Moore, Ellrich & Neal P.A

There is a general consensus among appraisers that a controlling ownership interest in a pass-through firm should not be worth much more than a controlling ownership interest in an otherwise identical double-tax firm. This “general consensus” primarily stems from empirical studies that have compared the pricing multiples of pass-through firms to that of double-tax firms in the market for control. For example, in a recent study of the Pratt’s Stats Database, the author of this post compared the pricing multiples of over 7,000 market transactions and found very weak, if any, statistical evidence in support of a pass-through premium in the market for controlling ownership interests. As such, many appraisers have concluded that a pass-through premium should not apply when determining the fair market value of a controlling ownership interest in a pass-through firm.

The business valuation community has long debated the merits of applying an S-Corporation Premium to a controlling ownership interest in a private business, and sometimes with mixed results. One of the first studies that I am aware of was published by Merle Erickson, associate professor of accounting at the University of Chicago Graduate School of Business (see “Tax Benefits in Acquisitions of Privately Held Corporations,” Capital Ideas 3, no. 3, Winter 2002). In that study, Professor Erickson and his colleague, Shiing-wu Wang, compared the purchase prices of 77 matched pairs of taxable stock acquisition of S and C Corporations and concluded that S-Corporations were priced 12 to 17 percent higher than C-Corporations. A second study, however, performed by Michale J. Mattson, MBA, Donald S. Shannon, PhD, CPA, and David E. Upton, PhD, CFA, which was based upon transactions in the Pratt’s Stats Database, found little empirical evidence to support the existence of an S-Corporation premium. Since then, several other articles have been published debating the merits of the S-Corporation Premium. To my knowledge, the most recent empirical study was performed in 2004 by John R. Phillips (see “S Corp or C Corp? M&A Deal Prices Look Alike,” Shannon Pratt’s Business Valuation Update, March 2004). In that study, Phillips, who also analyzed deal information in Pratt’s Stats, essentially confirmed the findings of the Mattson et. al study (i.e. that an S-Corp Premium did not exist).

The price-to-revenue multiplier is a popular valuation multiple, especially for service firms such as accounting practices or insurance companies. Mechanically, valuing a company using a price-to-revenue multiple is relatively straightforward (i.e. multiply the underlying revenue of the subject company by the revenue multiplier to derive an indication of value). However, proper application of the price-to-revenue multiplier is more complicated than the simple mathematics suggest, as profit margins have a significant theoretical impact on the size of the price-to-revenue multiplier.

In constructing the cost of equity capital, Duff & Phelps currently recommends that investors/valuation analysts use a 5.5% equity risk premium and a 4% normalized risk-free rate (i.e. a total cost of equity capital of 9.5%). The normalized risk free rate, which is based upon a long-term average rate, is used in place of the spot yield during those months in which Duff & Phelps believes the risk-free rate is artificially low (however that is determined). In my opinion, while the Duff & Phelps methodology develops an appropriate base cost of capital that is consistent with other metrics that I commonly rely upon, the concept of “normalizing” the risk free rate is problematic for two reasons. First, normalizing the risk free rate creates an “artificial” rate of return that is not available for investors to actually purchase. Second, normalizing the risk-free rate distorts the composition of investor’s future expectations of returns relative to other models.