In re: Marriage of Hewitson

[142 Cal.App.3d 874, 191 Cal.Rptr. 392 (1983)]
In valuing closely-held stock appraisers should consider each of the eight factors set forth in Revenue Ruling 59-60.

This 1983 case asking the Second District Court of Appeal to address the issue of determining the value of closely–held stock that is part of the marital estate set forth several seminal rules, not the least of which is that the trial court may rely on “investment value” rather than “market value” in determining the value of the marital estate pursuant to then Civil Code §4800, though neither of these terms is clearly defined.

The Court also decried the use of price/earnings ratios from publicly traded stocks as the sole indicator of value for closely held shares that are part of the marital estate, finding that such a method is “....unreliable … to determine the value of close corporation shares …[because] closely held corporations possess characteristics which make them inherently different from publicly held corporations, with the primary difference being the lack of marketability” (142 Cal.App.3d 886, citing In re Marriage of Lotz, 120 Cal.App.3d at 384).

Here, the Court was presented with a trial court decision embracing the $9 million value for the community-owned corporate stock found by wife’s expert, who relied chiefly on the price/earnings ratios of companies that had been acquired by other corporations in exchange for stock in the acquirer, rather than price/earnings ratios from stocks that are listed on a stock exchange or over-the-counter.

Consideration of Rev. Ruling 59-60. Our discussion here, though, is focused on another holding of the Court, that “… the [valuation] of infrequently sold, unlisted, closely held stock is a difficult legal problem. Most of the cases illustrate [that] there is no one applicable formula that may be properly applied to the myriad factual situations calling for the valuation of closely held stock. It is therefore, incumbent upon a court faced with such a problem to review each factor that might have a bearing upon the worth of the corporation and hence upon the value of the shares. Unless there is some statutory or decisional proscription on their use, the factors listed in Revenue Ruling 59-60 should be consulted and used to evaluate closely held stock.” (supra. at page 888).

Current business appraisal literature embraces this notion, little of which existed at the time of this decision, and most appraisers would agree that the 8 factors set forth in Revenue Ruling 59-60 are the fundamental considerations in appraising stock in closely-held entities. These factors are listed in every appraisal textbook and on the lips of every business appraiser.

The Eight Factors. The eight factors given in Revenue Ruling 59-60 1 are:

(a) The nature of the business and the history of the enterprise from its inception;
(b) The economic outlook in general and the condition of the specific industry in particular;
(c) The book value of the stock and the financial condition of the business;
(d) The earning capacity of the company;
(e) The dividend-paying capacity;
(f)  Whether or not the enterprise has goodwill or other intangible value;
(g) Sales of stock and the size of the block of stock to be valued; and
(h) The market price of stock of similar corporations engaged in the same or similar line of        business having their stock actively traded in a free and open market, either on an        exchange or over-the-counter.

So in-grained in the appraisal profession are these eight factors, that many business appraisers organize their written reports under these eight headings and cross reference each of their considerations to the list of factors.

In 1983, when Hewitson was published, the business appraisal profession was in its infancy. Today, nearly 20 years later, the literature is well developed, and much has been written about the tenets of Revenue Ruling 59-60. Numerous texts fully discuss the implications of each of the eight factors in the valuation of interests in closely-held companies.

The use of publicly traded stock by analogy as a proxy for the value of stock in closely-held corporations (or other business entities, for that matter) is a widely accepted technique today, notwithstanding the holding of the Hewitson Court.

The Court confuses the matter further by misunderstanding the terms “market value:

Fair Market Value. Court seemed to be looking for a valuation method that generated an estimate of the Fair Market Value of the closely-held shares, though it never clearly indicated this. At 142 Cal.App.3d 882 the Court attempts to identify methods that result in the market value of the shares. It cites methods that rely on comparisons between the subject shares and publicly traded shares. These methods are known today as Guideline Public Company Methods, and estimate the value of the closely-held shares by multiplying the price/earnings ratio of publicly traded shares in similar companies by the earnings of the subject company.

As we related in our previous issue, this 1983 case asking the Second District Court of Appeal to address the issue of valuing the value of closely–held stock that is part of the marital estate set forth several seminal rules, not the least of which is that the trial court may rely on “investment value” rather than “market value” in determining the value of the marital estate pursuant to then Civil Code §4800, though neither of these terms is clearly defined.

Here, the Court was presented with a trial court decision embracing the $9 million value for the community-owned corporate stock found by wife’s expert, who relied chiefly on the price/earnings ratios of companies that had been acquired by other corporations in exchange for stock in the acquirer, rather than price/earnings ratios from stocks that are listed on a stock exchange or over-the-counter.

The Court also decried the use of price/earnings ratios from publicly traded stocks as the sole indicator of value for closely held shares that are part of the marital estate, finding that such a method is “....unreliable … to determine the value of close corporation shares …[because] closely held corporations possess characteristics which make them inherently different from publicly held corporations, with the primary difference being the lack of marketability” (142 Cal.App.3d 886, citing In re Marriage of Lotz, 120 Cal.App.3d at 384).

Investment Value. Citing a bad holding in Estate of Rowell (132 Cal.App.2d 421 [1955]) the Hewitson Court carefully distinguished between the investment value of shares in a closely-held company and market value, though it did not so carefully identify the reasons why this difference (if indeed it actually exists) was important to them.

The Court recited three approaches to value, 1) the capitalization of earnings approach, 2) the dividend-paying capacity, and 3) the book value or net asset approach, and stated unequivocally that the application of these methods results in the “investment value” of the shares in the closely-held company: “The application of these approaches… will determine the investment value of the closely-held shares, not their market value.” It’s unclear whether the Court believed that “market value” and “fair market value” mean the same thing.

Confusion Reigns. To say that the Hewitson court was confused is understatement. Where the assumed standard of value is fair market value - which it usually is in family law matters - all of the methods cited by the Court normally result in an estimate of Fair Market Value of the shares. The notion of investment value is unrelated to the issues before the Court in this case (see sidebar below). As the Court acknowledged, “...the determination of the value of infrequently sold, unlisted closely held stock is a difficult legal problem.” Perhaps it’s a problem best left to qualified appraisers.