The Top-Down Valuation Process for Equity Securities

by Linda Ray

There is a vast amount of data that must be considered when developing the value of a business for equity securities and shareholder information. Mergers and acquisitions also rely on an effective valuation process during business negotiations. The Internal Revenue Service sets the framework in which a top-down valuation occurs.

Guidelines

IRS Revenue Ruling 50-60 provides established guidelines that prevail in the valuation industry. The guidelines simplify the top-down valuation process by providing a framework that relies on an eight-point list of factors to consider. The ruling is recognized by accountants, attorneys and regulators. A top-down evaluation following IRS Revenue Ruling 50-60 takes into consideration the company’s history and the economic and market outlook for the industry. It calls for you to look at the company’s financial records to include dividend-paying and earnings capacity, past stock sales and the size of the stock blocks sold. A comparison of prices for similar companies and the amount of goodwill earned by the company also are considered.

Purpose

While a fair market valuation is necessary when a company is being sold, the fair value is determined for investment purposes and doesn’t hinge on an expected sale. Discounts aren’t applied when performing a top-down valuation for equity security purposes because of the volatility of the market. The investment value is more relevant for shareholders and is especially important when the company does not have many competitors with which you may compare it and no market exists for that kind of stock at the moment.

Angles

The top-down valuation process begins with the big picture and includes current market forces and overall economic activity. It then narrows down to focus on the internal details of the company. You may follow three approaches to discovering a fair value of a company and its stock. The income approach considers future gains and converts them into current levels of income to produce a picture of the company’s health in today’s market. Using the angle of the market approach, you would consider the value of similar businesses in the same industry or companies that share similar business interests. The third approach is taken from the angle of current assets and bases value on the company’s liabilities and assets to come up with a net equity.

Conclusions

An appraiser may utilize a number of valuation approaches and compare the various results. Reconciling any differences can help you see the flaws in different approaches and look for the best indicators of the company’s equity. The bottom line must coincide with a reasonable valuation based on all the eight factors prescribed by the IRS. For example, applying the reasonable test, if a stock seems overly valued, then trying another angle to value the stock may be appropriate to determine a final valuation that makes more sense and is in line with a general consensus.

About the Author

Linda Ray is an award-winning journalist with more than 20 years reporting experience. She's covered business for newspapers and magazines, including the "Greenville News," "Success Magazine" and "American City Business Journals." Ray holds a journalism degree and teaches writing, career development and an FDIC course called "Money Smart."

Photo Credits

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