The Method of Comparables in Tax Court Valuation of Privately-Held Firms: An Empirical Investigation
Posted: 25 Jun 1998
Date Written: March 1996
This research project investigates private firm valuation in the estate and gift tax area. The research is important because there are substantial differences of opinion among practitioners about how to perform valuations and many of the expert valuation approaches rely on untested assertions. Our paper is the first to provide a formal, comprehensive analysis of one of the commonly used approaches, the "method of comparables." We investigate three primary areas of concern in applying this approach: (1) what valuation model to apply, (2) how firm size affects valuation, and (3) how industry classification impacts the estimated model. Accordingly, we analyze the price prediction performance of alternative valuation models that incorporate earnings, book value, and dividends. We also identify under what model specifications size is related to firm values. Finally, we evaluate the performance of our valuation models applied to both the total sample and industry subsamples. Our review of estate and gift tax valuation court cases identifies one preeminent application of the "method of comparables" that assumes price is proportional to the average P/E ratio for a set of comparable firms. We show that the performance of the average P/E model is inferior to sixteen parsimonious alternative models. Further, our results indicate that all thirteen of our proportional pricing models produce prediction errors that are negatively correlated with earnings or book value, suggesting underpricing for the smallest firms. Although on average earnings receive a higher weight than book value with multivariate proportional pricing, book value receives more weight than earnings for 40% of the industry subgroups. We demonstrate that a multivariate linear regression model incorporating an intercept, earnings, book value of equity, and dividends corrects for the econometric problems of the proportional models used in practice. The significant linear model intercepts of $2.00 to $4.00 shed serious doubt on the general applicability of these proportional models. Our results also suggest that earnings, book value, and (to a lesser extent) dividends provide important incremental information in predicting price. Finally, we document a surprisingly small improvement in explanatory power of models estimated on industry subsamples. This paper provides tax practitioners and valuation consultants with an easily implementable model that corrects for potentially serious problems in current practice. Further, we believe that a valuation approach that avoids clear biases and explains over 70% of the cross-sectional variation in stock price can be useful for litigation-based valuation. Finally, judges and regulators may choose to consider our approach to identify and quantify the biases introduced by experts in private firm valuation exercises. In this fashion, dead weight losses from valuation disagreements may be reduced in estate and gift tax cases.
JEL Classification: G12, K34
Suggested Citation: Suggested Citation