The People’s Lawyer (TPL) is an interesting blog for some unique views on the practice of tax law. TPL has been on a tear as far as Gifts & Estate tax planning and has some fun with the valuation “experts” in a case involving the value of certain water rights owned by Garwood Irrigation Company as of January 1, 1997. This particular case involved the conversion of the entity from a C corporation to an S corporation. Reorganization of corporate structures tend to capital gains tax if the value of the asset or entity exceeds its tax basis. The two “experts” were Terry Lloyd for the taxpayer and John Camp for the IRS. I have no idea as to the credentials of these two “experts”, but I can see why their estimates were as far apart as TPL suggests. The entire issue seems to rest on differing opinions as to the facts as to the expected future highest and best use of the asset involved.
In many tax valuation cases, the facts are not at controversy as much as the methodology chosen by the “expert” for the taxpayer – who often goes out of his way to lowball the value of an enterprise in order to allow his client to get away with a lower tax bill. While we love to beat up on James Glassman, let me suggest he’d do a much better job at rebutting this taxpayer advocacy than many of the supposed IRS experts. Let me explain with a simple example of a privately held S corporation that has no debt (I’m simplifying so that operating profits and earnings are equivalent).
Suppose I own a company with $100 million per year in sales and an expected operating margin equal to 10% so my profits = $10 million. Also suppose that my company has $50 million in tangible assets. Whether I’m contemplating a corporation reorganization or transferring the intangible assets to a Cayman Island entity (attorneys are thinking section 367(d) and section 482 with this latter tax angle), I might pay big bucks if some appraiser would argue that the market value of my entity is a mere $50 million. This valuation estimate would be credible only if the cost of capital for my enterprise is 20%. As we shall note later, Glassman might argue that the cost of capital is only 5%. But I’m already jumping ahead with a discounted cash flow (DCF) model without laying the foundations just yet.
Let’s backtrack and talk about “market” multiples – as if the market for my stock was precisely the same as the market for “comparable” stocks. Of course, one could always claim that the market for ground beef was the same as the market for ahi tuna, but go to any grocery store and notice that the latter costs more per pound. I’m sure someone at the IRS would argue that the price-earnings ratio should be 25, while some private practitioner would say it should be 5. Glassman once claimed that price-to-sales ratio are often one, but a price-to-sales ratio is really the product of the profit margin times the price-earnings ratio. And his book with Kevin Hassett was not suggesting that the typical price-earnings ratio is 10.
So let’s return to the DCF approach and assume the simple example of a steady state where sales and profits (in real terms) are expected to grow 3% per year. If Glassman argued that the cost of capital was only 5%, then the ratio of enterprise value to cash flows would be 50. Of course, he and Hassett forgot that cash flows are less than profits. In our example, reinvestment to support growth would be about 15% of profits (3% times tangible assets = $1.5 million) so cash flows would be about 85% of profits in our steady state example. In other words, his model would suggest that the enterprise value was $425 million – not $50 million.
You might be thinking that the wide difference in value estimates ($50 million v. $425 million) comes from extreme assumptions as to the cost of capital (20% v. 5%) and if one assumed a 10% cost of capital, then the value estimate would reasonably be around $120 million. Since I’ll argue for a somewhat lower cost of capital and the hacks who represent taxpayers often argue for higher cost of capital, I have provided a few examples of how the cost of capital impacts the value estimate in our scenario. Often these hacks learned valuation from the writings of Shannon Pratt who also wrote Cost of Capital who has this habit of providing an anything goes approach to estimating the cost of capital:
Exercises estimating cost of capital by the build-up model and the Capital Asset Pricing Model
Now you might know what CAPM is, but what is this “build-up model”? Whereas CAPM would estimate the cost of capital as the sum of the risk-free rate (e.g. 4%) and the premium for bearing systematic risk, Pratt tells his readers to also add a premium for bearing diversifiable risk – even though this add-on factor is inconsistent with the Arbitrage Pricing Theorem. Estimating the premium for bearing systematic risk requires an estimate of the equity risk premium for the overall stock market and an estimate of the unlevered beta coefficient for entities such as the one we are valuing (unlevered as we are assuming our entity has no debt). On the former, Hassett & Glassman were arguing for an equity risk premium of only 2% whereas Aswath Damodaran suggested equity risk premium between 4% and 8%. We shall assume that the equity risk premium is 6% and that the unlevered beta coefficient for our entity is 0.5. The build-up approach implicitly assumes that beta equals one and then starts adding on ad hoc factors. In other words, this approach starts with a 10% discount rate and then adds-on illogical nonsense until the spreadsheet lowers the value estimate to what the taxpayer wants to see.
The sad part is that taxpayer advocates often get away with this junk analysis as the IRS “experts” have often learned from the same set of books. I would like to say that tax valuations are done by true experts in financial economics. When Glassman lives in the real world of valuing companies for clients trying to make investment decisions, his willingness to make extreme assumptions and mathematical errors loses consulting opportunities for him (at least I hope it does). But in the world of tax advocacy, his willingness to inflate valuations by ignoring the reinvestment requirements from growth might actually serve to offset the dishonest advocacy from representatives of taxpayers. And if you think these experts for the taxpayer are smart enough to point out that value-to-profits (or price-earnings ratios) must be lower than the value-to-cash flow ratio, let me reassure the IRS that these Pratt trained appraisers often make the same mistake that Hassett & Glassman do. And yet, these goofballs often beat the IRS “experts” in court, which has to tell you why the rich realize they can get away with low-ball tax valuations.