A Contextual Analysis of Incomeand Asset-Based Approaches to Private Equity Valuation

Abstract

The question of how to best value privately held businesses for purposes of taxation and other legal reasons remains open to debate. In general, valuation models are asset-based, income-based, or hybrid models that aggregate asset and income information. An example of the latter is the controversial excess earnings method recommended by IRS Rev. Rul. 68–609. In this research, we focus on the relative performance of the excess earnings method vis-a`-vis other widely used valuation models. We consider the valuation accuracy of each model in a general setting along with examining contextual performance under varying levels of intangible versus tangible assets and varying levels of business profitability. We show that the hybrid model provides superior valuation accuracy in general and more consistent valuation accuracy across the contexts examined. We also show that the inclusion of two capitalization rates in the excess earnings method, which is required in order to distinguish returns from tangible versus intangible assets, provides increasing relative valuation accuracy over that of the single-rate earnings capitalization model as the two rates diverge. In summary, we demonstrate that for privately held firms, which typically lack analyst following and independent earnings forecasts, the excess earnings method represents a viable valuation alternative.