When considering an appropriate rate of return for a closely held business, alternative investments must be used as a benchmark ("What's It Worth to You?" July). On July 6, 1982, an investor could expect to earn a 14% rate of return on 30-year U.S. Treasury securities. Why would a rational investor buy the assets of a small, risky business with the expectation of earning only a 12% rate of return? Since the stocks of major publicly traded companies are currently priced to earn an expected return of more than 17%, the least an investor in a small business should expect to earn at this time would be approximately 20%.
Assuming that the $67,200 pretax earnings figure for the business valued in Mr. Howard's article is reasonable for the business to expect in the future, paying $381,680 for the company and then adding $40,000 in working capital implies the investor will have an aftertax return of less than 13%. Given the risk involved in a small company, this is not adequate.
Mr. Howard replies: The 12% rate was used only for tangible assets that are reasonably secure and well sheltered from taxes (unlike Treasury securities). The blended rate of return for the business used in the example was 20.2%, close to Mr. Ryan's suggested return.
The IRS so frequently employs the basic methodology used in my method that it is often called "the IRS Method." My approach is much more precise and structured, particularly with respect to definition of earnings and capitalization of excess earnings.
Such flaws in the IRS approach as use of average return on assets for publicly held companies often lead to excessively high valuation.