Some time ago, an attorney called saying he was in the midst of a negotiation with the Internal Revenue Service regarding the enterprise value of a business. The company was in a cyclical industry and the appraiser had used a ten year analysis of historical earnings in developing his estimate of earning power for capitalization.
The IRS officer objected, suggesting that only a five year look was appropriate. Naturally, the last five years had been pretty decent. However, a ten year or longer look indicated the true cyclicality of the company’s earnings – and the reasonableness of the appraiser’s ten year analysis.
The attorney asked me to address the following question in memorandum form for purposes of his negotiations with the IRS.
What is the appropriate period for the historical financial analysis in an appraisal?
The answer to the question seemed so obvious to me that I had never written about it. The answer must have seemed obvious to other writers as well, because of the limited addressing of the question in their books.
I responded as follows.
The basic answer to the questions is that it depends on a variety of facts and circumstances relevant to each particular appraisal situation. It is true that many appraisals provide a five year historical analysis. It is also true that other appraisals use shorter or longer time periods for analysis, as appropriate.
In my experience, companies in cyclical industries and those whose customer bases are cyclical in nature often require analysis for longer time periods than the “typical” five-year look. When companies have cyclical earnings or are dependent on cyclical customers, it is often appropriate to consider the use of an earning power estimate based on a longer period than five years. Valuation analysts often use simple averages or weighted averages of earnings in these circumstances. The selection of a specific number of years and the particular type of average to use would be a function of a number of factors, including:
- Where in a particular earnings cycle the appraiser believes the company is at the valuation date.
- The history of observed cycles.
- Analysis of the underlying economic conditions that give rise to apparent cyclicality of earnings.
- The actual near-term and longer-term outlooks as of the valuation date.
In recent appraisals, I have considered historical analysis of earning power over periods of five years, six years, eight years, ten years, and twenty years. In each case where we considered historical performance longer than five years, there was a specific factual basis for the selection.
The question of the time period for analysis is one of those that is so basic that it does not get a lot of treatment by valuation writers. In all the books and articles I’ve written, I have never addressed the issue in as much depth as in the paragraphs above. Most writers make the basic point that the period for historical financial analysis should be appropriate for the company being valued based on the particular facts and circumstances present at the valuation date.
A review of a number of prominent valuation texts suggests agreement with my basic position. In each case, I am quoting the entire discussion in each text that is directly relevant to the question posed.
Basic Business Appraisal.1 Ray Miles wrote this early text. He notes:
Financial statements are by far the best source of information about the financial history of the business. Such financial statements should include both annual income/expense (or profit/loss) statements and annual balance sheets and should cover a period of at least the last several years.
As a rule of thumb, the appraiser should obtain copies of financial statements covering a period of at least five years leading up to the date of appraisal. However, if the business exhibits an unstable or erratic pattern of sales or profits, statements covering a period of more than five years may be needed as part of the effort to identify whatever trends may exist. Of course, if the business has not been in existence for as long as five years, the appraiser must work from financial statements covering the shorter period. (emphasis added)
Valuing a Business.2 Shannon Pratt writes in his fifth edition in a section entitled “Relevant Time Period”:
When asking for historical financial statements on the subject property, one should endeavor to study statements during a relevant period. The most commonly used period is five years, but this should not be used as a rote number of h years. Conceptually, the relevant period covers the most recent period of time immediately prior to the valuation date during which the statements represent the company’s general operations.
If the company significantly changed its operations a few years before the valuation date, only those previous years may represent the relevant period. On the other hand, if the business has a long history and some or all recent years were abnormal in some way (such as during a cyclical pead or trough in the company’s industry), statements for the past seven, ten, or more years may constitute a relevant period for valuation purposes. (emphasis in original)
Understanding Business Valuation.3 Gary Trugman echos the theme.
Most business valuation analysts will request at least five years of financial information about the subject company. I like to request six. This way we can calculate a five year cash flow for the subject company. The amount of data will depend on the facts and circumstances of each assignment. However, a good rule of thumb is to ask for enough years of data to cover a complete business cycle. This will allow the valuation analyst to create a spreadsheet looking for trends that may have occurred, as well as inconsistencies in the reported data. (emphasis added)
Guide to Business Valuations.4 Jay Fishman also writes on the issue briefly:
Historical financial statements are important for identifying key variables and trends for valuation analysis. Accordingly, complete financial statements (including footnotes and any supplemental data) should be obtained for a sufficient, relevant period to allow reliable analysis. Generally, the consultant should obtain year-end financial statements for the most recent five years preceding the valuation date. A longer period may be needed if (a) significant changes such as technological trends, product shifts, or environmental changes have occurred or (b) the five-year period is not long enough to assess the company’s performance during changes in its business cycle or economic conditions. Sometimes a period less than five years may be appropriate if the company’s operations have changed significantly in recent years, such as through mergers, divestitures, or changes in product lines. (emphasis added)
Finally, Revenue Ruling 59-60 addresses the issue in the context of fair market value determinations. Relevant quotes from this historical ruling follow:
- “A determination of fair market value, being a question of fact, will depend upon the circumstances in each case. No formula can be devised that will be generally applicable to the multitude of different valuation issues arising in estate and gift tax cases…”
- “Detailed profit-and-loss statements should be obtained and considered for a representative period immediately prior to the required date of appraisal, preferably five or more years.”
- “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.”
Revenue Ruling 59-60 also states that the appraiser should consider all relevant information in the context of the exercise of “common sense, informed judgment and reasonableness.”
It should be clear that when dealing with a cyclical company, or one that has a history of going through cycles that may pertain to the national economy or to major customers whose businesses are also cyclical, it is appropriate to consider periods of longer than five years in the historical analysis and in the development of earning power. This is clear both from a review of valuation textbooks and from Revenue Ruling 59-60.
I hope this discussion of the length of the appropriate period for historical financial analysis is helpful.
1 Miles, Raymond C., Basic Business Appraisal (New York: John Wiley & Sons, Inc., 1984), p. 62-63.
2 Pratt, Shannon P., with Alina V. Niculita, Valuing a Business: The Analysis and Appraisal of Closely Held Companies (Fifth Edition) (New York, McGraw Hill, 2008, p. 79.
3 Trugman, Gary R., Understanding Business Valuation: A Pracical Guide to Valuing Small to Medium Sized Businesses (New York, American Institute of Certifief Public Accountants, 2008), p. 156.
4 Fishman, Jay E., et al, Guide to Business Valuations (Fort Worth, TX, Thompson Reuters, 2010, Section 402.2.