The Economic Section of Business Appraisal Reports: Where’s the Beef?

August 20, 2015  |   Blog   |     |   0 Comment

The credibility of the appraisal profession suffers when economic sections of business valuation reports contain unfocused recitation of peripheral data.

Misapplication of Rev. Rul. 59-60.

It has been 56 years since the issuance of Revenue Ruling (Rev. Rul.) 59-60. 1 Its survival in its original form, and the fundamental reliance of most aspects of business valuation on its core precepts, suggest that the author (albeit apparently anonymous) of this Revenue Ruling should be acknowledged as the father or mother of modern valuation approaches. There are probably no responsibly-prepared business appraisals which do not incorporate its precepts. And conversely, failure to consider those precepts can often lead to demonstrably incorrect opinions. Misapplication of Rev. Rul. 59-60 As is the case with many guidelines and theories, however, Rev. Rul. 59-60 can be subject to misapplication, at least in part. Having reviewed hundreds of business appraisals over the last three decades, the present authors believe that the Rev. Rul. 59-60 prescription which is most abused is Section 4.01(b). This section states that one fundamental factor requiring careful analysis in each case is: The economic outlook in general and the condition and outlook of the specific industry in particular. All too often, appraisers use this section as a justification to blindly inflate the page content of their reports in order to impress clients with purported depth of thinking behind the ultimate opinion, and provide an ostensible basis for a larger fee. Unfortunately, the prevalence of commercially available economic summaries sometimes leads to the economic summary not being the work of the appraiser. And worse, sometimes the business appraiser assumes that breadth and purported depth replace a focused analysis of the interrelationship of economic indicators to the future performance of the appraisal subject.

Use of Filler.

Several years ago, one of us was serving as a mentor for a gentleman working on a demonstration report for his Certified Business Appraiser designation. The subject of the appraisal was a minority interest in a title company operating locally in a tourist and agriculture-oriented area of a western state. The first draft of the appraisal report was nearly 140-pages long. It was really pretty, but it was clearly dominated by filler material. The economic section was over 20 pages long and covered most aspects of the U.S. economy. The local section of the economic write-up included a paragraph of over 100 words describing the installation of a new radar system at the local (non-commercial) airport. We attempted to figure out why this information was included, but could arrive only at a tenuous connection between the ease of flying your own plane into a local landing strip and the future performance of the local residential real estate market. On reviewing the appraiser’s resume we realized that he was a private pilot, and while the information he included was of great interest to him it had no fundamental relevance to the appraisal problem (or to the company being valued).

In another more recent review, a candidate for the ASA designation prepared a demonstration report on a single-dentist general dentistry practice in the mid-south. Clearly, the driving economic factors should have been the population trends within a reasonable market radius from the office location and whether, within that area, per capita disposable income was and would remain sufficient to pay for dental services. These micro-economic factors were addressed only in passing, but there was significant information within another 20+ page economic section about abstruse and functionally irrelevant economic elements such as exchange rates and the trade balance. We questioned the candidate about why there was so little focus, but the response was not surprising. The data and related write-up had been downloaded from a subscription service, and the appraiser could see no benefit in editing out the chaff and focusing on a few choice grains.

Irrelevant Discussion.

Most recently, in a 2012 appraisal of a very small motor sports dealer in a rural area of a mid-south state, the appraiser’s economic section started out with a discussion of Hurricanes Katrina and Rita seven years earlier, which had no material local effect. He then spent the next several pages in a year-by-year exposition of irrelevant economic events in the years before the 2009 establishment of the business. This was followed by numerous single-spaced pages cut and pasted from a service, and included a discussion of the level of Greek debt maturing in 2012. At the end of the section was a printout from another service (but with data originally from the U.S. Census Bureau) containing demographic data on the subject’s home county. What made the work stand out was that there was no explicit attempt to tie any of the data to the valuation subject. It was simple regurgitation.

What Must the Report Include?

The questions remain: (1) what must and (2) what should be in the economic section of the report? The answer to the first question may be (dependent on the situation): nothing. That answer may surprise many, because arriving at it requires a careful reading of the question. Clearly, Rev. Rul. 59-60 is prescriptive, but it does not prescribe what must be written; instead, it prescribes what must be considered. For direction on what must be written, appraisers have to rely on the standards promulgated by the various certifying organizations.

Uniform Standards.

Standard 10 of The Uniform Standards of Professional Appraisal Practice (USPAP) covers appraisal reporting, but makes no specific reference to a mandatory economic report. It limits its comment to a reference to Standard 9, 2 which substantively quotes Rev. Rul. 59-60 and says: An Appraisal Report must include sufficient information to indicate that the appraiser complied with the requirements of STANDARD 9. The amount of detail required will vary with the significance of the information to the appraisal. Depending on the appraisal subject, compliance might require a detailed exposition; in others, it might be de minimis. Note that the USPAP contains a scope of work rule that requires that the work in the development of an appraisal be sufficient to develop a credible appraisal conclusion. A complement to this rule related to reporting is in USPAP Section 10-2: The appropriate reporting option and the level of information necessary in the report are dependent on the intended use and intended users. For situations in which the subject property is relatively immune from general economic conditions (for example, an early-stage biotech company with adequate funding), there may be no need for an economic section at all, particularly for a USPAP restricted report. Our favorite restricted report economic section is “Omitted by agreement with client.” Sometimes, however, a picture can be worth a thousand words; we may, for example, in the early-stage biotech case, add a chart showing the relative performance of an industry stock index to the broad market.

American Society of Appraisers.

The Standards of the American Society of Appraisers are, not surprisingly, in substantive conformity with the USPAP requirements, stating:

A comprehensive written business valuation report must include a business description that covers relevant factual matters related to the business, such as:…
G. Outlook for the economy, industry, and business (emphasis added)

Consistent Approach.

Those business appraisers not bound by the USPAP or ASA standards are generally bound by the Professional Standards of the National Association of Certified Valuators and Analysts (NACVA), the Statement on Standards for Valuations Services No. 1 (SSVS1) of the American Institute of Certified Public Accountants, or both. Because the AICPA took pains to avoid contradicting USPAP and the ASA, and the NACVA standards were designed to be in substantive conformity with the other commonly applicable standards, it should not be surprising that the issue of the economics section is consistent across the board. Paragraphs 51 through 70 of SSVS1 contain prescribed and suggested elements for a detailed report, as defined in the standard. Paragraph 51 notes that certain sections should be in a detailed report, but it does not prescribe an economic section, requiring “Analysis of the subject entity and related non-financial information.” Paragraph 53(h) requires disclosure of the source of any economic data used in the report. The requirements for a summary report, covered in Paragraphs 71-72, are even less specific. The NACVA Standards conform to those of the SSVS1.

What Should Logically be Included?

Having answered the first question, “What must be in the economic section?”—the second question remains—“What should logically be in an economic section of a business appraisal?” Clearly, consideration of the economy in the development of the appraisal conclusion is mandatory. No valuation standard permits ignoring the economy, and only the rarest of companies can operate without the economic environment in which they exist having an effect on them.

Nexus to Estimate of Future Growth.

The answer to the second question goes back to one of the fundamental questions driving any valuation assignment, and the comment in Rev. Rul. 59-60 that valuation is a prophesy. The relevance of the past is directly related to its utility in providing a window on the future. The future is represented by the growth rate of the free cash flow (available for distribution or discretionary reinvestment) of the subject business. The core purpose of an economic section in an appraisal report is the exposition of the facts and logic used to develop the estimate of future growth. Economic “analysis” which lacks a meaningful nexus to the estimation of future growth is, for appraisal purposes functionally irrelevant.

In unrestricted reports, as a matter of setting a platform for the view of the business in the economy, the focus should generally be on the following base indications:

    1. Real and nominal gross domestic product.
    2. Treasury yield curve at the valuation date and in comparison to the yield curves immediately prior to and during the Great Recession.
    3. Inflation, typically as represented by the all-items Consumer Price Index.
    4. Unemployment, as represented by the “headline” level (U-3 in technical terms).
    5. Job creation (non-farm).

These five factors provide a reasonable base for general analysis; other factors commonly discussed tend to correlate with them, if not contemporaneously, then with a lead or a lag.

Core Economic Elements.

Where appropriate, a detailed report must also discuss core economic elements (which are often industry-specific) which have event-driven or cyclical relevance to the subject. For example, it would be difficult to consider the value of a trucking business without a focus on fuel costs, and the firm’s ability to pass changes in cost through to customers without adversely affecting demand. Similarly, a lumber yard’s business cycle is inextricably tied to that of the housing industry. Sometimes, it is critical to focus on even micro-economies. As an example, assume that a child care center is located in an established sub-market in a rapidly growing metropolitan area. Once the center is operating at physical capacity, its ability to grow economically without material capital investment is limited by the price elasticity of its fees. Raise them too much, and customers could be driven away. If inflation is 3% and the metropolitan area population is growing at 3%, there is no assurance that revenue can be increased by +/- 6%. Inflation might well be the limit. However, if the population of children under five-years old in the immediate area is shrinking due to changes in demographics, the entire assumption of growth could be wrong despite inflation and regional expansion. If a major company located in the vicinity of the child care facility were to close, revenue could fall dramatically. Just as all politics is, ultimately, local, in some cases, the most meaningful economic indicators are local.


The all-too typical inclusion in a report of an economic section of ten or more pages with unfocused data, lacking nexus to the valuation subject, is damaging both to the appraiser and to the profession. A sophisticated client will, on reading (or more often, ignoring) this data will ask “Why is this relevant and why did my appraiser include it?” Too often, the answer is that the information was not relevant, and there was no reason for inclusion other than to justify a larger charge for the appraisal. When attorneys and judges see this lack of focus repeated regularly by members of the appraisal community, appraisers’ credibility as professionals suffers. Rev. Rul. 59-60 provides valuable guidance to appraisers in the form of eight identified areas for consideration. The fact that earnings and dividend capacity are accounting-driven does not mandate a detailed examination and written exposition about the contents of the prepaid expenses account. Similarly, the prescription to consider the economic outlook in general does not, and should not, lead to unfocused recitation of economic data which is, all too often, peripheral at best.

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