the proper analysis for determining
admissibility of scientific evidence is now under the
SCRE. When admitting scientific evidence under Rule
702, SCRE, the trial judge must find the evidence will
assist the trier of fact, the expert witness is qualified, and
the underlying science is reliable. The Wisconsin
Court of Appeals, in City of West Bend v. Wilkens, 278
Wis.2d 643, 693 N.W.2d 324, 329 (Wis. App. 2005),
said: Wisconsin, unlike the federal courts, considers the
reliability of scientific evidence a question of weight and
credibility for the trier of fact to decide. . . . Wisconsin
is not a Daubert state.
On the other hand, Daubert has been adopted as the
standard for admissibility of expert testimony in the
following states: Alaska, Marron v. Stromstad, 123
P.3d 992 (Alaska 2005); Arkansas, Farm Bureau
Mutual Insurance Co. v. Foote, 14 S.W.3d 512 (Ark.
2000); Connecticut, State v. Porter, 698 A.2d 739, 746
(Conn. 1997) (criminal case); Delaware, M.G.
Bancorporation v. Le Beau, 737 A.2d 513, 521 (Del.
1999); Georgia, Moran v. Kia Motors Am., Inc., 276
Ga. App. 96, 97 (Ga. Ct. App. 2005); Idaho, State v.
Parkinson, 909 P.2d 647, 652 (Idaho 1996) (criminal);
Indiana, Smith v. Yang, 829 N.E.2d 624, 626 (Ind. App.
2005) (Daubert analysis is permitted but not required);
21
becomes which expert is more credible, and which

experts work product carries the greater weight.
Iowa, Leaf v. Goodyear Tire & Rubber Company, 591

N.W.2d 10 (Iowa 1999) (Daubert allowed but not
required); Kentucky, Goodyear Tire and Rubber Co. v.
Thompson, 11 S.W.3d 575, 577-78 (Ky. 2000); Louisiana, State v. Foret, 628 So. 2d 1116, 1123 (La. 1993)
(criminal); Maine, Searles v. Fleetwood Homes of
Pennsylvania, Inc., 878 A.2d 509 (Me. 2005) (Daubert
and general acceptance standards both apply); Massachusetts, Commonwealth v. Patterson, 840 N.E.2d 12
(Mass. 2005) (Daubert and general acceptance standards both apply); Michigan, Gilbert v. DaimlerChrysler Corp., 685 NW2d 391 (2004); Mississippi, Poole v.
Avara, 908 So. 2d 716, 722 (Miss. 2005); Montana,
Hart-Albin Company v. McLees Inc., 870 P.2d 51, 56
(Mont. 1994); Nebraska, Schafersman v. Agland Coop.,
262 Neb. 215 (Neb. 2001); New Hampshire, Baker
Valley Lumber, Inc. v. Ingersoll-Rand Company, 813
A.2d 409 (N.H. 2002); New Mexico, State v. Torres,
976 P.2d 20 (N.M. 1999) (application of the Daubert
factors is unwarranted in cases where expert testimony
is based solely on experience or training, citing Compton v. Subaru of Am. Inc., 82 F.3d 1513, 1518 (10th Cir.
1996)); Ohio, State v. Williams, 446 N.E.2d 444, 446-47
(Ohio 1983) (rejecting the general acceptance test long
before Daubert was handed down); Oklahoma, Christian v. Gray, 65 P.3d 591 (Okla. 2003) (adopting Daubert but only with regard to novel expert testimony or
where the experts method has not been established);
Oregon, State v. Brown, 687 P.2d 751, 759 (Or. 1984)
(a Daubert-like case that predated Daubert); Rhode
Island, State v. Quattrocchi, 681 A.2d 879, 884 (R.I.
1996) (applied to novel scientific evidence); South
Dakota, State v. Guthrie, 2001 SD 61, P33 (S.D. 2001)
(adopting Kuhmo Tire); Tennessee, Brown v. Crown
Equipment Corp., 181 S.W.3d 268 (Tenn. 2005); Texas,
E.I. du Pont de Nemours and Co. v. Robinson, 923
S.W.2d 549, 556 (Tex. 1995); Utah, Haupt v. Heaps,
775 P.2d 388 (Utah App. 2005) (heightened vigilance in
cases involving scientific methods and techniques);
Vermont, USGen New England, Inc. v. Town of Rockingham, 862 A.2d 269 (Vt. 2004); West Virginia, Wilt
v. Buracker, 443, S.E.2d 196, 203 (W. Va. 1993), cert.
denied, 511 U.S. 1129 (1994); Wyoming, Hoy v. DRM,
Inc., 114 P.3d 1268 (Wyo. 2005).
McCord v. Commissioner of Internal Revenue, 120 T.C.

358, 374 (May 14, 2003), said:
In deciding valuation cases, courts often look to
the opinions of expert witnesses. Nonetheless, we
are not bound by the opinion of any expert witness, and we may accept or reject expert testimony
in the exercise of our sound judgment. Helvering
v. Natl. Grocery Co., 304 U.S. 282, 295, 58 S.Ct.
932, 82 L.Ed. 1346 (1938); Estate of Newhouse v.
Commissioner, supra at 217. Although we may
largely accept the opinion of one party's expert
over that of the other party's expert, see Buffalo
Tool & Die Manufacturing Co. v. Commissioner,
74 T.C. 441, 452, 1980 WL 4569 (1980), we may
be selective in determining what portions of each
expert's opinion, if any, to accept, Parker v. Commissioner, 86 T.C. 547, 562, 1986 WL 22106
(1986). Finally, because valuation necessarily
involves an approximation, the figure at which we
arrive need not be directly traceable to specific
testimony if it is within the range of values that
may be properly derived from consideration of all
the evidence. Estate of True v. Commissioner, T.C.
Memo.2001-167 (citing Silverman v. Commissioner, 538 F.2d 927, 933 (2d Cir.1976), affg. T.C.
Memo.1974-285).
The issues discussed in this article can apply both to
admissibility and persuasiveness. For some time,
business valuators could skate by in reliance on illinformed lawyers and judges who did not understand
business valuation methods. Slowly that is beginning to
change, and questions are being raised and assumptions
challenged, and as time goes on business valuators will
have to endure more rigorous assessment of their
methods.
D. HOW MIGHT THESE STANDARDS APPLY
TO BUSINESS VALUATION? In considering the
intersection of business valuation and the law, it is good
to remember the statement of the U.S. Court of Appeals
for the District of Columbia Circuit, which said we do
not sit as a panel of statisticians, but as a panel of
generalist judges. AEP Texas North Co. v. Surface
Transp. Bd., 609 F.3d 432, 443 (D.C. Cir. 2010) (while
considering the relative merits of the Capital Asset
Pricing Model and Discounted Cash Flow methods of
With all the focus on admissibility it is easy to forget the

fact that admissibility is just a threshold, and the event
is only won if the evidence persuades the finder of fact.
In many courtroom business valuation disputes, both
experts will pass the admissibility test. The question
22
valuing businesses). A bankruptcy appellate panel in

Rhode Island noted the irony that judges, few of whom
would qualify as expert witnesses in any trial of asset
valuation, regularly determine the worth of assets . . . .
Many of the fundamental principles of valuing
privately-owned business are generally accepted.
Whether all of these generally-accepted principles can
be shown to be reliable close inspection is less certain.
There is general acceptance for the use of the Capital

Asset Pricing Model (CAPM) (see Section V.B below)
to determine a Discount Rate in finance theory. However, the U.S. Tax Court has rejected the CAPM for use
in valuing small, privately-owned businesses, several
times. See Section V.J.5. On the other hand, there is
general acceptance of using the Build Up Method (see
Section V.F below) as a way to arrive at a Discount Rate
to determine the present value of future benefits to be
derived from owning a company, but the Industry
Premium and Size Premium used in the Build Up
Method both constitute adjustments to the CAPM. The
Build Up Method is in fact an extension of the CAPM
(see Section V.F.6 below), and close analysis of the
constituent parts of each method presents difficult
reliability issues (see Sections V.G, V.H, V.I, V.J, V.K
and V.L below). There is general acceptance of different
approaches to a Discount For Lack of Marketability
(DLOM). However, a close Daubert analysis of the
bases for quantifying a DLOM reveals important
weaknesses. Similar concerns arise with the Discount
for Lack of Control (DLOC). These issues are explored
later in this Article. Also, some states disregard the
DLOM and DLOC in divorce cases. See Section VIII.E
below.
In many states, general acceptance of basic principles

can be demonstrated by adherence to Revenue Ruling
59-60. See e.g. Wright v. Quillen, 909 S.W.2d 804
(Tenn. App. 1995) (recognizing Revenue Ruling 59-60
as an acceptable approach to valuation). General
acceptance can also be shown by referring to Treasury
Regulations on valuation. General acceptance can be
shown by referring to private publications on business
valuation, such as Shannon Pratts VALUING A BUSINESS: THE ANALYSIS AND APPRAISAL OF CLOSELY HELD
COMPANIES (5th ed. 2008). General acceptance of both
methodology and historical data is reflected in IBBOTSON SBBI VALUATION YEARBOOKS. Widespread acceptance of valuation theory can be demonstrated by course
materials from AICPA or NACVA or ASA continuing
education courses. Valuation principles for some types
of businesses are set out by the Appraisal Institute. On
some of the close questions in business valuation,
however, general acceptance breaks down into competing schools of thought, so that general acceptance is
harder to demonstrate. Some degree of acceptance can
be gleaned from federal court cases that accept or reject
particular assumptions or particular techniques in cases
that come before them. See ASARCO LLC v. Americas
Mining Corp., 396 B.R. 278, 361 (S.D. Tex. 2008)
(federal district judge rejected the Fama-French method
of valuation, saying that FamaFrench may be prevalent in academia and may be used in the investment
community. It may eventually evolve into the preferred
approach universally; however, this is not the method
that the parties in this case (or a hypothetical willing
buyer and willing seller) would have utilized to determine the value of SPCC's stock in 20022003.) In re
Mann, 249 B.R. 831, 839 (1st Cir. Bankr. Panel R.I.
2000). Some state court cases also accept or reject
approaches that are presented in the cases they adjudicate. These decision often are ad hoc, and mostly do not
engender general principles that can be applied across
the board to other fact situations. Sometimes what these
opinions say reflects an embarrassing lack of understanding of acceptable business valuation practices.
IV. THE INCOME APPROACH (EARNINGS AND

CASH FLOW). The Massachusetts Supreme Court said
in Adams v. Adams, 945 N.E.2d 844, 864 (Mass. 2011):
The consensus approach to valuation deployed by
appraisers and experts in marriage dissolutions has
coalesced around some variation of what is known
as the income approach. S.P. Pratt, R.F. Reilly,
& R.P. Schweihs, Valuing Small Businesses and
Professional Practices 724725 (3d ed. 1998). The
income approach rests on the proposition that [i]n
theory, the value of a business or an interest in a
business depends on the future economic benefits
that will accrue to that business, with the value of
those future benefits being discounted back to
present value at some appropriate discount rate.
S.P. Pratt & A.V. Niculita, Valuing a Business:
The Analysis and Appraisal of Closely Held
Companies 175 (5th ed. 2008). In other words,
the basic concept of the income approach is to
project the future economic income associated
with the investment and to discount this projected
income stream to a present value at a discount rate
appropriate for the expected risk of the prospective
income stream. Id.
23
Mercer Capital identifies two generic subsets of the

income approach: single period capitalization and
discounted future benefits.13 Single period capitalization
methods apply a pricing multiple, which embodies the
risk profile and growth expectations of a company as
determined from the perspective of an investor, to an
appropriate earnings measure for a reporting unit. Id. at
1. These pricing multiples for the subject company can
be obtained by comparison to publicly-traded guideline
companies, or they can be obtained by estimating the
companys cost of equity or cost of capital and the
companys sustainable growth rate. Id. at 1. Discounted
future benefits methods, primarily the Discounted Cash
Flow (DCF method), are used when the company being
valued is not expected to have stable earnings, which
requires the valuator to separately forecast the benefits
(i.e., earnings or cash flow) to be received from each
future period until stable earnings are expected to be
achieved. The discounted future benefits method has
three critical components: (i) forecasting future benefits;
(ii) determining terminal value, and (iii) determining the
appropriate discount rate. Id.
The most important input necessary for performing

a proper DCF is a projection of the subject company's cash flows. Without a reliable estimate of
cash flows, a DCF analysis is simply a guess.
Revenue Ruling 59-60 says this:
Potential future income is a major factor in many
valuations of closely-held stocks, and all information concerning past income which will be helpful
in predicting the future should be secured. Prior
earnings records usually are the most reliable
guide as to the future expectancy, but resort to
arbitrary five-or-ten-year averages without regard
to current trends or future prospects will not
produce a realistic valuation. If, for instance, a
record of progressively increasing or decreasing
net income is found, then greater weight may be
accorded the most recent years' profits in estimating earning power.
Rev. Rul. 59-60, para. 3.02.d, pp. 11-12. In many
instances, the business valuator will look at the companys historical income as reflected in its income
statements as a basis for projecting future income.
Where growth in earnings is expected to vary from past
earnings, then the business valuator will have to project
future earnings on some other basis. The valuator might
rely upon the companys management to provide
projections of cash flow, or might have to independently
develop new cash flow projections.
To recap, where the valuator expects stable growth in

earnings, the valuator uses a Capitalization of Earnings
method to value the company, whereby a Capitalization
Rate is applied to projected future earnings to derive a
present value. Where the growth of future earnings is
expected to be variable, then the valuator typically
switches to the Discounted Cash Flow (DCF) method,
whereby a Discount Rate is applied to the cash flow that
is projected for each period of the future until earnings
are assumed to stabilize, after which all subsequent
earnings are capitalized using an appropriate capitalization rate.
Many business valuators like to consider the future

benefits as being earnings before interest and taxes
(EBIT) or earnings before interest, taxes, depreciation,
and amortization14 (EBITDA), because these measures
are independent of the companys capital structure (mix
of debt and equity). See Koeplin, Sarin and Shapiro, The
Private Company Discount, 12 JOURNAL OF APPLIED
CORPORATE FINANCE 94, 96 (2000).15 Others prefer to
use free cash flow, which is the total amount of cash
that can be generated by an entity, or the amount of cash
than can potentially flow to the stakeholders of a company. IBBOTSON SBBI 2011 VALUATION YEARBOOK, p.
199. Ibbotson elaborates that free cash flow consists of
earnings before interest and taxes (EBIT), plus
depreciation, amortization and deferred taxes, less
capital expenditures and changes in working capital. Id.
at 14. Ibbotson says:
Warning. In Adams, the Supreme Court reversed the

trial judge for adopting a capitalization of earnings
approach instead of a discounted cash flow approach,
because the capitalization of earnings approach assumed
earnings in perpetuity and the evidence showed that the
husbands future earnings were actuarially set at 17
years. Id. at 868-69. The Court did not realize that the
discounted cash flow approach involves a terminal value
that is capitalized in perpetuity.
A. PROJECTING FUTURE CASH FLOWS. As
Vice Chancellor Strine wrote in Delaware Open MRI
Radiology Associates, P.A. v. Kessler, 898 A.2d 290,
332 (Del. Ch. 2006):
Free cash flow is the relevant cash flow stream
24
because it represents the broadest level of earnings

that can be generated by the asset. With free cash
flow as a starting point, the owners of a firm can
decide how much of the cash flow stream should
be diverted toward new ventures, capital expenditures, interest payments, and dividend payments. It
is incorrect to focus on earnings as the cash flow
stream to be valued because earnings contain a
number of accounting adjustments and already
include the impact of capital structure.
expenses have been reported, so that past cash flows are

more comparable to business practices of companies
listed on national stock exchanges. Professor Aswath
Domodoran put it delicately: Many private businesses
understate earnings to reduce their tax liabilities, and the
expenses at many private businesses often reflect the
blurring of lines between private and business expenses. Aswath Damodoran, APPLIED CORPORATE
FINANCE: A USER'S MANUAL, ch. 12.19
1. Adjustments to the Income Statement. Potential
adjustments to the income statement are to: (i) remove
nonrecurring income and expenses; (ii) adjust owner
compensation to the market rate for hiring a replacement; (iii) add back unreasonably high fringe benefits;
(iv) adjust other employees salaries and benefits to
market rates; (v) add back depreciation to income; (vi)
add back R&D expenses if they are going to be reflected
as assets in the adjusted balance sheet; and (vii) adjust
leases to market rates. Chris Mercer describes normalizing adjustments to income statements in Chapter 4 of his
book, Z. Christopher Mercer and Travis W. Harms,
BUSINESS VALUATION: AN INTEGRATED THEORY 107125 (2nd ed. 2008) (Mercer & Harms). Mercer distinguishes between three types of adjustments to company
earnings: normalizing adjustments, control adjustments,
and fundamental adjustments. Id. at 107. Normalizing
adjustments are made to develop private company
earnings that correspond to the valuation multiples of
guideline companies to yield marketable minority
indications of value. Id. at 107. Control adjustments are
earnings adjustments that relate to the other enterprise
levels of value, namely the financial control and strategic control levels of value. Id. at 107. Fundamental
adjustments relate appropriate private company valuation multiples to the median or average multiples of
guideline company groups. Id. at 107.
Id. at 14.
In a Discounted Cash Flow (DCF) method, the valuator
separately forecasts the cash flow for each future period
(during the forecast period) until a stable income stream
is achieved (at which point the Terminal Value is
determined). Some writers recommend pushing the
forecast period as far into the future as reliability
permits. Lawrence A. Hamermesh & Michael L.
Wachter, The Short and Puzzling Life of the Implicit
Minority Discount in Delaware Appraisal Law, 156
UNIV. OF PENNSYLVANIA LAW REVIEW 1, 29 (2007)
(Hamermesh).16 However, some business valuators
use an arbitrary cut-off, such as 5 years, to be the point
at which they assume stable income will be achieved.
Foretelling the end of the forecast period involves some
degree of subjectivity. If the firm is presently losing
money, it may still have positive future cash flows in the
future if the current losses are transient, for example if
they are attributable to the spot in the business cycle, or
result from one time charges against profits, or poor
management, or participation in a sector of the economy
that is in its early stages.17
Mercer Capital points out that business valuators assume
either that all cash flows in a year are received midway
through the year, or that the cash flows are received at
the end of the year of the discrete forecast period.
Mercer Capital, A Users Guide to Understanding the
Discounted Future Benefits (Cash Flow) Valuation
Methods.18 Using the mid-year assumption causes some
valuators to discount Terminal Value (see Section IV.D
below) from 4.5 years instead of 5 full years. Id. at 6.
a. Normalizing Adjustments. Mercer says that

normalizing adjustments should eliminate one-time
gains or losses, other one-time events, abandoned lines
of business, expenses of non-operating assets, and other
items of such nature. He calls these Type 1 Normalizing Adjustments. Id. at 113. Mercer also lists adjustments to normalize officer/owner compensation and
other discretionary expenses that are not characteristic
of publicly-traded companies. He calls these Type 2
Normalizing Adjustments. Id. at 113. Mercer observes
that some business valuators consider Type 2 Normalizing Adjustments to be control adjustments and thus
refuse to make them when determining a nonmarketable
B. NORMALIZING HISTORICAL EARNINGS

OR CASH FLOW. Business valuators consider past
performance as a basis for projecting future performance. Since many private companies are operated in an
idiosynchratic manner, it is often necessary for the
valuator to make adjustments to the way income and
25
minority interest. Id. at 113-14. Mercer disagrees, in that

both types of adjustments are needed to arrive at an
accurate projection of future earnings that is necessary
to make accurate comparisons between the subject
company and publicly-traded companies. Id. at 107.
C. DETERMINING AN EXPECTED GROWTH

RATE. To project future cash flows during the forecast
period, the business valuator must project the growth
rate of earnings or future cash flows. Many times
valuators will use the subject companys historical
growth rate as the basis for a projecting future growth.
Professor Aswath Damodoran says that company
fundamentals may be the better choice. He says what
really counts is the firms reinvestment policy and its
project quality. Aswath Damodaran, Discussion Issues
and Derivations, p. 1.22 He suggests that the expected
growth in earnings is the product of the reinvestment
rate multiplied times the return on investment. Id. at 1.
He suggests that a greater current growth rate means a
longer period of above stable growth. Also, barriers to
competitors entry into the market (patents, brand
names, etc.) increase the period of high growth. He
suggests that the larger the firm is, the shorter the high
growth period. Id. at 1. He also comments that net
capital expenditures and the growth rate are connected;
net capital expenditures will decline as the growth rate
declines. Id. at 2. In estimating the Terminal Value at the
end of the high growth period, it is necessary to assess
the stable growth rate at that point in time. One consideration is that no firm can, in the long run, grow faster
than rate of growth of the economy in which it operates.
Id. at 2. It also follows that the stable growth rate cannot
exceed the Discount Rate, since the Risk Free Rate
embedded in the Discount Rate (DR) is based on real
growth in the economy. Id. at 2. Also, if the stable
growth rate exceeds the DR, then the value of the
company would rise to infinity.23 In practice, many
valuators set the subject companys long-term growth
rate at the expected growth rate for the economy as a
whole. Historically, the growth rate of the U.S. economy
has been about 3.25% per year. This growth rate may
not be sustainable due to the triple threat of deficits,
debt, and demographics. Robert D. Arnott, Equity Risk
Premium Myths p. 84 (Dec. 2011).24
b. Control Adjustments. Mercer suggests two types

of control adjustments: financial control adjustments and
strategic control adjustments. Financial control adjustments reflect adjustments that the purchaser of a controlling interest in the business could make to improve the
normalized earnings stream. Mercer and Harms, p. 118.
Strategic control adjustments reflect synergies that
would result from a strategic buyers addition of the
business to the buyers portfolio. Id. at 119-20.20
c. Fundamental Adjustments. Mercers third
category of adjustments he calls fundamental adjustments. Mercer and Harms, pp. 129-52. Fundamental
adjustments come into play when the business valuator
is using the guideline company method as part of the
market approach, and is contemplating multipliers
involving public company earnings, such as the price-toearnings ratio. Id. at 129 & 139. The problem is to
reconcile differences between expectations of growth in
future earnings of public companies and of the privatelyowned company being valued. Id. at 107-08, 134-35.
d. Determining Reasonable Compensation. The
valuation firm of Stout*Risius*Ross (SRR) has posted
a short piece on assessing the reasonableness of owners
compensation. Jesse A. Utiz, The Reasonbleness of
Owners Compensation: An Often Overlooked But Key
Assumption in Valuing a Business.21 The article notes
that C-corporations sometimes pay owners abovemarket compensation to reduce corporate taxes, while Scorporations underpay owners so as to reduce payroll
taxes. Id. at 1. Normal compensation can be sought from
(i) compensation databases and surveys; (ii)
compensation-to-reverse ratios drawn from guideline
companies; and (iii) compensation-to-equity ratios
drawn from guideline companies. Id. at 3.
D. DETERMINING TERMINAL VALUE. Under

the DCF method, valuators forecast earnings for each of
the years in the forecast period, until the companys cash
flows are expected to stabilize. At that point a Terminal
Value is calculated for the company. The Terminal
Value is fixed by determining the then-present value of
all subsequent cash flows by capitalizing them. Terminal
Value is extremely important in the business valuation.
Mercer Capital, A Users Guide to Understanding the
Discounted Future Benefits (Cash Flow) Valuation
Methods.25 Mercer Capital estimates that the Terminal
2. Applicable to the Market Approach as Well.

Adjustments to historical earnings or cash flows are
used not only in the Income Approach, but also as part
of the Market Approach to valuation. See Section VI
below. While the Market Approach typically involves
multiples of things other than earnings or cash flow, the
multiples that do involve earnings or cash flow will
require normalizedt earnings or cash flow.
26
Value arrived at by the business valuator represents

between 65% and 70% of the total discounted present
value of the business. Id. at 6. In Estate of Maggos v.
C.I.R., T.C. Memo. 2000-129, 2000 WL 366265, *12
(U.S. Tax Ct. 2000), the court said: A DCF analysis
contains an inherent difficulty when used for a company
that has a significant residual value because to determine
the present value of a company, the DCF analysis
requires an estimate of what a company will be worth at
the end of the forecast period (residual value).
mixing together sufficiently different investments that

the individual risks of the individual investments cancel
each other out. Markowitz argued that the necessary
degree of diversification could be measured by assessing
the degree to which the returns on various investments
in the portfolio were correlated (or covariant), and to use
this knowledge to avoid over-weighting the portfolio
with assets that would all decline in value at the same
time. See Frank J. Fabozzi, Francis Gupta, & Harry
Markowitz, The Legacy of Modern Portfolio Theory, 11
THE JOURNAL OF INVESTING 7, 7-8 (Fall 2002).30 In this
view, the riskiness of an asset could be measured by the
degree to which its expected returns varied from the
mean (numerical average) of the returns of all assets in
the portfolio. This mean variance theory became a
cornerstone of finance theory, and Markowitzs overall
approach, called Modern Portfolio Theory (MPT),
brought him the 1990 Nobel Prize in Economics.31
Two popular approaches to determining Terminal Value

are: (i) the Gordon Growth Model and (ii) the comparable company method. Hamermesh, pp. 26-27. 26 The
Gordon Growth Model is a simplified model that says
the value of stock is the expected dividend per share
divided by a quantity consisting of the required rate of
return less the expected growth rate.27, 28The comparable
company method uses multiples observed for companies
traded on public stock exchanges, be they price-toearnings ratios, stock price to book value, stock price to
EBITDA, etc. Id. at 27. The Gordon Growth Model
calculation is based on firm-specific information, while
the comparable company method uses information from
other companies. The latter may be necessary where the
valuator cannot reliably determine the specific companys future growth rate. Id. at 27. In either event, all
future earnings after the terminal date must be capitalized using some Capitalization Rate, either developed by
the valuator or taken from the market multiples of
comparable companies. Hamermesh, p. 29.
B. CAPM. In 1960, while Markowitz was working at

the Rand Corporation in Los Angeles, a 26-year old
graduate student knocked on his door, asking for help in
selecting a dissertation topic. Markowitz suggested
MPT. Even before completing his dissertation, the
student prepared a paper on his ideas, and in 1962
submitted the paper to THE JOURNAL OF FINANCE, which
rejected it. The student asked for a new referee, and the
editor of the journal changed, and the paper was accepted and published in 1964. 32 The paper extended
MPT by applying Markowitzs principles to the task of
pricing an individual security that is being considered
for inclusion in a portfolio of investments. The student
was William F. Sharpe, and the article Capital Asset
Prices: A Theory of Market Equilibrium Under Conditions of Risk, published in 29 THE JOURNAL OF FINANCE
425-442 (September 1964),33 became the foundation for
what would come to be called the Capital Asset Pricing
Model (CAPM).34 The CAPM now dominates investment theory and practice. The paper, and follow-up
work by himself and others, earned Sharpe part of the
same 1990 Nobel Prize in Economics that was awarded
to Markowitz.35
V. THE INCOME APPROACH (DEVELOPING

A CAP RATE/DISCOUNT RATE). The techniques
that business valuators use to develop an appropriate
Discount Rate to use in discounting to present value a
businesss future benefits can profitably be viewed in an
historical context. The background is Modern Portfolio
Theory, and its implementation through the Capital
Asset Pricing Model.
A. MODERN PORTFOLIO THEORY. In 1952,
Harry Markowitz published an article in THE JOURNAL
OF FINANCE entitled Portfolio Selection.29 In it he
outlined a theoretical approach which investors should
pursue in constructing a portfolio, based on the expected
performance of the investments and the risk appetite of
the investor. Its purpose was to show how an investor or
portfolio manager could maximize return while minimizing risk. The key to Markowitzs approach was to
reduce the downside risk of the overall portfolio by
Sharpes seminal article made four major points. First,

he divided investment returns into two components: the
price of time (i.e., the time value of money) and the
price of risk. Id. at 425. He visualized this proposition as
a graph plotting risk (Y-axis) over expected rate of
return (X-axis), with a line rising upward and to the
right. Id. at 420, Figure 1. The line rises above the X
axis (zero risk) at the point representing the pure
27
interest rate (now called the Risk Free Rate).36 Each

investor could stake out his own position on the line that
balances risk against the expected rate of return, based
on the investors tolerance for risk and motivation for
reward. Sharpe called that line the Capital Market
Line. Id. Sharpes second point was that the decision to
invest was driven by the expected future value of the
investment, and the risk that that value would not be
realized. Id. at 427-8. Sharpes third point was that the
action of all investors, seeking their unique points on the
Capital Market Line, would clear the market and lead
to the equilibrium of a stable price for each stock. Id. at
433-36. This achieving of equilibrium was based on two
assumptions that Sharpe admitted were highly restrictive and undoubtedly unrealistic37: that all investors
could borrow and lend at the Risk Free Rate, and that all
investors agreed on all aspects of various investments.
Id. at 433-34.38 In his fourth point, Sharpe accepted
MPTs idea that diversification enables the investor to
escape all but the risk resulting from swings in economic activitythis type of risk remains even in efficient
combinations. Id. at 441. Sharpe called this
undiversifiable risk systematic risk, Id. at 436, and
suggested that the systematic risk of a particular investment could be measured by the deviation of the investments return from the overall return on the entire
portfolio. Id. at 436-442.
owner of an investment. By discounting the future

benefits, the investor can calculate the price s/he should
pay for a particular companys stock, based solely on
the history of the variability of the stocks returns
compared to the variability of the return on the stock
market as a whole (this variability is called volatility).
The hypothesis that the single parameter volatility
captures allrisk is dependent on the assumption that you
can diversify away the risks that are individual to the
particular investment. It is also dependent on the assumption that there is a stable relationship between
volatility and return. The CAPMs attraction, that risk
could be assessed by statistical analysis, also made the
theory verifiable, and it has not held up well under
scrutiny. Note that the CAPM relies upon a single
index for calculations; this index is a proxy of stock
market value, such as the S&P 500.
Subsequent empirical studies have suggested that
volatility does not have a stable relationship with
investment returns, and cannot alone provide a reliable
basis for valuing stocks. Subsequent theorists have
added other parameters to the CAPM, including measures unique to the particular company such as the bookto-market ratio, earnings-to-price ratio, or the dividend
yield (effectively modifying the assumption that all risks
individual to the company can be ignored due to diversification). Another problem with CAPM is that the
returns predicted for small companies based on their
Beta are too low. Some theorists and practitioners
therefore add to the CAPM formula an additional factor
(a premium) related to the size of the company (as
measured by market capitalization or some other parameter). These patches suggest that the CAPM is not valid
for its intended use, but no other mathematical/statistical
approach for quantifying risk has been able to supplant
the CAPM, so its widespread acceptance continues.
To recap, the CAPM posits a straight-line correlation

between the value of an asset and its risk. Building on
Markowitzs idea of diversification, Sharpe assumed
that part of the risk inherent in an investment can be
eliminated by adding it to a diversified portfolio, and he
focused his attention on the part of the risk that could
not be diversified away. Sharpe proposed that, while
investors viewed the outcome of an investment in
probabilistic terms, the decision to invest could be
reduced to two parameters: the expected future value of
the investment and the probability that the expected
future value would be achieved. Id. at 427-28. Sharpe
suggested that this probability could be determined on
a forward-looking (ex ante) basis by calculating the
historical variance between the investments return and
the return of the portfolio as a whole. Id. at 438-39. This
variance is now called Beta. See Section V.E.1 below.
Thus, Sharpe was suggesting that an uncertain future
could be predicted by statistical analysis of the past.
A lucid explanation of the important aspects of the

CAPM is set out in Andr F. Perold, The Capital Asset
Pricing Model, 18 JOURNAL OF ECONOMIC PERSPECTIVES 3 (2004).39
C. THE RISK FREE RATE. In theory, there is an
investment that has no risk of default, and the rate of
return on that investment is the "Risk Free Rate" (RFR).
In simplified models, this rate of return is taken to
reflect the time value of money. (Sharpe called this the
pure interest rate.) Roger Grabowski says that the
RFR reflects a return on three components: the rental
rate (real return for lending funds over the investment
Nowadays, the CAPM (or some variation) is often used

to determine the appropriate Discount Rate to apply to
the stream of future benefits expected to flow to the
28
period); inflation (the expected rate over the term of the

investment); and maturity risk or investment rate
risk (risk that the bond values will rise or fall during
the period to liquidation of the investment due to
fluctuations in market interest rates). Roger J. Grabowski, Problems with Cost of Capital Estimation in the
Current Environment Update (Feb. 4, 2009);40 Roger J.
Grabowski, Developing the Cost of Equity Capital:
Risk-Free Rate and ERP During Periods of Flight to
Quality p. 2 (Jan. 29, 2011).41
value of the risk and the interest which he must pay

for the capital if borrowed. 44 This insight was largely
forgotten in subsequent decades. Then in 1921, a
Chicago economist Frank Knight suggested that investors should and do demand compensation for making a
risky investment by requiring increased returns on the
investment. Knight differentiated quantifiable from
unquantifiable risk, but he did not suggest a method to
quantify risk. Knight, RISK, UNCERTAINTY AND PROFIT
(1921).45 In 1924, Edgar Lawrence Smith published a
book in which he advocated investing in stocks as a way
to achieve higher returns than investing in bonds, and
backed up his suggestion with a comparison of historical
returns on stocks versus bonds.46 In 1925, Yale University Professor Irving Fisher published a paper suggesting
that the safety of bonds was illusory due to inflation risk
and that the risks of investing in stocks could be reduced
by diversification. Irving Fisher, Stock vs. Bonds,
AMERICAN REVIEW OF REVIEWS (July 1925).47 In 1938,
Alfred Cowles III published a study of stock prices and
dividends from 1871 to 1937, using the technique of
reinvesting dividends so as to avoid the difficulty of
having to track income and capital appreciation separately.48 Cowles also tracked virtually all stocks on the
New York Stock Exchange and capital-weighted them.
Id. Also in 1938, John Burr Williams published The
Theory of Investment Value, in which he was the first to
calculate the risk premium for stocks by comparing the
historical rate of return on stock investments versus
investments in long-term government bonds.49 Thus,
while the idea that an investor is attracted to investing in
order to obtain a return in excess of the time value of
money dates back to the mid-1800s, it was not until the
1930s that people began to focus on quantifying the
return on investments in companies.50
For short term investments, the Risk Free Rate in the

U.S. is sometimes taken to be the yield on U.S. Treasury
notes (up to one-year maturity). However, for
longer-term investments, a longer-term government
security (2, 3, 5, 7, 10, or 20- yr. notes, or 30-yr. bond)
would be considered the Risk Free Rate. With S&P's
downgrade of the United States' long term sovereign
credit rating, it makes less sense to talk of a Risk Free
Rate.42 However, U.S. Treasury securities probably still
represent the safest investment in the American economy (perhaps we should call this the Least Risk Rate),
and any risk in buying Treasuries is presumably reflected in the yield-to-maturity required to attract buyers
to Treasury Securities. As a practical matter, it is unlikely that the U.S. government would ever actually
default on its security obligations. In a fiscal crisis, the
Federal Reserve Bank would create dollars to retire
maturing Treasury securities and to buy newly-issued
Treasury bills, notes, and bonds. This would increase the
money supply and reduce the purchasing power of
existing dollars, causing price inflation. The risk of
inflation depresses the price and drives up the yield on
longer-term Treasury bonds, resulting in an upward
sloping Yield Curve.43 Some theorists argue that Treasury Inflation-Protected Securities (TIPS) of five, ten
or thirty year maturities, are the best measure of the Risk
Free Rate, because they eliminate inflation risk. Additionally, with the Federal Reserve System presently
buying U.S. government bills, notes and bonds in order
to artificially depress the rate on U.S. Treasury securities, the Risk Free Rate is no longer solely determined
by market forces and may therefore be sending inaccurate signals about investors' expectations. See Section
V.G., which discusses problems with determining the
Risk Free Rate.
Under the current paradigm, the "Equity Risk Premium"

(ERP) is the additional return investors expect to receive
to compensate for the additional risk associated with
investing in the stock market as opposed to investing in
risk-free government securities. The ERP is the expected
excess return of stocks (dividends plus capital gains
upon liquidation) over bonds (interest plus return of
capital upon maturity). Usually the ERP, or extra return
required to induce an investor to move from super-safe
government bonds into the riskier stock market, is
measured by comparing the historical rate of return on
the stock market as a whole versus the historical rate of
return on government notes, bills, or bonds over the
same period. Concerns with this conceptualization are
discussed in Section V.H. below.
D. THE EQUITY RISK PREMIUM. John Stuart

Mill, in his famous book PRINCIPLES OF POLITICAL
ECONOMY (1848), wrote that an investor would buy
land if it afforded a surplus profit in excess of the
29
The fundamental problem is that the ERP is not an

observable quantity, and there is no universally agreedupon method for determining the ERP. Generally
acknowledged methods for estimating the ERP are: (i)
surveys, (ii) ex post analysis of historical data (i.e.,
hindsight), and (iii) ex ante modeling of future circumstances. Domantas Skardziukas, Practical Approach to
Estimating Cost of Capital p. 32 (9/20/2010)
(Skardziukas).51
Professors John R. Graham and Campbell R. Harvey of

the Fuqua School of Business at Duke University
analyzed the results from a survey of CFOs conducted
in 2010:
We analyze the history of the equity risk premium
from surveys of U.S. Chief Financial Officers
(CFOs) conducted every quarter from June 2000 to
June 2010. The risk premium is the expected
10-year S&P 500 return relative to a 10-year U.S.
Treasury bond yield. While the risk premium
sharply increased during the financial crisis peaking in February 2009, the current surveys show
that the premium has returned to levels observed in
late 2006 and early 2007.
1. Surveys. One way of determining the current ERP

is to sample current opinions on that issue. Traditionally, few business valuators rely on surveys to indicate
the current ERP. Professor Aswath Damodaran asserts
that his 2010 study showed no predictive power or
possibly even an inverse relationship for surveys. But as
time goes on serious surveys are being undertaken with
more diverse samples that should improve representativeness. And it should be remembered that the most
important thing about the ERP to a business valuator is
to capture investors expectations, regardless of whether
those expectations are in fact accurate. If a survey
captures investors current expectations of risk and
future rates of return, then it is valid for use in business
valuation, regardless of how correct it may ultimately
prove to be.
Graham & Harvey, The Equity Risk Premium in 2010

(August 9, 2010). 53 The survey results, in more detail,
indicated:
During the past ten years, we have collected
13,668 responses to the survey. Table 1 presents
the date that the survey window opened, the
number of responses for each survey, the 10-year
Treasury bond rate, as well as the average and
median expected excess returns. There is relatively
little time variation in the risk premium. This is
confirmed in Fig. 1, which displays the historical
risk premiums contained in Table 1. The current
premium, 3.00%, is considerably lower than the
peak premium of 4.74% observed in February
2009. The June 2010 survey shows that the expected annual S&P 500 return is 6.31% and the
implied risk premium is 3.00% (6.31% - 3.31%).
The expected annual S&P 500 return is the lowest
observed in the history of the survey.
In March/April 2011, Professor Pablo Fernndez sent

19,500 emails to finance and economics professors,
analysts, and companies, asking for their estimates of
the required ERP in the USA. He received 5,731
specific estimates, of which 1,438 related to the USA. In
a 2011 paper, Professor Fernndez published the following estimates for the forward-looking ERP: professors
(mean=5.7%; median=5.5%); analysts (mean=5.0%;
median=5.0%); companies (mean=5.6%; median=5.2%).
Pablo Frnandez, Market Risk Premium Used in 2010 by
Analysts and Companies: A Survey with 2,400 Answers
(May 2011).52
Panel B of Table 1 presents some summary statistics that pool all 13,668 responses. The overall
average ten-year risk premium return is 3.40%.3
The standard deviation is 3.25%.
Psychological analysis of the problem suggests that

investors are more influenced by recent price movements, and that fear of loss of value is weighted more
greatly than the enticement of increase in value (called
myopic loss aversion). For purposes of business
valuation, however, whether investor sentiment it purely
rational or not makes no difference; it is the present
perception of future rewards for undertaking risks
among competing investments that matters, not the
reality of it.
Id.
The Graziadio School of Business at Pepperdine University conducts the Pepperdine Private Capital Markets
Project (PPCMP), a survey designed to capture the
thinking of 2,500 business people across the world,
including bankers, venture capitalists, owners of
privately-held businesses, and business valuators.
Survey Report V (Summer 2011). At Figure 26, the
30
PPCMP sets out risk premiums used by the survey

respondents who were business valuators. On average
the business valuator respondents used a RFR of 4.35%
and an ERP of 6.99%. Id. at 32.
future performance. It reflects the belief that future

expectations are shaped by past experience. The problem with ex post analysis is the possibility that the
future may not turn out to be like the past.56 From a
business valuators perspective, however, what counts
is what most investors are doing, not whether the
prevalent approach to estimating the ERP is the best
one.
Professor Roger G. Ibbotson has expressed reservations

about surveys (he uses the term consensus method).
Professor Ibbotson says:
Most of these investors have no clear opinion
about the long-run outlook. Many of them have
only very short-term horizons. Individual investors
often exhibit extreme optimism or pessimism and
make procyclical forecasts . . . . I have seen surveys . . . that do not seem to even clarify whether
the questionnaire refers to arithmetic mean returns
or geometric mean returns. Many returns also do
not make clear whether the ERP to which they
refer is the excess return of stocks over government bonds or Treasury bills or some other type of
bond. This lack of clarity makes the surveys very
difficult to interpret.
There are many sources for ex post determinations of

the ERP. Two of the most prominent are IBBOTSON
SBBI VALUATION YEARBOOK, and Duff & Phelps.
Many of the troubling issues that can arise from using
the ex post method of determining the ERP are discussed in Section V.H. below.
3. Ex Ante Analysis. Another way to infer the
current and expected future ERP is the ex ante (forward
looking) approach which usually involves feeding
observable current market data into a financial model
and then solving for the ERP. Models include the
CAPM, the Arbitrage Pricing Theory, the Gordon
Growth Model (of stable dividend growth), as well as
other models discussed below and many more. The data
that is fed into the models include current stock prices,
current and expected dividend yields, projected cash
flows, analyst estimates, volatility,57 default spreads
between government and corporate bonds,58 the Risk
Free Rate, price/earnings ratios, future growth in the
economy, future inflation rates, etc.
Roger G. Ibbotson, The Equity Risk Premium, RETHINKING THE EQUITY RISK PREMIUM p. 20 (Dec. 23, 2011).54
Admissibility in Court. From a Frye standpoint, the fact
that the use of surveys to establish the ERP is not yet
generally accepted in the business valuation community
is grounds for exclusion. From a Daubert reliability
standpoint, general acceptance is only one of the relevant factors so a lack of general acceptance is not fatal.
However, the fact that the surveys are not yet sufficiently random to be statistically valid creates a risk of
exclusion. Importantly, even imperfect surveys may be
more reliable than formulaic reliance on historical data,
for example if the window of the historical data is too
short to be statistically reliable.
Dimson, Marsh and Staunton suggest that the ex ante

ERP can be determined by taking analysts projections
of the current dividend yield, and adding the expected
dividend growth rate, plus or minus any change in the
price-to-dividend ratio, less the RFR.59
A supply side estimate of the ERP is based on the idea
that stock market returns have to come from the
productivity of corporations in the real economy. Peng
Chen, Will Bonds Outperform Stocks Over the Long
Run? Not Likely, RETHINKING THE EQUITY RISK
PREMIUM p. 125.60 In this view, the two main
components of equity returns are dividends and earnings
growth (which translates into capital gains), with an
adjustment for inflation. Id. at 126-27. However,
historically the increase in stock prices exceeded
earnings growth because investors were willing to pay
more and more for a level of earnings, which raised the
price-to-earnings (P/E) ratio. According to this view, in
the past, return on stocks has consisted of three
2. Ex Post Analysis. The most prevalent approach to

estimating the present ERP is the ex post (backward
looking) approach. Robert S. Harris and Felicia C.
Marston, The Market Risk Premium: Expectational
Estimates Using Analysts' Forecasts, 11 JOURNAL OF
APPLIED FINANCE 1 (2001).55 The ex post method of
determining the RFR compares the historical return on
stocks to the historical yield to maturity on U.S. Treasury bills, notes, or bonds, over specified periods of
time. This is called the excess historical return. The ex
post method is based on the assumption that past actual
performance is a valid proxy for current expectations of
31
components: current dividend yield + earnings growth

+ P/E change. Id. at 118. The P/E ratio rose from 10.22
in 1926 to 20.61 in 2009, although it reached a high of
136.50 in 1931 and a low of 7.07 in 1948. Id. at 126-27.
This amounts to an average annual increase of 0.84% in
P/E ratio from 1926-2009. Id. at 127. To calculate future
stock returns, Ibbotson Associates (where Chen works)
subtracts the P/E ratio growth rate from the historical
ERP, because we do not believe that the P/E will
continue to increase in the future. Id. at 127. After
removing past expansion in the P/E rating, Ibbotson
calculates the expected future return on stocks as
follows: dividend yield plus real growth in earnings per
share, plus the inflation rate. Id. at 127. Ibbotson
assumes that the historical ERP of 4.16% will continue
into the future, so subtracting the P/E expansion rate of
0.84% from the historical ERP leaves a supply side
estimate of the geometric (compounded) ERP over the
next 20 years of 3.34%which is 0.82% lower than the
historical average. Id. at 128. In 2011, a supply side
estimate of the ex ante ERP was determined by Richard
C. Grinold, Kenneth F. Kroner, & Laurence B. Siegel,
in A Supply Model of the Equity Premium, CFA
Institute's RETHINKING THE EQUITY RISK PREMIUM 56
(2011) ("Grinold").61 Projecting a nominal (i.e.,
including inflation) return on equities (dividends and
stock repurchases) of 1.98% and capital gains of 5.05%,
they arrived at a total expected return on equities of 7%.
Subtracting the yield on 10-year Treasury bonds of
3.4%, they arrived at an expected ERP of 3.6%. Id. at
67-68. The figure is based on geometric mean; an
arithmetic mean-derived ERP is 4.63%. Id. at 68. Vice
Chancellor Strine, in Global GT LP v. Golden Telecom,
Inc., 993 A.2d 497, 516 (Del. Ch. 2010), compared an
ex post assessment of the ERP against a supply side
assessment of the ERP, and decided to go with the
supply side assessment.
Equity Risk Premium. Market Beta is set to one

(because the index by definition is the market).
Solve for the ERP using Ki - Rf = ERP.62
Stephen Hassett is a businessman, a University of
Virginia Business School graduate with a background in
mergers and acquisitions, who developed a model for
determining the implied ERP and published it in The
Risk Premium Factor Valuation Model for Calculating
the Equity Market Risk Premium and Explaining the
Value of the S&P with Two Variables, in 22 JOURNAL OF
APPLIED CORPORATE FINANCE 118-130 (SPRING 2010).63
Hassett believes that fluctuations in the ERP (as
measured by the S&P 500) are attributable to three
factors: earnings, growth, and the RFR. He uses the
formula P=E/(C-G) (where P is the price of the
investment, E is projected earnings, C is the cost of
capital, and G is the growth rate) to determine what he
calls the Risk Premium Factor, which he then uses in
cost of capital caluculations instead of the ERP. Hassett
attributes the decline in the ERP since the early 1980s to
a lowering of the RFR over that same period. Duff &
Phelps considered Hassetts estimation of the ERP as
one factor in making its determination of the U.S. ERP
as of September 30, 2011.64
Aswath Damodaran is a Professor of Finance at the
Stern School of Business of New York University.
Professor Damodaran regularly calculates an ERP for
the S&P 500 and publishes it at his web site.65 Damodaran employs a two-stage model (5 years and >5 years)
based upon an average of analysts projections of stock
dividends and buybacks for a period of five years, and
the RFR thereafter.66 Duff & Phelps considered
Damodarans estimation of the ERP as one factor in
making its determination of the U.S. ERP as of
September 30, 2011.67
Duff & Phelps (D&P) is an investment research and
investment advice company headquartered in New York
City. D&P publishes a Recommended U.S. ERP which
it updates when they feel that it needs to be changed.
D&Ps Recommended U.S. ERP was 5.5% from July
2011 to September 29, 2011, then it was raised to 6%
from September 30, 2011 to January 14, 2012, when it
was dropped back to 5.5%.68 Duff & Phelps analyzes
general economic conditions, and the results of ex ante
models such as Hassetts and Damodarans, in making
its assessment of the current ERP. For more thorough
analysis, see Roger J. Grabowski, Developing the Cost
of Equity Capital: Risk-Free Rate and ERP During
The accounting conglomerate Grant Thornton has a

computer program for inferring the current ERP. It
works like this:
On a company-by-company basis for all
companies comprising the applicable stock index,
(i) future cash flows are estimated based on a
consensus of analysts, and (ii) an expected rate of
return (ERR) is determined for the stocks making
up that index. Those calculations are fed into the
CAPM formula, Ki = Rf + *(ERP), where Ki is
the index level expected rate of return, Rf is the
risk free rate, is Market Beta, and ERP is the
32
Periods of Flight to Quality.69
variability of the return earned by the market as a whole

is assigned the number 1, and the measure of the
variability of a specific companys return compared to
that of the market as a whole (the Beta coefficient,
called Beta and symbolized as ) can be calculated
using historical numbers. A security with a Beta of more
than 1 means a systematic risk of fluctuating return that
is greater than the systematic risk of the market as a
whole; a security with a Beta of less than 1 means it has
systematic risk of fluctuating return that is less than the
systematic risk of the market as a whole. U.S. Treasury
securities have a Beta of zero because they do not
covary with the stock market. A negative Beta means
that the return on that investment moves in the opposite
direction from the return on the stock market as a whole.
An investor considering a stock with a Beta greater than
1 would pay less for the anticipated return because only
by lowering the purchase price can the investor achieve
the higher rate of return that the greater risk (expressed
as a larger Beta) requires. A stock with a Beta less than
1 can justify a higher purchase price since there is a
greater likelihood that the anticipated rate of return will
be realized. There are a number of financial services that
publish Betas for publicly-traded stocks, including
Bloomberg, Ibbotson-Morningstar, Merrill Lynch,
Standard & Poors, Trade Line North America, and
Value Line. For further discussion see Section V.I,
Problems with Beta.
Although ex ante analysis of the ERP has its adherents,

it has not yet achieved widespread acceptance, which
might undermine admissibility under the Frye test.
Under a Daubert analysis, however, general acceptance
is just one factor, and an ex ante model can be tested by
applying it to various historical dates to determine an
error rate in predicting the ERP. Again, however, testing
a model against historical data conflates past accuracy
with the models ability to discern present expectations
of future returns. Accuracy is the concern of the
portfolio managers and investors; current expectations
is the concern of business valuators.
E. MODERN APPLICATIONS OF MPT AND
THE CAPM. In Modern Portfolio Theory, risk is
conceived as the likely variance around an expected rate
of return. The Capital Asset Pricing Model (CAPM)
provides that the risk of a particular investment is
broken down into two components: (i) firm-specific
risk, and (ii) systematic market risk. It is assumed that
an investor can eliminate all firm-specific risk by
widely-diversifying his overall investment portfolio,
leaving as the only remaining risk the risk associated
with the market as a whole (market risk or systematic
risk). The reward for taking on the risk of the market as
a whole (i.e., systematic risk) is called the Equity Risk
Premium (ERP). The ERP is by definition the amount
of additional reward an investor requires before he will
move from a risk free investment (i.e., U.S. government
securities) into riskier corporate stock.
2.
The CAPM Formula. The CAPM formula is a

simple equation:
E(Ri) = Rf + i (Em - Rf)
Under the CAPM, this expected rate of return (the RFR

plus the ERP) can be used to determine the price an
investor should pay to buy stock in a particular
company, by taking the estimated future benefits to be
received from stock ownership (dividend reinvestment
plus proceeds from eventual sale of the stock) and
dividing that by the rate of return required by the
investor to offset the risk of the investment.
E(Ri)= the expected rate of return on an individual

security i
Rf = the risk free rate (RFR)
i = Beta for the individual security i
Em = the expected return on the market as a whole
Rf = the Risk Free Rate
(Em - Rf) = the Equity Risk Premium (ERP).
The formula can be restated by saying that the expected
rate of return on an individual security is the rate of
return of the risk free investment, plus the product of
multiplying the extra return required to draw investors
into equity investments (the ERP) by the divergence of
the specific companys returns (Beta) from the stock
markets return as a whole:
1. Beta. In the CAPM, the risk associated with

buying stock of a particular company is said to be
statistically determinable by calculating the variance of
past returns from the expected rate of return. This could
be done by assessing the variability of the companys
dividend payment history and stock price, but the
conventional approach is to calculate the variance of the
companys historical rate of return compared to that of
the stock market as a whole. In the CAPM, the
E(Ri) = Rf + i ERP
33
Put in different words, under the CAPM, the expected

rate of return on an investment varies with the risk of the
investment. Because optimal diversification is assumed
to eliminate Specific Company Risk, the sole risk factor
of a specific company that must be compensated is the
extent to which that companys return is expected to
deviate from the return on the stock market as a whole.
This deviation is the companys Beta, which is
measured by seeing how much the companys return has
changed in the past when the return on entire market
changed by one percent, usually viewed over an
historical period of five years. A market index, like the
S&P 500 or Wilshire 5000, is taken to represent the
entire market for purposes of determining a companys
Beta. A Beta greater than 1 means that the stock return
has been more volatile than that of the market; a Beta of
1 means that the stocks return has moved up and down
in step with the market; a Beta between 1 and zero
means the stocks return has been less volatile than the
market; a Beta of zero means there is no correlation
between the return on the companys stock and the
market (which would apply to cash and to risk-free
investments like Treasury bills); a negative Beta means
that the return on the investment moves inversely to the
return of market (i.e., decreases when market return goes
up, or vice versa).70
the Beta-adjusted Size Premium based on the size of

the companys market capitalization. See IBBOTSON
SBBI VALUATION YEARBOOK (2011), pp. 44-45 & 87.
The Pepperdine University Private Capital Markets
Project Survey for 2011 (Business Appraiser Survey
portion) showed that the respondents used the following
size premiums based on EBITDA (not market cap):
$250 million, 3.78%; $25 million, 5.13%; $1 million,
6.4%. PPCMP (Summer 2011) p. 32, Figure 26. The
Business Appraiser Survey included 271 persons, of
whom 39% were CPAs, 30% were ABV, and 35% were
ASA certified, and 60 had over 10 years in business
appraising. Id. p. 29. In Estate of Hendrickson v. C.I.R.,
T.C. Memo. 1999-278, 1999 WL 637089, *18 (U.S. Tax
Ct. 1999), an experts opnion of value based on the
CAPM was rejected for his failure to utilize a size
premium. In Gesoff v. IIC Indus., 902 A.2d 1130, 1159
(Del. Ch. 2006), the Chancery Judge said that [t]he
small-size premium, although somewhat controversial,
is a generally accepted premise of both financial
analyses and of this courts valuation opinions. See
Delaware Open MRI Radiology Associates, 898 A.2d
290, 338 n.129 (Del. Ch. 2006) (endorsing the small size
premium, despite the great debate over is
appropriateness); ONTI, Inc. v. Integra Bank, 751 A.2d
904, 920 (Del. Ch. 1999) (This court has traditionally
recognized the existence of a small stock premium in
appraisal matters). See discussion in Lawrence A.
Hamermesh & Michael L. Wachter, The Short and
Puzzling Life of the Implicit Minority Discount in
Delaware Appraisal Law, 156 UNIV. OF PENNSYLVANIA
LAW REVIEW 1, 48 (2007).71 Michael Barad, of Ibbotson
Associates, cautions on the difference between the Small
Stock Premium and the Size Premium, both of which are
included in the IBBOTSON SBBI VALUATION YEARBOOK.
The small stock premium is meant for use by security
analysts to construct expected returns for a small stock
benchmark, while the Size Premium is intended to use
to determine a Discount Rate to discount future cash
flows. The Size Premium removes the return attributable
to Beta, to avoid double counting when the Size
Premium is used in the CAPM or Build Up methods.
Michael W. Barad, Technical Analysis of the Size
Premium (undated).72
3. Size Premium. Under the CAPM, the expected

rate of return of an investment is supposed to be equal to
the Risk Free Rate, plus the product of the companys
Beta times the Equity Risk Premium. Over time, people
noticed that small companies on the national stock
exchanges garner a return in excess of what the CAPM
predicted given their Betas. In fact, the smaller the
company, the greater the extra return. Yale University
Finance Professor Roger Ibbotson suggests adding a
Size Premium to the standard CAPM formula, because
although Betas for small companies are greater than
Betas for large companies, small company stocks have
had returns in excess of those implied by their betas.
IBBOTSON SBBI VALUATION YEARBOOK (2011), p. 87.
Implicit in the discussion is the recognition that the
outsized returns for investing in small companies results
from the investor paying less to buy the companys
stock, and then achieving or exceeding the expected
dividend income and/or stock price appreciation. Ibbotsons modified CAPM formula is:
4. What Constitutes Diversification. According to

one study, in 1997 it took 20 stocks to eliminate nonsystematic firm-specific risk; today it takes 40 stocks.
Jason Zweig, Simple Index Funds May be Complicating
the Markets, THE WALL STREET JOURNAL (Feb. 18-19,
2012), p. B-1.73 A convenient way for an investor to
Ks = Rf + (sERP) + SPs
Ks is the expected rate of return on security s, and SPs is
34
diversify is to invest in an index fund. In 1976,

Vanguard launched the first market index fund, which
was a passive (essentially unmanaged) fund that was
invested in a portfolio of stocks that matched the S&P
500 based on relative market capitalization. 74 The Beta
of the portfolio was essentially the Beta of the stock
market, which was 1. In the intervening years, index
funds have proliferated to the point that they are starting
to affect the behavior of the overall market. See Jason
Zweig, Id.
determining a Beta for each factor, and combining these

measures into an overall Beta for that investment.75
Successive efforts to make the CAPM more robust have
addressed particular criticisms, but on the whole,
according to Professor Eugene F. Fama, "the empirical
record of the model is poorpoor enough to invalidate
the way it is used in applications." Eugene F. Fama &
Kenneth R. French, THE CAPITAL ASSET PRICING
MODEL: THEORY AND EVIDENCE (2004) p. 1.76 Despite
these criticisms, the CAPM has endured as a central
tenet of portfolio management, investment analysis, and
business valuation.
5. Using the CAPM to Value Private Businesses.

Many business valuators use the CAPM as the starting
point for determining the appropriate Discount Rate to
apply to the projected future cash flows of a closely-held
business in order to determine a value for the business.
The CAPM claims to capture the risk associated with
investing in a publicly-held company through the
companys Beta coefficient. The theory goes that, if
selected publicly-traded companies are comparable to
the privately-owned business being valued, then by
taking the Discount Rate suggested by the CAPM for
those publicly-traded comparables, after adjusting for
differences, and adding risk premia to account for risks
associated with the subject company that are not
reflected in Beta and cannot be diversified away, the
CAPM can be used to establish a Discount Rate to apply
to projected future cash flows of a privately-held
company to arrive at a value. However, as Shannon Pratt
notes: A major weakness of using the CAPM for its
original purpose of understanding the value of securities
in a portfolio is the measurement of the various
components of the CAPM equation. Pratt, VALUING A
BUSINESS: THE ANALYSIS AND APPRAISAL OF CLOSELY
HELD COMPANIES 211 (5th ed. 2008) (Pratt). These
problems are carried over to the domain of business
valuation when the CAPM is used as the foundation for
developing a Discount Rate for business valuation
purposes.
F. BUILD UP METHOD. Another popular approach

to determining an appropriate Discount Rate for the
income approach to valuing a business is the Build Up
Method. Using the Build Up Method, the Discount
Rate for use in discounting projected future cash flows
of a business is determined by adding together various
components, as follows:
Risk Free Rate
+ Equity Risk Premium
+ Size Premium
+/- Industry Risk Premium
+ Specific Company Risk Premium
Discount Rate
The Build Up Method is an additive model in which the
required rate of return on an investmentwhat would be
sufficient to attract a buyer--is estimated by taking the
Risk Free Rate and adding to that the Equity Risk
Premium and other risk premia that reflect the various
risks associated with buying an interest in a privatelyowned company. These additional risk premia include
the Firm Size Premium, the Industry Premium, and the
Specific Company Risk Premium.
It is important to note that the Build Up Method for
valuing the stock in a small, closely-held company is, in
essence, the CAPM, where the Beta of the industry is
substituted for the Beta of the stock, and where the
CAPM is adjusted for smaller company size, and where
the non-systematic risk of the company is assessed
rather than being diversified away.
6. Alternative Asset Pricing Models. Some have

noted that the original CAPM was based on simplifying
assumptions that have caused the model to perform
poorly against empirical data. Different theorists have
undertaken to modify the original CAPM to make it
better accord with the data. Many theorists have
proposed various modifications to the CAPM. In 1976,
the Arbitrage Pricing Theory was suggested as a better
way to determine Beta for an individual investment by
comparing the investment's correlation to multiple
macro-economic factors (GDP, inflation rate, etc.),
Recall that under the CAPM it is assumed that all risks

associated with investing in a specific company can be
eliminated from an investment portfolio by investing in
a sufficient number of diverse companies that the
Specific Company Risks cancel each other out. One
35
recent estimate is that it takes 40 well-chosen companies

to achieve the necessary diversification. Jason Zweig,
Simple Index Funds May be Complicating the Markets,
THE WALL STREET JOURNAL (Feb. 18-19, 2012), p. B1.77 There is reason to doubt whether the potential
buyers of a small, closely-held company are looking for
increased risk/increased return in order to offset supersafe investments in their existing portfolios. It is much
more likely that potential investors are looking to buy a
small, privately-owned company in pursuit of returns
that exceed the returns on even high Beta stocks traded
on an exchange. Viewed in this light, the key difference
between the CAPM and the Build Up Method thus lies
in the CAPMs ignoring Specific Company Risk while
the Build up Method reflects it in a specific premium.
Specific Company Risk can only be assessed using
Fundamental Analysis of the companys unique
advantages and disadvantages.
3. The Size Premium. Studies have shown that the

return on small cap stocks is higher than the CAPM
predicts. IBBOTSON SBBI 2011 VALUATION YEARBOOK
83 (IBBOTSON SBBI). Ibbotson and Duff & Phelps
(D&P) both present size premia that are based on
statistical analysis of historical data of stocks listed on
the American stock exchanges. Ibbotson started his Size
Premium in 2000, with ten size categories (deciles)
based on market capitalization. The 10th Decile includes
the smallest 10% of stocks on the NYSE, AMEX, and
NASDAQ, based on market cap. In 2001, Ibbotson
broke up the smallest Decile (the 10th decile) into two
subcategories, 10a and 10b. Then in 2010, Ibbotson
broke the 10th Decile down into four subcategories: 10w,
10x, 10y and 10z. IBBOTSON SBBI p. 89. D&P publishes
its own Size Premium data. Duff & Phelps, LLC, Risk
Premium Report.78 D&P uses eight alternate measures of
company size to break NYSE-listed companies into 25
size-ranked portfolios of equal size, then adds to that
pool, companies listed on the AMEX and NASDAQ
(mostly to the small cap end of the portfolios). Id. at 47. D&P measures size in various ways, including
accounting measures (such as assets, net income) as well
as non-accounting measures (such as number of
employees). Id. at 5, 28. Concerns about the validity of
the Size Premium are discussed in Section V.K. below.
1. The Risk Free Rate. As used in the Build Up

Method, the Risk Free Rate (RFR) is the same concept
we saw in Section V.C. above. It represents the yield to
maturity of U.S. Treasury notes, bills or bonds. Since
longer-term securities usually have higher yields (the
Yield Curve), the choice of Treasury security used in
the calculation affects the RFR, and thus the Discount
Rate. Temporary anomalies affecting the RFR can be
avoided by taking an historical average RFR instead of
the current RFR, or by making adjustments to offset
temporary irregularities. See Section V.G. below.
However, making such adjustments may introduce other
errors, so caution is advised.
4. The Industry Risk Premium. Researchers and

statisticians testing the CAPM noticed that individual
company Betas were too variable to be considered
reliable, so they began to aggregate groups of stocks in
order to reduce statistical noise. Some researchers
began to aggregate companies by industry in order to get
a more reliable Beta. Starting in 2000, Ibbotson began
publishing an Industry Risk Premium (IRP), using to the
following formula:
2. The Equity Risk Premium. As used in the Build

Up Method, the Equity Risk Premium (ERP) is the same
concept we saw in Section V.D above. It represents the
reward for investing money in the U.S. stock market
instead of U.S. Treasuries. While it is the expected
future ERP that concerns business valuators, it is
common to use the historical ERP as a proxy for the
expected future ERP. While the use of the historical
ERP in developing a Discount Rate is generally
accepted in the business valuation community, concerns
have been raised about the accuracy of this approach to
determining the forward-looking ERP. See Section V.H.
Ironically, since business valuators are dealing with the
expectations of a hypothetical investor, a generally
accepted view of the forward-looking ERP will work for
business valuation, regardless of whether that prevailing
view is right or wrong.
IRPi = (RIi x ERP) - ERP

IRPi= industry risk premium for industry "i"
RIi = risk index for industry "i"
ERP = Equity Risk Premium.
To identify each industry, Ibbotson adopted the United
States Census Bureaus Standard Industrial
Classification Codes (SIC Codes). Ibbotson developed
a risk index for each industry, using the full information
Beta of that industry. He multiplied that form of Beta
times the ERP to get an adjusted ERP, then subtracted
the unadjusted ERP to isolate the adjustment, which he
called the Industry Risk Premium. Thus, the IRP is a
36
CAPM Beta for a particular industry as a whole. As

such, the IRP indicates the degree to which the return on
stocks of companies in the industry (i.e., sharing the
same SIC Code) vary with changes in the return of the
overall stock market. If the industry moves in tandem
with the overall market, the Industry Risk Index is 1 and
the IRP is zero. If the industry moves more than the
market, the Industry Risk Index is more than 1, and the
IRP will be a positive number that will increase the
Discount Rate. If the Industry Risk Index is less than 1,
the IRP will be a negative number, and will lower the
Discount Rate. An IRP greater than 0 means that the
industry is riskier than the market. See Michael Barad &
Tara McDowell, Capturing Industry Risk in a Buildup
Model.79 The Betas for the industries are calculated
using the return on the S&P 500 as a proxy for the
market return and the yield on 30-day Treasuries as a
proxy for the RFR. Id. at 3.
limited access to capital markets; a narrower customer

base; a limited geographic area; dependency on key
executives; limited product line or services offered;
litigation or regulatory risk; industry volatility; etc.
Because other premia sometimes capture parts of these
risks, care must be taken not to double-count any of
these risks by including them in two premia, which
would overstate the Discount Rate.
In most instances, the SCRP is a subjective assessment
by the business valuator. Duff & Phelps has taken a step
to introduce more objectivity into the process of arriving
at an SCRP. D&P has taken its Size Premium database
and segregated publicly-traded companies based not on
size alone but rather on various risk factors. The results
are published in its Risk Premium Report. D&P suggests
using its risk figures in a modified CAPM formula,
where the Required Rate of Return (Discount Rate) is
equal to the RFR plus a risk premium that consists of the
ERP, plus a Size Premium, plus a Specific Company
Risk Premium (SCRP) constructed using comparisons
from its Risk Premium Report. Duff & Phelps, LLC,
Risk Premium Report 2010 (excerpt) pp. 33-34, 44-46. 83
As noted above, the Build Up Method ignores individual

company Beta. Adding an IRP to the Build Up
effectively substitutes the Industry Beta for the
individual company Beta adjustment in the traditional
CAPM formula. Viewed this way, the Build Up Method
is in essence a modified CAPM. Being the product of a
CAPM analysis, the IRP (and a Build up using the IRP)
is subject to the same concerns that surround the CAPM.
See Section V.J.
6. The Build-Up Method as an Extension of the

CAPM. While some courts and some business valuators
treat the Build-Up Method as if it is different from the
CAPM, they are in fact very similar. Under the CAPM,
the Discount Rate consists of the RFR, plus the ERP
multiplied by the firms Beta. Theorists have suggested
that Industry Betas are more reliable than firm Betas,
and that the Beta of the industry in which the firm is
located should be substituted for firm Beta. Ibbotson
and others note that the CAPM is too high for large cap
stocks and too low for small cap stocks. Ibbotson
suggests adding a Size Premium to the Build-Up
Discount Rate. So a modified CAPM would consists of
the RFR, plus the ERP multiplied by the Industry Beta,
plus a Size Premium. If you convert Industry Beta to an
Industry Premium (which Ibbotson does in his SBBI
VALUATION YEARBOOK), and add a Size Premium, then
the modified CAPM is essentially the Build-Up Method,
with the exception that Specific Company Risk is
diversified away in the CAPM but it is explicitly
included in the Build Up Method as the Specific
Company Risk Premium (SCRP). Viewed in this way,
the Build Up Method is the modified CAPM with a
Specific Company Risk Premium (SCRP) added. Since
the SCRP is arrived at subjectively, not statistically like
the other components of the CAPM, there is reason to
wonder why the Build Up Rate has been accepted by
5. The Specific Company Risk Premium. "Specific

Company Risk" (SCR) has been defined to be "[a]n
unsystemic risk specific to a certain company's
operations and reputation."80 The Specific Company
Risk Premium (SCRP) is central to business valuations
of closely-held companies, because the SCRP represents
the risks inherent in investing in a privately-owned
business that has lower sales and thinner capitalization
and a more vulnerable market position and less
management depth than the smallest companies traded
on the national stock exchanges. Ownership interests in
a privately-held company cannot be valued objectively
by comparison to a stock price on a liquid national
exchange. The challenge, then, about the SCRP is that,
by necessity, it is unique to the company being valued,
and thus cannot be standardized or subjected to
statistical analysis. See Section V.N. below.
A good explanation of the SCRP is available at
Mercercapital.com.81 One effort to objectify Specific
Company Risk is described at BVresources.com.82
Factors contributing to the SCRP are: smaller size; more
37
many as being more reliable than a modified CAPM in

determining an appropriate Discount Rate to use in
valuing privately-owned companies.
the time value of money.

3. Negative Yields. In principle, the RFR is the
minimum rate of return an investor would require before
making a risky investment, because no investor will
accept risk unless the potential rate of return is greater
than the Risk Free Rate. However, the RFR turned
negative in the USA in 2008 and again in Germany in
2011-2012, when investors bid up the price of
government securities to the point that the price paid
compared to the coupon rate on the security resulted in
a negative yield to maturity. These were temporary
conditions that manifested the flight to quality carried
to its extreme, where investors were so worried about
holding alternative investments, including currency, that
they were willing to pay a premium just to have the
government hold their money.88 If the present RFR in
fact reflects a transient perception of the riskiness of
other investments, then adding the historical ERP to the
current RFR would understate the Discount Rate and
make businesses seem more valuable than they are.
When this occurs, Duff & Phelps normalizes the RFR
used in its calculations of the ERP, such as by using a
trailing 12-month average.89
G. PROBLEMS WITH THE RISK FREE RATE.

In selecting a Risk Free Rate (RFR) for business
valuation purposes, the following issues can arise.
1. Nominal vs. Real Yields. The RFR is the
theoretical rate of return of an investment with zero risk.
As used in finance, the RFR includes expected inflation
(nominal yield).84 However, if TIPS are used to establish
the RFR, that rate would filter out the expectation of
inflation (real yield). The U.S. government did not
introduce TIPS until 1997, so real returns prior to that
date must be calculated by subtracting the inflation rate
from nominal bond yields.85 If the nominal RFR is used,
the valuator should use future cash flows that are
nominal (i.e., reflect future inflation). If the real RFR is
used, then real future cash flows should be used. Roger
J. Grabowski, Cost of Capital Estimation in the Current
Distressed Environment, 4, JOURNAL OF APPLIED
RESEARCH IN ACCOUNTING AND FINANCE 31, 32 (2009)
(Grabowski).86
4. The Flip Side of Fear. In 2011-2012, the RFR

was reduced by panicked flight-to-quality investors
from around the world bidding up the price of U.S.
Treasury securities. This drove the yields down, which
reduced the RFR and thus the Discount Rate used by
business valuators. This would cause businesses to
appear to be more valuable than otherwise. Grabowski,
p. 33. When people are so scared of investment losses
that they flock to government bonds, does that really
mean that risky businesses are worth more? 90 Common
sense would suggest that the same fear that is driving
down the RFR is at the same time driving up the risk
premium for investing in equities (the ERP), and that,
after netting the downward movement of the RFR
against the upward movement of the ERP, the Discount
Rate should be higher now than in a non-fearful
environment. Business valuators who are combining the
current RFR with an historical ERP are not adjusting for
the effect of fear on the current ERP. For further study,
see Roger J.Grabowski, Developing the Cost of Equity
Capital: Risk-Free Rate and ERP During Periods of
Flight to Quality, pp. 17-23.91
2. Risk Free You Say? Another concern is the

impact of the growing awareness that U.S. Treasury
securities are no longer risk free, and perhaps havent
been for some time. Stern, Stewart & Co.s Equity Risk
Measurement Handbook (2001)87 suggests that, since
the early 1970s, long term U.S. government bonds (if
sold prior to maturity) have been positively correlated
with the stock market, suggesting systematic risk if you
do not hold the bond to maturity. Id. at 5. This study
underscores the fact that U.S. Treasury securities are
risk free only if they are held to maturity. Also, on
August 6, 2011, Standard & Poors downgraded U.S.
Treasury securities from AAA to AA+ status, below the
level of Liechtensteins debt. In reality, the RFR doesnt
really exist, because all investments have risk, even U.S.
Treasury securities. Billions of dollars were lost in 2011
and 2012 by investors and money managers, as well as
European banks and a particular American hedge fund,
who ignored the fact that European sovereign debt was
not truly risk free. Time will tell how long it will be
before investors in U.S. Treasuries realize that their
investments will either be defaulted or repaid in
excessively inflated dollars leading to rising interest
rates and a decline in value of unmatured securities.
Realizing that U.S. Treasuries are not risk free calls into
question the practice of using Treasuries as a proxy for
5. Government Manipulation. At various points of

U.S. history, the federal government has manipulated
the interest rate on its Treasury securities so that they do
38
no reflect market forces. This occurred from 1942 to

1951, when the FED was buying U.S. Treasury
securities to pay for World War II and later was
depressing the interest rate to avoid a relapse into
depression. Roger J. Grabowski estimates that this tenyear intervention into the market overstated the ERP by
5% for ten years.92 Government manipulation of the
RFR occurred beginning September 21, 2011, when the
Federal Reserve started artificially depressing long-term
T-bond rates (by swapping short term Treasuries for
long term T-bonds in Operation Twist). As of March,
2012, Treasury yields are near a 70-year low. The
current artificially-depressed yield on Treasury
securities has had the effect of moving investors away
from U.S. Treasuries and into more risky investments
like equities and gold, thus artificially boosting the
prices of stock in the equity markets (as Ben Bernanke
intended) and of precious metals. An artificiallydepressed RFR reduces the Discount Rate used to
discount a businesss future cash flows. A lower
Discount Rate increases the present value of future cash
flows. So an artificially low RFR makes a business
valued using the CAPM or Build Up Method appear to
be more valuable than it would otherwise, for those who
are using the current RFR in arriving at a Discount Rate.
Duff & Phelps said:
current long-term Treasury yield.

6. Selecting the Right Security. The valuator must
select which instruments s/he will take as representing
the RFR. U.S. Treasury securities are as free from risk
as investments can be in the USA, but there are many
Treasury securities to choose from, each with a different
yield to maturity. The yield to maturity on the 3-month
U.S. Treasury note is sometimes used by finance
professors as the Risk Free Rate. This maturity is too
short to serve as a basis for long-term investment
decisions. Some writers use 5-year Treasury notes, and
business valuators frequently use Treasury securities
with a 10-yr. or 20-yr. or 30-yr. maturity for the RFR.
Shorter term securities lower the RFR, since short term
securities are usually on the low end of an upward
sloping Yield Curve. Also, short term rates are more
volatile and more subject to government manipulation.
Ibbotsons SBBI uses the yield on existing Treasury
securities with 20 years to maturity to construct his
RFR. IBBOTSON, SBBI VALUATION YEARBOOK (2011),
p. 55. Duff & Phelps also uses the 20-year yield on U.S.
government bonds.96 Another question is whether
instead to use the TIPS (inflation-protected) yields,
which do not reflect a premium for inflation risk. An
RFR based on TIPS is a real yield, not a nominal
one. As noted above, if a real yield is used for the RFR,
related calculations should be based on real (i.e.,
inflation adjusted) numbers. Finally, a Treasury STRIP
is a security that is purchased at a discount, pays no
interest, and then pays the coupon amount on maturity.
Ibbotson suggests that if the asset being measured will
spin off cash periodically, the Treasury bond should be
used, but if the investment will merely provide a single
payoff at the end of the term, then the Treasury STRIP
should be chosen. IBBOTSON, SBBI VALUATION
YEARBOOK (2011) p. 44.
Because of the impact of the Feds unprecedented

quantitative easing measures on the economy and
financial markets, many of the relationships we
historically held true in finance are no longer
stable or very meaningful.93
In reaching its January 2012 ERP recommendation, Duff
& Phelps used a normalized 20-year yield on U.S.
government bonds of 4.0%. D&P spokesman Jim
Harrington said: Had we used the spot yield-tomaturity of 2.6% as of mid-January, 2012, we would
have arrived at an overall discount rate inappropriately
low vis-a-vis the risks currently facing investors.94
D&Ps normalizing of the RFR has been criticized.
Moore, Elrich & Neal, PA, Thoughts on Duff & Phelps
Normalizing Risk Free Rate.95 Current manipulation of
the RFR does not send an accurate market signal and
should not be allowed to have an untoward effect on the
value of closely-held businesses, since the manipulation
of interest rates is short term while potential buyers of a
business would be considering the long term. For this
reason, business valuators should consider using an
historical average RFR, or a current RFR adjusted to
remove government interference, in preference to the
7. Matching Horizons. The maturity date on the

Treasury security (2, 3, 5, 7, 10, 20, or 30-yr.) used for
the RFR should be matched to the period over which
cash flows will be discounted in the business valuation
at hand. IBBOTSON, SBBI VALUATION YEARBOOK (2011)
p. 44.97 Ibbotson suggests that, in valuing a business as
a going concern, the appropriate yield is that of a long
term Treasury Bond. Id. at 44. Ibbotson uses the yield
on U.S. Treasury securities with 20 years to maturity. Id.
For more precision, each future period being discounted
should be matched to a risk-free security that has the
same maturity date. See Skardziukas, p. 8.
39
Stocks Over the Long Run? Not Likely, RETHINKING THE

EQUITY RISK PREMIUM p. 120.100 Yields are so low now
that this bonanza cannot be repeated. Id. at 120. In the
present environment, the only returns on bonds will be
the interest paid.
8. Compounding. Another choice is whether to use

compounded or simple interest in determining the RFR.
Finance Professor Siegel of Wharton School published
a paper reflecting the RFR since 1802. 98 His numbers
show the differences between the real (inflation
adjusted) returns on bonds and bills, with interest
compounded and with simple interest:
1926-2004
1946-2004
1946-1965
19661981
1982-1999
1982-2004
Compound
Bond
Bill
Simple
Bond Bill
2.25%
1.44
-1.19
-4.17
8.40
8.01
2.77% 0.75
2.04 0.62
-0.95 -0.75
-3.86 -0.13
9.28 2.92
8.74 2.33
0.69%
0.56
-0.84
-0.15
2.91
2.31
H. PROBLEMS WITH THE EQUITY RISK

PREMIUM. The Equity Risk Premium (ERP) is an
essential element of both the CAPM and the Build Up
Method of arriving at a Discount Rate. One study found
that estimating the ERP is the source of the highest rate
of errors in valuing businesses (i.e., calculating the cost
of capital). Wayne Ferson & Dennis Locke, Estimating
the Cost of Capital Through Time: An Analysis of the
Sources of Error, MANAGEMENT SCIENCE pp. 480-500
(April 1998). Another study estimated that different
assessments of the ERP caused the cost of equity to vary
from 2% to 4%. Seth Armitage, THE COST OF CAPITAL:
INTERMEDIATE THEORY, pp. 319-20 (2005), cited in
Skardziukas, p. 32, n. 28.
Id. It is evident that the compounded RFR is lower than

the arithmetic RFR. Since the return on equities is
usually based on the assumption that all dividends
received are reinvested in equities (i.e., compounded),
an arithmetic-based RFR compared with a compounded
return on equity is a mismatch.
In theory, the ERP is the extra return-on-investment

required to lure investors away from the risk free
investment (i.e., U.S. govt securities) and into corporate
stock traded on the NYSE, AMEX, and NASDAQ
exchanges. Under prevailing financial theory, the ERP
is measured by the difference between the currently
expected return on stocks and the currently expected
return on government securities (the difference being
called excess return). In most instances, business
valuators use the historical excess return as a proxy for
the expected future excess return. The attraction of this
assumption is simplicity and low cost, but not accuracy.
9. Historical vs. Current. The question arises

whether to use historical average yields or current yields
on U.S. Treasuries. Finance Professor Jeremy J. Siegel,
at Wharton School, found that the compound annual real
(inflation-adjusted) return on U. S. Treasury bonds from
1802-1998 was 3.5%, while the real return from 19261998 was 2.2%, and the real return from 1946-1998 was
only 1.3%. Jeremy J. Siegel. The Shrinking Equity
Premium: Historical Facts and Future Forecasts, 26
THE JOURNAL OF PORTFOLIO MANAGEMENT 10 (Fall
1999).99 Siegel surmises that bursts of unanticipated
inflation after World War II and in the 1970's reduced
the real return on long-term bonds. However, the yield
on 10 and 20-year TIPS bonds was 4% in August of
1999. Siegel concluded:
An ERP between 5% and 7% is widely used in the

business valuation community.101 However, there are
concerns about the various ways that the ERP is
determined for purposes of valuing closely-held
businesses. Interested persons should express gratitude
to the Research Foundation of the CFA Institute for
publishing, on December 23, 2011, a 154-page grouping
of papers called RETHINKING THE EQUITY RISK
PREMIUM. The grouping includes papers from some of
the brightest stars in the ERP constellation, including
among others Roger G. Ibbotson, Clifford Asness,
Jeremy J. Siegel, and Rajnish Merha.
The market projects real returns on risk-free assets

to be substantially higher in the future than they
have been over most of the [Twentieth] [C]entury.
Id at 12. At the other end of the last inflationary period,
persons who bought government bonds at those
historically high interest rates had capital gains on their
bonds as interest rates fell in the ensuing years. Thus,
over the past 40 years, bond investors have enjoyed
abundant returns. Peng Chen, Will Bonds Outperform
1. The Equity Premium Puzzle. Much ink has been

spilled over the Equity Premium Puzzle, the anomaly
noted in a 1985 article published in the JOURNAL OF
MONETARY ECONMICS by Rajnish Mehra & E. C.
40
Prescott, entitled The Equity Premium: A Puzzle,102

which suggested that, in 20th Century America, the
excess of returns of stocks against government securities
exceeded any reasonable ex ante perception of risk. This
suggests that investors in 20th Century America were
just plain lucky (e.g., we won two World Wars and one
Cold War) to experience high excess returns and that
this history of excess returns overstates the historical ex
ante premium that investors actually required at
different points in the past to invest in equities. Many
explanations have been suggested for the Equity
Premium Puzzle. For example, Wharton Finance
Professor Jeremy Siegel observed that, until the second
half of the Twentieth Century, investors were probably
ignorant of the true risks and returns from holding
stocks and may have underestimated returns and
overestimated the risk of investing in stocks. Jeremy J.
Siegel, Perspectives on the Equity Premium Puzzle, 61
FINANCIAL ANALYSTS JOURNAL 61, 65 (2005). 103
Professor Siegel also suggests that the expansion of taxsheltered plans over the past few decades has
tremendously increased the demand for equities. Id. at
65. Professor Siegel also noted the unexpectedly poor
return on bonds in the 35 years following World War II,
including the period of extreme inflation in the 1980s,
which caused the actual RFR to be lower than expected.
This would have caused the ex post ERP to be higher
than what was expected ex ante. Id. at 65. Professor
Mehra himself recently attributed 2% of the excess ERP
to his understating the Risk Free Rate (RFR) by using Tbills as the proxy for the RFR whereas he now thinks
that 25-year TIPS are a better RFR proxy. Rajnish
Mehra, The Equity Premium Puzzle Revisited,
RETHINKING THE EQUITY RISK PREMIUM p. 150
(2011).104 Making the substitution brings his ERP down
from 6% to about 4%. Id.
explains at least part of the Equity Premium Puzzle.

2. Different Windows Into the Data. One troubling
feature of the ex post approach to determining the ERP
is that the historical ERP varies depending on the time
frame (window) examined. Some studies of the
historical ERP begin in the 1870s, others (e.g., Ibbotson)
in 1926, others in the mid-1950s, or in the 1960s.
Jeremy J. Siegel, Professor of Finance at the Wharton
School of the University of Pennsylvania, published a
paper in 2005 entitled Perspectives on the Equity Risk
Premium.106 Professor Siegel studied historical asset
returns since 1802. He found that the compound annual
real return on equity has averaged 6.82 percent over the
past 203 years. Id. at 62. Here is a table of his results
for the compounded ERP based on long-term
government bonds, using different windows:
ERP
1801-2004
1871-2004
3.31%
3.86%
1802-1870
1871-1925
1926-2004
2.24%
2.89%
4.53%
1946-2004
1946-1965
19661981
1982-1999
1982-2004
5.39%
11.21%
3.81%
5.22%
1.46%
Id. at 62. Professor Siegels article reflects that real

(inflation-adjusted) return on bonds was 2.25% from
1926-2004, but was -4.17 between 1966 and 1981, and
was 8.4% from 1982-1999 and dropped to 8.01% from
1982-2004. Id. at 62. Professor Siegel also points out
that investors could not obtain the indicated returns prior
to the rise of automatic dividend reinvestment and of
index funds, because brokerage commissions for buying
and selling individual stocks were fixed by the stock
exchanges at high levels. Id. at 64.
An interesting explanation for the Equity Premium

Puzzle was suggested by Lungu & Minford (2006),105
who said that many equities are held in retirement plans,
where investors have very long-term investment
horizons. They also suggested that older people can only
sell their stock to younger people. They acknowledged
that Total Return on U.S. equities has been several
multiples of Total Return on U.S. government securities
for most periods in the past 110 yrs. This reflects a
perception of high risk for stockshigher than proved
to be trueor the so-called Equity Premium Puzzle.
They note that the stock market has had dramatic swings
over the last 110 years. They suggest that the fear of low
values at the time of retirement drives up the ERP, and
An article on the Internet commented: "If we do a little

data picking, we can see that long-term Treasury bonds
have outperformed stocks since the summer of 1987,
and come in just behind stocks since late 1980.
Reasonable people can disagree but that certainly
sounds like the long-term to me. This means that you
41
Measurement Handbook (2001),112 explained why it

uses a 50-year history of the ERP in its analysis. It
points to Steven Webers 1997 article, The End of the
Business Cycle, in FOREIGN AFFAIRS, which makes a
strong case for fundamental structural economic and
capital market changes making observations of events in
U.S. history less representative of responses in the
future. Id. at 1. The Handbook notes changes in
globalization and growth, labor mobility, market
sophistication resulting from individuals investing
through managed funds, information and information
technology, agency costs, and government
regulation and policy. Id. at 2. The Handbook says that
the . . . risk of holding equities has generally declined
while, at the same time the risk of investing in
government bonds has increased, thus reducing the
ERP. Id. at 1.
could have sat out the entire stock market over the last
28 years, parked your money in long-term T-bonds and
done just as well as the stock market, which we know
beats the vast majority of fund managers."107 Thus, long
term rates of return on stocks and government securities
can be affected by the beginning and ending points of
the historical time period (window) you select.
Another problem is that the length of the window affects
the validity of the conclusion. Goetzmann and Ibbotson
have written that a very long time series of stationary
returns is required to achieve a high degree of
confidence in the estimate of the Equity Risk
Premium.108 New York University Professor Aswath
Damodaran (2010) wrote that shorter periods have a
higher standard error, as follows:
5 years
10 years
25 years
50 years
80 years
8.94%
6.32%
4.00%
2.83%
2.23%
Roger J. Grabowski, of Duff &Phelps, has written that

the 1926-to-today time period can be divided into two
parts: up to the mid-1950s, and since the mid-1950s.
Grabowski says that after that dividing line the stock
market has been more stable but the bond market has
been more volatile. His review of the data suggests that
the lesser volatility of stocks and the greater volatility of
bonds has reduced the relative risk of stocks versus
bonds, thus reducing the ERP. Grabowski therefore
questions the validity of using the arithmetic average of
one-year returns since 1926 as the basis for estimating
todays ERP.113 Grabowski goes on to say that the
actual return on equity investments exceeded the
anticipated return on equity investments during the
second half of the Twentieth Century, due to factors
(such as an increase in the price-to-earnings ratio) that
will not be repeated. Id. at 14-16. He cites studies that
show a realized risk premium of 6.7% but an actual risk
premium of 4.0 to 5.2%. Id. at 14-15.
Aswath Damodaran Equity Risk Premiums (ERP):

Determinants, Estimation and Implications The 2012
Edition p. 23 (March 2012).109 The Standard Error is
the estimated standard deviation of the sampling
distributions of a statistic. The smaller the standard
error, the more representative the sample is of the entire
population. Some analysts prefer longer time periods
which reduce "statistical noise."110
On the other hand, some analysts prefer a shorter, more
recent time period because of fundamental changes that
have occurred in the economy at various points in time,
or because risk aversion fluctuates over time. Then
again, some analysts believe that the ERP depends on
the economys spot in the business cycle. Some believe
that recent returns are more reflective of current
expectations than older returns. Roger Barad, at
Ibbotson Associates, points out that there is zero
correlation between the ERP from one year to the next.
That means that the ERP is unpredictable based on the
prior years performance. Michael W. Barad, Ibbotsons
Answer.111
Goetzman and Ibbotson noted that part of total returns

of the stock market have come from price-earnings ratio
expansion. This expansion is not predicated to continue
on indefinitely, and should logically be removed from
the expected risk premium. William N. Goetzman and
Roger G. Ibbotson, History and the Equity Risk
Premium p. 11.114 The same point was made by Robert
D. Arnott, in Equity Risk Premium Myths, CFA
Institute's RETHINKING THE EQUITY RISK PREMIUM 8182 (2011).115 In the 85 years of Ibbotson data from 1926
to 2011, stocks delivered a real (after factoring out
inflation) return of 6.6% against a real return of 2.1% for
bonds, or excess earnings of 4.5%. Id. at 81. Much of
3. Is Older Data Relevant? Some hold to the view

that long look-back periods in determining the ERP are
undesirable due to structural and market changes in the
American economy. The worldwide management
consulting firm Stern, Stewart & Co., in its Equity Risk
42
that gain can be attributed to the 1980s and 1990s,

which experienced soaring valuation multiples and
tumbling yields. Id. at 75. Ignoring these soaring
multiples and tumbling yields reduces the ERP to 2% to
3%, according to Arnott. Id. at 78.
1926-2004 4.53
1946-2004 5.39
1946-1965 11.21
19661981 3.81
1982-1999 5.22
1982-2004 1.46
Grinold, Kroner and Siegel wrote that from 1926 to

2010, the U.S. Treasury bond market delivered nominal
(including inflation) compound annual returns of 5.4%,
compared to 9.87% for the U.S. stock market, resulting
in average historical excess earnings of 4.5%. Richard
C. Grinold, Kenneth F. Kroner, & Laurence B. Siegel,
A Supply Model of the Equity Premium, CFA Institute's
RETHINKING THE EQUITY RISK PREMIUM 56 (2011)
("Grinold").116 This calculation was based on the
arithmetic difference between geometric means. The
geometric difference between geometric means was
4.27%. Id. at 56 n. 6. Earnings per share grew at about
4.9% per year (or 1.9% after subtracting inflation). Id. at
56. Grinold wrote that, from year-end 1925 to year-end
2010, the price/earnings ratio of the stock market rose
from 11.3 to 18.5. Id. at 57. He mentions a common
view that this increase can be explained by technological
and financial innovations during the latter Twentieth
Century. Id. at 57. Financial innovations include mutual
funds that give inexperience investors access to active
portfolio management, and the creation of index funds
that allow more investors to diversify more cheaply. Id.
at 57. Grinold finds that the current P/E ratio of 18.5 is
modestly higher than the 1900-2010 average P/E ratio of
15.7, and is lower than the average 1970-2010 P/E ratio
of 18.9. Id. at 66. He projects neither an increase nor a
decrease in the U.S. stock markets P/E ratio over the
next ten years. Id. at 66.
6.09
6.27
10.86
-0.21
10.71
7.16
6.01 8.02
6.35 7.77
12.34 12.14
5.24 1.51
5.03 1.38
1.90 8.32
Id. Professor Siegels data show that the highest ERP is

achieved by using the arithmetic mean of stock returns
less the simple interest yield on short term T-bills. Id. at
63.
Professor Damodoran made the following comparison of
the ERP viewed through shorter look-back periods:
Time Period
1928-2008
1967-2008
1997-2008
geometric
4.29%
2.74%
-7.22%
arithmetic
5.56%
4.09%
-3.68%
Professor Damadoran believes that the geometric mean

better reflects long-term returns, while the arithmetic
mean better reflects the next period's returns. Ibbotsons
tables use the arithmetic mean.
Professor Pablo Fernndez, in Market Risk Premium:
Required, Historical & Expected (Oct. 2004), wrote:
<The geometric average is always equal to or
smaller than the arithmetic average.
<The more variable (volatile) the returns, the
greater the difference between the arithmetic
average and the geometric average.
<The geometric average depends only on the price
level at the beginning and end of the period
studied. The arithmetic average, however, tends to
rise as the period used shortens. For example, the
arithmetic average calculated using monthly
returns is usually greater than the arithmetic
average obtained using annual returns.
<The difference between the geometric averages of
two series is not equal to the geometric average of
the difference. However, the arithmetic average of
the difference between two series is equal to the
difference between the arithmetic averages.118
4. Geometric Versus Arithmetic Mean. The

outcome of the ex post analysis is affected by whether
you use the geometric or the arithmetic mean of returns.
A geometric mean is the compounded annual return over
the estimated period (i.e., assuming dividend
reinvestment), while the arithmetic mean is the simple
average of annual returns over each period. Professor
Siegel of Wharton School published a paper reflecting
the ERP since 1802.117 His numbers show the
differences between the EPR using Geometric versus
Arithmetic averages:
Another cautionary consideration is that the total return

calculated for investments in equities assumes that all
dividends are reinvested in more equities (as with a
dividend reinvestment program). In actuality, portfolio
managers who constantly rebalance their portfolios are
The Equity Risk Premium

Geometric
Arithmetic
Bond
Bill
Bond
Bill
%
%
%
%
43
moving in and out of equities and elderly widows are

often living off of their dividends instead of reinvesting
them. Both factors skew the actual experience of
investors away from the assumptions underlying our
models that assume total dividend reinvestment. A
business valuator could reasonably ask whether a buyer
of a closely-held business would reinvest all of the
profits in the business. If so, a geometric mean of
historical market returns would be more suitable. If not,
then the arithmetic mean would be preferred.
be forced to sell low in the meantime?

(4) If you use the current depressed RFR and high
ERP, your valuation will fluctuate as the RFR and
the ERP fluctuate. (Think of the fluctuations
resulting from the slow-moving drama of shoring
up the Greek national debt).
Damodarans Conclusion: 1 & 2 are internally
inconsistent. 3 is better suited to long-term investors
with staying power. 4 is better suited to short term
investors. He asks: Is your willing buyer likely to be a
#3 or a #4?
Michael W. Barad, of Ibbotson Associates, states Ibbotsons veiw that the ERP to be used in discounting
future cash flows should be calculated using arithmetic
computations. The arithmetic mean takes into account
uncertainty of period-to-period returns. He explains:
The greater the standard deviation for a return series,
the higher the arithmetic mean will be compared to the
geometric mean. This type of period- to-period riskiness
must be accounted for when forecasting. Michael W.
Barad, Ibbotsons Answer.119
7. Survivor Bias. Ibbotson's historical returns are

measured against the S&P 500, which tracks only
surviving companies, not ones that failed. So investors'
historical perceptions of equity risk may have included
the risk of company failure, but companies that failed
were dropped from the stock exchange so that their loss
of capital does not show up in the S&P 500 data. This
may explain part of the Equity Risk Puzzle.
5. Matching Maturities. The ERP calculation should

be matched to the government security that is used to
determine the RFR. For example, if the current yield to
maturity of 10-year bills is used for the RFR, then the
ERP should be determined by historical market returns
in excess of 10-year Treasury bills. Ibbotsons SBBI
VALUATION YEARBOOK uses Treasury bonds with 20year maturities as the indicator of the RFR. IBBOTSON
SBBI VALUATION HANDBOOK (2011) p. 8. So the
current RFR that should be paired with Ibbotsons
historical ERP is the current yield on T-bonds with 20
years to maturity. Skardziukas, p. 8. A valuator who
prefers to use a 10-year T-bill as the RFR will need to
develop his/her own historical ERP as opposed to using
the Ibbotson SBBI VALUATION YEARBOOK ERP.
8. The ERP is Cyclical. Some say that the ERP

cycles inversely with the business cycle, so where you
are in the business cycle affects the ERP. When the
economy is in or near recession, the ERP is high. When
the economy improves the ERP moves downward.
When the economy is at the peak of the business cycle,
the ERP is low.120 Roger J. Grabowski estimates that the
upper and lower boundary of the point-in-time ERP
varies from 3.5% to 6.0% over the entire business
cycle.121
To reflect this cyclicality, the investment advisory firm
of Duff & Phelps (D&P) distinguishes between the
unconditional ERP and the conditional ERP. The
unconditional ERP is the long-term average ERP that
disregards current market conditions. The conditional
ERP reflects current economic conditions. Duff &
Phelps Client Alert (October 17, 2011).122 The objective
of D&Ps unconditional ERP is to develop a range for
the ERP that can be expected for the entire business
cycle. Id. at 4. As of October 17, 2011, D&Ps range for
the unconditional ERP in the U.S.A. was 3.5% to 6.0%.
Id. at 4-5. As of that same date, D&Ps conditional ERP
for the U.S.A. was 6.0%. Id. As of January 14, 2012,
D&P reduced its assessment of the U.S.A. conditional
ERP to 5.5%.123
6. Mismatched Time Frames. Professor Damodaran

says:
(1) If you combine the current RFR with the Ibbotson historical ERP, you are combining a crisis-driven RFR with a good times ERP, thus
overvaluing businesses.
(2) If you combine the historical RFR with the
current crisis-driven ERP, your DR is too high and
you undervalue companies.
(3) If you use historical numbers for both the RFR
and the ERP, you are betting that things will return
to the historical average. But when? And will you
According to Professors Graham and Harvey, based on

a limited number of interviews conducted in connection
44
with the Duke CFO Survey, the CFOs believe that the
risk premium is a longer-term measure of expected
excess returns and best covered by our question on the
expected excess return over the next ten years-rather
than the one-year question. Graham & Harvey, The
Equity Risk Premium in 2010 p. 6 (August 9, 2010).124
governments annual deficit and national debt, the

actuarial insolvency of U.S. government programs like
Social Security and Medicarethe list could go onall
greatly increase systemic risk of the financial system
beyond the levels of the past. This suggests that the
prices of investments may be subjected to more frequent
and more extreme swings than in the past, which could
lower the RFR and raise the ERP in the future.
9. Ex Post Is Not Ex Ante. Shannon Pratt notes that

research by Roger Grabowski and David King suggests
that the historical realized ERP may overestimate the
forward-looking ERP. Pratt, VALUING A BUSINESS 210
(5th ed. 2008).
11. Other Problems. Other problems with the ERP as

it is frequently determined on an ex post basis:
<
Goetzman and Ibbotson commented:

A major conceptual problem with equating the ex
post historical realization of the equity premium
with its ex ante expectation is that history could
simply have turned out better than people
expected.125
<
In an interview given October 10, 2011, Professor Roger

Ibbotson said that he had often dismissed the historical
way of estimating the ERP. This was particularly so in
the early 2000s. However, after the drop in stock prices
as a result of the 28-2009 financial crisis, the Professor
believed that the historical ERP from 1929 to 2010, of
4.4% is not an unreasonable estimate of the premium in
todays market.126
<
10. Increased Systemic Risk. In Modern Portfolio

Theory, Specific Company Risk is diversified away,
leaving the ERP as the measure of overall risk to
investments in equities. This risk is called Systematic
Risk. The events of 2008-2009 have demonstrated the
increased importance of another type of risk, called
Systemic Risk. Systemic Risk is the risk that a shock
to one part of the economy, or to one category of
investments, will spread across the entire economy, or
all investment classes. Securitization of individual debts
into investment vehicles sold worldwide, the
development of derivatives that subject supply-anddemand markets to the pressures of speculation, the
widespread use of leverage to amplify the swings in
investment values, banks that are too big and that have
become more like investment vehicles than financial
intermediaries, the increased ownership of stocks and
commodities through funds that aggregate thousands of
investors, increased investment in index funds that move
in tandem with the market, the U.S.A.s increased
dependence on foreign oil, the size of the U.S.
<
VolatilityExpected rates of return change over

time. When times are bad and fear is high, the rate
of return required to induce an investment in
equities is higher than when times are good. 127
However, value investors like to buy in bad times
because P/E ratios are lower and they like sell
when P/E ratios are at a historical high.
Current expectations are based on recent history,
not distant history. People act on their own
experiences, not that of their parents or
grandparents. Ibbotsons Long-Horizon ERP from
2000 to 2010 was -2.4, meaning equities lost value
during that decade. That is what todays investors
have personally experienced.
Some studies indicate that the Beta for individual
stocks changes over time. The Beta for portfolios
of stocks are more stable but still fluctuate over
time. Wayne Ferson & Dennis Locke, Estimating
the Cost of Capital Through Time: An Analysis of
the Sources of Error, MANAGEMENT SCIENCE pp.
411 (April 1998).128
Retiring baby boomers are wanting to convert
equities to cash, but young workers will not have
the earnings to absorb all the equities being
brought to market. This could cause equity prices
to fall.
12. Recap of Problems with Estimating the ERP.

<
<
<
<
<
45
The ERP is not an observable quantity.

The ERP is not the same for all investors.
The surveys that have been done are not
statistically valid (not truly random samples).
Also, the surveys are unclear about which RFR
respondents are using.
Historical ERP may not equal either past or current
expected rates of return.
Historical ERP depends on the window.
<
<
<
<
<
Historical ERP depends on arithmetic vs.

geometric mean.
The ERP fluctuates. Fluctuations are leveled by
long term averages. But it is unclear that the
present circumstances match the long-term
historical average.
Historical data ignores companies that failed
(survivor basis).
Ibbotson vs. Duff & Phelpsthese two providers
of the historical ERP use differing assumptions.
Analysts predictive ability is unproven (or disproven).
if you dont adjust for risk by using higher

discount rates, how do you adjust for risk or do
you?
Buffett: Well, we adjust by simply trying to buy it
at a big discount from the present value calculated
using the risk-free interest rate. So if interest rates
are 7% and we discount it back at 7% (which
Charlie says I never do anyway which is
correct), then wed require a substantial discount
from that present value figure in order to warrant
buying it.131
In his 2000 Chairmans Letter, Mr. Buffett wrote:
13. What Would Warren Buffett Do? Warren

Buffett, Americas most successful living investor, does
not use the CAPM or Build Up Method. In his 2008
letter to the shareholders of Berkshire Hathaway, Buffett
wrote:
The oracle was Aesop and his enduring, though

somewhat incomplete, investment insight was a
bird in the hand is worth two in the bush. To flesh
out this principle, you must answer only three
questions. How certain are you that there are
indeed birds in the bush? When will they emerge
and how many will there be? What is the risk-free
interest rate (which we consider to be the yield on
long-term U.S. bonds)? If you can answer these
three questions, you will know the maximum value
of the bush and the maximum number of the
birds you now possess that should be offered for it.
And, of course, dont literally think birds. Think
dollars.132
Investors should be skeptical of history-based

models. Constructed by a nerdy-sounding
priesthood using esoteric terms such as beta,
gamma, sigma and the like, these models tend to
look impressive. Too often, though, investors
forget to examine the assumptions behind the
symbols. Our advice: Beware of geeks bearing
formulas.
Warren E. Buffett, Letter to Shareholders of Berkshire
Hathaway, Inc. (2008).129 Instead, Buffett evaluates his
investment opportunities in this way:
What Mr. Buffett is saying is that he doesnt fret over

calculating a precise discount rate based on the risk of
the investment. He ignores the ERP. He discounts
projected future benefits at the RFR, in order to
determine the maximum he would pay for an
investment. If the risk is manageable, and the price is
sufficiently below the maximum, hell buy. To Mr.
Buffett, the arguable precision associated with the Betas,
and the ERP, and the other risk premia, are not
important. Mr. Buffets approach would probably not be
admissible under either the Frye general acceptance test
or under the Daubert reliability test. Does that indicate
a flaw in Mr. Buffetts approach or a problem with our
standards of admissibility?
We dont discount the future cash flows at 9% or

10%; we use the U.S. treasury rate. We try to deal
with things about which we are quite certain. You
cant compensate for risk by using a high discount
rate. [Emphasis added.]130
Mr. Buffetts view that you cant compensate for risk
using a high discount rate contravenes the CAPM and
even MPT generally. What did he mean by that? This
author thinks Mr. Buffett meant that justifying a risky
investment on the ground that it has a higher rate of
return doesnt count for much when the business goes
bust and you lose your money. A classic value
investor, Mr. Buffett never undertakes an investment
where there is a significant risk he will lose money, no
matter how high the projected rate of return might be.
Mr. Buffett also is reported to have said:
14. Is the Game Worth the Candle? In 2000,

Professors Sougiannis and Yaekura published a study of
36,532 firm-observations over a 19-year period,
attempting to measure the accuracy of analysts
earnings projections over one to four-year periods. They
compared projections (i) using the relevant RFR plus an
Shareholder: Following up on that other question
46
ERP of 6% or (ii) using the CAPM with the same RFR

and firm-Beta-adjusted ERP, or (iii) using industryspecific discount rates, or (iv) using a discount rate of
12% for all firms. Interestingly, the study found that
using the fixed 12% discount rate had the best
performance. Theodore Sougiannis and Takashi
Yaekura, The Accuracy and Bias of Equity Values
Inferred From Analysts Earnings Forecasts, p. 5
(2000).133 In second place was the RFR plus an ERP of
6%; in third place was the industry-specific rates; and in
last place were firm specific discount rates. Id. at 11.
Valuations of privately-owned companies fall in this last
category.
start of the period. Skardziukas, pp. 10-11. The effects

of September 11, 2001 on the airlines, or the
deregulation of the electrical industry, are examples of
events that might require a shortening of the estimation
period so as to start the window after such gamechanging events occurred. IBBOTSON SBBI VALUATION
YEARBOOK (2011), p. 71-72.
3. Return Interval. Another factor that can affect the
determination of Beta is the return interval. Information
can be retrieved from the market on an annual, monthly,
weekly, or daily basis, or even throughout the day.
Using shorter return intervals increases the number of
observations available to use in the linear regression, but
it introduces statistical noise in the data, and for
companies whose stock does not trade frequently it
introduces a downward bias in the companys Beta.
Damadoran, APPLIED CORPORATE FINANCE: A USER'S
MANUAL, ch. 4, Beta, p. 4.135 Pratt notes that Betas of
some companies are measured infrequently, perhaps
only a few times a year. The reported Betas are often
several months older than the publication date. Pratt, at
211. Additionally, some Beta providers make their
observations on the last trading day of each week, while
others use the last Friday of the month, etc. Id. at 211.
See generally IBBOTSON SBBI 2011 VALUATION
YEARBOOK , p. 72.
I.
PROBLEMS WITH BETA. The mathematics of
calculating the Beta coefficient of a publicly-traded
company involves performing a linear regression on
historical total returns of the company compared to
historical total returns of the market as a whole. See
Domantas Skardziukas, Practical Approach to
Estimating Cost of Capital p. 9 (Munich Personal
RePEc Archive, October 1, 2010) (Skardziukas). 134
However, the Betas published by different investment
information services vary. One reason for this is that
these services use different inputs to construct Betas.
Another is that these services make different
adjustments to their Beta calculations, in pursuit of
differing conceptions of accuracy.
4. Adjustments to Beta. Another cause of variations

is that various services make different adjustments to
their Beta figures. Some reporting services make the
same adjustment to all Betas, while others adjust Betas
using a variety of aspects particular to the subject
company. Grabowski points out that Bloombergs
adjustments to Beta are not based on specific industry or
company factors, but instead are somewhat arbitrarily
adjusted toward 1 on the assumption that all companies
Betas ultimately converge on market Beta. Roger J.
Grabowski, Problems with Cost of Capital Estimation in
the Current Environment Update p. 13 (Feb. 4, 2009).136
1. Differing Market Indexes. Some Beta reporting

services use as their market proxy the S&P 500; others
use the Value Line Index, or the Russell 1000, or
Russell 2000, or Russell 3000. Pratt, VALUING A
BUSINESS 211 (5th ed. 2008) (Pratt). Ibbotson says that
the choice of the market index to use as a market proxy
does not affect the CAPM result very much, because of
a high correlation between different market indexes.
IBBOTSON SBBI VALUATION YEARBOOK (2011), p. 71.
2. Estimation Period. The length of the estimation
periods used to determine Beta varies among Betaproviding services. For example Bloomberg uses a 2year estimation period, while Standard & Poors, Ibbotson, Merrill Lynch, and Value Line use a 5-year period.
Skardziukas, pp. 10 & 74. Using a longer estimation
period provides more information and thus reduces the
standard error in the regression analysis (thereby
increasing statistical validity), but may bias the results
if the risk characteristics of the company have changed
(e.g., changes in business mix or capital structure) over
time or if the market has significantly repriced since the
5. Unrelated Market Pricing. The Betas of

companies can be skewed by unusual events elsewhere
in the stock market. For example, the inordinate rise in
tech stock prices during the dot-com bubble reduced the
Betas of mature industries until the bubble burst. The
effect continued after the collapse because of the lookback period used in determining Betas. Skardziukas, p.
11; Grabowski, pp. 1 & 10-11.137 In the 2007-2008
financial crisis, the severe drop in value of highlyleveraged companies and financial companies reduced
47
the Betas of companies with low leverage (low debt

ratios). Skardziukas, p. 11; Grabowski, p. 33. Another
complicating factor is that almost one-third of the
money invested in the stock market today is invested
through index funds that are designed to move and down
with the market as a whole. Since the mid-1990's, the
correlation of stocks moving up and down in tandem has
quadrupled. Jason Zweig, Simple Index Funds May be
Complicating the Markets, THE WALL STREET JOURNAL
(Feb. 18-19, 2012), p. B-1.138
The foregoing discussion suggests, that these two issues

can be problematic. Additionally, the main attraction of
the CAPM is the mathematical verifiability of company
Betas, which vanishes when it is applied by analogy to
companies with no observable Betas.
9. Admissibility in Court. The use of Beta in
connection with asset pricing models in determining the
price to pay for acquiring stock is generally accepted,
both for portfolio management and for small business
valuation. This approach would seem to meet the Frye
test of admissibility. See Section III.A. With regard to
Daubert reliability, at first blush parts of Beta
determination seem to meet the five non-exclusive
Daubert factors. See Section III.B. However, some
aspects of Beta determination are subject to variant
approaches, which demonstrates some degree of
subjectivity. The larger concerns about Beta go beyond
the determination of Beta to the underlying validity of
using Beta to quantify the risk of investing. The CAPM
is nothing with Beta, so problems with Beta effect the
validity of the CAPM in the valuation process.
6. High Betas Can Be Good. If a company or

industry is hit by a downturn, and their stock prices drop
dramatically, their Betas will be large and perceived risk
under the CAPM will increase. A value investor,
however, would see the lower price-to-earnings ratios as
an indicator of reduced risk and a greater prospect of
growth, which is a signal to buy. This points out the fact
that, while larger Betas accentuate the lows, larger Betas
also accentuate the highs, and buying a volatile stock at
a low suggests that your potential profit will be higher
on the upside (if you dont lose all your money in the
meantime.) For people who see stock prices as being
cyclical rather than straight line, high Beta stocks that
are at their cyclical low offer more opportunity for profit
than stocks with a Beta of less than 1.
J.
PROBLEMS WITH THE CAPM.
1. Statistical. Because the Capital Asset Pricing

Model, proposed by Sharpe and later Lintner, is
mathematically and statistically-based, both its
assumptions and its accuracy can be tested against
market data. In the 1972 article by Fischer Black,
Michael C. Jensen, and Myron Scholes, The Capital
Asset Pricing Model: Some Empirical Tests,139 the
authors announced their testing of the CAPM against
historical data. Their focus was the usual form of the
CAPM, which they described as saying that the
expected excess return on a security is equal to its level
of systematic risk, , times the expected excess return on
the market portfolio. Id. at 42. They concluded: These
results indicate that the usual form of the asset pricing
model . . . does not provide an accurate description of
the structure of security returns. The tests indicate that
the expected excess returns on high-beta assets are lower
than [the usual form] suggests and that the expected
excess returns on low-beta assets are higher than [the
usual form] suggests. Id. at pp. 3-4. The authors go on
to say that the expected return on an asset is not strictly
proportional to its , and we believe that this evidence,
coupled with that given in Section IV, is sufficiently
strong to warrant rejection of the traditional form of the
model given by [the usual formula]. Id. at 4.
7. Conservatism. Measuring risk by variability from

the mean of all investments is an inherently conservative
approach, since the goal of investing from this
perspective is to do no worse than the mean. The flip
side is that you do no better than the mean. If you do no
better than the mean, then you never make a killing.
Most portfolio managers investing other peoples money
dont strive to make a killing. They expect to keep
their jobs and not get sued by never doing much worse
than the stock market as a whole. This does not suit
everyones risk profile, and it especially probably
doesnt match the risk profile of people who might
invest in small, privately-owned companies.
8. Comparability to Privately-Owned Businesses.
A more fundamental question exists as to whether the
risk captured by Beta can be carried over to a privatelyowned business operating on a much smaller scale than
companies in the S&P 500 Index. Shannon Pratt notes
that the use of the CAPM in valuing a privately-owned
business involves two important assessments with
regard to Beta: (i) what is the correct Beta for the
guideline companies used in the valuation; and (ii) what
is the correct Beta for the subject company? Pratt at 211.
48
Eugene F. Fama, Professor of Finance at the Chicago

Graduate School of Business, and Kenneth R. French,
Professor of Finance at Dartmouth College School of
Business, issued a paper in 2004 examining how well
the CAPM held up to empirical testing. The paper is
entitled The Capital Asset Pricing Model: Theory and
Evidence.140 They report that early empirical tests of the
CAPM focused on three things: (i) whether an assets
expected return correlated with its Beta and not some
other variable; (ii) whether the Beta premium is positive,
meaning that the market portfolios returns exceeded the
expected returns on assets with zero Beta (i.e., had no
correlation with the market); and (iii) whether the return
on uncorrelated assets equaled the RFR (as the SharpLintner model predicted). Id. at 8. Early tests revealed
that estimated Betas for individual investments are
imprecise, creating problems with measurement. Id. at
9. So researchers shifted to testing portfolios of stocks
that they constructed rather than individual investments.
Id. at 9. These tests reflected that the returns on the low
Beta portfolios were too high and the returns on the high
Beta portfolios were too low. Id. at 12. Early tests on the
second and third prongs were favorable. Id. at 15.
However, tests in the 1970s began to show that the
variation of expected return on market investments is
unrelated to market Beta. Id. at 15. Basu showed in 1977
that future returns on companies with high earnings-toprice ratios were higher than the CAPM predicted. Id. at
16. Banz showed in 1981 a size effect, that average
returns on small cap stock were higher than predicted by
the CAPM. Id. at 16. Bhandari in 1988 showed that
highly-leveraged companies (high debt-to-equity ratios)
had returns higher than the CAPM predicted. In 1980
Statman, and then in 1985 Rosenberg, Reid, and Lanstein, showed that stocks with high book-to-market
equity ratios (the ratio of book value of common stock
to its market value) have high returns not predicted by
their Betas. Id. at 16. These studies showed that size, as
well as earnings-to-price, debt-to-equity, and book-tomarket ratios, correlate to returns in a way that is
different from market Betas. Id. at 16. According to
Fama and French, later research showed that Betas do
not suffice to explain expected returns. Id. at 16. This
meant that differences in expected returns are not
completely explained by differences in beta, and that
there must be undiversifiable risks (covariances) in
returns that are not captured by the market return and are
priced separately from market betas.Id. at 19-20. Fama
and French reacted to these problems in 1993 and again
in 1996 by offering a three-factor model for projecting
expected returns: adding to the RFR (i) the beta-adjusted
ERP, (ii) plus the beta-adjusted difference between

returns of small versus large market cap companies, (iii)
plus the beta-adjusted difference between returns of
companies with high versus low book-to-market ratios.
Id. at 20. Fama and French assert that the model
captures much of the variation in average return for
portfolios formed on size, book-to-market equity, and
other price ratios that cause problems for the CAPM.
Id. at 21. Fama and French conclude their 2004 paper:
despite its seductive simplicity, the CAPMs empirical
problems probably invalidate its use in applications. Id.
at 28. Fama and Frenchs three-factor model commands
a chapter in IBBOTSON SBBI VALUATION YEARBOOK
(2011), p. 107-111. Ibbotson does not go so far as to
declare the CAPM dead, but he suggests that
Practitioners are encouraged to use multiple models in
estimating cost of equity to triangulate a more precise
result and add significance to the analysis, and he goes
on to explain how Ibbotson data can be applied to the
three-factor model to estimate a cost of equity. Id. at
109.
Arnott, Hsu and Moore141 have considered problems
with using as a market proxy an index that assigns
weight to individual stocks, based on the stocks market
capitalization divided by the total market cap of all
stocks in the index. They believe that a market capbased index has an unintended bias of emphasizing past
winners and deemphasizing past losers, in what amounts
to a buy high and sell low strategy that violates the
principles of value investing, made prominent by
Graham and Dodd in 1934,142 where the investor uses
Fundamental Analysis 143 to identify and buy
undervalued stocks while identifying and selling
overvalued stocks. See Warren E. Buffetts Letter To the
Shareholders of Berkshire Hathaway Inc. pp. 5-6
(2011),144 in which he describes why he is happiest
when stock prices are down.
William Sharpe himself believes the CAPM is still
valid.145 He defends his equilibrium analysis, and holds
to the view that expected return is proportionate to Beta
of a companys stock relative to the market portfolio. 146
He points out that in his original paper he allowed that
there could be more than one adjusting factorfive, or
twenty, or as many as there are securities in the
market.147 Sharpe says that the theory holds true then
and now, in its key insight:
The key insight of the Capital Asset Pricing Model
is that higher expected returns go with greater risk
49
of doing badly in bad times. Beta is a measure of

that. Securities or asset classes with high betas
tend to do worse in bad times than those with low
betas.148
the upcoming investment period will be like the last.

Markowitz observes:
The truth is that there is no right answer because
we are dealing with the world of uncertainty. This
is also true for the cases of obtaining estimates for
the variances and correlations.
All told, the attractive simplicity of the original CAPM

equation has not withstood the test of time, but after all
it was admittedly an oversimplification of the
complexities of investing in an uncertain world.
However, the validity of the studies that have
discredited the original version of the CAPM have
themselves been challenged. Competing models have
usually just substituted more or different measures for
the role of simple company Beta in the original CAPM
formula, rather than suggesting a new approach to
quantifying risk. Two fundamental limitations may keep
us from resolving the disputes any time soon: Betas may
change over time, and the proxies we use to determine
the return of the market (i.e., S&P 500, etc.) may not
accurately reflect true market return. We may be in a
situation where the predictive ability of the CAPM has
been discredited, but the model cannot be disproved. In
the absence of a credible alternative model, the CAPM
continues to be used by those who wish to employ a
statistical approach to assessing investment risk. Despite
all the criticism, the underlying belief--that meaningful
information about an investment can be gleaned from a
close study of how the investment has varied from some
base line norm--continues to be generally accepted as a
way to quantify the risk of various investments.
Id. at 10. Markowitz goes on:

In reality, as mentioned earlier, if portfolio
managers believe that the inputs based on the
historical performance of an asset class are not a
good reflection of the future expected performance
of that asset class, they may objectively or
subjectively alter the inputs. Different portfolio
managers may have different beliefs, in which case
the alterations will be different.5 The important
thing here is that all alterations have theoretical
justifications, which, in turn, ultimately leads to an
optimal portfolio that closely aligns to the future
expectations of the portfolio manager.
Id. at 11. It appears that Markowitz generally considers
historical inputs to be a reliable starting point, but that
portfolio managers must exercise judgment in using
historical inputs to make projections of future returns.
Many studies suggest that historical returns exceeded
the rates of return that investors in the past actually
required as a condition to buying equitiesthis is the
Equity Premium Puzzle.150 Some say that the actual
excess returns that came to pass do not really reflect the
historical ex ante expected or required rates of return.
Also, historical excess returns of equities over
government bonds have not occurred in the past decade
and there are many reasons to believe that the level of
excess returns in the 1970's and 1980's cannot be
expected recur in the future.
2. The Need to Adjust Inputs. The progenitor of

Modern Portfolio Theory, Harry Markowitz, coauthored a 2002 article entitled The Legacy of Modern
Portfolio Theory,149 on the 50th anniversary of his breakthrough article on portfolio selection. In the 2002 article,
Markowitz and his co-authors noted that people using
Modern Portfolio Theory for asset allocation begin by
selecting a set of asset classes (such as domestic largecap and small-cap stocks, long-term bonds, international
stocks), and then obtain estimates of the returns and
volatilities and correlations of these asset classes using
the historical performance of the indexes representing
these asset classes. Id. at 9. They then use these inputs
in some sort of mean-variance optimization process,
like the CAPM or its modifications, to pick an optimal
portfolio. Id. at 9. Markowitz noted that a number of
different approaches could be used to get the inputs for
the optimization process, of which historical
performance is one. Id. The problem with using
historical performance is that there is no assurance that
3. The CAPM Assumes Stable Inputs. The CAPM

formula is considered to be a single periodestimate,
with a fixed RFR, a fixed ERP, and a fixed Beta, and
thus a fixed Discount Rate. In actuality, all three inputs
can change over time. To calculate an accurate present
value of future cash flows over multiple periods, you
would need to use the appropriate Discount Rate that
applies to each future period.
4. What Market Proxy to Use. Under Modern
Portfolio Theory, the diversification that eliminates
50
Specific Company Risk requires great diversity in the

choices of investments. Under the CAPM, the ERP
derives from, in theory, the entire world of equity
investments. In practice, however, a proxy is used in the
CAPM to represent the available equity investments.
The most common proxy is the S&P 500 Composite
Index. Before 1957, the Index consisted of 90
companies; since March of 1957, the Index has covered
500 companies. Ravi Jagannathan, Ellen McGratten, and
Anna Scherbina, The Declining U.S. Equity Premium,
27 FEDERAL RESERVE BOOK OF MINNEAPOLIS
QUARTERLY REVIEW 3, 5 (2000) (Jagannathan).151
liquid than publicly-owned companies. The main thing

the CAPM has going for it is general acceptance.
General acceptance is the test under Frye, and is one of
the Daubert factors. Markowitzs view expressed above,
that portfolio managers might want to objectively or
subjectively alter the inputs to the standard investment
model, is no doubt a wise investment strategy, but the
impact of making subjective alterations to the standard
inputs, on the admissibility of expert opinions, is not
part of Markowitzs calculus. The problem is that the
greatest acceptance of the CAPM is for portfolio
management, and financial research, not valuing small
privately-owned companies. The U.S. Tax Court has
been hostile to the use of CAPM for valuing small,
privately-owned businesses. In Furman v.
Commissioner, the Tax Court said:
As of year 2000, the market cap for the S&P 500 stocks
constitutes 75% of the market cap of all stocks traded on
major U.S. stock exchanges. Id. at 5. A broader index
can be drawn from data maintained by the Center for
Research and Security Prices (CRSP Index). The CRSP
Index included only NYSE stocks from 1926 to 1972; in
1972, the AMEX was added; and in 1973 the NASDAQ
was added. Id. at 5. In 2000, the CRSP Index contained
over 8,000 stocks. Id. at 5. These stock exchanges
include only publicly-traded stocks, whereas many
corporate stocks are not publicly-traded. The FEDs
Board of Governors (BOG) publishes information on all
stocks held by U.S. residents. This information dates
back to 1946. Id. at 5. According to Jagannathan, the
yields on the BOG stocks ran about 1.5% higher than
the S&P 500 or the CRSP until the 1980s, when the
BOG stock yield was 2.5% higher (12.27% vs. 9.8%); in
the 1990s the BOG stock yield was 3% higher (10.84%
vs. 7.84%). Id. at Table 2.
We do not believe that CAPM and WACC are the

proper analytical tools to value a small, closely
held corporation with little possibility of going
public. CAPM is a financial model intended to
explain the behavior of publicly traded securities
that has been subjected to empirical validation
using only historical data of the two largest U.S.
stock markets. Raabe & Whittenburg, Is the
Capital Asset Pricing Model Appropriate in Tax
Litigation?, Valuation Strategies 1215, 36
(Jan./Feb. 1998); see Brealey & Myers, supra at
166 (citing Fama & MacBeth, Risk, Return and
Equilibrium: Empirical Tests, 81 Journal of
Political Economy 607636 (1973)). Contrary to
the assumptions of CAPM, the market for stock in
a closely held corporation like FIC is not efficient,
is subject to substantial transaction costs, and does
not offer liquidity. Mr. Shelton did not increase
our confidence in his choice of method when he
computed the cost of equity using an
unsubstantiated risk-free rate and risk premium
that were not in conformance with the amounts
stipulated, and when he arbitrarily assigned a beta
to FIC's common stock. Beta, a measure of
systematic risk,FN10 is a function of the
relationship between the return on an individual
security and the return on the market as a whole.
Pratt et al., supra at 166. Betas of public
companies are frequently published, or can be
calculated based on price and earnings data.
Because the calculation of beta requires historical
pricing data, beta can not be calculated for stock in
a closely held corporation. The inability to
calculate beta is a significant shortcoming in the
The Jagannathan study suggests that the S&P 500 Index

and the CRSP data have only a small difference in
yields, but when you include non-publicly traded stock
the overall yield climbs substantially. The extent to
which the higher yield is associated with smaller size
(market cap) or less liquidity is debatable, and is being
debated. See Sections V.K and V.M below. The
Jagannathan study suggests that the need to add a size or
liquidity premium to the CAPM calculation may be a
consequence of using a market proxy that excludes nonpublicly-traded stocks.
5. Admissibility in Court. The CAPM is dependent
on its inputs: the RFR, the ERP, and company or
industry Beta. The problems with each become
problems with the CAPM. Then there is the issue of
whether the CAPM can validly be applied to privatelyowned companies that are smaller and significantly less
51
use of CAPM to value a closely held corporation;

this shortcoming is most accurately resolved by
using the betas of comparable public companies.
Id. at 175. Mr. Shelton's unsubstantiated statement
regarding the standing of BKC in the fast food
industry is hardly a sufficient basis for arriving at
a beta of 1.0 for FIC. Mr. Shelton did not provide
any evidence that he had researched or calculated
the betas of BKC or any other public company. He
seems to have assumed, without further
explanation, that FIC and BKC were comparable
companies for this purpose. Finally, we reject Mr.
Shelton's methodology for estimating FIC's beta,
since it was based on BKC's industry standing and
not on references to the volatility of stock in FIC
in comparison to the market as a whole.FN11 See
Brealey & Myers, supra at G2 (defining beta as a
measure of market risk).
the Tax Court said:

In closely held small companies, the use of a DCF
analysis is also suspect when the discount rate is
calculated by a weighted average cost of capital
(WACC) determination. Such determinations often
include a determination of the cost of capital using
the capital asset pricing model (CAPM). This
Court has recently observed:
We do not believe that CAPM and WACC
are the proper analytical tools to value a
small, closely held corporation with little
possibility of going public. CAPM is a
financial model intended to explain the
behavior of publicly traded securities that has
been subjected to empirical validation using
only historical data of the two largest U.S.
stock markets. * * *
Furman v. Commissioner, T.C. Memo.1998157, 1998

WL 209265, *11 (U.S. Tax Ct. 1998).
[Furman v. Commissioner, T .C. Memo. 1998157.]
In Estate of Gallagher v. C.I.R., T.C. Memo. 2011-148,

2011 WL 2559847, * 14 (U.S. Tax Ct. 2011), the Court
said:
While the viability of a financial technique does not rise

and fall on one court case, or even several court cases,
the trial courts disapproval of the CAPM and WACC in
the foregoing cases is a danger sign.
Mr. May used the capital asset pricing model

formula (CAPM) FN14 to derive a 13.5percent cost
of equity capital for PMG; Mr. Thomson, in
contrast, calculated a 20percent cost of equity
capital under the buildup method.FN15 We agree
with Mr. Thomson that the buildup method is the
appropriate method by which to compute PMG's
cost of equity capital. The special characteristics
associated generally with closely held corporate
stock make CAPM an inappropriate formula to use
in this case.
6. Uncharacteristic Market Behavior. The CAPM

assumes that stock prices reflect the true values of
different investments. We all know this is not true in
instances where the stock market as a whole undergoes
substantial drops or rises that are based on immediate
reactions to unexpected developments or reflect
decisions based on emotions and not reasoning or
analysis. But we also know that the stock market can be
inaccurate because in hindsight we sometimes see that
certain stocks were previously undervalued or
overvalued. Analyst Mark Kritzman has been studying
financial turbulence, which he defines to be a condition
in which asset prices, given their historical patterns of
behavior, behave in an uncharacteristic fashion,
including extreme price moves, decoupling of correlated
assets, and convergence of uncorrelated assets. Mark
Kritzman & Yuanzhan Li, Skulls, Financial Turbulence,
and Risk Management, 67 FINANCIAL ANALYSTS
JOURNAL 30-41 (2010).152 Kritzman suggests that, in
periods of financial turbulence, returns poorly
compensate for risks, and that such periods arrive
unexpectedly and can persist for long periods of time.
Accord, Hoffman v. C.I.R., T.C. Memo. 2001-109, 2001

WL 490399, *13 (U.S. Tax Ct. 2001) (The use of
CAPM is questionable when valuing small, closely held
companies); Estate of Klauss v. C.I.R., T.C. Memo.
2000-191, 2000 WL 823377, *4 (U.S. Tax Ct. 2000);
Estate of Hendrickson v. C.I.R., T.C. Memo. 1999-278,
1999 WL 637089, *16 (U.S. Tax Ct. 1999).
It should be noted that the using the Weighted Average
Cost of Capital (WACC) to determine a Discount Rate
has also been dismissed by virtue of its association with
the CAPM. In Estate of Maggos v. C.I.R., T.C. Memo.
2000-129, 2000 WL 366265, *12 (U.S. Tax Ct. 2000),
52
one of companies that are losing money, have high debt,

or are in bankruptcy. Duff & Phelps, LLC, Risk
Premium Report 2010 (excerpt) pp. 4-5, 28. 154
K. PROBLEMS WITH THE SIZE PREMIUM.

The idea of a Size Premium developed from
observations that the rates of return on small companies
were higher than their Betas predicted under the CAPM.
IBBOTSON SBBI 2011 VALUATION YEARBOOK 87
(IBBOTSON SBBI). The problem with using Ibbotsons
Size Premia in valuing privately-owned businesses is
that, while size premia for public companies can be
determined on an ex post (backward looking) basis, the
size premium for a particular privately-owned company
cannot. Here are other concerns about the Size Premium.
5. Does the Size Premium Double Count? Another

issue, to be considered when using a modified CAPM
(i.e., the CAPM with additional risk premia added) to
value of business, is that the risk associated with small
size is to some extent built into the companys Beta.
Shannon Pratt, VALUING A BUSINESS 212-13 (5th ed.
2008). Ibbotson says that his size premia are adjusted to
exclude the portion of excess returns that is attributable
to company Betas. IBBOTSON SBBI p. 27.
1. Using Market Cap to Measure Size. Using

market cap (market value of equity) as a measure of
size, which Ibbotson does, may be a problem. Market
value is a function not only of size but also of the
Discount Rate. Some companies are small because they
are risky, not risky because they are small. Duff &
Phelps, LLC, Risk Premium Report 2010 (excerpt) pp.
4-5, 28.153 Also, Duff & Phelps (D&P) points out that
even companies with large sales or operating income
can have a small market value of equity if they are
highly-leveraged. Id. at 5. D&P, in its Size Premium
data, uses eight alternate measures of company size,
including fundamental accounting data like sales and
book value. Id. at 4-5.
6. Excess Returns are Cyclical. The excess returns

of small cap stocks over their CAPM expected target is
variable, and large cap stocks have outperformed small
cap stock in four out of the last ten years. IBBOTSON
SBBI, p. 100. There is no way to tell whether we are in
a period that favors large size or small size companies.
7. The January Effect. The returns on small cap
stocks reflect a so-called January effect. The excess
returns of small cap stocks during the other months of
the year are mostly negative, but in January the rates of
return have regularly been high enough to affect the
entire annual return. IBBOTSON SBBI p. 96. The January
effect has not been satisfactorily explained, but for
Ibbotson the inability to explain it does not itself negate
the Size Premium. IBBOTSON SBBI p. 96-97. Professor
Aswath Damodaron points out that the January effect
cannot be explained by size because companies that are
small in January are small the rest of the year as well.
Aswath Damodaran, Equity Risk Premiums (ERP):
Determinants, Estimation and Implications The 2011
Edition p. 33 (Feb. 2011).155
2. The Smallest Public Companies are not

Comparable. The market cap of companies in
Ibbotsons Decile 10z range from a high of $85,670,000
to a low of $1,222,000. IBBOTSON SBBI p. 89 & 196.
The bulk of companies in Decile 10z are still far bigger
than the typical privately-owned company.
3. Beta Reversal. Shannon Pratt notes that research
by Roger Grabowski indicates that the Beta of 10b is
less than the Beta of 10a, which is an anomaly. Shannon
Pratt, VALUING A BUSINESS 212-13 (5th ed. 2008).
8. Circularity. Determining the appropriate Size

Premium for a privately-owned company requires that
you know the value of outstanding equity of the
company, which is a number you cant determine until
after you complete the Build Up of the Discount Rate
using the very Size Premium you are trying to
determine. Ibbotson charitably calls this the circular
challenge. IBBOTSON SBBI p. 91. Duff & Phelps says
that its use of fundamental accounting measures, such as
assets or net income, to measure size reduces the
circularity problem.156
4. Small Caps in Financial Trouble. Another

problem with the Size Premium is that some publiclyowned companies with small market caps are in
financial trouble, so that their shares are trading more
like options. Shannon Pratt, VALUING A BUSINESS 21213 (5th ed. 2008). Ibbotsons does not cleanse its data
to remove financially distressed firms. IBBOTSON SBBI
p. 99. Ibbotson says it has tested the difference and that
the outcomes from cleansed and uncleansed data is
small, and arguably negligible. Id. at 99. Duff &
Phelps separates its data presentation into two portfolios,
one with a track record of profitable performance and
53
9. The Breakpoints Between Deciles. Ibbotsons

Size Premia range from negative 0.38% for Decile 1 to
6.36% for Decile 10. The Size Premia for Decile 10
range from 3.99% for Category 10w to 12.06% for
Category 10z. In moving from Decile 9 to Decile 10, the
Size Premium jumps from 2.94% to 6.36%. IBBOTSON
SBBI p. 196. However, within Decile 10 the Size
Premia are: Category 10w=3.99%; Category
10x=4.96%; Category 10y=9.15%; Category
10z=12.06%. Id. Thus, the Discount Rate can change
dramatically when you cross some Decile or category
breakpoints. And yet changes in the overall stock
market can change the market cap of stocks near a
breakpoint enough to change Deciles or categories, even
when the economics of the company do not
meaningfully change. Ibbotson recognizes the potential
impact of crossing breakpoints, and says there are two
decision paths for the business valuator. The improper
path is to choose the size premium that achieves the
self-serving goal of influencing the enterprise value in
the direction most desired. IBBOTSON SBBI p. 90. The
proper path is to choose the size premium that is
most statistically relevant for your application. Id.
Ibbotson says that choosing the right Size Premium
depends on two factors: how close to a size category
boundary the subject company falls, and how confident
the valuator is in his/her estimate of equity value. Id.
Ibbotson gives as an example a company near the
breakpoint of the 10b category, which is in the middle
of the 10th Decile and toward the bottom of the MicroCap (9th and 10th Deciles combined). Ibbotson would
reject the Micro-cap category as too broad since the
subject firm falls in the lower range of the Micro-cap
category. He would reject the 10b category as being too
narrow because the subject company would barely fall
within that category. So Ibbotson prefers the 10th Decile,
because [w]e can say with confidence that the 10th
decile puts our company among the most peers of
similar size. Id. at 90.
that size is correlated to liquidity, but that liquidity is a

much stronger effect. Id. at 101. See Section V.M.
below. If the Size Premium reflects a lack of liquidity,
then to what extent is an additional liquidity discount
(Discount for Lack of Marketability) appropriate?
10. Size Premia are Historical. The Size Premia are

based on the historical returns of companies. For Ibbotson, they date back to 1926. The concerns regarding the
advisability of using long-range historical figures to
determine the ERP, see Sections V.H.2 & 3, resurface in
connection with the Size Premium.
M. SHOULD THERE BE A LIQUIDITY

PREMIUM? Zhiwu Chen and Roger Ibbotson have
written that liquidity impacts the value of a company.
IBBOTSON SBBI 2011 VALUATION YEARBOOK. p. 101.
Ibbotson defines the liquidity premium as [t]he
excess valuation that a liquid security has relative to an
illiquid security. In other words, illiquid securities are
valued at an illiquidity discount relative to liquid
securities, and consequently illiquid securities have
higher expected returns. IBBOTSON SBBI 2011
VALUATION YEARBOOK, p. 200. While the customary
12. Are There Better Measures of Risk Than Size?

Duff and Phelps suggests that size is not a very good
measure of risk. For example, a large but highlyleveraged company may have a small market cap
because of the amount of its debt, but still be a low risk
company. Duff & Phelps, LLC, Risk Premium Report
2010 (excerpt) p. 30.157 On the other hand, some small
cap companies operate in a geographic area or market
niche that gives it less risk than other companies of
similar size. Id. at 30. Likewise, sales is not a good
measure of risk because companies with similar sales
can have divergent profits. Id. at 30. Perhaps size,
whether based on market cap or otherwise, masks
underlying risks that have not yet been recognized.
L. PROBLEMS WITH THE INDUSTRY RISK
PREMIUM. There are some problems with the Industry
Risk Premium (IRP) published by Ibbotson. First, it is
based on the CAPM, which has conceptual, statistical,
and legal problems of its own. See Section V.J. Also, the
industry categories (SIC codes) contain varying numbers
of companies; some categories have a small number of
companies. Having more companies makes better data.
Also, some companies in the same SIC code category
may not be comparable, and the question arises whether
they should be excluded from the calculation. Also,
most IRPs are negative, and can be used selectively to
lower the Discount Rate which increases the value of the
company being valued. Also, Ibbotsons proxy for the
RFR used in calculating the industry ERP is the yield on
30-day T-bills,158 which is at the low end of the Yield
Curve, resulting in a mismatch when used as part of a
Build Up Method for a long term investment.
11. Size Versus Liquidity Premium? Professor

Ibbotson writes: Captialization is not necessarily the
underlying cause of the higher returns for small
companies. IBBOTSON SBBI p.83. Ibbotson suggests
54
approach is to reduce the value of the entire business by

a liquidity discount, Chen and Ibbotson suggest a
liquidity adjustment can also be made by adding a
premium to the Build Up Method. Id. Ibbotson has
written that (t)he liquidity premium is perhaps as
important as any of the risk premiums. Roger G.
Ibbotson, The Equity Risk Premium, p. 23.159 See
Interview with Roger Ibbotson on August 17, 2010
regarding a liquidity premium.160
appropriateness."41 Defendants accept this burden

and point the Court to cases in which the Court has
deemed a company-specific risk premium to be
appropriate.42 Yet as Vice Chancellor Strine
explained in one of the cases defendants cited,
even though courts may approve the use of these
premiums, "[t]o judges, the company specific risk
premium often seems like the device experts
employ to bring their final results in line with their
clients' objectives, when other valuation inputs fail
to do the trick."43 Proponents of a
company-specific risk premium thus not only bear
a burden of proof but also must overcome some
level of baseline skepticism founded upon judges'
observations over time of how parties have
employed the quantitative tool of a
company-specific risk premium.
In Table 7-16 of the 2011 VALUATION YEARBOOK,

Ibbotson presents a 4x4 table correlating compound
annual returns based on company size versus liquidity.
Id. at 102. The small companies with lowest liquidity
show an 18.17% return compared to the return on the
large companies with highest liquidity which is 9.87%.
Id. at 201. However, the fourth column, which ranks
highly liquid companies based on company size, shows
that the larger highly-liquid companies have a higher
rate of return than the smaller highly-liquid
companiesa result that is contrary to the expectation
that return on smaller companies is higher than the
return on larger companies (which underpins the Size
Premium). Author Robert Comment concludes that the
Ibbotson data evidence a liquidity effect, but that it is
confounded by a reverse size effect, which robs a
liquidity premium of reliability sufficient to meet
Daubert standards. Robert Comment, Business
Valuation, DLOM and Daubert: The Issue of
Redundancy, 29 BUSINESS VALUATION REVIEW pp. 2021 (2011).161
42 See, e.g., Delaware Open MRI Radiology

Assoc. P.A. v. Kessler, 898 A.2d 290, 340-41
(Del. Ch. 2006) (declining to "quibble" with
including a company-specific risk premium, and
ultimately selecting the more conservative of the
two premiums the parties presented); Henke v.
Trilithic Inc., 2005 WL 2899677, at *10 (Del. Ch.
Oct. 28, 2005) (agreeing that an upwards
adjustment to account for company-specific risk
was appropriate); Lane v. Cancer Treatment Ctrs.
Of Am., Inc., 2004 WL 1752847, at *30-31 (Del.
Ch. July 30, 2004) (accepting adjustments for
company-specific risk); ONTI, Inc. v. Integra
Bank, 751 A.2d. 904, 919-20 (Del. Ch. 1999)
(applying a company-specific risk premium yet
reducing the suggested value thereof after finding
that not all risks outlined by valuation experts were
risks specific only to the company).
N. PROBLEMS WITH THE SPECIFIC

COMPANY RISK PREMIUM. The Specific
Company Risk Premium (SCRP) is supposed to reflect
risks of the privately-owned company being valued that
exceed risks associated with publicly-owned companies.
Because these risks are by nature unique to the company
being valued, there is no way to calculate this
component of risk. And yet it must be quantified in
order to arrive at an appropriate Discount Rate. The
SCRP is the epitome of a subjective opinion that would
seem to be anathema to a Daubert analysis.
43 Delaware Open MRI, 898 A.2d at 339.

Consol. C.A. No. 16089-CC, In the Court of Chancery
of the State of Delaware, In re Sunbelt Beverage Corp.
Shareholder Litigation, MEMORANDUM OPINION,
Date Submitted: November 20, 2009, Date Decided:
January 5, 2010, Date Revised: February 15, 2010. 162
Judges are sometimes skeptical about the Specific

Company Risk Premium, as the following passage
indicates:
Ignoring Specific Company Risk is not a good solution

to the problem of subjectivity because the consequence
is that, without the SCRP, the small privately-owned
company is treated as having no greater risk than the
smallest-sized publicly-traded companies, which we
intuitively know is wrong. Since complete objectivity is
In an appraisal action, "the proponent of a

company specific premium bears the burden of
convincing the Court of the premium's
55
not achievable in valuing privately-owned companies,

the subjectivity of a SCRP is unavoidable and it is better
to receive it into evidence and let the fact finder
synthesize into an opinion of value than it is to reject a
SCRP altogether.
the company we are interested in valuing. Such

value characteristics include risk, growth rate,
capital structure, the size and timing of cash flows,
and liquidity. In most cases, only the data for
transactions of public firms are available and the
value characteristics of the public firms are often
quite different than those of the private firms.
Thus, a discount may be applied to account for
these differences in characteristics. The most
obvious difference is the lack of liquidity for stock
in private companies as compared to stock in
public companies. Specifically, stockholders in
public companies typically have a ready market in
which to sell their shares, whereas stockholders in
private companies lack that outlet.
VI. THE MARKET APPROACH. Wikipedia gives a

serviceable definition of the market approach to
business valuation:
The market approach to business valuation is
rooted in the economic principle of competition:
that in a free market the supply and demand forces
will drive the price of business assets to a certain
equilibrium. Buyers would not pay more for the
business, and the sellers will not accept less, than
the price of a comparable business enterprise. It is
similar in many respects to the "comparable sales"
method that is commonly used in real estate
appraisal. The market price of the stocks of
publicly traded companies engaged in the same or
a similar line of business, whose shares are
actively traded in a free and open market, can be a
valid indicator of value when the transactions in
which stocks are traded are sufficiently similar to
permit meaningful comparison.163
John Koeplin & Alan C. Shapiro, The Private Company

Discount, 12 JOURNAL OF APPLIED FINANCE 94 (2007)
(Koeplin).164
Shannon Pratt recognizes two types of market approach:
one involving guideline publicly-traded companies, and
the other involving guideline merged-and-acquired
companies. Shannon Pratt, VALUING A BUSINESS 950
(5th ed. 2008). To that can be added two more
categories: transactions involving comparable privatelyowned companies and prior transactions involving the
subject company.
Yale School of Management Professor Roger Ibbotsons

publication SBBI VALUATION YEARBOOK says this
about the market approach:
A. THE GUIDELINE PUBLIC COMPANY

METHOD. Under the guideline publicly-traded
company method, the business valuator develops
"valuation multiples" based on the prices at which stock
representing minority interests in stock exchange-listed
comparable companies are trading. These multiples
might compare stock price to net sales, gross cash flow,
net cash flow, net income before taxes, net income after
taxes, EBIT, EBITDA, book value, etc. Shannon Pratt,
VALUING A BUSINESS 265 (5th ed. 2008). A popular
multiple is price-to-earnings ratio, which is share price
divided by net earnings per share after taxes. Many
times valuators will compare companies based on EBIT
and EBITDA, to permit a more standardized comparison
between different companies.
Implementation of the market approach using

publicly traded companies typically relies on the
use of financial ratios that compare the stock price
of a company to its various accounting measures
of fundamental data. Many ratios contain stock
price or market value of equity and work well in
the market approach to determining value:
Price to Earnings
Price to Cash Flow
Price to Shareholders' Equity
IBBOTSON SBBI 2011 VALUATION YEARBOOK, p. 18.
Professors John Koeplin and Alan C. Shapiro wrote:
Generally business valuators will derive multiples from

publicly-owned companies in the same industry as the
subject company, because companies in the same
industry are subject to similar macroeconomic forces.
Generally it is safer to use several multipliers as points
of comparison so as to capture different contributions to
Despite the appeal and widespread use of the

comparables approach, its reliability depends on
the ability to identify transactions that display
"value characteristics" that are similar to those of
56
value. The amount of debt that a publicly-traded

company has can affect value. A high level of debt
entails interest expense that reduces net income.
Additionally, companies with high debt are riskier,
independently from their lower net income, because they
are more easily stressed by adverse events. A debt-toequity ratio can be used to focus on the effect of
different debt levels on value. There will usually be a
significant difference in size between the guideline
companies and the privately-owned company being
valued, making the comparisons difficult to maintain.
take-over attempt was announced. These business

valuators have called this price differential a control
premium. From this they reason that ordinary
transactions in the stock exchange, which involve
marketable minority interests in the company, are
trading at a discount from what a controlling interest is
worth. Accordingly, when determining an enterprise
value or valuing a controlling interest of a privatelyowned business based on the Guideline Company
Method, they add to the values indicated by market
multiples a premium in order to bring the marketably
minority interest up to control level. Delaware courts
have accepted this adjustment (sometimes misnamed a
control premium) for purposes of minority dissent
cases. See Doft & Co. v. Travelocity.com, Inc., 2004 WL
1152338, at *5 (Del. Ch. 2004) (Delaware law
recognizes that there is an inherent minority trading
discount in a comparable company analysis because the
[valuation] method depends on comparisons to market
multiples derived from trading information for minority
blocks of the comparable companies. . . . [T]he court,
in appraising the fair value of the equity, must correct
this minority trading discount by adding back a
premium designed to correct it.). Many business
valuators dispute whether this control premium exists,
and do not believe that a control adjustment is
appropriate. See Section VIII.D below.
In Estate of Gallagher v. C.I.R., T.C. Memo. 2011-148,

2011 WL 2559847, *8 (2011), the Tax Court said:
We find that Mr. Thomson improperly relied on
the guideline company method because the four
guideline companies alone were not similar enough to PMG to warrant its application. See, e.g.,
Estate of Hall v. Commissioner, 92 T.C. at 325,
341 (finding that the taxpayer's experts acted
reasonably in selecting six comparable companies
where those companies were involved in similar
businesses as, and occupied similar positions
within those industries as, the subject company);
Estate of Zaiger v. Commissioner, 64 T.C. 927,
935, 945, 1975 WL 3192 (1975) (finding that the
comparable companies the Commissioner's expert
used were not sufficiently comparable because of
differences in product mix and size operations).
Although the McClatchy Co. is arguably of
sufficient similarity to PMG, a single comparable
company is insufficient on which to base the
valuation method. See Estate of Hall v.
Commissioner, supra at 339.
B. THE MERGED-AND-ACQUIRED COMPANY

METHOD. Under the guideline merged-and-acquired
company method, the valuator develops "valuation
multiples" based on the transfers of controlling interests
in publicly traded companies. These multiples are
evidence of perceptions of value of comparable
investments traded in a liquid market. See John Koeplin
& Alan C. Shapiro, The Private Company Discount, 12
JOURNAL OF APPLIED FINANCE 94 (2007) (Koeplin). 165
These multiples are then adjusted to reflect the
differences between the comparables and the privatelyowned company being valued. As with any market
approach, the key to this version of the market approach
is the comparability of the selected exchange-listed
companies to the company being valued. The valuator
must assess the comparability of the companies in terms
of risk, industry, growth rate, capital structure, debt,
size, timing of cash flows, liquidity, etc. See Koeplin. p.
94. Caution is warranted. In many instances the price
paid in a merger/acquisition reflects the synergistic
value realized by the acquiring company when it absorbs
the company being acquired.166 This synergistic value
may not exist for other buyers, and the price paid may
See Heck v. C.I.R., T.C. Memo. 2002-34, 2002 WL

180879, *9 (U.S. Tax Ct. 2002) (As similarity to the
company to be valued decreases, the number of required
comparables increases in order to minimize the risk that
the results will be distorted by attributes unique to each
of the guideline companies. In this case, we find that
Mondavi and Canandaigua were not sufficiently similar
to Korbel to permit the use of a market approach based
upon those two companies alone.).
There is a large dispute over the so-called Implicit
Minority Discount and the Control Adjustment
associated with it. Some business valuators note that
take-overs of publicly-owned companies often occur at
a higher price than prevailed in the market prior to the
57
exceed the price that would be paid by a different

acquiring company or by a hypothetical willing buyer.
Thus, merged-and-acquired transactions may reflect
Investment Value, not Fair Market Value. See
Kleinwort Benson Ltd. v. Silgan Corp., 1995 WL
376911, at *3-4 (Del. Ch. June 15, 1995) (a minority
fair value appraisal action) (The acquiror may value the
target corporation above its going concern value because
of potential synergies or because the acquiror believes
it will manage the target better. This portion of a control
premium cannot be included in the appraisal value of a
corporation because it reflects value arising from the
accomplishment or expectation of the merger.). This
issue is discussed further in Section VIII.C. below.
APPROACH. Chris Mercer (in private conversation)

identifies the following key factors in using comparables
under the market approach:
C. COMPARABLE PRIVATELY-OWNED
COMPANIES. In some instances, there may be sales of
other privately-owned companies that are sufficiently
comparable to the subject company to provide useful
multiples. This could include the sale of franchise
operations, professional practices, and other businesses
that belong to a kind of local, regional, or national
market. Unlike publicly-owned companies, privatelyowned companies may require significant effort to
normalize their financial information, and comparability
may be impaired by circumstances peculiar to the
comparable or its sale. Another problem with privatelyowned company transactions is that reliable information
about such companies and the terms of their sale may be
absent for many or most transactions, which reduces the
representativeness of the private transactions that can be
identified and used as comparables. See Carl Lloyd
Sheeler, Business Valuation, pp. 735-36.167
Husband also argues that the partner's closely held

corporation was evaluated by multiplying its
pretax earnings by seven, and that this particular
formula is properly used in evaluating public
rather than private corporations. The wife's expert,
Mr. Weaver, testified that he inspected figures
published by Standard & Poors for some 5100
public corporations. This witness stated that the
price earnings ratio for publicly traded companies
who manufactured only women's clothing ranged
from 7.5 to 9.4. The witness also testified that he
made no concerted effort to find prices for closely
held corporations, claiming that this information is
not usually available.
<
<
<
<
F. PROBLEMS WITH THE MARKET

APPROACH. The challenges posed by the guideline
public company method are demonstrated in the case of
In re Marriage of Lotz, 120 Cal.App.3d 379, 383-84,
174 Cal.Rptr. 618, 620-21 (Cal. App. 2nd Dist. 1981):
We agree that the price earnings ratio of publicly

traded corporations have little relevance in valuing
a closely held corporation. There are enormous
differences between the two types of corporations.
The sales volume of publicly traded corporations
are much higher than the volume of closely held
corporations. The stock in a publicly traded
corporation has liquidity value because its owners
can sell stock and get money in a matter of days,
whereas the stock in Your Own Things has no
liquidity value. There is less risk in owning stock
in public corporations because they can miss on
two or three lines without being hurt too much.
Finally, the cost to go public is between
$150,000 and $200,000 for legal and accounting
fees. Therefore, there is no substantial support for
the use of the above formula in evaluating a closely held corporation, even considering the attempts
to adjust the formula.
D. PRIOR TRANSACTIONS INVOLVING THE

SUBJECT COMPANY. If there have been prior
transactions involving the sale or purchase of ownership
interests in the subject business, they may be considered
as suitable comparables for the purpose of developing
multiples. These transactions must be recent enough to
still be relevant, and they must reflect arms-length
transactions, and if not for cash they must be adjusted to
a cash sales price. Determining the true sales price may
be complicated by negotiated allocations of part of the
sales price to covenants not to compete and consulting
agreements with the departing owner that may represent
part of the sale price. Also, buy-sell provisions may
cause the transfer price to be not reflective of the true
value of the business interest being sold.
E.
Normalization
Identifying multiples
Selecting which multiples to use
Reconciling disparate indicators of value.
The concerns stated in Lotz were echoed in the case of
CHALLENGES IN USING THE MARKET
58
In re Marriage of Hewitson, 142 Cal.App.3d 874, 88586, 191 Cal.Rptr. 392, 398-400 (Cal. App. 2nd Dist.
1983):
merely holds assets, and does not actively engage in

profitable activities. Revenue Ruling 59-60 says that
adjusted net worth should be accorded greater weight
in valuing the stock of a closely held investment or real
estate holding company . . . than any of the other
customary yardsticks of appraisal, such as earnings and
dividend paying capacity. Rev. Rul. 5960, 5(b). The
U.S. Tax Court said: [P]rimary consideration is
generally given to earnings in valuing the stock of an
operating company, while asset values are generally
accorded the greatest weight in valuing the stock of a
holding company. Estate of Ford v. C.I.R., T.C. Memo.
1993-580, 1993 WL 501917, *5 (U.S. Tax Court 1993).
In determining the value of shares of a closely held

corporation, it is error for a trial court to rely
solely on the opinion of an expert regarding the
value of closely held corporate shares where such
opinion is based on the price earnings ratio of
publicly traded corporations, the so-called
comparable company method. . . . The reason for
such a rule is the unreliability of this method to
determine the value of close corporation shares.
First, it is extremely difficult, if not impossible, to
find sufficiently comparable companies. . . .
Second, closely held corporations possess
characteristics which make them inherently
different from publicly held corporations, with the
primary difference being the lack of marketability,
i.e., liquidity of close corporation stock. . . . FN12
These differences undermine the basic assumption
of the comparable company method that where a
price-earnings ratio of a publicly held corporation
is applied to a supposedly similar close
corporation, it represents a valid determination of
the market value of closely held corporate stock.
[Citations omitted.]
In Sfreddo v. Sfreddo,720 S.E.2d 145, 155-56 (Va. App.

2012), the court said:
In Virginia, the courts look to the intrinsic value
of the property to the parties to measure value for
equitable distribution purposes. . . . Since
intrinsic value must depend on the facts of the
case, we give great weight to the findings of the
trial court. . . . This Court will affirm if the
evidence supports the findings and if the trial court
finds a reasonable evaluation based on proven
methodology and on the application of it to the
particular facts of the case. Id. The intrinsic
value principle applies to stock in a family owned
company. . . . [Citations omitted.]
Lotz was cited favorably in Wallace v. Wallace, 733

S.W.2d 102, 107 (Tenn. App. 1987), where the
Tennessee Court of Appeals said:
We find the trial court properly valued APS

Investments. The evidence before the trial court
was that APS owned a single piece of property and
nothing else besides a bank account. Under these
circumstances, the trial court acted within its
discretion in holding the value of the property and
the bank account constituted the value of APS.
A public corporation's value is most reliably

determined using the market value method. Blasingame v. American Materials, Inc., 654 S.W.2d
659, 666 (Tenn.1983). This method presumes that
there is an established market for the corporation's
stock which will enable the court to arrive at the
price a willing buyer would pay for the stock. The
stock in closely held corporations is rarely traded.
Thus, it is improper to attempt to place a value of
a closely held corporation using the method
generally used to place a value on a public
corporation. Lotz v. Lotz, 120 Cal.App.3d 379,
384, 174 Cal.Rptr. 618, 621 (1981).
Using a net asset approach to value a construction

business was affirmed in Caveney v. Caveney, 960
N.E.2d 331, 338 (Mass. App. 2012).
Even when the primary valuation method is based on the
Income Approach, net asset value can set a floor on the
value of a business on the belief that a business is never
worth less than what the assets can be sold for in an
orderly liquidation of the businesss assets.
VII. NET ASSET APPROACH. The Net Asset

Approach involves calculating the value of a business
based upon the fair market value of the assets of the
business. The net asset approach to valuing a privatelyowned business is most suitable when the business
1. Adjustments to the Balance Sheet. In using the

Net Asset Approach, the business valuator will make
adjustments to the balance sheet of a business such as:
59
adjusting assets from depreciated historical cost to

market value; removing assets that do not contribute to
the cash flow (e.g., a corporate aircraft, season tickets,
hunting lease, vacation condominium); removing excess
cash; adding back the accounts receivable if they are
missing, or reducing accounts receivable for noncollectability; adjusting inventory value from LIFO to
FIFO by adding back the LIFO reserve; adding
intangible assets that are separately recognizable (e.g.,
assembled workforce) or legally enforceable (e.g.,
contracts, confidentiality agreements, covenants not to
compete, trademarks, trade names, etc.); adjusting debt
accruing interest at a rate that is above or below market
rate; subtracting contingent liabilities; etc.
premised on information pertaining to a companys

stock that can easily be sold in a liquid market at little
cost, at some point in the valuation process an
adjustment should be considered for the lesser liquidity
of the privately-held company.
In the courts, marketability arises in two settings:
disputes over whether a marketability discount is
allowable, and if is, the how it is to be determined.
Bajaj, p. 2. Section II.C above examines dissenting
minority shareholder cases, where the prevailing but not
universal view is to exclude a marketability discount
when determining the value of minority owners shares
in a business. Section VIII.E below examines the varied
approaches different states take regarding the
application of a marketability discount in divorce
valuations.
VIII.
DISCOUNT FOR LACK OF
MARKETABILITY, ADJUSTMENT FOR
CONTROL,
AND
CONTROL
P R E M I U M / M I N O R I T Y D I S CO U N T . In
conventional business appraisal practice, once an
enterprise value is determined many business valuators
will apply a marketability discount to reflect difficulties
in selling a privately-owned business. If partial
ownership interests are to be valued, then a premium is
sometimes added to the controlling interests pro-rata
share of enterprise value and a discount is subtracted
from each minority owners pro-rata share of enterprise
value. Some valuators find an implied minority
discount in publicly-traded stock and add a control
premium to the market prices of comparable guideline
companies when valuing a privately-owned company, or
a controlling interest in a privately-owned company.
There are controversies surrounding these discounts and
premium.
On the question of the size of the marketability discount,

author Robert Comment quotes David Laro, a Senior
Judge on the United States Tax Court, as saying:
The discount for lack of marketability is the largest
single issue in most disputes regarding the
valuation of businesses and business interests,
especially in tax matters. This is true both in the
number of cases in which the issue arises and the
magnitude of the differential dollars involved in
the disputes.
Laro and Pratt, BUSINESS VALUATION AND TAXES 283
(2005) (cited in Robert Comment, Business Valuation,
DLOM and Daubert: The Issue of Redundancy, 29
BUSINESS VALUATION REVIEW p. 6 (2011) 169 (R.
Comment). Bajaj et al. list five factors that affect
marketability: (1) uncertain asset value; (2) difficulty for
an outsider to appraise value; (3) the availability of close
substitutes; (4) the duration of restrictions on
transferability; and (5) the quantity of shares being sold.
Bajaj, p. 4.
A. D I S C O U N T
FOR
LACK
OF
MARKETABILITY. It is common knowledge,
supported by studies of the data, that investors value
liquidity, and that where two investments are equal in all
respects except that one can more readily be sold than
the other, investors will pay more for the investment that
is easy to sell. This ease in selling is called
marketability or liquidity. Liquidity can be viewed
as the ability to sell an asset for its fair market value
quickly, easily, and at low cost. Mukesh Bajaj, David J.
Denis, Stephen P. Ferris, & Atulya Sarin, Firm Value
and Marketability Discounts 1 (2002) (Bajaj).168
Stocks in companies that are traded on a national
exchange are the epitome of liquidity. Stock in a
privately-owned company is not. Where a fair-marketvalue valuation of a privately-owned business is
The traditional way to account for the lesser liquidity of

a privately-owned business is to reduce the calculated
value of a company by a certain percentage that is called
the Discount for Lack of Marketablity. The reader
who wishes to embark of a close study of the Discount
for Lack of Marketability (DLOM) is advised to start by
reading the IRS publication, Discount for Lack of
Marketability: Job Aid for IRS Valuation Professionals
(Sept. 25, 2009) <http://www.irs.gov/pub/irs-utl/dlom
.pdf>. The Job Aid is a 115-page overview of the many
60
issues surrounding the DLOM. A case that evaluated

three different approaches to a DLOM is Litman v. U.S.,
78 Fed. Cl. 90, 137-38 (Fed. Cl. 2007).
component of compensation. See Koeplin, p. 95. Other

criticisms include: the limited number of transactions
observed in the studies; the data is too old to be relevant;
the range of values in the studies is too large to provide
guidance; the companies studied didnt pay dividends.
See Z. Christopher Mercer and Travis W. Harms,
BUSINESS VALUATION: AN INTEGRATED THEORY 186188 (2nd ed. 2008) (Mercer & Harms). Additionally,
the purchasers at private offerings are often institutions
like life insurance companies and pension funds, who
likely would not demand a discount just because stock
had a 2-year holding period.171 Many of the restricted
stock studies were done at a time when SEC regulations
required a 2-year holding period for privately-placed
stock. In 1997, the SEC reduced the holding period to
one year,172 and in 2008 it reduced the holding period to
six months.173 As a consequence, the holding period is
now so short that current price differentials are not held
up as a measure of illiquidity. Barklay, Holderness, and
Sheehan argue that the claim that private placement
discounts represent compensation for monitoring
management (the monitoring hypothesis) or for
certifying management's claim that the firm is
undervalued (the certification hypothesis), hold only
for a minority of private placement transactions.
Barclay, Holderness, & Sheehan, Private Placements
and Managerial Entrenchment, 13 JOURNAL OF
CORPORATE FINANCE 461, 463 (2007). 174 They propose
instead an entrenchment hypothesis, where
management places stock with friendly investors who
will not rock the boat. Id. at 462. The authors also
state:
1. Benchmark Studies. Business valuators striving

for greater objectivity in determining a DLOM or
Liquidity Discount often rely on so-called benchmark
studies. The benchmark studies fall into two main
categories: restricted stock studies and studies of initial
public offering (IPO) pricing. Some work has been done
on a third method, where acquisitions of private
companies were compared to acquisitions of similar
publicly-owned companies, in order to derive a measure
of the effect of liquidity.
a. Restricted Stock Studies. Federal Regulations
(presently SEC Rule 144) impose temporary restrictions
on the sale, through the open market, of certain stock in
certain companies for specified periods of time. The
restricted stock of a public company is identical to its
normal stock except for these transfer restrictions.
Restricted shares trade at a discount compared to their
unrestricted counterparts. Revenue Ruling 77-287
attributed this discount to four factors: earnings patterns,
sales (low sales mean largest discounts), trading market
(discounts were greatest where unrestricted counterparts
traded over-the-counter, and less for those traded on the
NYSE), and resale agreements (that affect risk and
liquidity). Since the Specific Company Risk for
restricted and unrestricted shares in the same company
is the same, and the only distinction is being unable to
sell the restricted security prior to the end of the holding
period, many view the discount for restricted stock as a
measure of lack of marketability. Studies have been
done that claim to have measured that difference.
However, those studies have been challenged on the
ground that restricted stock sales often involved large
blocks of stock sold to large institutional investors who
are not representative of the average market participant.
Koeplin, Sarin, and Shapiro, The Private Company
Discount, 12 JOURNAL OF APPLIED CORPORATE FINANCE
94, n. 3 (2000) (Koeplin).170 And use of restricted
stock studies to evidence the value of liquidity has been
criticized on the ground that a variety of other factors
could contribute to the price differential between
restricted and unrestricted shares, including a reward for
the due diligence of the informed investor buying stock
in a private offering, and the fact that investors who buy
restricted stock often commit to providing advisory
services to the company, so that part of the belowmarket price of privately-placed stock may include a
Over the years many have claimed that the

pervasive discounts on private placements reflect,
in large part at least, the apparent unregistered
status and the consequent illiquidity of private
placements (for example, Silber, 1991). Our
analysis of the law and a variety of empirical
regularities, some of which have not yet been
reported in the literature, suggests that this is
unlikely to be the case.
Id. at 482. Bajaj et al. note that one of the studies, the
SEC Study that found an average Liquidity Discount of
23%, had discounts ranging from -15% to 80%, which
is too varied to be useful. Bajaj, p. 9. Bajaj also reviews
the Silber study and finds that the discount varies from
company to company based on different characteristics
of each firm. Bajaj, pp. 9-10.
61
The more current FMV Restricted Stock Study

Database175 carries about 596 restricted study
transactions as of December 31, 2010. One business
valuation group has criticized the database in that: (i) the
companies are not representative of American
businesses; (ii) the companies are mostly unprofitable,
non-dividend-paying risky companies; (iii) data
involving the 2-year holding period is limited and old;
and (iv) the majority of transactions are subject to
registration rights, which increases marketability.
Moore, Elrich & Neal, P.A., FMV Restricted Stock
Study Not So Relevant (Feb. 7, 2012).176
The Tax Court rejected an experts reliance on pre-IPO

studies in McCord v. Commissioner, 120 T.C. 358, P. 25
(2003).
c. Comparing Acquisitions. Koeplin, Sarin and
Shapiro, in The Private Company Discount, 12 JOURNAL
OF APPLIED CORPORATE FINANCE 94, 96 (2000), 182
studied 192 acquisitions of privately-owned companies
between 1984 and 1998. Each privately-owned company
was matched with a publicly-owned company in the
same industry that was acquired in the same year in the
same country. Eighty-four of the acquisitions were of
American companies. Koeplin measured comparability
based on ratios such as price-to-earnings, price-to-sales,
and price-to-book-value. Id. at 98, Table 2. Bajaj et al.
wrote that the private and public companies may be
intrinsically different, and that private sales may have
been complicated by disguising sales price as consulting
arrangements. Bajaj, at 14-15.
b. Pre-IPO Pricing. The pre-IPO studies compare

the prices at which a companys stock is issued privately
versus the price at the time the company offers shares to
the public in an Initial Public Offering (IPO). See Pratt,
VALUING A BUSINESS 434-439 (5th ed. 2008). Some
theorists assume that the price differential is solely
attributable to the greater liquidity of the stock after the
IPO. There are several alternative explanations for the
difference, however: new capital raised through the IPO
may be taken by outside investors as a signal of an
increase in rate of growth of future earnings; funds
raised in the IPO may be used to pay off debt, or at least
reduce the debt-to-equity ratio, thus improving cash
flow and reducing risk; IPO pricing may be partly
emotional and not based on business fundamentals;
picking the date of the IPO as the date of measurement
is somewhat arbitrary, as market prices shortly after
issuance can be substantially higher or lower than on the
date the stock is first offered publicly.177 The pre-IPO
study by John D. Emory, published in 2002 and which
found an average discount of 45%,178 generally did not
involve arms length sales for cash. Koeplin, p. 96. Also
most of the transactions examined were for restricted
options granted to management, not the exchange of
shares for cash. Id. And part of the difference in prices
reflect changes in the market price multiples between
the time of the private transaction and the time of the
IPO. Id. at 96.179 Also, Emorys study made no
adjustment for the length of time between private
offerings and the IPO, thus ignoring the time value of
money.180 Additionally, there is some indication that
private placement offerings are seen as an opportunity
for a company to signal that their marketable securities
are undervalued.181 Bajaj et al. criticized the Emory
study in that: (i) the discounts seem implausibly large;
(ii) pre-IPO sales are to different kinds of people than
IPO sales; (iii) sample bias, in that IPOs that failed to
get to market are excluded from the study. Bajaj, p. 8.
2. Survey-Based Approaches. In the Pepperdine

University Private Capital Markets Project Survey
(PPCMP) for 2011, the business valuators who
responded used the following DLOM, which varied
according to company size as measured by EBITDA:
EBITDA
$250M
$25m
$1m
DLOM for
Controlling
Interest
DLOM for
Minority
Interest
13.98%
16.61%
20.7%
20.29%
23.98%
28.94%
PPCMP (Summer 2011) p. 33, Figure 27. The Business

Appraiser Survey included 271 persons, of whom 39%
were CPAs, 30% were ABV, and 35% were ASA
certified, and 60 respondents had over 10 years in
business appraising. PPCMP (Summer 2011) p. 29.
3. Does the Marketability Discount Apply to a
Controlling Interest? Shannon Pratt suggests that there
are five transactional considerations that controlling
owners face in marketing a privately-owned business
and that support applying a DLOM to a controlling
interest: (i) the uncertain time horizon to complete the
sale; (ii) the cost of preparing for sale and closing the
sale; (iii) risk concerning the eventual sales price; (iv)
noncash or deferred sales proceeds; and (v) the inability
to borrow against the business. Pratt, VALUING A
BUSINESS 441 (5th ed. 2008). Chris Mercer challenges
62
VALUATION REVIEW p. 2 (2011)183 Comment argues

that liquidity and marketability are highly correlated
with company size, and that discounts for lack of
liquidity or marketability are just relabeled versions of
the already ample discounting for lack of size that is
inherent in the core methodologies [such as DCF]. Id.
at 16. Comment concludes that the DLOM is
substantially redundant although not completely
redundant. Id. at 16. Comment criticizes Shannon
Pratts rationale supporting a DLOM. Dr. Pratt
countered with criticisms of Comments criticisms. See
Pratt says Prof. Comments DLOM paper has serious
flaws.184
each of these rationales. Mercer and Harms, pp. 94-98.

As to item (i), the time horizon until closing a sale,
Mercer says that the passage of time would be
detrimental to a controlling interest holder only if the
expected cash flows during the holding period are less
than the discount rate used to discount future cash flows,
which would not occur if the discount rate is accurate.
Mercer and Harms, p. 96. As to item (ii), the costs of
sale, Mercer differentiates between net sales proceeds
and the value of the company, the latter being the
purpose of a business appraisal. Id. at 96. Mercer rejects
item (iii), risk regarding the eventual sale price, because
the discount rates and earnings multiples are taken from
market data that reflect similar uncertainty. Id. at 96-97.
As to item (iv), non-cash consideration, deferred
payments, and special payment terms are just a
reflection that the value being paid is in actuality
different from the agreed-upon sales price. Id. at 97. As
to item (v), the inability to hypothecate the business,
Mercer ties that to the holding period already
considered, which is detrimental only if cash flows
during the holding period leading up to sale are less than
the discount rate, which would not happen if the
discount rate is appropriately chosen. Id. at 97.
5. Is Cost of Later Sale Properly Considered?

Some states allow the court to take into account the cost
of later sale of a marital asset, and some do not. A
typical example would be reducing the value of the
marital home on the ground that a realtors fee and
closing costs will later have to be paid when the house
is sold. If costs of later sale are allowed in a divorce
valuation, then by extension the costs of a later sale of
a privately-held business interest should also be
considered. For states that do not permit consideration
of the costs of a later sale, then some thought needs to
be given to the marketability discount applied to a
business, which often contains a component
representing the cost of selling the business. In that
situation, the hypothetical sale construct of the Fair
Market Value concept, which is an imagined sale at the
time of valuation, raises the question of whether the
costs of an imagined sale can be subtracted from the
value of a business even absent evidence that a real sale
will occur at divorce or shortly after divorce. It would be
inconsistent to say that the cost of selling the family
home cannot be subtracted from value while the cost of
selling the family business can. This raises the larger
question that is not considered enough: in determining
the Fair Market Value of a business for purposes of
divorce, are we measuring the price a hypothetical buyer
would pay, or are we measuring the net proceeds to the
seller out of the sale? This question arises not only in
connection with the cost of sale, but also in connection
with tax that may be due upon sale of the business. See
Section XII.A & D below.
Mercer believes that, if enterprise value is determined

based on expected cash flow, expected growth in that
cash flow, and the risk associated with that cash flow,
then there is no justification for applying an additional
adjustment for lack of liquidity to a controlling interest.
When valuing partial interests, Mercer believes that
controlling interests and minority interests should be
valued based upon their respective shares of enterprise
cash flow, and their respective risks and expected
growth. Id. at 94-95. Mercer believes that the factors
that affect liquidity are built into these assessments.
The Connecticut intermediate appellate court, in
Ferguson v. Ferguson, 1998 WL 851426, *3 (Conn.
Super. 1998), upheld the trial court in a divorce applying
a marketability discount to a 100% ownership interest in
a business, but the appellate court reduced the
marketability discount from 35% to 15%.
4. Double-Counting With Size Premium. Author
Robert Comment argues that Both [liquidity and
marketability] discounts presumptively fail the Daubert
test for reliability due to redundancy with the
commonplace practice of discounting for lack of size.
Robert Comment, Business Valuation, DLOM and
Daubert: The Issue of Redundancy, 29 BUSINESS
B. DISCOUNT FOR LACK OF CONTROL

(MINORITY DISCOUNT). Once the value of a
private company is determined, if partial ownership
interests are being valued then the valuator typically
considers a control premium and a discount for lack of
63
control (DLOC), also called a minority discount. While

these adjustments are widely used, they are subject to
criticism both as to theory and as to application.
many states the powers of a controlling owner are

circumscribed by legal limitations imposed by law, or
by contractual duties owed by the controlling owners to
minority owners. In many situations control is a matter
of degree.
1. Comparability to a Marketable Minority

Interest. The market data relied upon in many business
valuations represents sales of minority interests in
companies with thousands of shareholders. One might
think that applying a DLOC to a privately-owned
business might not be needed when using sales of
marketable minority interests as market indicators for
purposes of valuation. However, publicly-traded
companies are subject to a myriad of constraints that
curb potential abuses by management that might harm
owners of marketable minority interests. Additionally,
publicly-traded companies are run by employees who do
not own a controlling interest and can be fired by the
Board of Directors if there is sufficient dissatisfaction
among shareholders (i.e., minority owners). 185 Finally,
minority owners of public companies can vote with
their feet by selling their shares. If enough minority
owners do that, stock prices will drop, pressuring
management to change its policies. Additionally, most
publicly-owned companies have so many shareholders
that abuses in compensation to top management and the
like are spread so thin that the cost per share is too low
to affect share price. The situation is different for
owners of nonmarketable minority interests in a
privately-owned business. They cannot fire the
managers, they cannot easily sell their stock, and the
effect of abuses by management can be significant at the
individual minority shareholder level. Abuses can only
be rectified by minority oppression lawsuits which are
expensive, lengthy, and difficult to win. However, there
is good reason not to assume that every controlling
owner will abuse every minority owner, and that the
vulnerability of minority status should be evaluated on
a case-by-case basis. If minority owners are actually
being taken advantage of by controlling owners in a
company, a DLOC is easy to justify. In either event, it
is difficult to find objective measures of the amount of
the DLOC.
3. Is a 50% Interest a Minority Interest? An

investor who owns a 50% interest in the company does
not have control, but at the same time the other owners
of the business do not have control either. So is a 50%
interest a minority interest?
In Owens v. Owens, 589 S.E.2d 488, 494 (2003), the
Virginia Supreme Court rejected a contention that a 50%
ownership interest required a DLOC:
When analyzed under the intrinsic value approach,
husband's position as a 50% owner does not
necessarily mandate the use of a minority discount.
Though husband's brother serves as office
manager, no evidence suggested the brother ever
used this position to exercise authoritarian control
of the company or in any way to imperil husband's
equal share of the distributive profits. Nor did any
evidence show that the brothers have ever
disagreed about the strategic direction of the
company or disputed among themselves the
management of the finances.
While the potential for disharmony always exists
between co-owners, so too do legal and equitable
remedies. . . .
*
*
*
In this case, given the absence of any suggestion of
actual oppression relating to husband's alleged
minority status coupled with the availability of
judicial remedies for the most egregious forms of
potential oppression, we reject husband's assertion
that his position as an equal co-owner should
entitle him as a matter of law to a minority
discount for equitable distribution purposes.
4. What if There is No Controlling Interest? In
some businesses there is no controlling ownership
interest. This is true for nearly all publicly-traded
companies and some businesses with two or more
owners. If no single owner is controlling, then it would
take an alignment of minority owners to create a control
group that could oppress the minority. Good relations
between owners may make such factionalization so
improbable that it can safely be ignored for business
2. What Constitutes Control? Control of a business

is the right to make significant decisions about the
business. In a simple situation, owning more than 50%
of the business gives one control. In some businesses
(like for example limited partnerships), however, control
is not determined by ownership percentages, but instead
is governed by organizational documents, agreements
pertaining to voting rights, or is affected by state law. In
64
valuation purposes. On the other hand, if the business

valuator chooses to assume, or is required by law to
assume, a hypothetical sale to a stranger, then this
assumption could lead to a concern that the nonselling
owners might tend to create a faction that would oppress
the new owner. This hypothesis is an artifact of the
willing buyer/willing seller construct, and in a divorce
it could convert a remote possibility into a real
possibility that would diminish value even when no sale
to an outsider will actually occur in connection with the
divorce or soon thereafter.
cash flows that will be realized by minority owners, to

reflect increased risk.
C. CONTROL PREMIUM. In the context of
business valuation, control of a business means that,
because of the interest owned, the shareholder can
unilaterally direct corporate action, select management,
decide the amount of distribution, rearrange the
corporation's capital structure, and decide whether to
liquidate, merge, or sell assets. Theophilos v. C.I.R., 85
F.3d 440, 449 (9th Cir. 1996) (quoting Estate of Newhouse v. Commissioner, 94 T.C. 193, 251-52, 1990 WL
17251 (1990)). A control premium is an adjustment that
is supposed to isolate the extra amount that an investor
would pay to acquire control of a company. The control
premium is the counterpart to the discount for lack of
control (i.e., minority discount). Whatever the value the
minority owners lose due to lack of control should be an
enhancement to the controlling ownership. That
assumes, however, that the controlling interest has the
greater claim to the benefits of ownership. If the
controlling interest does not own the greater part of the
businesss ownership rights, then the control premium
is not the exact counterpart to the minority discount.
5. Where Should Lack of Control be ReflectedIn

Projected Revenues, the Discount Rate, or an Ending
Adjustment? The conventional approach is to treat the
DLOC as a reduction in the minority owners
proportionate share of enterprise value. Some of the
disadvantages of the lack of control could result from
mismanagement that reduces profitability of the
company, and from unfair practices like
overcompensating management, employing
noncontributing family members, and the like. If those
adjustments are backed out, then some of the
disadvantages to minority ownership will be included in
a reduced enterprise value, and would not need to be
included in a separate minority discount. Chris Mercer
suggests constructing a Discounted Cash Flow analysis
of the interim cash flows and terminal value that the
owner of a nonmarketable minority interest can expect
to receive, and using that value instead of making an
adjustment to the minority owners proportionate share
of enterprise value. Mercer & Harms, p. 172-178. In
instances where the cash flows to the minority owners
are equal to the minority owners proportionate share of
enterprise cash flows, then no adjustment is needed to
reflect minority status on account of reduced
participation in company cash flows. Mercer cautions
that the holding period until a minority owner can
realize his terminal value is not subject to the minority
owners control, and may be longer than conventional
assumptions; this could affect the accuracy of a
discounted cash flow analysis that is based upon a
terminal date that is unrealistic in the particular
circumstance. Id at 181-83. Even if current company
cash flows are being shared in proportion to ownership,
there is always a risk that things could change. The
controlling owner could reduce distributions of cash to
all owners, or to minority owners disproportionately.
This risk could be addressed by developing alternate
cash flow projections, or it could be addressed by
increasing the Discount Rate applied to the projected
When an entire business is sold, and the proceeds must

be allocated between the controlling interests and
minority interests, a question arises as to whether the
control premium applies just to 50.1% of the controlling
owners shares, and the balance of that persons
ownership should be valued at a minority interest level.
Where ownership and control are separated, as in a
limited partnership, percentage ownership interests do
not have the attribute of control. In the typical limited
partnership, the general partner (who has total control of
the entity) typically will have 1% or less ownership
interest, and sometimes no ownership interest. In such a
situation, the controlling interest has such a small claim
on the partnerships distributions that even a large
control premium does not add much value to the general
partner interest. In these situations, some thought should
be given to whether the write-down of the collective
value of minority interests should be many times larger
than the write-up in value of the controlling interest.
This is especially true when the minority owners suffer
no detriment from lack of control apart from the reduced
marketability of their minority interests. The wealthdestroying features of isolating and segregating control
from the other benefits of ownership, as in a family
limited partnership, is an important technique for
65
reducing estate and gift taxes that has been accepted by

the IRS and the U.S. Tax Court. The policy
considerations in divorce cases are entirely different,
however, and contrived minority discounts that result
from the fracturing of ownership and control for tax
purposes may need to be evaluated differently if they
impact a property division upon divorce. Special caution
is required for partnerships generally, because the
partnership agreement may allocate distributions
differently from ownership percentages, and may
impose constraints on the controlling interest that erode
the advantages to control that might otherwise exist.
Where a controlling interest in a business is being

valued, and the company is being mismanaged, and a
hypothetical buyer may be expected to improve
profitability or cash flows, there could be a post-sale
benefit to minority owners who will now own an interest
in a more profitable business. To the extent that such
increased value will be shared with minority owners, it
may tend to reduce the control premium that a buyer
who is buying a controlling interest that is less than
100% of the company would be willing to pay. Also,
business valuators normalize earnings and cash flows in
the process of conducting a Discounted Cash Flow
analysis. If enterprise value is determined based on
projections that have eliminated under-performance and
irregular compensation practices, etc., then some care
needs to be taken to align any control premium with
adjustments that were made to revenue and cash flow
projections.
Author Robert Comment, in Business Valuation, DLOM

and Daubert: The Issue of Redundancy, 29 BUSINESS
VALUATION REVIEW p. 29 (2011),186 defined a control
premium as a percentage adjustment thought to be
applicable when the asset being valued is a controlling
block of shares. Comment points out that, where
evidence specific to the company being valued reflects
that the controlling owner has actually captured a private
benefit from control, the net cash flows in a Discounted
Cash Flow analysis can be adjusted to reflect the
respective claims of different owners to the future
benefits, eliminating the need for a final adjustment
based on control (or lack of control). Id. at 30. In some
instances the control premium reflects a buyers
expectation of the degree to which profits can be
increased by implementing operating efficiencies,
eliminating nepotism, and from prospective reductions
in executive or owner/operator compensation. Id. at 30.
Comments says: Buyers (even hypothetical ones), pay
control premiums because their information leads them
to believe that they can deliver more cash flow to
shareholders than what existing management has been
delivering. Id. at 30. Comment notes that premiums are
sometimes paid because of shared synergies and tax
benefits, Id. at 30, but such a premium could reflect
investment value and not Fair Market Values
hypothetical willing buyer and thus would be excluded
from consideration when the standard of value is Fair
Market Value. Thus, Comment divides control
premiums into situations where company-specific
evidence reflects private benefits to the controlling
interest or inefficiencies from the exercise of control,
and situations where no such evidence exists. Id. at 30.
In the latter situation, absent company-specific evidence,
Comment says that what he calls an unconditional
takeover premium is appropriate, which one study
suggests was 1.4%. Id. at 30.
D. IMPLIED MINORITY DISCOUNT;

CONTROL ADJUSTMENT. Very few publiclyowned company transactions involve selling the whole
company. Author Robert Comment suggests that, among
the smallest public companies (with annual sales
revenue of less than $10 million), only 0.8% to 1.0% of
transactions per year are whole-company transactions. 187
When the business valuator is determining the enterprise
value of a privately-owned company, and uses stock
market transactions to develop ratios or multipliers,
these ratios or multipliers are based on a marketable
minority interest. Some argue that the ratios or
multipliers should be adjusted upward when used to
value a controlling interest in a closely-held company.
This rationale was accepted by the Vermont Supreme
Court in the case of In re 75,629 Shares of Common
Stock of Trapp Family Lodge, Inc., 725 A.2d 927, 93435 (Vt. 1999). The Delaware Supreme Court pointed
out, in Rapid-American Corp. v. Harris, 603 A.2d 796,
807 (Del. 1992), that the adjustment made to a
marketable minority interest comparable, in order to
make it fit a controlling interest in the subject company,
is not a control premium in the traditional sense, but is
rather an adjustment to make the appraisal more
accurate. However, this view assumes that shareholders
in publicly-traded companies suffer some detriment due
to their lack of control. This may not be the case. See
Section VIII.C.1 below. See Kleinwort Benson Ltd. v.
Silgan Corp., 1995 WL 376911, *3 (Del. Ch. 1995)
(Paone premised his use of a control premium on the
theory that the market price for publicly traded shares
contains an inherent minority discount. Paone's decision
66
to remove a minority discount imbedded in the market

price does not violate Delaware law. . . . However,
Petitioners cannot add a premium to the market price
unless they prove that publicly traded shares include a
minority discount.). In Salomon Bros. Inc. v. Interstate
Bakeries Corp., 1992 WL 94367, *5-6 (Del. Ch. 1992),
the Chancery Court judge said:
He suggested that such premiums were offered when:

the company being acquired was being mismanaged and
could be operated more efficiently by the acquirer; the
company was well-run but outside investors did not
know this; and where the acquisition was a strategic
acquisition with value to the acquirer that did not exist
for other buyers. Id. at 40. Nath reached five
conclusions: (i) that takeovers represent a tiny portion
of the marketplace and are not representative of the
vast majority of public companies that are used by
appraisers as comparables; (ii) that most takeovers of
public companies are driven by strategic considerations;
(iii) that the range of high and low and even negative
control premiums suggest that the data are unreliable;
(iv) that minority interests are sometimes acquired at a
premium; and (v) that takeover transactions are unique
and time-specific and thus cannot be generalized. Id. at
41-43. Nath argues that prices on the stock exchanges
are close to controlling interest values. Id. Also see the
discussion of fundamental adjustments in Section IV.B.1
above. When market data is taken from mergers or
acquisitions, involving the acquisition of controlling
interests, a control adjustment would have no
application.
The experts' historical earnings valuations,

likewise, present some problems. The most notable
one is Hempstead's use of a 15% adjustment to
compensate for what he called an implicit
minority discount. Hempstead explained that the
adjustment was necessary because his historical
earnings analysis used multipliers that were
designed to reflect the market value of IBC on a
minority interest basis. Therefore, according to
Hempstead, the 15% adjustment factored out the
minority discount inherent in a market value.
I find that the 15% adjustment should not be
considered in the determination of fair value. First,
I am not satisfied from the record in this case that
a market value adjustment to compensate for an
implicit minority discount is a valuation method
that is generally accepted in the financial
community. Weinberger v. UOP, Inc., Del.Supr.,
457 A.2d 701, 713 (1983). Magro testified that he
never heard of the expression implicit minority
discount or the concept as articulated by Hempstead. Moreover, Magro does not agree with the
underlying premise that market value is inevitably
less than intrinsic value. Hempstead testified that
the concept is widely recognized in the financial
community. However, on cross-examination, he
could not recall ever using an implicit minority
discount in any of the many other cases for which
he has provided expert testimony on appraisal.
Thus, there is a real question whether an
adjustment of the sort Hempstead advocates is
recognized and accepted in the financial
community.
The Appraisal Foundation (which issues USPAP) is

examining the advisability of publishing a best practice
standard for the use of control premiums in the mergedand-acquired valuation method. The Foundation
solicited public comment on whether market prices of
marketable minority interests do or do not reflect a
control value, and if not, then how would an adjustment
from minority to control value be measured. The
Foundation suggested that arguments in support of a
control premium include: (i) the fact that premiums are
routinely paid in control acquisitions of public
companies, (ii) something in excess of the current
trading price is needed to acquire the shares necessary to
have control; (iii) the authority to set policy and make
decisions for the business has value, and (iv) American
and International accounting standards acknowledge
control premiums. The Appraisal Foundation says that
arguments against a control premium include: (i) most
companies are operating optimally, which is why they
are not takeover targets; (ii) empirical studies
unavoidably include only successful takeovers; and (iii)
companies that are not taken over have no incremental
value to an acquirer sufficient to justify paying a control
premium. In 2010, Duff & Phelps (D&P) took a public
position that a control premium was appropriate, but that
mergers and acquisitions involve not just one premium,
Eric W. Nath, in his then-controversial but now

respected article Control Premiums and Minority
Interest Discounts in Private Companies, 9 BUSINESS
VALUATION REVIEW 39 (1990),188 presented several
arguments against the use of a control adjustment. He
pointed out that true control premiums, where the
acquiring company paid more than market price to
acquire another company, are infrequent. Id. at 40-41.
67
supply-and-demand. Id. at 3. The Chairman of the

International Association of Consultants, Valuators and
Analysts, headquartered in Ontario, Canada, supports a
control premium where normal trading volumes are
small in relation to total shares outstanding and an
acquiring company must offer a bonus to encourage
reluctant sellers to act. Letter from James P. Catty to
The Appraisal Foundation (Jan. 14, 2010).191 However,
most public companies are well-run, and a premium for
control is not justified by any prospect of increasing
cash flows to the new owner, which means a control
premium is not justified. Id. at 2. Chris Mercer sent a
comment that the supposed control premium reflected
only two different prices for the company (before and
after takeover), and suggested nothing about a control
premium. Chris Mercer email to The Appraisal
Foundation (Jan. 15, 2010), p. 1.192 Based on a review of
29 banking transactions reported in Mergerstat Review
2009, Mercer argued that apparent control premiums
vary so widely that their standard deviation is larger
than the average of the premia, meaning they offer no
value for companies not in the study. Id. pp. 2-3. He
suggests that business appraisers confine themselves to
the economics of the transaction, using conventional
multiples. Id. at 2-3. Ryan A. Gandre, of Stout Risius
Ross, Inc., submitted comments, as well. Letter from
Ryan A. Gandre to The Appraisal Foundation (Jan. 15,
2010).193 Speaking for himself only, he suggested that
the value of control is the ability to benefit from higher
cash flows that result from having control. Id. at 1. He
says that an investor would not pay a premium to
acquire control of a business unless the investor could
receive higher cash flows than existed before the
acquisition. Gandre also believes that market
participants value control or minority cash flows using
the same multiples or discount rates, and that a higher
value exists for a controlling interest only when a
strategic buyer can unlock preferential cash flows due
to control. Id. at 2. Gandre points out that minority
shareholders of publicly-owned companies are not at a
disadvantage against a controlling buyer since they have
equal access to information, enjoy legal protections, and
are equal beneficiaries of cash flow relative to their
ownership interests. Id. at 2. Gandre concludes that
financial control and minority cash flows may converge
for well-run, efficient public companies. Id. at 2.
but three premia: an optimization premium, an

acquisition premium, and company-specific synergies,
of which only the acquisition premium should be
considered. Paul F. Barnes, Letter to The Appraisal
Foundation, Working Group 3 Control Premiums p. 2
(Jan. 15, 2010).189 The optimization premium is [t]he
incremental value related to the improvement or
optimization of the operations of a company on a
stand-alone basis, that can result from improvements
such as: [i]ncreasing cash flows from assets in place;
[i]ncreasing expected growth (higher reinvestment rate
or a higher return on capital on new investments or
both); [l]engthening the period of high growth; [r]educing the cost of financing; or [m]anaging non-operating
assets more effectively. Id. at 2. The acquisition
premium results from [m]arket participant synergies
resulting from the expectation of cash flow
enhancements achievable only through the combination
with another company, which may come in the form
of cost reductions or revenue improvements that would
generally be available to market participants. Id. at 2.
Company-specific (or buyer-specific) synergies are
derived from the expectation of cash flow enhancements
resulting from the combination of the specific buyer
with the target company that are not generally available
to other market participants, but are unique to the
specific buyer such as . . . : unique access to a key raw
material; unique distribution network; unique access to
a certain customer channel; unique technology platform;
among others. Id. at 3. D&P says that the Acquisition
Premium is the only component of a control premium
that should generally be considered. Id. at 3. Since
there is no way to isolate this element other components
of value, D&P suggests that the only means of
quantifying synergies is through an explicit analysis of
expected cash flow savings (or revenue enhancements)
that might be realized should the subject entity be sold
and combined with the existing operations of a market
participant. Id. at 3. Business valuator Eric Nath was
strongly critical of a control adjustment, arguing that
public investors ability to sell the stock at will
eliminates virtually all risk associated with not having
control. Eric Nath, Email to The Appraisal Institute (Jan.
14, 2009), p. 3.190 Nath also believes that the ability of
stockholders to diversify away specific company risks
allows companies to trade close to their intrinsic value,
which is at or near a control value. Id. at p. 4. Nath
attributes the apparent control premium to the fact that
an acquisition temporarily raises the demand for a
companys stock above its equilibrium point prior to the
takeover, and reflects nothing more than ordinary
Shannon Pratt in 1996 endorsed the use of a control

adjustment based on merger and acquisition data, in the
third edition of VALUING A BUSINESS. Pratt announced
a change in his view in 1999, and the fourth edition of
68
VALUING A BUSINESS Pratt cautioned against making a

control adjustment. In the fifth edition, published in
2008, Pratt wrote:
9.06 In short, the task force believes that it is not

appropriate to include a control premium or
acquisition premium in the enterprise value used in
valuing the minority interest securities within the
enterprise, except to the extent that such a
premium reflects improvements to the business
that a market participant would expect under
current ownership.
In general, the only measure of a control premium

is in the public market, when a public company is
taken over. But this measurement includes the
value of synergies as well as the value of control.
Most analysts tend to draw conclusions from these
data that exaggerate the value of control, as
analyzed in this chapter.
Id. at 80.
A comprehensive treatment of the debate over an
Implied Minority Discount and control premia is
contained in Jim Hitchner, 35 FINANCIAL VALUATION
AND LITIGATION EXPERT (Feb./Mar. 2012), pp. 1-14. 195
An extensive analysis of the case law and business
valuation aspects of this question is contained in Gilbert
E. Matthews, Misuse of Control Premiums in Delaware
Appraisals, 27 BUSINESS VALUATION REVIEW 107
(2008).196 Another review of the development of the
Control Premium in Delaware law is William J. Carney
& Mark Heimendinger, Appraising the Nonexistent: The
Delaware Courts Struggle With Control Premiums, 152
UNIV. OF PENNSYLVANIA LAW REVIEW 845 (2003).197 A
review of the law and financial theory that debunks an
Implied Minority Discount is Lawrence A. Hamermesh
& Michael L. Wachter, The Short and Puzzling Life of
the Implicit Minority Discount in Delaware Appraisal
Law, 156 UNIV. OF PENNSYLVANIA LAW REVIEW 1
(2007).198
th
VALUING A BUSINESS p. 393 (5 ed. 2008).

Gary Trugman, in UNDERSTANDING BUSINESS
VALUATION, A PRACTICAL GUIDE TO VALUING SMALL
TO MEDIUM SIZED BUSINESSES (3rd ed. 2008), wrote that
we cannot determine if there is a true premium being
paid for control or if the acquiring company is paying
for synergies that cannot be separately measured. Id. at
411. He noted the difficulty in determining what the
cash equivalent price was for some takeovers. Id.
Roger Ibbotson, in IBBOTSON SBBI 2011 VALUATION
YEARBOOK pp. 61-62, comes out strongly against
making a Control Adjustment based on merger and
acquisition data. He notes that most companies on the
S&p 500 are minority held, but also that the returns
generated on those companies are returns to all equity
holders. He says there is no evidence that higher rates
of return could be earned if these companies were
suddenly acquired by majority shareholders. . . . There
is no distinction between minority owners and
controlling owners. Id. at 61-62. He notes that [m]ost
public companies have no majority or controlling owner.
There is thus no distinction between owners in this
setting. One cannot assume that publicly held companies
with no controlling owner have the same characteristics
as privately held companies with both a controlling
interest owner and a minority interest owner. Id. at 6162. He suggests that adjustments for minority or
controlling interests of privately-owned companies be
made to projected cash flows and not the Discount Rate.
Id.
E. APPLICABILITY OF DISCOUNTS TO
DIVORCE VALUATIONS. Different states take
different approaches to the use of the DLOC and DLOM
in divorce valuations.
The Alabama Court of Appeals, in Grelier v. Grelier,
44 So.3d 1092, 1098 (Ala. App. 2009), reversed a trial
court for applying a marketability and a minority
discount to a closely-held business interest.
The Alaska Supreme Court ruled that a minority
discount was allowed in a divorce, in Hayes v. Hayes,
756 P.2d 298, 300 (Alaska 1988).
The AICPA has published a draft of a WORKING DRAFT-PRACTICE AIDVALUATION OF PRIVATELY HELD
C OMPANY E QUITY S E C UR IT IES I SSUED AS
COMPENSATION (2011).194 After discussion of the issues,
Section 9.06 of the Draft Practice Aid concludes:
The Colorado Supreme Court, in In re Marriage of

Thornhill, 232 P.3d 782, 785 (Colo. 2010), held: we
decline to adopt a per se rule against marketability
discounts and instead hold that trial courts may, in their
discretion, choose to apply such discounts when valuing
an ownership interest in a closely held corporation in a
69
divorce proceeding.
The Missouri Court of Appeals, in Short v. Short, 2011

WL 5057209, *9 (Mo. App. E.D. 2011), held that it was
not error to reject a 42.5% discount for lack of
marketability and minority interest, in that while the
large discount used by the wife's accountant was
appropriate for estate planning interests, it was not
appropriate for determining market value upon divorce,
because the wife would sell her interest in the family
company to a family member, not a third party.
The Connecticut intermediate appellate court, in

Ferguson v. Ferguson, 1998 WL 851426, *3 (Conn.
Super. 1998), held that it was not reversible error for the
trial court to use a marketability discount for a 100%
interest in a privately-owned business in a divorce, but
the appellate court reduced the marketability discount
from 35% to 15%.
The Iowa Supreme Court, in the case of In re Marriage
of Muelhaupt, 439 N.W.2d 656 (Iowa 1989), upheld the
application of minority and marketability discounts for
purposes of divorce (both sides experts applied such
discounts). The court of appeals in In re Marriage of
Hogeland, 448 N.W.2d 678, 681 (Iowa App. 1989),
said: Generally, stock should be valued at market value
if the market value can be ascertained. . . . However,
restrictions on marketability and legal restrictions on
sale can justify a discount of the stock. [Citations
omitted.]
The Montana Supreme Court, in In re Marriage of

Jorgensen, 590 P.2d 606, 610 (1979), ruled that it is
proper to discount the value per share of stock held by
a minority interest holder in closely held corporations
because of the lack of ability of such minority holder to
control salaries, dividends, distribution of profits and the
day-to-day operations of the company.
The New Jersey Court of Appeals, in Brown v. Brown,
792 A.2d 463, 476-78 (N. J. App. 2002) held that it
would be inequitable to apply a marketability discount
to the husbands minority interest in a business, saying:
While there is no ready market for the shares and
consequently no fair market value of Florist, James's
shares in the going concern have value to him and to his
co-owners that does not depend upon a theoretical sale
to an outsider and has not changed as a result of the
divorce complaint or judgment. The court also rejected
applying a minority discount.
The Massachusetts Supreme Court, in Bernier v.

Bernier, 873 N.E.2d 216, 232 (2007), said that a
marketability discount was not warranted in light of the
husband's testimony negating any possibility of a sale.
In the later case of Caveney v. Caveney, 960 N.E.2d
331, 339-40 (Mass. App. 2012), the Massachusetts
Court of Appeals held that it was error to subject the
spouses interest in a closely-held business to a minority
discount:
The New York intermediate appellate court, in Cohen

v. Cohen, 719 N.Y.S.2d 700, 701 (N.Y. App. Div.
2001), said: The discount for lack of marketability
should only be applied to the portion of the value of the
corporation that is attributable to goodwill (Matter of
Whalen v. Whalen's Moving & Stor. Co., 234 A.D.2d
552, 651 N.Y.S.2d 579; see, Matter of Cinque v. Largo
Enters., 212 A.D.2d 608, 622 N.Y.S.2d 735; Matter of
Blake v. Blake Agency, 107 A.D.2d 139, 149, 486
N.Y.S.2d 341). Here, the subject real estate holdings
consist solely of real property. Therefore, the Supreme
Court properly determined not to apply a discount for
lack of marketability as to that portion of the property
subject to equitable distribution.
A minority or lack of control discount

recognizes that controlling shares are worth more
in the market than are noncontrolling shares and
that [m]arketability problems often affect shares
of closely held corporations. . . . FN17 Although
a minority discount was not specifically at issue in
Bernier, the court, through dictum, made clear that
such a discount should not be applied absent
extraordinary circumstances. . . . . Again, as a sale
of the businesses is not presently anticipated, and
in the absence of what we would perceive as
extraordinary circumstances, it was error for the
judge to adopt a valuation for the wife's interest in
the businesses which utilizes a lack of control
discount. [Citations omitted.]
The North Dakota Supreme Court, in Fisher v. Fisher,

568 N.W.2d 728, 731 (N.D. 1997), upheld a trial courts
refusal to apply a minority discount to a minority
interest held by the wife in a corporation where her
husband was the majority shareholder. In Kaiser v.
Kaiser, 555 N.W.2d 585 (N.D.1996), the Supreme Court
The Mississippi Court of Appeals, in Cox v. Cox, 2011

WL 208312 (Miss. App. 2011), ruled that the trial court
properly applied a 50% DLOM in a divorce.
70
upheld an 11.3% discount of a minority interest in a

family-held corporation in a divorce case against a claim
that the discount should have been greater.
While husband did not have a controlling interest

in the Landrum partnership, he was certainly the
most important of the three equal partners because
he had effective control of the corporate tenant
from which the income was derived. There was no
evidence that any interest would be disposed of or
that the partnership would cease to be the way the
family derived income from Lane Press. Reducing
the value of the partnership interest, while husband
received full income from the partnership based on
full valuation, would be unfair to wife.
The Oregon Court of Appeals held, in Barlow and

Barlow, 832 P.2d 455 (Or. App. 1992, rev. denied), that
it was inappropriate for the court in a divorce to apply a
marketability discount to the husbands minority interest
in an entity that owned a small family farm, based on
testimony that partial interests in such entities are not
sold, coupled with testimony that no partial sale was
contemplated. In Matter of Marriage of Tofte, 895 P.2d
1387, 1390-92 (Or. App. 1995), the Court of Appeals
made it clear that a marketability and minority discounts
could be used in a divorce, even absent evidence of an
intended sale, in situations unlike those in Barlowe.
Id. at 190. The Court distinguished two earlier cases

where it had a affirmed the trial courts applying a
minority discount, saying that to apply the discount was
within the trial courts discretion based on the facts of
those cases.
The South Dakota Supreme Court said, in Fausch v.

Fausch, 697 N.W.2d 748, 752-53 (S.D. 2005), that
[w]e have not adopted a bright line rule prohibiting
marketability discounting in a divorce case where a sale
is not contemplated. Whether or not it is fair or
appropriate to apply a discount in a divorce case where
no immediate sale is contemplated is for the trial court
to determine based upon the evidence of the case.
The Virginia Supreme Court, in Owens v. Owens, 589

S.E.2d 488, 494 (2003), said that a minority discount
would be appropriate in a divorce valuation only when
actual suppression of the minority owner had been
shown:
[W]hen the controlling interests in a family
company oppress a minority shareholder or use a
substantial amount of the corporation's assets for
their own personal benefit, the trial court may take
that fact into consideration in determining the
value, if any, of the minority interest. Jacobs v.
Jacobs, 12 Va.App. 977, 979, 406 S.E.2d 669, 671
(1991). But when no evidence suggests that the
stock should be discounted because it represented
a minority holding, Bosserman, 9 Va.App. at 9,
384 S.E.2d at 110, the trial court should give the
stock its proportionate value.
The Tennessee Court of Appeals, in Anderson v.

Anderson, 2006 WL 2535393, *4 (Tenn. App. 2006),
reversed a trial court for applying a minority discount to
a privately-owned company when no sale was ordered
and there is no indication in the record that the husband
has any intention of selling his minority stock.
The Utah Court of Appeals, in Morgan v. Morgan, 854
P.2d 559, 565-66 (Utah App. 1993), held that a trial
court did not err by failing to apply a minority discount
in a divorce, where the partnership agreement said that
a withdrawing partner would receive fair market value
for his interest. Accord, Weston v. Weston, 773 P.2d
408, 410 (Utah App. 1989) (not reversible error to reject
minority discount when one appraiser applied the
discount and the other did not).
The Washington Court of Appeals, in Baltrusis v.

Baltrusis, 113 Wash. App. 1037, 2002 WL 31058365
(Wash. App. 2002) (unpublished opinion), held that the
trial court did not err in refusing to apply a minority
discount when ordering the wife to purchase the
husbands shares in a company controlled by wifes
family. The court analogized the husbands position to
that of a dissenting shareholder.
The Vermont Supreme Court in Drumheller v.

Drumheller, 972 A.2d 176, 190 (Vt. 2009), upheld the
trial courts decision not to apply a minority discount to
the husbands one-third ownership interest in a
partnership that held land and a building rented to a
captive business. The husbands partners were his two
brothers. The Court said:
The Wisconsin Court of Appeals, in Arneson v. Arneson, 355 N.W.2d 16 (Wis. App. 1984), upheld the trial
courts application of a 25% combined minority and
marketability discount to a husbands one-third interest
71
in a family business.
was not valuing husband's contractual withdrawal

rights, the trial court was not precluded from using
the stock purchase agreementwhich is an arm's
length buy-out agreementto determine the
community interest in the business. In assessing
whether to use a formula set forth in a buy-sell
agreement, the trial court should consider (1) the
proximity of the date of the agreement to the date
of separation to ensure that the agreement was not
entered into in contemplation of marital
dissolution; (2) the existence of an independent
motive for entering into the buy-sell agreement,
such as a desire to protect all partners against the
effect of a partnership dissolution; and (3) whether
the value resulting from the agreement's purchase
price formula is similar to the value produced by
other approaches.
The Wyoming Supreme Court, in Cross v. Cross, 586

P.2d 547, 549 (Wyo. 1978), held that it was proper to
apply a minority discount to the valuation of a family
owned corporate ranching business in a divorce.
IX. BUY-SELL AGREEMENTS AND TRANSFER
RESTRICTIONS. Different states have different rules
regarding the impact of buy-sell agreements and
restrictions on transfer of ownership, when the issue
arises in a divorce.
Arizona. In Mitchell v. Mitchell, 732 P.2d 208, 212-12
(Ariz. 1987), the Supreme Court said: We believe the
better approach is to consider the terms of the
partnership agreement as one factor in the determination
of the value of the community interest in goodwill
without treating the agreement as conclusive. In re
Marriage of Slater, 100 Cal.App.3d at 246-47, 160
Cal.Rptr. at 689; In re Marriage of Fonstein, 131
Cal.Rptr. at 877, 552 P.2d at 1173; Weaver v. Weaver,
72 N.C.App. 409, 324 S.E.2d 915 (N.C. App.1985).
This approach recognizes that partnership agreements
are designed to deal with particular aspects of the
business, and simply do not address the considerations
involved in valuation for a marital dissolution. Clauses
which establish value of assets between partners may be
only minimally relevant when a partner's business
continues but the partner's marriage ends.
Colorado. In In re Marriage of Keyser, 820 P.2d 1194,

1196-97 (Colo. App. 1991), the court said:
In a majority of jurisdictions, the price fixed in a
partnership or corporate buy-sell agreement is not
considered binding for equitable distribution
purposes when the other spouse did not consent to
or was not otherwise bound by its terms. . . .
Instead, it is to be weighed along with other factors
in evaluating the asset. See, e.g., Bettinger v.
Bettinger, 183 W.Va. 528, 396 S.E.2d 709 (1990).
*
*
*
Some courts hold that buy-sell provisions
presumptively control value, see, e.g., Stern v.
Stern, 66 N.J. 340, 331 A.2d 257 (1975), while a
small minority regard the value specified in the
agreement as controlling. See, e.g., Hertz v. Hertz,
99 N.M. 320, 657 P.2d 1169 (1983).
Arkansas. In Cole v. Cole, 110 S.W.3d 310, 316 (Ark.

App. 2003), the court reversed a trial judge for setting
the value of a business at the figure set in a buy-sell
agreement, without independently determining a fair
market value for the interest. The court noted that
although the husband could sell his shares only at the
buy-sell price, he was not required by the divorce court
to sell his shares and he would continue to enjoy the
benefits of ownership.
We believe that the majority rule provides the

most reasonable approach. The price, or pricing
formula, fixed in a buy-sell agreement is not
facially dispositive, but must be considered in light
of its provisions and all of the circumstances
pertinent to the agreement. See Rev. Rul. 5960,
8, 19591 C.B. 237; see generally 2 J.P. McCahey,
Valuation & Distribution of Marital Property,
22.08[2][b] (1991).
California. In the case of In re Marriage of Nichols, 27

Cal.App.4th 661, 672, 33 Cal. Rptr.2d 13, 19 (1994), the
court of appeals said:
Wife argues the court erred in using the stock
purchase agreement to value husband's shareholder
interest because the agreement merely measures a
shareholder's contractual withdrawal rights and it
was undisputed that husband was not withdrawing
from McDonough. We disagree. Even though it
Accordingly, we hold that the trial court could

independently value goodwill notwithstanding that
it was excluded from the shareholders' buy-sell
agreement. [Some citations omitted.]
72
Florida. In Moebus v. Moebus, 529 So.2d 1163, 1165

(Fla. App. 1988), the court of appeals said:
ownership documents. Indeed, the Indiana Court of

Appeals in Porter v. Porter, 526 N.E.2d 219 (Ind. Ct.
App.1998), disapproved on other grounds in Yoon, 711
N.E.2d at 1269, specifically confirmed that a partnership
agreement's treatment of enterprise goodwill is not
dispositive of the issue whether the enterprise goodwill
is a marital asset for dissolution purposes. Id. at 223
(citing Poore v. Poore, 75 N.C.App. 414, 420; 331
S.E.2d 266, 270 (1985)) (rejecting minority rule from
other jurisdictions that enterprise goodwill is not a
marital asset). In Nill v. Nill, 584 N.E.2d 602, 609 (Ind.
App. 1992), the court of appeals endorsed the rule that
a buy-sell agreement is not binding on the court, but it
may be considered in light of all the circumstances and
its provisions.
Even if we were to consider goodwill of a

professional business as an asset for purposes of
dissolution, it would not be applicable in the case
sub judice where the actual evidence introduced at
trial shows that in this community goodwill is not
taken into consideration in the sale of such a
specialized practice. This position is buttressed by
the stockholder's agreement covering the husband's
business, which specifically states that goodwill is
not to be considered in valuing the P.A. We
recognize that the agreement is not binding upon
the wife, but it is permissable evidence as to how
the principals to the agreement treated goodwill
and is properly considered in determining the
question.
Iowa. In the divorce case of In Re Marriage of Moffatt,

279 N.W.2d 15, 18 (Iowa 1979), the court considered a
buy-sell restriction that gave the company a right to
purchase the wifes shares at a set price. However, that
price had not been updated for three years. Also, the
option was not exercised when wifes parents gifted the
stock to wife and her sister. Also, wife and her sister
were equal owners, so that wife would have to concur
for the option to be exercised. The Supreme Court said:
We conclude that the 1975 option price is merely one
factor to be considered in determining the value of
Lynn's 1978 interest in the Moffatt Corporation and is
not determinative. In In re Marriage of Hogeland, 448
N.W.2d 678, 681, (Iowa App. 1989), the court said:
Generally, stock should be valued at market value if the
market value can be ascertained. . . . However,
restrictions on marketability and legal restrictions on
sale can justify a discount of the stock. . . . The Iowa
court has recognized the value of stock in a dissolution
is not necessarily decided by a value fixed in a stock
redemption agreement where there is a finding that as a
practical matter, the spouse owning the stock is not
limited to the option price. . . . In such a case, the stock
option price is one factor to be considered in
determining the value of the interest. . . . Unlike the
stock in Moffatt, we find it is probable John will be
required to sell the stock at the stock option price.
Georgia. In Barton v. Barton, 639 S.E.2d 481, 482 (Ga.

2007), the Georgia Supreme Court said:
We recognize that a minority of jurisdictions hold
that in a divorce case the non-shareholder spouse
should be bound by the shareholder spouse's
valuation agreement. Hertz v. Hertz, supra. See
also McDiarmid v. McDiarmid, 649 A.2d 810
(D.C. 994). However, a clear majority of courts
hold that the value established in the buy-sell
agreement of a closely-held corporation, not
signed by the non-shareholder spouse, is not
binding on the non-shareholder spouse but is
considered, along with other factors, in valuing the
interest of the shareholder spouse. Cole v. Cole,
82 Ark.App. 47, 110 S.W.3d 310, 314 (2003). See
also Bettinger v. Bettinger, 183 W.Va. 528, 396
S.E.2d 709, 714, 715 (1990), and cases cited
therein. The rationale for the majority rule is
simple-the buy-sell price in a closely-held
corporation can be manipulated and does not
necessarily reflect true market value. Bettinger v.
Bettinger, supra; Bosserman v. Bosserman, 9
Va.App. 1, 384 S.E.2d 104, 108 (1989). In our
view, the majority rule is more sound and it was
applied properly in this case.
Minnesota. In Rogers v. Rogers, 296 N.W.2d 849, 854

(Minn. 1980), the Minnesota Supreme Court said:
Indiana. The Indiana Superior Court, in Bobrow v.

Bobrow, 2002 WL 32001420, *20 (Ind. Super. 2002),
said: There is no support in Yoon for the proposition
that the inclusion of a business's enterprise goodwill in
the marital estate is governed by the business's
We also believe that the buy-sell agreement, while

not dispositive as to value, should be considered in
determining the form of the award. Although, as
respondent points out, it is speculative that
73
appellant might die or become disabled before he

realizes the full value of his interest in RFA, it
would seem unfair to award respondent a fixed
amount based upon the most optimistic appraisal
of the circumstances. It would be more
appropriate, we believe, to make a present award
to respondent of her share of the $254,000
purchase price set by the buy-sell agreement,
which represents the minimum appellant will
realize on his stock.[FN5] The decree could then
provide for a future adjustment in the award to
augment respondent's share if appellant lives out
his expected working life, or if he sells RFA or
modifies the buy-sell agreement.[FN6] Finally, the
trial court is not precluded from reconsidering the
award of alimony after re-evaluating the property
settlement.
sell agreement as a preeminent factor in valuing the

husbands interest in a business, saying: [b]ecause the
substantive rights of the shareholders consist only of
those specified in the Agreement, the trial court
committed no error by viewing it as the preeminent
factor in estimating the fair market value of those
rights.
New Mexico. The New Mexico Supreme Court held, in
Hertz v. Hertz, 657 P.2d 1169, 1174 (1983), that a
non-shareholder spouse is bound to the same terms of a
shareholder valuation agreement which affects the
shareholder spouse. This insures that the non-shareholder spouse does not receive a greater value than that of
the shareholder.
New Jersey. New Jersey presumptively adheres to the
value in a buy-sell provision, when the books of the firm
are well kept and the formula amount has been
periodically and carefully reviewed. Stern v. Stern, 66
N.J. 340, 345, 331 A.2d 257, 260-1 (1975) (applying a
death-related buy out to the husbands interest in a law
partnership for purposes of divorce).
Missouri. The trial court was reversed for relying on a

buy-sell formula in a divorce, in Wood v. Wood, 2011
WL 5926162 (Mo. App. E.D. 2011) (formula amount
was higher than testimony of fair market value). In the
case of In re Marriage of Morris, 588 S.W.2d 39, 43
(Mo. App. 1979), the court wrote in dicta that the parties
had led the trial court into error by agreeing that the
value of the husbands interest in a law firm was
measured by a buy-sell agreement: Here, the objective
was to determine the true value of Harry's marital
shares, and in arriving at this determination the court
was not restricted to various valuation methods provided
in the redemption agreement when obviously none of
the methods contemplated the situation before the
court.
The court in Bowen v. Bowen, 96 N.J. 36, 473 A.2d 73,

77-78 (1984), said:
The buy-sell agreement among the three
stockholders prohibited a transfer of the stock
unless offered to the other stockholders or the
corporation at a price computed in the agreement.
The agreement provided that each partner's share
would be determined on the basis of book value,
provided that the minimum value of defendant's
interest was $25,000. It provided that book value
was to be established by the corporation's
accountant. In the event of disagreement with a
shareholder's accountant, then a Certified Public
Accountant shall be appointed by the presiding
judge of the Somerset County Court * * * [who]
shall determine the book value of the shares of
corporate stock in accordance with this formula
and the determination by said Accountant shall be
binding upon all parties to this Agreement. The
formula established by the agreement specifically
excluded goodwill or other intangible assets but
otherwise specified how accounts receivable,
inventory, machinery, fixtures, taxes, and life
insurance policies were to be valued. In addition,
the agreement provided for installment payments
over a period of years with stated interest. The
Montana. The Montana Supreme Court, in In re

Marriage of Jorgensen, 590 P.2d 606, 609 (1979), ruled
that, where all of the stockholders of the company
entered into a written agreement whereby the price of
each share of stock was fixed at $750.00 and the sale of
such shares was restricted to the remaining shareholders
or to the company, it was not error for the trial court to
set the value of the stock at $750 per share for purposes
of divorce. The court said: As long as the agreement is
operative no shareholder can go upon the market and
obtain more for his shares. Each shareholder is restricted
to the price and to the purchasers set forth in the
agreement.
New Hampshire. The New Hampshire Supreme Court,
in In re Watterworth, 821 A.2d 1107, 1114-15 (N.H.
2003), upheld the trial courts consideration of a buy-
74
agreement also provided that the parties would

periodically fix a value in a Certificate of Agreed
Value. No Certificate existed here.
partner's share, and the value determined in accordance

with that method, $18,900, must be regarded as
controlling. However, in Butler v. Butler, 663 A.2d
148, 152-53 (Pa. 1995), the Supreme Court drew a
distinction that the agreement in McCabe provided a
formula whereby the value could be calculated, whereas
in Butler the agreement stated a fixed number as the
value of the interest in the business. The Court then
went on to undercut McCabe, by saying that the value
established by the agreement was merely presumptive.
Id. at 153-56.
We agree with the trial court's conclusion that this

buy-sell should not control because it did not
contemplate the circumstances when the
stockholder's status with the corporation and his
fellow stockholders was to remain the same. Under
these circumstances, Polycel's assets of goodwill
and other intangibles (including considerable
technical expertise) should have been included to
reflect fair value.
South Dakota. In Fausch v. Fausch, 697 N.W.2d 748,

752-53 (S.D. 2005), The South Dakota Supreme Court
held that it was not error for the trial court in a divorce
to find a value of a business at variance with the formula
in a buy-sell agreement, where the wifes expert
reported the companys administrator as saying that the
husband would likely get his capital investment back,
regardless of the agreement, and where the agreement
would not apply if the entire business were to be sold.
New York. In the divorce case of Amodio v. Amodio,

509 N.E.2d 936, 937 (N.Y. 1987), the highest court in
New York said: If transfer of the stock of a closely held
corporation is restricted by a bona fide buy-sell
agreement which predates the marital discord, the price
fixed by the agreement, although not conclusive, is a
factor which should be considered . . . .
Oklahoma. In Mocnik v. Mocnik, 838 P.2d 500, 506
(Okl. 1992), the Supreme Court held that . . . the trial
court erred in awarding the wife judgment based on an
interest in the goodwill of her husband's medical
practice because the value of the Husband's interest was
determined by the stockholder's agreement.
Tennessee. In Harmon v. Harmon, 2000 WL 286718, *9

(Tenn. App. 2000), the court ruled that a buy-sell
provision was not binding on the court in a divorce,
saying: In a majority of jurisdictions, the price set by
a buy-out provision does not control the determination
of value when the other spouse did not consent or was
not otherwise bound by its terms. This is so even though
the agreement was executed after the marriage. The
reason for rejecting the value set by buy-out provisions
is that they do not necessarily represent the intrinsic
worth of the stock to the parties. . . . We find that the
majority view is more consonant with the valuation
approach outlined in Tennessee decisions such York v.
York. The York court rejected the notion of
mathematical formulas for such a valuation and
emphasized that valuation of a professional corporation,
such as Husband's in this case, is a factually driven
inquiry that requires the trial court to weigh and evaluate
all relevant evidence regarding value.
Oregon. In the case of In the Matter of the Marriage of

Belt, 672 P.2d 1205, 1208 (Or. App. 1983), the court
held that a buy-sell agreement that was no more than a
right of first refusal did not set the value of the stock,
but also noted that the existence of the right of first
refusal, both in the corporation and in the other
stockholders in proportion to their respective interests,
probably would discourage a stranger from spending the
time and money necessary to make a knowledgeable
appraisal of the value of the stock to form the basis of an
offer.
Pennsylvania. In McCabe v. McCabe, 575 A.2d 87, 88
(Pa. 1990), the Pennsylvania Supreme Court held that
the formula in a buy-sell agreement was controlling as
to the value of the interest in a divorce: The substantive
rights of a partner consist only of those specified in the
partnership agreement, and, in appraising this bundle of
rights, the agreement cannot be disregarded. Indeed, the
agreement must be viewed as the preeminent factor in
valuing a partner's rights. The present agreement sets
forth a method for determining the realizable value of a
Texas. Texas law on the effect of buy-sell provisions on

divorce is unsettled. In Finn v. Finn, 658 S.W.2d 735,
742 (Tex. App.--Dallas 1983, writ ref'd n.r.e.) (en banc),
a plurality of the court of appeals held that a law firm's
commercial goodwill was not divisible upon divorce,
because [t]he [partnership] agreement does not provide
any compensation for accrued goodwill to a partner who
ceases to practice law with the firm, nor does it provide
any mechanism to realize the value of the firm's
75
goodwill. In Keith v. Keith, 763 S.W.2d 950, 953 (Tex.

App.--Fort Worth 1989, no writ), the court specifically
disagreed with Finn and held that the formula set forth
in the partnership agreement with respect to death or
withdrawal of the partner is not necessarily
determinative of the value of a spouse's interest in the
ongoing partnership as of the time of divorce. The case
of Von Hohn v. Von Hohn, 260 S.W.3d 631, 64041
(Tex. App.--Tyler 2008, no pet.), involved the
husbands minority interest in a law firm whose
partnership agreement contained a buy-sell provision.
The appellate court said that the law firm was an
ongoing partnership as of the time of divorce, and the
husband had not died or withdrawn from the
partnership, and, thus, none of the triggering events
specified in the partnership agreement had occurred:
[c]onsequently, the formula in the partnership
agreement was not determinative of the value of [the
husbands] interest in the . . . Law Firm. In Mandell v.
Mandell, 310 S.W.3d 531, 540-41 (Tex. App.--Fort
Worth 2010, pet. denied), the appellate court declined to
follow Von Hohn, Keith, and Finn, because they were
partnership cases, and ruled that a husbands interest in
a professional association was controlled by the formula
in a buy-sell agreement.
Utah. In Argyle v. Argyle, 688 P.2d 468 (Utah 1984), the

Utah Supreme Court held that a buy-sell restriction
giving other owners a first option to buy the spouses
interest in the company for $1 did not control the value
of the interest for purposes of divorce.
Virginia. The Virginia Supreme Court, in Howell v.
Howell, 523 S.E.2d 514, 517 (2000), held that buy-sell
agreements are not conclusive on divorce valuation, but
rather are a factor to consider:
Closely held shares may be subject, for example,
to mandatory buy-out provisions at artificially low
prices. Such provisions do not necessarily
represent the intrinsic worth of the stock to the
parties and thus are not conclusive as to the
value of the stock. Bosserman, 9 Va.App. at 6, 7,
384 S.E.2d at 108. The marketability restriction
should be viewed simply as one factor in the
valuation model.
See Bosserman v. Bosserman, 384 S.E.2d 104, 108
(1989) (When stock is subject to a restrictive transfer
agreement or by-law the price fixed by such provisions
will not control its value, but the restriction on transfer
is a factor which affects the value of the stock for
purposes of equitable distribution).
In Beavers v. Beavers, 675 S.W.2d 296, 299 (Tex.

App.--Dallas 1984, no writ), the husbands shares
representing a one-third interest in a corporation were
restricted by a requirement that they be offered first to
other shareholders at book value. Experts from both
parties testified that essentially because of this
restriction, the market value of the stock was zero. The
court of appeals held that [w]hile market value is
usually the best evidence of the value of the personal
property, in the absence of a market value, the actual
value of the property to the owner may be shown. In
R.V.K. v. L.L.K., 103 S.W.3d 612, 619 (Tex. App.San
Antonio 2003, no pet.), three justices, constituting a
plurality of the court sitting en banc, believed that the
buy-sell agreement relating to the husbands medical
practice did not set the value of the business for
purposes of divorce. Id. at 618. However, those three
justices voted to reverse the trial judge for failing to
consider the buy/sell agreements' significant restriction
on the marketability of the stock. The dissenting Chief
Justice, Id. at 619, and two dissenting Justices, Id. at
621, agreed that the buy-sell agreement did not control
the value of the ownership interest upon divorce, but
differed on whether the marketability discount used by
the trial court was proper.
Washington. In Suther v. Suther, 627 P.2d 110, 114

(1981), the court followed out-of-state decisions that
said a buy and sell agreement is a factor to be
considered, but is not determinative of the stock's value.
West Virginia. The Supreme Court of West Virginia
said, in Bettinger v. Bettinger, 396 S.E.2d 709, 714-15
(W. Va. 1990):
[A] majority of courts which have considered a
buy-sell agreement in a closely held corporation
setting the stock value for equitable distribution
purposes has determined that such agreement
should not be considered as binding, but rather
should be weighed along with other factors in
making a determination as to the value of such
stock. . . . It is apparent that buy-sell agreements
in a closely held corporation can be manipulated
by the shareholders to reflect an artificially low
value. This is why caution should be exercised in
accepting their value for equitable distribution
purposes. [Citations omitted.]
76
value of the putative noncompetition covenant,

corresponding to the value of enhanced earnings
above the business's tangible assets, which are
attributable to husband's individual skills,
qualities, reputation, or continuing presence.
X. ENTERPRISE VS. PERSONAL GOODWILL.

The complex subject of enterprise goodwill and personal
goodwill upon divorce is the focus of a separate paper
included in the course materials. See:
<http://www.orsinger.com/PDFFiles/goodwill-upon-divorce.pdf>.
Accord, In re Marriage of Hanscam, 247 Or.App. 207,

268 P.3d 715, 727 (Or. App. 2011).
XI. COVENANTS NOT TO COMPETE. An issue

can arise as to whether a business should be valued upon
divorce as if the spouse-owner was selling the business
to a third party and signing a covenant not to compete.
The court in Slater and Slater, 245 P.3d 676, 682-83
(2010), rev. den., 256 P.3d 121 (Or. App. 2011),
summarized the issue in this way:
The court in Kricsfeld v. Kricsfeld, 588 N.W.2d 210,

221 (Neb. App. 1999), cited cases on both sides of the
issue:
Many courts have held that the value of covenants
not to compete are not marital property. See, e.g.,
Lowe v. Lowe, 372 N.W.2d 65 (Minn. App .1985)
(affirming trial court's conclusion that spouse
should not benefit from valuation method that
denies or restricts other spouse's future
employment options); Theilen v. Theilen, 847
S.W.2d 116, 120 (Mo. App. 1992) (holding
covenant not to compete should not be included in
valuation of professional practice and observing,
Perhaps a reason for this rule is that no
professional practitioner is required to give up his
profession in order to be divorced); Ellerbe v.
Ellerbe, 323 S.C. 283, 473 S.E.2d 881 (1996)
(holding covenant not to compete is not marital
property); Marriage of Monaghan, 78 Wash.App.
918, 899 P.2d 841 (1995) (observing that covenant
not to compete is separate property of covenantee
because it restricts covenantee's future conduct).
Courts which have included the value of covenants
not to compete in the marital estate have generally
done so on the theory that covenants not to
compete are merely another form of goodwill
which those courts, unlike Taylor v. Taylor, 222
Neb. 721, 386 N.W.2d 851 (1986), recognize as
divisible marital property. See, e.g., Carr v. Carr,
108 Idaho 684, 701 P.2d 304 (Idaho App. 1985);
Reese v. Reese, 671 N.E.2d 187 (Ind. App. 1996).
Did the trial court err in premising the value of

husband's chiropractic business on the assumption
that husband would be bound by a noncompetition
covenant? Although no Oregon appellate decision
has addressed that question, courts in other
jurisdictions have. Among those courts, there is a
split of authority, with most having concluded that,
to the extent that a noncompetition covenant
corresponds to the business's future earning
capacity attributable to an individual's skills,
qualities, reputation, or continued presence, the
value of that covenant is not cognizable in a
marital property division. . . .
We agree with the majority approach. When
executed incident to a sale of a business, a
noncompetition covenant ensures that the former
business owner will not take any customers or
patients with him or her and will not compete
against the new business owner in the same
general area for a reasonable period of time. The
value of that covenant depends, at least in part, on
the ability of the covenantor to attract future
business based on his or her personal services and
personality or reputation, separate and apart from
his or her association with the business.
*
*
*
The consequence of the foregoing is that the
valuation of Slater Chiropractic as a marital asset
could not properly be predicated on an assumption
that, at the time of a putative sale, husband would
be bound by a noncompetition covenant, thus
enhancing the value of the business. Or, stated
conversely, any valuation of Slater Chiropractic so
predicated must concomitantly be reduced by the
But see McReath v. McReath, 789 N.W.2d 89, 97-99

(Wis. App. 2010) (holding that salable professional
goodwill represented by a covenant not to compete is a
marital asset).
XII. TAX-EFFECTING THE VALUE OF THE
BUSINESS. There are differing perspectives on whether latent or unrealized tax effects, not triggered by
divorce, should be subtracted from divorce valuation.
77
Additionally, there is an issue among valuation theorists

whether Subchapter S businesses should be tax-effected
in a valuation.
to a suit for dissolution of a marriage, the court

may consider:
(1) whether a specific asset will be subject to
taxation; and
(2) if the asset will be subject to taxation,
when the tax will be required to be paid.
A. TAX-EFFECTING DIVORCE VALUATIONS.

The following divorce cases held that the tax to be paid
upon future sale of property to a third party are too
speculative to warrant a reduction in the other spouse's
share unless it could be ascertained that under the court's
decree, such sale would actually occur: In re Marriage
of Goldstein, 583 P.2d 1343 (1978); Levan v. Levan,
545 So.2d 892 (Fla. App.1989); Burkhart v. Burkhart,
349 N.E.2d 707 (Ind. 1976); Nemitz v. Nemitz, 376
N.W.2d 243 (Minn. App.1985); In re Marriage of Beck,
631 P.2d 282 (Mont. 1981); Orgler v. Orgler, 568 A.2d
67 (N. J. Super. 1989); Sommers v. Sommers, 660
N.W.2d 586, 590 (N.D. 2003) (In Kaiser v. Kaiser . .
. we held that in valuing a company that . . . potential
taxes should be considered in valuing marital assets in
only limited circumstances and theoretical tax liabilities
that are not going to be incurred because there is not
going to be a liquidation should not be deducted. Lewis
v. Lewis, 2008 WL 2609462, *5-6 (Ohio App. 2008); In
re Marriage of Rodenbeck, 266 P.3d 162 (Or. App.
2011) (error to reduce wifes award by the taxes
husband must pay on the earnings he will use to pay her
divorce judgment); Hovis v. Hovis, 541 A.2d 1378 (Pa.
1988); Bettinger v. Bettinger, 396 S.E.2d 709, 716 (W.
Va. 1990). Pennsylvania has adopted a statute that says:
Factors which are relevant to the equitable division of
marital property include the following: . . . [t]he Federal,
State and local tax ramifications associated with each
asset to be divided, distributed or assigned, which
ramifications need not be immediate and certain.
Pennsylvania Civil Statutes Annot. 3502, Equitable
division of marital property. In Durnell v. Durnell, 460
S.E.2d 710, 717 (W.Va. 1995), the court said: Unpaid
taxes are rather clearly a valid lien or encumbrance
against accounts receivable, or will become such a lien
or encumbrance as soon as the accounts receivable are
collected, and the Court believes that if the trial court
did fail to give Thomas A. Durnell credit for taxes
ultimately payable on the receipt of the accounts
receivable, the trial court erred.
Considering the later capital gain tax upon sale of the

business is different from considering latent taxes
associated with a business, as discussed below.
B. TAX-EFFECTING S-CORPORATIONS. Under
Federal tax law, a C-corporation must pay corporate
income tax on corporate income, and it gets no
deduction for dividends paid to shareholders, who must
pay a personal income tax on the dividends they receive.
An S-corporation does not pay corporate income tax.
Instead, the owners pay a personal tax on all Scorporation taxable income. In Gross v. Commissioner,
T.C. Memo 1999-254, affd 272 F.3d 333 (6th Cir.
2001), the Tax Court held that it was improper, in
valuing an S-corporation, to reduce the value of the
company by subtracting the taxes that would be paid if
the company were a C-corporation. In Dallas v.
Commissioner, T.C. Memo 2006-212, the taxpayer tried
to distinguish Gross on the ground that nearly all
income earned by the company in Gross was distributed,
whereas in Dallas the company distributed only enough
income to pay the pass-through tax liability. The Tax
Court rejected the argument. In essence, the Tax Court
held that an S-corporation should be valued higher than
an identical C-corporation solely based on the
perspective of the after-tax benefits received by the
owners of each type of entity. Accord, Estate of
Gallagher v. C.I.R., T.C. Memo. 2011-148, 2011 WL
2559847, *12 (2011).
In Denis and Sarin, Taxes and Relative Valuation of S
Corporations and C Corporations, JOURNAL OF APPLIED
FINANCE 7 (Fall/Winter 2002),199 the authors argue that
an S-corporation should be valued at a premium over an
identical C-corporation. Id. at 8. The difference in value
is the present value of the tax differentials between the
two corporate forms. Id. at 11. The S-corporation
premium would apply whenever the acquisition of the Scorporation is structuresd as a taxable acquisition or
whenever the acquirer is able to maintain S-corporation
status after the acquisition. Id. at 8. If the acquirer is a
C-corporation, then S-corporation status can be
maintained only if the C-corporation acquires a minority
interest in the S-corporation. Id. at 8. The premium is
In Texas, the issue of tax-effecting divorce valuations

has been addressed by the Legislature, as follows:
Tex. Fam. Code 7.008. Consideration of Taxes
In ordering the division of the estate of the parties
78
Id. at 2. The interim cash flows of each type of entity

can then be compared. Id. at 2-3.
highest when 100% of the S-corporations earnings are

paid out as dividends to shareholders. If the Ccorporation retains earnings, and those retained earnings
are ultimately taxed at capital gains rates when the
investor sells the C-corporation stock, the tax advantage
of the S-corporation is lessened. Id. at 9. This view
holds if the corporation is valued based on the present
value of after-tax dividends received by shareholders.
Id. at 9. Tax treatment can be an issue when a market
approach is used to value an S-corporation, using Ccorporations as a benchmark. Id. at 9. Professors Denis
and Sarin suggest that, in valuing an S-corporation
based on C-corporation benchmarks, the valuator should
adjust the C-corporations values by adding a premium
to reflect the S-corporations ability to avoid double
taxation. Id. at 14.
A consequence of ignoring all taxes in an S-corporation

valuation is that the value shown for S-corporations can
exceed the cost of converting the S-corporation to a Ccorporation. In 2005, Franklin M. Fisher, Christopher F.
Noe, and Evan Sue Schouten published an article
entitled The Sale of the Washington Redskins:
Discounted Cash Flow Valuation of S-Corporations,
Treatment of Personal Taxes, and Implication for
Litigation, 2 STANFORD JOURNAL OF LAW, BUSINESS &
FINANCE. (2005).201 The authors said the following:
This paper presents an economic argument for how
a discounted cash flow (DCF) analysis should
properly account for taxes when valuing an S
corporation. Through a simple numerical example,
we demonstrate that ignoring taxes in a DCF
analysis when valuing an S corporation potentially
leads to an overestimation of value. To produce
more meaningful valuation estimates, we propose
that any DCF analysis used to value an S
corporation should adjust cash flows to reflect its
owners' personal tax burdens. Our approach has
the possibility to affect litigation outcomes
irrespective of whether the valuation estimates are
used independently or in comparison to market
prices. The advantage of our approach is that it
results in claimants being "made whole" nd
nothing more.
The opposite perspective is presented in an article by

Mercer Capital, which points out that, for Ccorporations (and real estate investment trusts and
closed-end mutual funds), the taxable income to
investors is identical to cash distributed to investors.
Mercer Capital, Converting Distributions From S
Corporations and Partnerships to a C Corporation
Dividend Equivalent Basis, p. 192, p. 1.200 For Scorporations and partnerships, however, taxable income
can vary from distributions to investors. Id. at 1. When
the pass-through entity distributes less than all of its
taxable income, the owners must still pay the tax on the
full amount of the entitys taxable income, meaning that
the effective tax rate on the portion of the income that
was distributed is higher than it would be for
shareholders of an equivalent C-corporation. Id. at 1.
Mercer Capital says that, given that distributions from
an S-corporation may be worth considerably less than
distributions from a C-corporation
Id. at 18.
In Bernier v. Bernier, 873 N.E.2d 216, 228 (Mass.
2007), the Massachusetts Supreme Court held that the
trial court should not have applied the 35% tax rate of of
a C-corporation in estimating the fair market value of an
S corporation using the income approach, absent
evidence that the S-corporation would convert to Ccorporation status. In Sieger v. Sieger, 8 Misc.3d
1029(A), 806 N.Y.S.2d 448, 2005 WL 2031746, *18
(N.Y. Sup. 2005), the New York intermediate appellate
court rejected
a business valuators downward
adjustment of S-corporation income based on the
possibility that the current owner might switch to Ccorporation status or a potential buyer might not qualify
for S-corporation status, saying that [t]he court finds,
however, that the more appropriate valuation to be
placed on the facility is its value as currently operated
by defendant. Id. at *18, n. 19.
it is clearly appropriate to adjust the S

corporation or partnership distribution to a C
corporation equivalent basis before making
comparisons for valuation purposes. Such an
equivalency is derived by grossing up the
distribution by dividing the net, after-tax
distribution by one minus the blended state and
Federal personal income tax rate . . . .
Id. at 2. The article goes on to say that dividends from
C-corporations are usually quoted on a pre-personalincome-tax basis, so that grossing up the after-tax
distribution yield for an investment in an S-corporation
or partnership establishes a C-corporation equivalency.
79
in the business in order to meet his obligations imposed

by the court. The Tennessee Court of Appeals ruled it
was permissible to disregard tax that would come due
upon sale of corporate stock when the stock was
awarded to the husband/owner and offsetting value was
awarded to the wife, and husband testified that he did
not intend to sell the stock. Watson v. Watson, 309
S.W.3d 483, 493 (Tenn. App. 2009). In the case of In re
the Marriage of Hay, 907 P.2d 334, 335 (Wash. App.
1995), the Washington court of appeals held that it was
improper for the trial court to consider a future capital
gain tax on the partnership interest awarded to the
husband when he testified he had no plan to sell his
interest. At issue in these cases, however, were potential
capital gain tax from later sale of the stock being
awarded in the divorce, rather than built-in capital gains
inside the business.
C. CONSIDERING TAX ON THE LIFO

RESERVE. Inventories are usually valued on a LIFO or
FIFO basis. Under LIFO (last in-first out), the most
recent inventory purchases are used to determine the
cost of goods sold during the year. Under FIFO (first infirst out), the earliest inventory purchases are used to
determine the cost of goods sold for the year. In an
economy where the cost of inventory purchases is rising
over time, LIFO increases the cost of goods sold which
reduces profits, which reduces taxable income as newer,
more expensive inventory items are used in production.
GAPP requires companies to carry a LIFO reserve,
which represents the difference between the LIFO
calculation and the FIFO calculation. Adding the LIFO
reserve to the value of the assets is a common
adjustment made to the balance sheet when doing a
business valuation. This adjusts the inventory value to
be closer to market value. But when the old inventory
items are actually sold, the cost of goods sold will be
lower and profits will be higher and taxable income will
be higher. So, a tax will eventually have to be paid on
that LIFO reserve. If the company is sold, it can be
argued that a potential buyer of the business will include
the tax on the LIFO reserve as a latent liability of the
business, and will take that into account in setting a
purchase price. If the sale of the business is an asset sale,
the selling company will harvest taxable income to the
extent that the investment sells for more than its book
value. Either way, an argument can be made that an
adjustment for unrecognized tax on the LIFO reserve
should be considered in a business valuation.
D.
2. Embedded Capital Gains. In Estate of Davis v.

Comm'r, 110 T.C. 530, 1998 WL 345523 (1998), the
United States Tax Court held that, in valuing a
privately-owned company, it was proper to discount the
value of the company based upon trapped-in capital
gains that the buyer would take into account in buying
the company. The Tax Court said:
We are convinced on the record in this case, and
we find, that, even though no liquidation of [the
corporation] or sale of its assets was planned or
contemplated on the valuation date, a hypothetical
willing seller and a hypothetical willing buyer
would not have agreed on that date on a price for
each of the blocks of stock in question that took no
account of [the corporation's] built in capital gains
tax. We are also persuaded on that record, and we
find, that such a willing seller and such a willing
buyer of each of the two blocks of [the
corporation's] stock at issue would have agreed on
a price on the valuation date at which each such
block would have changed hands that was less
than the price that they would have agreed upon if
there had been no ... built-in capital gains tax as of
that date .... We have found nothing in the ... cases
on which respondent relies that requires us, as a
matter of law, to alter our view ....
CONSIDERING CAPITAL GAINS.
1. Future Capital Gains on Sale of Ownership

Interest. In Adams v. Adams, 945 N.E.2d 844, 869
(Mass. 2011), the Massachusetts Supreme Court said:
The special master was certainly correct to tax affect
the transfer of the wife's portion of the present value of
the partnership interest. The Iowa Supreme Court in In
re Marriage of Friedman, 466 N.W.2d 689, 691 (Iowa
1991), held that it was improper to reduce the value of
a business awarded to the husband in a divorce based on
the tax that he would ultimately have to pay upon
eventual sale. The Nebraska Court of Appeals in Shuck
v. Shuck, 806 N.W.2d 580, 592-93 (Neb. App. 2011),
held that a trial judge should not consider capital gains
tax on the ultimate sale of a business (or built-in
depreciation recapture) unless there is a reasonably
certain sale of the business in the near future, or the
property division requires the spouse to sell his interest
In two other cases, the Tax Court allowed a built-in

capital gain adjustment to be included as part of the
discount for lack of marketability. See Estate of
Borgatello v. Comm'r, 80 T.C.M. (CCH) 260, 264
(2000) (the Tax Court allowed a 24% valuation discount
80
Id. at 372.
for future corporate income taxes, but treated it as part

of the aggregate 33% discount for lack of marketability);
Estate of Dailey v. Comm'r, 82 T.C.M. (CCH) 710
(2001) (discount for unrealized capital gains was
allowed as part of the lack of marketability discount). In
the gift tax case of Eisenberg v. Comm'r, 155 F.3d 50,
57 (2nd Cir. 1998), the Second Circuit Court of Appeals
allowed an adjustment for unrealized capital gains even
though no liquidation of the corporation or sale of
corporate assets was imminent or contemplated at the
time of the gift. The Court said that a willing buyer
would demand a discount in recognition of the fact that
eventually the tax would have to be paid. The Court
commented: One might conclude from this example
that the full amount of the potential capital gains tax
should be subtracted from what would otherwise be the
fair market value of the real estate. This would not be a
correct conclusion. Id. at 58 n. 15. After Eisenberg, the
IRS fought over the size of the discount for unrealized
capital gains, but not the existence of it.
In Estate of Dunn v. Comm'r, 301 F.3d 339, 354 (5th

Cir. 2002), the Fifth Circuit Court of Appeals ruled that,
when a company held assets such that a buyer would be
buying the company for its assets, and was thus being
valued using a net asset approach, in that situation it
must be assumed that a hypothetical willing buyer
would immediately liquidate the corporation, triggering
a tax on the built-in gains. The Eleventh Circuit Court of
Appeals, in Estate of Jelke v. C.I.R., 507 F.3d 1317,
1331-32 (11th Cir. 2007), adopted the Estate of Dunn
approach of assuming that all built-in capital gains taxes
would be recognized on the date of sale. The court
acknowledged that this approach was arbitrary; the
virtue to this approach was that it substituted certainty
for courts having to gaze into a crystal ball, flip a coin,
or, at the very least, split the difference between the
present value calculation projections of the taxpayers on
the one hand, and the present value calculation
projections of the Commissioner, on the other. Id. at
1332.
In Estate of Jameson v. Comm'r, 267 F.3d 366 (5th Cir.

2001), the Fifth Circuit Court of Appeals considered an
appeal regarding the value of a company that held
timber for harvesting and also served as an investment
company. The Tax Court, using a net asset valuation
approach, had allowed a partial discount for the net
present value of the capital gains tax liability on the
timber property that would be incurred as the timber was
cut, over a nine-year period. However, the Tax Court
refused to allow any capital gains discount for the
investment property. Id. at 370-71. The Fifth Circuit
reversed the Tax Court, saying that the lower court had
envisioned a strategic buyer that would maintain the
timber business, whereas the fair market value concept
required a hypothetical buyer, and this does not mean
that the first, or economically rational, purchaser of
Johnco stock would so operate or lease the property. Id.
at 372. The Fifth Circuit also criticized the Tax Courts
rationale for why a buyer would harvest the timber over
time, saying:
The Nebraska Court of Appeals held, in Shuck v. Shuck,

806 N.W.2d 580, 592-93 (Neb. App. 2011), that a trial
court should not reduce the value of a business for
embedded capital gains, unless there is evidence that the
business will have to be sold in the near future, or that
the property division will force the business to be sold.
In Wechsler v. Wechsler, 866 N.Y.S.2d 120, 125-26
(2008), appeal dismissed, 910 N.E.2d 1007 (2009), the
New York appellate court ruled that the value of the
husbands C-corporation, that held securities for
investment, should be reduced to reflect the federal and
state taxes embedded in the securities owned by the
company due to the unrealized appreciation of those
securities. The amount of the adjustment was the taxes
the corporation would incur as a result of selling the
assets. The North Dakota Supreme Court ruled in
Kaiser v. Kaiser, 474 N.W.2d 63, 68-70 (N.D. 1991),
that it was improper to subtract capital gains that would
arise from liquidation of the companys assets, where
these gains were not immediate.
The Tax Court's internally inconsistent

assumptions, that a hypothetical purchaser of
Johnco stock would engage in long-range timber
production even though the Timber Property's
annual rate of return is substantially lower than the
investor's required return, fatally flawed its
decision to discount the future flow of capital
gains taxes.
81
ENDNOTES The following URLs are web-enabled. Click the link to go to the cited authority.
1. Revenue Ruling 59-60 <http://www.aticg.com/Documents/Revenue/RevRule59-60.pdf> [3-30-2012].
2. <http://asc.fasb.org/imageRoot/00/7534500.pdf > [2-22-12].
3. <http://www.newyorkfed.org/banking/regrept/2q08002.pdf > [2-22-12].
4. <http://www.mercercapital.com/print/?id=214> [3-6-2012].
5. Mercer Capital, Fair Value is Redefined by the Mississippi Legislature (2008).<http://208.112.16.118/index.cfm?action=page&id=214>
[3-27-2012].
6. <http://www.berkshirehathaway.com/ownman.pdf> [3-28-2012].
7. <http://www.chicagobooth.edu/faculty/selectedpapers/sp16.pdf> [3-30-12].
8. <www.businessdictionary.com/definition/fundamental-analysis.html> [2-22-12].
9. <http://www.investopedia.com/terms/l/liquidation-value.asp> [2-22-12].
10. <http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1019977_code12696.pdf?abstractid=274973&mirid=1> [2-25-2012].
11. <http://www.financial-dictionary.thefreedictionary.com/going+concern+value> [2-22-12]
12. <http://www.naepc.org/journal/issue07f.pdf.> [3-27-2012].
13. Mercer Capital, Conducting a Discounted Future Benefits Analysis p. 1 <http://www.mercercapital.com/print/?id=218> [3-17-2012].
14. Depreciation and amortization, expense reflects the years allocated portion of the cost of tangible and intangible assets.
15. Koeplin, Sarin and Shapiro, The Private Company Discount, 12 JOURNAL OF APPLIED CORPORATE FINANCE 96 (2000).
<http://business.scu.edu/asarin/PublishedPapers/Discount.pdf> [3-26-2012].
16. Lawrence A. Hamermesh & Michael L. Wachter, The Short and Puzzling Life of the "Implicit Minority Discount" in Delaware Appraisal
Law, 156 UNIV. OF PENNSYLVANIA LAW REVIEW 1 (2007)
<http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1372853_code711466.pdf?abstractid=961022&mirid=2> [4-1-2012].
17. Aswath Damodaran, Chapter 12 derivations p. 3
<http://pages.stern.nyu.edu/~adamodar/New_Home_Page/AppldCF/derivn/ch12deriv.html> [3-17-2012].
18. Mercer Capital, A User's Guide to Understanding the Discounted Future Benefits (Cash Flow) Valuation Methods p. 5
<http://www.mercercapital.com/print/?id=209> [3-17-2012].
19. Aswath Damodoran, APPLIED CORPORATE FINANCE: A USER'S MANUAL, ch. 12
<http://people.stern.nyu.edu/adamodar/New_Home_Page/AppldCF/derivn/ch12deriv.html> [3-23-2012].
20. Strategic control adjustments would be used in establishing investment value but arguably not fair market value based on an unknown
hypothetical buyer.
21. Jesse A. Ultz , The Reasonableness of Owners' Compensation: An Often Overlooked But Key Assumption in Valuing a Business
<http://www.srr.com/article/reasonableness-owners-compensation-often-overlooked-key-assumption-valuing-business> [3-23-2012].
22. Aswath Damodaran, Chapter 12 derivations <http://pages.stern.nyu.edu/~adamodar/New_Home_Page/AppldCF/derivn/ch12deriv.html>
[3-17-2012].
23. <http://pages.stern.nyu.edu/~adamodar/pdfiles/valn2ed/ch13.pdf> [3-29-2012].
82
24. Robert D. Arnott, Equity Risk Premium Myths p. 84 (Dec. 2011) <http://www.cfapubs.org/doi/pdf/10.2470/rf.v2011.n4.3> [3-27-2012].
25. Mercer Capital, A User's Guide to Understanding the Discounted Future Benefits (Cash Flow) Valuation Methods p. 5
<http://www.mercercapital.com/print/?id=209> [3-17-2012].
27. Dividend Discount Model <http://en.wikipedia.org/wiki/Dividend_discount_model> [4-1-2012].
28. Gordon Growth Model <http://www.investopedia.com/terms/g/gordongrowthmodel.asp> [4-1-2012].
29. Harry Markowitz, Portfolio Selection, 7 The Journal of Finance 77 (1952) http://www.gacetafinanciera.com/TEORIARIESGO/MPS.pdf
[3-29-2012].
30. Frank J. Fabozzi, Francis Gupta, & Harry Markowitz, The Legacy of Modern Portfolio Theory, 11 The Journal of Investing 7, 7-8 (Fall
2002)http://www.simonemariotti.com/downloads/Papers%20finanziari/Fabozzi-Gupta-Mar.pdf [3-29-2012].
31. <http://www.nobelprize.org/nobel_prizes/economics/laureates/1990/press.html> [2-27-2012].
32. <http://www.stanford.edu/~wfsharpe/art/djam/djam.htm> [2-27-2012].>.
33.
<http://efinance.org.cn/cn/fm/Capital%20Asset%20Prices%20A%20Theory%20of%20Market%20Equilibrium%20under%20Conditions%20o
f%20Risk.pdf> [2-27-2012].
34. Sharpe says that Economist Eugene Fama gave his theory the name of Capital Asset Pricing Model. See
<http://www.stanford.edu/~wfsharpe/art/djam/djam.htm> [2-27-2012].
35. <http://www.nobelprize.org/nobel_prizes/economics/laureates/1990/press.html> [2-27-2012].
36. In modern finance articles and texts, the rate of return is often on the Y-axis.
37. Sharpe defended these two assumptions on the grounds that the proper test of a theory is not the realism of its assumptions but the
acceptability of its implications and a plea that criticism be tempered due to the dearth of alternative models. Id. at 434.
38. Sharpe credits Markowitz with showing how to create an efficient frontier, and James Tobins 1958 paper saying that, if you can borrow
or lend at the risk free rate to invest, then the efficient frontier is a single portfolio of risky securities with borrowing or lending as an option.
<http://www.stanford.edu/~wfsharpe/art/djam/djam.htm> p. 4 [2-27-2012].
39. Andr F. Perold, The Capital Asset Pricing Model, 18 JOURNAL OF ECONOMIC PERSPECTIVES 3 (2004)
<http://www.faculty.fairfield.edu/NLAOPODIS/the%20capm.pdf> [4-1-2012].
40. <http://www.duffandphelps.com/sitecollectiondocuments/cost_capital_update_012909.pdf> [3-12-2012].
41.
<http://www.duffandphelps.com/sitecollectiondocuments/articles/Article_Grabowski_Risk_Free_Rate_and_ERP_During_Flight_to_Quality_0
1_29_11.pdf> [3-12-2012].
42. See <http://www.standardandpoors.com/ratings/articles/en/us/?assetID=1245316529563> [2-22-12]. Perhaps U.S. Treasury securities
should be called the least risky alternative. See Robert S. Harris & Felicia C. Marston, The Market Risk Premium: Expectational Estimates
Using Analysts' Forecasts 11 JOURNAL OF APPLIED FINANCE 1, 4 n. 1 (2001)
43. The "yield curve" is a graphical line that plots the yield (i.e., the interest rate divided by value of the bond), at different points in time, of
bonds having equal credit quality, but differing maturity dates. The most frequently-reported yield curve compares the 3-month, 2-year, 5-year
and 30-year U.S. Treasury debt. The slope of the yield curve can be measured as the difference between the interest rates at two selected
maturities. Long-term interest rates are influenced by expectations regarding future inflation. Thus, the shape of the yield reflects the market's
83
expectation of future interest rate changes.
44. William N. Goetzmann & Roger G. Ibbotson, History and the Equity Risk Premium p. 2 (Oct. 18, 2005) (Goetzmann)
<http://www.econ.ucsb.edu/conferences/equity05/papers/Goetzmann.pdf> [3-28-2012].
45. Goetzmann, p. 3.
47. Goetzmann, p. 5. Fisher suggested that the safety of bonds is largely illusory since every bondholder runs the risk of a fall in the
purchasing power of money and this risk does not attach to the same degree to common stock, while the risks that do attach to them may be
reduced, or insured against, by diversification . . . . Goetzmann, p. 5.
51. Domantas Skardziukas, Practical Approach to Estimating Cost of Capital (9/20/2010)
<http://mpra.ub.uni-muenchen.de/31325/1/MPRA_paper_31325.pdf?> [3-29-2012].
52. Pablo Frnandez, Market Risk Premium Used in 2011 by Professors, Analysts and Companies: A Survey with 5,731 Answers (May
2011). <http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1614842_code12696.pdf?abstractid=1609563&mirid=1 > [3-29-2012].
53. Graham & Harvey, The Equity Risk Premium in 2010 (August 9, 2010)
54. Roger G. Ibbotson, The Equity Risk Premium, RETHINKING THE EQUITY RISK PREMIUM.
<http://www.scribd.com/doc/83474634/Rethinking-the-Equity-Risk-Premium> [3-27-2012].
55. Robert S. Harris & Felicia C. Marston, The Market Risk Premium: Expectational Estimates Using Analysis Forecasts, 11 JOURNAL OF
APPLIED FINANCE 1 (2001). <http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID252671_code001205590.pdf?abstractid=252671&mirid=1>
[3-14-2012].
56. Zhiwu Chen & Roger G. Ibbotson, Liquidity as an Investment Style p. 5
57. The 2010 Duke CFO survey showed evidence of a strong positive correlation between market volatility and the long-term risk
premium. p. 12.
58. The 2010 Duke CFO Survey showed a highly significant correlation between the CFOs estimated ERP and the credit spread between
Moodys Baa rated bond yield less than 1-year T-bond yield. Graham-Harvey, The Equity Risk Premium in 2010 p. 13 (8-9-2010)
<http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1656092_code16198.pdf?abstractid=1654026&mirid=1> [3-27-2012]].
59. Shares and Shibboleths: How much should people get paid for investing in the stockmarket? THE ECONOMIST (3-17-2012)
<http://www.economist.com/node/21550273/print> [3-28-2012].
60. Peng Chen, Will Bonds Outperform Stocks Over the Long Run? Not Likely, RETHINKING THE EQUITY RISK PREMIUM p. 127 (2011)
61. Richard C. Grinold, Kenneth F. Kroner, & Laurence B. Siegel, A Supply Model of the Equity Premium, CFA Institute's RETHINKING THE
EQUITY RISK PREMIUM 56 (2011) <http://www.scribd.com/doc/83474634/Rethinking-the-Equity-Risk-Premium> [3-27-2012].
62. Grant Thornton, The Real-Time Equity Risk Premium: An Introduction
<http://www.grantthornton.com/staticfiles/GTCom/Advisory/Valuation/Files/risk%20premiums%20-%20white%20paper%20-%20FINAL.pdf
> [3-27-2012].
63. Hassett , <http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1663812> [3-27-2012].
84
64. Duff & Phelps Client Alert (October 17, 2011)
<http://www.duffandphelps.com/SiteCollectionDocuments/Articles/ERP_Update_10.17.11.pdf> p. 8 [3-10-2012].
65. Aswath Damodoran, Equity Risk Premiums (ERP): Determinants, Estimation and Implications The 2011 Edition (Feb. 2011)
<http://pages.stern.nyu.edu/~adamodar> [3-10-2012].
66. Aswath Damodaran, Equity Risk Premiums (ERP): Determinants, Estimation and Implicationthe 2011 Edition 56-71 (Feb. 2011)
68. <http://www.duffandphelps.com/expertise/hot_topics/pages/topicDetail.aspx?id=6&list=HotTopics> p. 5 [3-11-2012].
69.
1_29_11.pdf> pp. 16-17[3-12-2012].
70. See <www.businessdictionary.com/definition/beta.html> [2-22-12].
72. Michael W. Barad, Technical Analysis of the Size Premium (undated)
<http://corporate.morningstar.com/ib/documents/MethodologyDocuments/IBBAssociates/AnalysisSizePremium.pdf> [4-2-2012].
73. <http://online.wsj.com/article/SB10001424052970204059804577229201842045734.html> [2-22-2012].
74. William N. Goetzmann & Roger G. Ibbotson, History and the Equity Risk Premium, p.10 (Oct. 18, 2005)
75. Stephen A. Ross, An Arbitrage Theory of Capital Asset Pricing, 13 JOURNAL OF ECONOMIC THEORY 341360 (1976).
76. <http://www-personal. umich.edu/~kathrynd/JEP.Famaand French. pdf> [2-22-12].
78. Duff & Phelps, LLC, Risk Premium Report 2010 (excerpt)
<http://www.duffandphelps.com/sitecollectiondocuments/reports/Risk_Premium_Report_2010_EXCERPT.pdf> [3-25-2012].
79. Michael Barad and Tara McDowell, Capturing Industry Risk in a Buildup Model
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80. <http://financial-dictionary.thefreedictionary.com/Company-Specific+Risk> [2-22-12].
81. <http://www.mercercapital.com/print/?id=191>. [2-22-12].
82. <http://www.bvresources.com/bvwirecentral/material/bvwire54-1/ 0207BVUPB.pdf>. [2-22-12].
83. Duff & Phelps, LLC, Risk Premium Report 2010 (excerpt) pp. 33-34
84.
1_29_11.pdf> [3-12-2012].
85
85. Jeremy J. Siegel, Perspectives on the Equity Risk Premium, 61 FINANCIAL ANALYSIS JOURNAL 61, 63 (2005)
<http://info.freeman.tulane.edu/breese714/Investments%20Fall%202010/Perspectives%20on%20the%20Equity%20Risk%20Premium%20-%2
0Siegel.pdf> [3-29-2012].
86. Roger J. Grabowski, Cost of Capital Estimation in the Current Distressed Environment, 4 JOURNAL OF APPLIED RESEARCH IN
ACCOUNTING AND FINANCE 31, 32 (2009)
87. <http://www.sternstewart.com/research/200103_The%20Equity%20Risk%20Measurement%20Handbook.pdf>
88. Financial crises are often accompanied by a flight to quality. Investors are looking for places to park funds that they consider free
from [the risk of] loss of principal. They are not looking for yield. The nominal returns on risk-free securities fall dramatically for reasons
other than inflation expectations, and, thus, without adjustment, become less reliable as the best building block upon which to estimate the cost
of equity capital. The quotation, from Duff & Phelps Managing Director Roger Grabowski, is taken from Client Alert: Duff & Phelps
Increases U.S. Equity Risk Premium Estimate to 6% 7 (Oct. 17, 2011)
<http://www.duffandphelps.com/SiteCollectionDocuments/Articles/ERP_Update_10.17.11.pdf> [3-29-2012].
89. <http://www.duffandphelps.com/SiteCollectionDocuments/Articles/ERP_Update_10.17.11.pdf> p. 3 [3-10-2012].
90. In its October 17, 2011 Client Alert, Duff & Phelps said: In developing our ERP recommendation, we incorporate a normalized
20-year yield on U.S. government bonds of 4.0% (based on a trailing 12 month average) because, were we to use the spot yield-to-maturity of
2.66% as of September 30, 2011, we would arrive at an overall discount rate inappropriately low vis--vis the risks currently facing investors.
91.
1_29_11.pdf> [3-12-2012].
92.
1_29_11.pdf> pp. 10-11[3-12-2012].
93. Duff & Phelps Decreases U.S. Equity Risk Premium Recommendation to 5.5%, Effective January 15, 2012 (Jan. 27, 2012)
<http://www.duffandphelps.com/SiteCollectionDocuments/Articles/ERP_Update_1%2031%2012.pdf> [3-22-2012].
94. Current ERP at 5.5%, says new Duff & Phelps estimation (Jan. 25, 2012)
<http://www.bvresources.com/BVWire/January2012Issue112-4.html> [3-22-2012].
95. <http://www.mencpa.com/news-46/post-62-thoughts-on-duff-phelps-normalizing-risk-free-rate.aspx> [3-23-2012].
96. <http://www.duffandphelps.com/SiteCollectionDocuments/Articles/ERP_Update_10.17.11.pdf> p. 3 [3-10-2012].
97. The horizon of the chosen Treasury security should match the horizon of whatever is being valued. Ibbotson SBBI Valuation
Yearbook (2011) p. 44.
0Siegel.pdf> [3-27-2012].
99. Jeremy J. Siegel, The Shrinking Equity Premium <http://bbs.cenet.org.cn/uploadImages/20036131339163434.pdf> [3-22-2012].
100. Peng Chen, Will Bonds Outperform Stocks Over the Long Run? Not Likely, RETHINKING THE EQUITY RISK PREMIUM p. 127 (2011)
101. On October 17, 2011, Duff & Phelps issued a client alert recommending that the U.S. Equity Risk Premium was 6.0% as of September
30, 2001. <http://www.duffandphelps.com/SiteCollectionDocuments/Articles/ERP_Update_10.17.11.pdf> [3-10-2012]. It dropped the U.S.
ERP to 5.5% as of January 15, 2012. <http://www.duffandphelps.com/SiteCollectionDocuments/Articles/ERP_Update_1%2031%2012.pdf>
[3-10-2012].
86
102. Rajnish Mehra & Edward C. Prescott, The Equity Premium: A Puzzle, 15 JOURNAL OF MONETARY ECONOMICS 145 (1985)
<http://www.academicwebpages.com/preview/mehra/pdf/The%20Equity%20Premium%20A%20Puzzle.pdf> [3-27-2012].
103. Jeremy J. Siegel, Perspectives on the Equity Risk Premium, 61 FINANCIAL ANALYSIS JOURNAL 61, 65 (2005) (Siegal, Perspectives on
the Equity Risk Premium)
0Siegel.pdf> [3-27-2012].
104. Rajnish Mehra, Rethinking the Equity Risk Premium (2011)
105. Laurian Lungu & Patrick Minford, Explaining the Equity Risk Premium, 74 MANCHESTER SCHOOL 670-700 (2006)
<http://www.caerdydd.ac.uk/carbs/econ/lungul/lunguminfordriskp7.pdf> [link now dead].
106. Siegal, Perspectives on the Equity Risk Premium.
107. <http://seekingalpha.com/article/9878 4-what-equity-risk-premium> [3-27-2012].
108. Goetzmann & Ibbotson, History and the Equity Risk Premium, HANDBOOK OF INVESTMENTS: EQUITY RISK PREMIUM p. 13
109. Aswath Damodaran, Equity Risk Premiums (ERP): Determinants, Estimation and Implications The 2012 Edition (March 2012)
<http://people.stern.nyu.edu/adamodar/pdfiles/papers/ERP2012.pdf> [3-29-2012].
110. The longer the data series, the more accurate the equity risk premium calculation, as long as the fundamental expectations have
remained the same. Goetzmann & Ibbotson, History and the Equity Risk Premium, HANDBOOK OF INVESTMENTS: EQUITY RISK PREMIUM p.
13 <http://www.econ.ucsb.edu/conferences/equity05/papers/Goetzmann.pdf> [3-27-2012].
111. Michael W. Barad, Ibbotson's Answer (undated)
<http://corporate.morningstar.com/ib/documents/MethodologyDocuments/IBBAssociates/IntnlRiskPremium.pdf> [4-1-2012].
112. <http://www.sternstewart.com/research/200103_The%20Equity%20Risk%20Measurement%20Handbook.pdf>
113.
1_29_11.pdf> p. 12 [3-12-2012].
115. Robert D. Arnott, Equity Risk Premium Myths, RETHINKING THE EQUITY RISK PREMIUM.
116. Richard C. Grinold, Kenneth F. Kroner, & Laurence B. Siegel, A Supply Model of the Equity Premium, RETHINKING THE EQUITY RISK
PREMIUM. <http://www.scribd.com/doc/83474634/Rethinking-the-Equity-Risk-Premium> [3-27-2012].
0Siegel.pdf> [3-29-2012].
118. Pablo Fernndez, Market Risk Premium: Required, Historical & Expected (Oct. 2004),
<http://www.iese.edu/research/pdfs/DI-0574-E.pdf> [3-29-202].
119. Michael W. Barad, Ibbotson's Answer (undated)
<http://corporate.morningstar.com/ib/documents/MethodologyDocuments/IBBAssociates/IntnlRiskPremium.pdf> [4-1-2012].
87
121.
1_29_11.pdf> p. 16 [3-12-2012].
123. Duff & Phelps Client Alert (January 27, 2012)
<http://www.duffandphelps.com/SiteCollectionDocuments/Articles/ERP_Update_1%2031%2012.pdf> [3-29-2012].
124. John R. Graham & Campbell R. Harvey, The Equity Risk Premium in 2010 p. 13 (8-9-2010)
126. Scot Blythe, Ibbotson: Equity Risk Premium Still Out There (Oct. 10, 2011)
<http://www.investmentreview.com/analysis-research/ibbotson-equity-risk-premium-still-out-there-5565> [4-1-2012].
127. Wayne E. Ferson and Campbell R. Harvey, The Variation of Economic Risk Premiums, 99 JOURNAL OF POLITICAL ECONOMY 385, 412
(1991) (the expected risk premium increases during economic contractions speaks near business cycle troughs)
<http://faculty.fuqua.duke.edu/~charvey/Research/Published_Papers/P5_The_variation_of.pdf> [3-29-2012].
128. Wayne Ferson & Dennis Locke, Estimating the Cost of Capital Through Time: An Analysis of the Sources of Error, MANAGEMENT
SCIENCE pp. 411 <http://www-bcf.usc.edu/~ferson/papers/MANSCI98.PDF> [3-29-2012].
129. Warren E. Buffett, Letter to Shareholders of Berkshire Hathaway, Inc. (2008) <http://www.berkshirehathaway.com/letters/2008ltr.pdf>
[3-28-2012].
130. <http://whatheheckaboom.wordpress.com/2007/07/28/warren-buffetts-discount-rate-used-in-dcf> [3-6-2012].
133. Theodore Sougiannis & Takashi Yaekura, The Accuracy and Bias of Equity Values Inferred From Analysts' Earnings Forecasts (2000)
134. Domantas Skardziukas, Practical Approach to Estimating Cost of Capital
<http://mpra.ub.uni-muenchen.de/31325/1/MPRA_paper_31325.pdf> [3-29-2012].
135. <http://people.stern.nyu.edu/adamodar/New_Home_Page/AppldCF/derivn/ch4deriv.html#ch4.6> [3-23-2012].
136. Roger J. Grabowski, Problems with Cost of Capital Estimation in the Current Environment Update (Feb. 4, 2009)
<http://www.duffandphelps.com/sitecollectiondocuments/cost_capital_update_012909.pdf#page=1> [3-29-2012].
137. [B]ecause the stock market correction [in 2008-2009] has been heavily concentrated in the financial services sector and in highly
leveraged companies, the commonly-employed methods we use for estimating betas, the risk measure in the traditional CAPM, are potentially
flawed providing faulty estimates of risk. Roger J. Grabowski, Problems with Cost of Capital Estimation in the Current Evironment - Update,
(Feb. 4, 2009) <http://www.duffandphelps.com/sitecollectiondocuments/cost_capital_update_012909.pdf> [3-27-2012]. Because Beta
calculations are backward-looking, the effect of this anomaly will affect Betas in the future.
139. Black, Fischer., Michael C. Jensen, and Myron Scholes, The Capital Asset Pricing Model: Some Empirical Tests, pp. 79121 in M.
Jensen ed., Studies in the Theory of Capital Markets. (New York: Praeger Publishers, 1972)
88
140. Eugene F. Fama & Kenneth R. French, The Capital Asset Pricing Model: Theory and Evidence (August 2003)
141. Robert Arnott, Jason Hsu, and Philip Moore, Fundamental Indexation 61 FINANCIAL ANALYSTS JOURNAL 83-99 (2005), cited in
Zhiqu, Roger G. Ibbotson, and Wendy Y. Hu, Liquidity as an Investment Style (Sept. 10, 2010)
<http://www.zebracapital.com/files/LiqSty052311.pdf> [3-27-2012].
142. Benjamin Graham and David Dodd, SECURITY ANALYSIS (1934).
143. Fundamental analysis suggests that an individual security has an intrinsic value (equilibrium price) that depends on the security's
earning potential. Fama (1965) p. 3. This earning potential depends on fundamental factors such as the quality of management, outlook for the
industry, outlook for the economy, etc. Id. p. 3. Fundamental analysis proceeds through the study of an investment by looking at the firm's (1)
competitive advantage, (2) earnings growth, (3) sales revenue growth, (4) market share, (6) financial reserves, and (6) quality of management,
all as reflected in its financial statements. http://www.businessdictionary.com/definition/fundamental-analysis.html> [3-6-2012]. By this form
of analysis the investor can determine whether the current price of the security is above or below its intrinsic value. Because the actual price
tends to move toward intrinsic value, the investment can be made so as to profit from the move of the price to intrinsic value. Fama (1965) p.
3. Burton Malkiel, in Chapter 7 of his book A RANDOM WALK DOWN WALL STREET (1973), points out that fundamental analysis cannot
protect against random events, misleading financial data issued by companies, and human emotional factors.
144. Warren E. Buffett's Letter To the Shareholders of Berkshire Hathaway Inc. (2011) pp. 5-6
<http://www.berkshirehathaway.com/letters/2011ltr.pdf> [3-28-2012].
145. <http://www.stanford.edu/~wfsharpe/art/djam/djam.htm> p. 3 [2-27-2012].>.
149. Frank J. Fabozzi, Francis Gupta, and Harry M. Markowitz, 11 THE JOURNAL OF INVESTING 7 (Fall 2002) The Legacy of Modern
Portfolio Theory (2002) <http://www.simonemariotti.com/downloads/Papers%20finanziari/Fabozzi-Gupta-Mar.pdf> [2-26-2012].
150. Rajnish Mehra & Edward C. Prescott, The Equity Premium: A Puzzle, 15 JOURNAL OF MONETARY ECONOMICS 145 (1985)
<http://www.academicwebpages.com/preview/mehra/pdf/The%20Equity%20Premium%20A%20Puzzle.pdf> [3-27-2012].
151. Ravi Jagannathan, Ellen McGratten, and Anna Scherbina, The Declining U.S. Equity Premium, 27 FEDERAL RESERVE BOOK OF
MINNEAPOLIS QUARTERLY REVIEW 3, 5 (2000). <http://papers.ssrn.com/sol3/Delivery.cfm/nber_w8172.pdf?abstractid=263434&mirid=1> [327-2012].
152. Mark Kritzman & Yuanzhan Li, Skulls, Financial Turbulence, and Risk Management, 67 FINANCIAL ANALYSTS JOURNAL 30-41 (2010)
<http://apostleam.com.au/assets/Uploads/White-Paper-M.-Kritzman-Skulls-Financial-Turbulence-and-Risk-Management-2010.pdf> [3-282012].
153. Duff & Phelps, LLC, Risk Premium Report 2010 (excerpt) pp. 4-5, 28
154. Duff & Phelps, LLC, Risk Premium Report 2010 (excerpt) pp. 4-5
155. Aswath Damodoran, Equity Risk Premiums (ERP): Determinants, Estimation and Implications The 2011 Edition p. 33(Feb. 2011)
156. Duff & Phelps, LLC, Risk Premium Report 2010 (excerpt) p. 5
157. Duff & Phelps, LLC, Risk Premium Report 2010 (excerpt) p. 30
89
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Business Valuation Upon Divorce: How Theory

and Practice Can Lead to Problems In Court

AICPA/AAML Conference on Divorce

CURRICULUM VITAE OF RICHARD R. ORSINGER

Washington & Lee University, Lexington, Virginia (1968-70)

Organizations and Committees:

III. STANDARDS OF LEGAL ADMISSIBILITY... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

IV. THE INCOME APPROACH (EARNINGS AND CASH FLOW)... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

V. THE INCOME APPROACH (DEVELOPING A CAP RATE/DISCOUNT RATE).. . . . . . . . . . . . . . . . . . . .

3. The Size Premium.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

VI. THE MARKET APPROACH... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

VII. NET ASSET APPROACH.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

X. ENTERPRISE VS. PERSONAL GOODWILL.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77

Business Valuation Upon Divorce: How Theory and

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Business valuators apply indicators of value derived

Under the Frye case, the test for admissibility of an

The fair market value is the price at which the

the applicable valuation date.

able period. The average is to be determined in the

cable because actual sale prices and bona fide bid

(d) Based on incomplete selling prices or

(1) In the case of corporate or other

(e) Where selling prices or bid and asked

(g) Pledged securities. . . .

(f) Where selling prices or bid and asked

Id. If comparable companies whose shares are traded on

stances of the particular case. Little weight will be

Although Revenue Ruling 59-60 gives the market

Revenue Ruling 59-60 has endured remarkably well,

3. Rev. Ruling 59-60's Fair Market Value of a

Revenue Ruling 59-60 3.03 asserts that the best

FAIR VALUE (ACCOUNTING).

1. Definition of Fair Value (Accounting). The

to sell an asset or paid to transfer a liability in an

FASB ASC Topic 820 Implementation Guidance, p. 5

See FASB ASC Topic 820 Glossary.

FASB ASC Topic 820 Implementation Guidance, p. 5

A fair value measurement assumes that the

Fair value measurements of assets assumes

FASB ASC 820-20-05-1B (as amended May 2011).2

Here is what FAS 157 itself says about the hierarchy of

25. If the reporting entity holds a large

Fair Value Hierarchy

26. In some situations, a quoted price in an

23. The availability of inputs relevant to the

27. If the reporting entity holds a position in

[FN11] The guidance in this Statement

28. Level 2 inputs are inputs other than

a. Quoted prices for similar assets or

It is evident that a valuation of a closely-held business

29. Adjustments to Level 2 inputs will vary

C. FAIR VALUE (DISSENTERS RIGHTS). Many

unfairly transferring value from the minority dissenter to

stantially devoted to the mere possession of assets,

1. Colorado. In Pueblo Bancorporation v. Lindoe,

2. California. California Corporations Code 2000

Moore contends that the term fair value, as used

The trial judge had used a net asset value approach to