A. Market Value Method
A common error in the valuation of businesses - particularly with appraisers who are unfamiliar with the practice of family law - is the application of the market value method to privately-held companies. Using the market value method, the appraiser simply applies to the business being valued the price-earnings ratio of a comparable public company.
For example, if the business being valued is a cosmetic company, and publicly-held cosmetic companies are selling for twenty times earnings, then the subject cosmetic business would be valued by multiplying by twenty its annual earnings. If the current market price of a publicly-held cosmetic company were $50 per share, and there were ten million shares of stock outstanding, then the market value of the company would be $500 million. If the marketplace currently expects that the company will have annual earnings of $100 million dollars, then the price-earnings ratio would be 500 to 100, or 5 to 1. Using this approach, the privately-held cosmetics company with $2 million in earnings would be valued at $10 million, by using the price-earnings ratio of 5 to 1, or five times annual earnings.
Two cases, In Re Marriage of Lotz (1981) 120 Cal.App.3d 379, 174 Cal. Rptr. 618, and In Re Marriage of Hewitson (1983) 142 CaI.App.3d 874, 191 CaI.Rptr. 392, have held that relying solely on the price-earnings ratio of publicly-traded corporations to value privately-held companies is error. These cases have reasoned that one cannot compare the stock of a business owned by a single shareholder, responsible to no one, that cannot be easily sold, to a company that is publicly-held and easily sold. Furthermore, an owner of a private company may eliminate most of the corporate profits by paying himself a large salary; a public company will not arbitrarily eliminate profits by paying out large salaries.
B. Discounted Future Earnings Method
Another valuation method that is occasionally used is the "discounted future earnings method." This method equates the value of a company to the present discounted value of the company's expected future earnings. The evaluator, for example, may determine that the company will earn $2 million in the two years following valuation, $2.5 million in the next two years, and $3 million for each year thereafter. The present discounted value of those millions, after adding in the residual value of the business at the end of the cash flow stream, constitutes the business' value. This approach, while acceptable as a valuation method for certain businesses, should not be used in valuing a professional practice. As the court in Marriage of Fortier (1973) 34 CaI.App.3d 384, 109 CaI.Rptr. 915, held: "Since the philosophy of the community property systemis that a community interest can be acquired only during the time of the marriage, it would then be inconsistent with that philosophy to assign to any community interest the value of post-marital efforts of either spouse." In Re Marriage of King (1983) 150 Cal.App.3d 304, 197 Cal. Rptr. 716, similarly rejected a valuation where the appraisal was "replete with references to post-separation efforts of husband."