WALL v. COMMISSIONER

T.C. Memo. 2001-75

UNITED STATES TAX COURT

JOHN E. WALL, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

JOANNE WALL, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 1590-98, 1850-98. Filed March 27, 2001.

These are gift tax valuation cases in which the
transferred property is nonvoting common stock of a
family corporation given by petitioners to 20 trusts
for their 10 children. The value per share determined
by the statutory notices exceeded the value claimed in
the gift tax returns by only 17 percent. The reports
prepared by the experts for trial came up with values
that widened the gap between the parties’ initial
positions. In Buffalo Tool & Die Manufacturing Co. v.
Commissioner, 74 T.C. 441, 451-452 (1980), the Court
suggested that valuation cases should be settled, and
warned the parties that in some cases the Court might
be persuaded to adopt the position of one party, rather
than to split the difference between their positions;
these are such cases. Held: the determination of
value in the statutory notices is sustained.
 - 2 -

Rex A. Guest and Melvin L. Katten, for petitioners.

Michael F. O’Donnell and George W. Bezold, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

BEGHE, Judge: Respondent determined a $73,789 deficiency in

petitioner John E. Wall’s gift tax for calendar 1992. Respondent

also determined a $73,789 deficiency in the 1992 gift tax of Mr.

Wall’s spouse, petitioner Joanne Wall. Mrs. Wall is a party to

these consolidated cases solely because petitioners elected to

treat Mrs. Wall as the donor of one-half of the gifts Mr. Wall

made during 1992. See sec. 2513.1

The only issue for decision is the fair market value, as of

January 1, 1992, of 9,380 shares of Demco, Inc., nonvoting common

stock, which Mr. Wall gave on that date to 20 trusts for the

benefit of his children. Petitioners claimed on their gift tax

returns that the fair market value of the stock was $221.75 per

share. Respondent asserted in the statutory notices that the

correct value was $260.13 per share, approximately 17 percent

more than the value claimed by petitioners.

1
All section references are to the Internal Revenue Code in
effect for 1992, and all Rule references are to the Tax Court
Rules of Practice and Procedure, unless otherwise specified.
 - 3 -

FINDINGS OF FACT

Petitioners resided in Madison, Wisconsin, when they filed

the petitions in the cases at hand.

Demco, Inc. (Demco), is a Wisconsin corporation that has

elected to be an S corporation for Federal income tax purposes.

Mr. Wall was Demco’s sole stockholder immediately before the

gifts in issue. He owned all 1,200 issued and outstanding shares

of Demco’s voting common stock and all 12,000 issued and

outstanding shares of Demco’s nonvoting common stock.

On January 1, 1992, Mr. Wall (as grantor) and Michael O.

Hartz (as trustee) created two irrevocable trusts for the benefit

of each of Mr. Wall’s 10 children. Of these 20 trusts, 10 were

known as “annual exclusion” trusts, and 10 were known as

“nonvoting stock” trusts.

Also on January 1, 1992, Mr. Wall gave 443 shares of his

Demco nonvoting common stock to each of the annual exclusion

trusts and 495 shares of his Demco nonvoting common stock to each

of the nonvoting stock trusts. As a result of these

transactions, Mr. Wall gave 938 shares of the Demco nonvoting

common stock to trusts for the benefit of each of his 10

children, for total gifts of 9,380 shares (collectively, the

gifts).
 - 4 -

After the gifts, Mr. Wall continued to own all 1,200 shares

of Demco’s voting common stock and the remaining 2,620 shares of

Demco’s nonvoting common stock.

Demco’s stock was not listed on an exchange on or around the

date of the gifts, and there was no other public market for Demco

stock.

Demco’s History and Business

Demco is a direct mail distributor and manufacturer of

office supplies, furniture, and accessories. Demco’s principal

customers are libraries, schools, and professional and business

offices. Demco distributes its products nationwide and has over

100,000 customers.

Demco started doing business in 1906 as part of the Democrat

Printing Company of Madison, Wisconsin. In 1931, Demco was

chartered as Demco Library Supplies, Inc., a company owned and

operated by Norman Bassett. In January 1972, Demco became a

wholly owned subsidiary of George Banta Co. of Menasha,

Wisconsin, a publicly owned educational printer. In 1978,

following a failed takeover attempt by another corporation,

Demco’s management (including Mr. Wall, who was then Demco’s

president and chief executive officer) acquired Demco’s stock in

a leveraged buyout.

Demco’s headquarters are in Madison, Wisconsin. At the time

of the gifts, Demco also operated a 15,700 square foot
 - 5 -

distribution facility in Fresno, California, and a 131,000 square

foot distribution, manufacturing, and converting facility in

DeForest, Wisconsin.

Demco had built a strong reputation for quality, service,

and moderate pricing by the time of the gifts, all of which gave

Demco good name recognition and a strong market position. Demco

also had a strong continuing customer base which generated repeat

business.

Demco had an experienced management team at the time of the

gifts that had worked together for many years. Demco’s

relationship with its workforce (which was nonunion) was good,

turnover was low, and Demco had not experienced any difficulty

recruiting qualified employees at all levels. During 1991, the

year immediately prior to the gifts, Demco had approximately 235

employees.

Demco’s net revenues and net income for 1987-91 (the 5 years

prior to the gifts), and Demco’s projected net revenues and net

income for 1992 (the year of the gifts, as projected by

management around the time of the gifts) were as shown in the

following table:2

2
The financial information in the table was compiled from
Demco’s audited and unaudited financial statements and
management’s projections for 1992, as adjusted by petitioners’
expert Donna J. Walker (Ms. Walker) to eliminate the results of
Demco’s media division, which was sold in 1991. Respondent’s
(continued...)
 - 6 -

Year Net Revenues Net Income
1987 $21,922,286 $1,615,877
1988 25,060,137 1,314,997
1989 27,256,611 1,361,810
1990 29,770,281 1,002,367
1991 30,536,365 511,072
1992 (Projected) 31,260,786 1,434,198

As the foregoing table shows, Demco’s net revenues increased

steadily from 1987 to 1991 and were projected to continue to

increase in 1992. Demco’s net income, however, decreased from

1987-90, then fell more sharply in 1991, but was projected to

recover in 1992.

The decrease in Demco’s net income was not caused by any

increase in Demco’s cost of goods sold; Demco’s gross margin

increased from 43.9 percent of net revenues in 1987 to 45.5

percent of net revenues in 1991. Rather, Demco’s declining

profitability was attributable to increases in its marketing and

administrative expenses. From 1987 to 1991, Demco’s marketing

expenses increased from 16.5 percent of net revenues to 19.3

percent; administrative expenses increased even more sharply over

the same period, from 9.7 percent of net revenues to 16.3

percent.

2
(...continued)
expert Gary L. Schroeder (Mr. Schroeder) considered this
information to be reliable and used it to prepare his report.
 - 7 -

Demco’s management predicted that these trends would be

reversed and that Demco’s net income would return to historic

levels in 1992.3 Nevertheless, at the beginning of 1992 general

economic conditions were unfavorable and Demco’s principal

customers (libraries and schools) were suffering from budget

cuts. However, many economists predicted that a weak recovery

would begin in mid to late 1992.

Media Division Sale

From about 1970 or 1971 to June 1, 1991, Demco operated two

other businesses, which the parties refer to as Demco’s “media

division”. One of these businesses converted paperback books for

use in school libraries, by rebinding the books in hard covers

using Demco’s “Turtle Back” process. The other business provided

periodical subscriptions management services for libraries.

In June 1991, Demco discontinued the operations of the media

division and sold the division’s assets to a limited partnership.

An S corporation owned entirely by Mr. Wall was the purchasing

partnership’s 1-percent general partner; an irrevocable trust for

the benefit of Mr. Wall’s family was the purchaser’s 99-percent

limited partner.

3
In particular, Mr. Wall testified that the expenses of a
poorly performing division had caused 1991 earnings to decline by
approximately $535,000; that division was later terminated.
 - 8 -

The sales price for the media division’s assets was

$1,200,000. Of this amount, Demco received $120,000 in cash; it

also received the purchasing partnership’s note (media note) for

the remaining $1,080,000 due. The media note was collateralized

by substantially all of the acquired assets and bore interest at

7.64 percent. Mr. Wall expected Demco to receive full payment of

the media note, and the note’s outstanding principal amount had

been reduced to approximately $430,000 by the time of trial.

Prior Transactions in Demco Stock

The parties have identified six transactions in Demco stock

that occurred between 1978 and the gifts in 1992. All six

transactions involved the sale or repurchase of stock to or from

Demco employees. Three of the transactions occurred more than 5

years before the gifts. The three others occurred approximately

2 years before the gifts, on February 9, 1990, when Demco

redeemed a total of 600 shares of its voting common stock from

three of its officers.

The redeemed shares were subject to a buy-sell agreement at

the time of the redemptions. The redemptions were not made

pursuant to that agreement, because neither of the events that

would have triggered the agreement (the death or termination of

employment of any of the officers/shareholders) had occurred.

The redemption price paid to each officer was instead determined

through individual negotiations. However, under the terms of the
 - 9 -

buy-sell agreement, each officer ultimately would have been

entitled to receive the book value of his stock upon his death or

earlier termination of employment.4

The parties agree that the book value of the redeemed stock

shortly before the redemptions was $4,391 per share. The average

redemption price of $4,750 per share therefore exceeded that book

value by approximately 8 percent.

Demco’s equity capital immediately before the redemptions

consisted of 1,800 shares of voting common stock, 1,200 of which

were owned by Mr. Wall. The 600 shares redeemed therefore

represented a one-third, voting but noncontrolling, interest in

Demco. If (1) the average redemption price was equal to the fair

market value of the redeemed stock and (2) each share of Demco’s

stock had the same value, then after adjusting for the greater

number of shares (13,200) outstanding at the time of the gifts,

the $4,750 average redemption price would have been equivalent to

approximately $432 per share.5

4
As matters turned out, two of the officers did not retire
until 6 years after the redemptions, in 1998; the third officer
was still employed by Demco at the time of trial (March 1999).
5
The calculation is ($4,750 average redemption price per
share) times (1,200 shares outstanding after redemption) equals
($5,700,000 post-redemption value) divided by (13,200 shares
outstanding at time of gifts) equals ($432 per share).
 - 10 -

Demco’s net income fell sharply during the 2 years between

the redemptions and the gifts.6

OPINION

Preliminary Observations

Before discussing our findings and analysis of value, we

make some observations about the cases at hand and about

valuation cases generally.

First, the parties’ original positions, as set forth in the

gift tax returns and the statutory notices, were not very far

6
Petitioners asserted before trial that the redemptions and
the sale of the media division had “never been properly raised as
issues by respondent”. Petitioners objected on that ground to
our consideration of any facts or issues relating to those
transactions.

Notwithstanding their objections, petitioners introduced
evidence at trial concerning the redemptions and the media
division sale. Petitioners’ briefs do not mention any objection
to our consideration of this evidence. Moreover, petitioners’
briefs contain extensive proposed findings of fact concerning
both the redemptions and the media division sale; they also set
forth petitioners’ arguments on the effect those transactions
should have on our determination of the fair market value of
Demco stock. As a result, petitioners have waived their
objections. See Stringer v. Commissioner, 84 T.C. 693, 706
(1985), affd. without published opinion 789 F.2d 917 (4th Cir.
1986); Estate of Miller v. Commissioner, T.C. Memo. 1998-416
(objection to admission of testimony held waived because
objecting party’s brief proposed finding of fact and set forth
argument based on that testimony). We also note that the
original report of petitioners’ expert Ms. Walker discussed both
the redemptions and the media division sale. Petitioners
submitted a copy of that report with their gift tax returns and
rely on it in the cases at hand.
 - 11 -

apart. The $260.13 value determined in the notices was only 17

percent greater than the $221.75 value claimed in the returns.

Second, this litigation has not helped the parties settle

and compromise their differences; to the contrary, it has

driven the parties further apart. The overall value of $192.20

per share set forth in the revised report of petitioners’ expert

Donna J. Walker (Ms. Walker) is lower than the value claimed in

the gift tax returns; the overall value of $273.99 per share set

forth in the report of respondent’s expert Gary L. Schroeder

(Mr. Schroeder) is higher than the value determined in the

statutory notices, although respondent has not asserted an

increased deficiency.7

In light of these observations, what the Court had to say in

Buffalo Tool & Die Manufacturing Co. v. Commissioner, 74 T.C. 441

(1980), concerning the “pure factual issue” of valuation, is

particularly germane to the cases at hand:

As the Court repeatedly admonished counsel at trial,
the issue is more properly suited for the give and take
of the settlement process than adjudication. The
existing record reeks of stubbornness rather than
flexibility on the part of both parties, based upon "an
overzealous effort * * * to infuse a talismanic
precision" into their respective views as to valuation.

7
Notwithstanding their differing conclusions about value,
the parties’ experts agree on many important matters concerning
the proper measure of Demco’s historical financial performance,
the methods to be used to appraise value based on that
performance, and the availability and magnitude of lack of
marketability and nonvoting stock discounts. See infra p. 38.
 - 12 -

We are convinced that the valuation issue is capable of
resolution by the parties themselves through an
agreement which will reflect a compromise Solomon-like
adjustment, thereby saving the expenditure of time,
effort, and money by the parties and the Court--a
process not likely to produce a better result. Indeed,
each of the parties should keep in mind that, in the
final analysis, the Court may find the evidence of
valuation by one of the parties sufficiently more
convincing than that of the other party, so that the
final result will produce a significant financial
defeat for one or the other, rather than a middle-of-
the-road compromise which we suspect each of the
parties expects the Court to reach. * * * [Id. at 451-
452; citations omitted.]

Of course, because the parties have insisted that we value the

Demco stock, we shall do our job.

For the reasons set forth below, we conclude petitioners

have not shown that the value of the gifts was less than the

$260.13 per share respondent determined in the statutory notices.

To the contrary, the record persuades us that the value was at

least equal to that amount.

In reaching this conclusion, we are not imposing a sanction

on petitioners, cf. the taxpayer’s argument in Estate of Kaplin

v. Commissioner, 748 F.2d 1109, 1111-1112 (6th Cir. 1984), revg.

on another ground T.C. Memo. 1982-440, nor should Buffalo Tool &

Die be interpreted as expressing an intention to do so in any

comparable circumstances. See Parker v. Commissioner, 86 T.C.

547, 562 (1986). We have merely found respondent’s original

determination in the statutory notices to be closer to the actual
 - 13 -

value than either petitioners’ return position or the position

taken in petitioners’ expert’s revised report.

Relevant Law

Section 2512(a) provides that, if a gift is made in

property, “the value thereof at the date of the gift shall be

considered the amount of the gift.” Value for this purpose is

fair market value; i.e., the price at which the property would

change hands between a willing buyer and a willing seller,

neither being under any compulsion to buy or to sell, and both

having reasonable knowledge of relevant facts. See sec. 25.2512-

1, Gift Tax Regs.; see also United States v. Cartwright, 411 U.S.

546, 551 (1973).

Mr. Wall gave 9,380 shares of Demco nonvoting common stock

to 20 trusts for the benefit of his children on January 1, 1992.

The cases at hand therefore require us to determine the fair

market value of that Demco stock as of the date of the gifts,

January 1, 1992.

If stock is listed on an exchange or there is otherwise a

market for the stock, fair market value generally is determined

by reference to the stock’s quoted selling prices or bid and

asked prices, at or around the time of the gift. See sec.

25.2512-2, Gift Tax Regs. If there is no market for the stock,

arm’s-length transactions made in the normal course of business,

within a reasonable time before or after the date of the gift,
 - 14 -

may be the best evidence of fair market value. See Ward v.

Commissioner, 87 T.C. 78, 101 (1986); Estate of Andrews v.

Commissioner, 79 T.C. 938, 940 (1982); Duncan Indus., Inc. v.

Commissioner, 73 T.C. 266, 276 (1979).

Demco stock was not listed on an exchange at the time of the

gifts, and there was no other public market for Demco stock. The

parties have identified six transactions in Demco stock occurring

prior to the gifts. However, three of these transactions

occurred more than 5 years before the gifts. The three others

(the redemptions from Demco’s officers) were consummated almost 2

years before the gifts; Demco’s net income declined sharply

during those years. Moreover, the officers whose stock was

redeemed would have been entitled, under the terms of the buy-

sell agreement, to receive the book value of the stock upon their

deaths or earlier terminations of employment. The redemption

price actually paid was only slightly higher than book value.

For all these reasons, the redemptions and other prior

transactions in Demco stock are not the best evidence of, and

should not by themselves determine, the fair market value of

Demco stock on the date of the gifts.

In cases such as those at hand, where there is no market for

the stock to be valued and there are no dispositive arm’s-length

transactions, fair market value is to be determined by taking all
 - 15 -

“relevant factors” into account.8 See sec. 25.2512-2(f), Gift

Tax Regs. The factors we must consider are those that an

informed buyer and an informed seller would take into account.

See Hamm v. Commissioner, 325 F.2d 934, 938 (8th Cir. 1963),

affg. T.C. Memo. 1961-347. Rev. Rul. 59-60, 1959-1 C.B. 237,

“has been widely accepted as setting forth the appropriate

criteria to consider in determining fair market value”, Estate of

Newhouse v. Commissioner, 94 T.C. 193, 217 (1990); it lists the

following factors to be considered, which are quite similar to

the “relevant factors” listed in section 25.2512-2(f), Gift Tax

Regs.:

(a) The nature of the business and the history of the
enterprise from its inception.

(b) The economic outlook in general and the condition
and outlook of the specific industry in particular.

8
Petitioners’ expert Ms. Walker stated that the three
transactions in Demco stock that occurred more than 5 years
before the gifts were “not deemed relevant to the valuation” due
to the passage of time. By contrast, Ms. Walker asserted that
the redemptions were “not conclusively indicative of fair market
value” due to the buy-sell agreement. However, she never stated
that they were irrelevant.

We agree with Ms. Walker’s conclusion that none of the prior
transactions is determinative. However, we believe that the
redemptions, which took place at a price equivalent to
approximately $432 per share, are nevertheless relevant evidence
of the value of the gifts, to be taken into account with all
other relevant factors. Although the three officers/shareholders
could have received book value for their stock upon their deaths
or terminations of employment, two of the officers did not choose
to retire until 6 years after the redemptions; the third was
still in Demco’s employ at the time of trial.
 - 16 -

(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 the stock and the size of the block of
stock to be valued.

(h) The market price of stocks of corporations
engaged in the same or a similar line of business
having their stocks actively traded in a free and open
market, either on an exchange or over-the-counter.

In short, the fair market value of the Demco stock is a

question of fact that depends on all the circumstances. See

Anderson v. Commissioner, 250 F.2d 242, 249 (5th Cir. 1957),

affg. in part and remanding in part on another ground T.C. Memo.

1956-178; Estate of Newhouse v. Commissioner, supra at 217;

Skripak v. Commissioner, 84 T.C. 285, 320 (1985). The weight to

be accorded any particular evidentiary factor is also to be

determined by the circumstances. See sec. 25.2512-2(f), Gift Tax

Regs.

As is customary in valuation cases, the parties primarily

rely on expert opinion evidence to support their positions.

We evaluate expert opinions in light of the demonstrated

qualifications of each expert and all other evidence in the

record. See Anderson v. Commissioner, supra at 249; Parker v.

Commissioner, supra at 561. We have broad discretion to evaluate
 - 17 -

“‘the overall cogency of each expert's analysis.’” Sammons v.

Commissioner, 838 F.2d 330, 334 (9th Cir. 1988) (quoting Ebben v.

Commissioner, 783 F.2d 906, 909 (9th Cir. 1986), affg. in part

and revg. in part T.C. Memo. 1983-200), affg. in part and revg.

in part on another ground T.C. Memo. 1986-318. Expert testimony

sometimes aids the Court in determining value; sometimes it does

not, particularly when the expert is merely an advocate for the

position argued by one of the parties. See, e.g., Estate of

Halas v. Commissioner, 94 T.C. 570, 577 (1990); Laureys v.

Commissioner, 92 T.C. 101, 129 (1989).

We are not bound by the formulas and opinions proffered by

an expert witness and will accept or reject expert testimony in

the exercise of sound judgment. See Anderson v. Commissioner,

supra at 249; Estate of Newhouse v. Commissioner, supra at 217;

Estate of Hall v. Commissioner, 92 T.C. 312, 338 (1989). Where

necessary, we may reach a determination of value based on our own

examination of the evidence in the record. See Lukens v.

Commissioner, 945 F.2d 92, 96 (5th Cir. 1991) (citing Silverman

v. Commissioner, 538 F.2d 927, 933 (2d Cir. 1976), affg. T.C.

Memo. 1974-285)). Moreover, while we may accept the opinion of

an expert in its entirety, see Buffalo Tool & Die Manufacturing

Co. v. Commissioner, 74 T.C. at 452, we may be selective in the

use of any part of such opinion or reject the opinion in its

entirety, see Seagate Tech., Inc. v. Commissioner, 102 T.C. 149,
 - 18 -

186 (1994), and authorities cited therein. Finally, because

valuation necessarily results in an approximation, the figure at

which we arrive need not be directly attributable to specific

testimony if it is within the range of values that may properly

be arrived at from consideration of all the evidence. See

Silverman v. Commissioner, supra at 933; Alvary v. United States,

302 F.2d 790, 795 (2d Cir. 1962).

Petitioners’ Expert’s Reports

Petitioners rely on two reports prepared by Ms. Walker as

the primary evidence in support of their position. Ms. Walker

received a bachelor of arts degree from the University of

Wisconsin at Madison. She is a Chartered Financial Analyst and a

member of the American Society of Appraisers, holding the

Accredited Senior Appraiser (business valuation) designation.

Ms. Walker prepared her first report several years before

trial; a copy of that report was submitted with petitioners’ gift

tax returns for the year in issue.9 Ms. Walker prepared a

revised report shortly before trial, to respond to respondent’s

criticism of Ms. Walker’s failure to include an “income-based”

9
Although Ms. Walker’s original report concluded that the
overall value of the gifts was $211.20 per share, petitioners
reported a 5 percent higher value, $221.75 per share, on their
gift tax returns. Mr. Wall testified that the reason for this
was his accountants’ advice, based on their experience with
respondent’s local personnel, that the lack of marketability and
nonvoting stock discounts determined by Ms. Walker “might better
be a little more conservative”.
 - 19 -

determination of value in her original report.

Ms. Walker was a principal of Willamette Management

Associates, Inc., when she prepared her original report. She was

a principal of Columbia Financial Advisors, Inc., when she

prepared her revised report; she was still a principal of

Columbia at the time of trial. Respondent stipulated Ms.

Walker’s qualifications and expert status.

Ms. Walker’s Original Report

In her original report, Ms. Walker relied almost entirely on

the “guideline public company”, or “market-based”, approach to

appraise the fair market value of the Demco stock.10 In one

variation of this approach, Ms. Walker calculated several

measures of Demco’s historical financial performance; she then

used her guideline company data to determine how the public stock

markets would have valued a company with those performance

measures. In the other variation, Ms. Walker applied the

guideline public company data to three measures of Demco’s

projected financial performance for 1992, the year of the gifts.

10
Ms. Walker’s original report did include one “income-
based” approach, in which Ms. Walker appraised Demco’s value by
capitalizing Demco’s distributions to stockholders for 1991 (as
adjusted by Ms. Walker). However, Ms. Walker concluded that this
approach deserved very little weight.
 - 20 -

Historical Performance Measures Approach

To avoid having to take into account differing amounts of

leverage, Ms. Walker decided to perform her analysis on a “debt

free” basis. She examined Demco’s audited and unaudited

financial statements for the 5 years prior to the year of the

gifts, i.e., for 1987-91; she then used those statements to

develop measures of what Demco’s financial performance would have

been, if it had had no debt.11

The debt-free performance measures Ms. Walker developed were

the following:

1. Earnings before interest and taxes (EBIT) for 1991 and
for 1987-91.

2. Earnings before depreciation (including amortization),
interest, and taxes (EBDIT) for 1991 and 1987-91.

3. Debt free net income (DFNI) for 1991 and 1987-91.

4. Debt free cash-flow (DFCF) for 1991 and 1987-91.

5. Debt free book value of total invested capital (BVIC)
for 1991.

Ms. Walker determined that seven publicly traded companies

were sufficiently similar to Demco to serve as guideline

companies.12 She examined the performance measures and trading

11
Because she wanted to perform her analysis on a
continuing operations basis, Ms. Walker further adjusted her
performance measures to eliminate financial results attributable
to Demco’s media division, which was sold in June 1991.
12
The companies were Action Products International, Inc.;
(continued...)
 - 21 -

prices of the guideline companies, in order to determine the

multiples of the performance measures at which the public stock

markets valued the total invested capital of the guideline

companies. Applying these multiples to Demco’s performance

measures, and giving greater weight to the indicated values

developed from the earnings based measures, Ms. Walker determined

that the publicly traded equivalent value of Demco’s total

invested capital, as of December 31, 1991, was $10,550,000.13

Ms. Walker then subtracted the book value of Demco’s debt

($5,636,000) from this amount, to conclude that the indicated

fair market value of Demco’s equity (before applying any

discounts) was $4,914,000.

Because the guideline public company method determines value

by reference to the trading prices of minority interests, Ms.

Walker did not apply a minority discount to her indicated value

of Demco’s equity. However, on the basis of several studies

12
(...continued)
Banta Corp.; Educational Development Corp.; Kleer-Vu Industries,
Inc.; Library Bureau, Inc.; Stuart Hall Co., Inc.; and United
Stationers, Inc.
13
Although Ms. Walker’s reports appraised the value of
Demco stock as of Dec. 31, 1991, the day before the date of the
gifts, the parties have not suggested and nothing in the record
suggests that Ms. Walker’s opinion would be any different with
respect to the stock’s value as of the date of the gifts. For
convenience, we hereinafter discuss Ms. Walker’s reports and
opinions as though they referred to fair market value as of the
date of the gifts rather than the day before.
 - 22 -

comparing the trading prices of restricted stock with freely

traded stock, and other studies comparing the trading prices of

stock before and after initial public offerings, Ms. Walker

concluded that a 40-percent lack of marketability discount should

be applied to her guideline public company value. In addition,

on the basis of other studies comparing prices of voting and

nonvoting stock, Ms. Walker concluded that a further 5-percent

discount should be applied to reflect the nonvoting status of the

stock given by Mr. Wall.

After having applied these discounts, under Ms. Walker’s

historical performance measures/guideline public company approach

the fair market value of the Demco nonvoting common stock as of

the date of the gifts was $212.20 per share.14

Forecasted-Earnings Approach

Ms. Walker also applied the guideline public company

approach to Demco’s projected earnings for 1992, the year of the

gifts. Using projections made by Demco’s management, Ms. Walker

calculated three forecasted earnings measures for Demco: 1992

EBIT, EBDIT, and after tax earnings. Applying multiples derived

from two of her guideline companies to these forecasted earnings

14
The calculation is (total equity value) times (1 minus
lack of marketability discount) times (1 minus nonvoting
discount) divided by (number of shares outstanding), or
($4,914,000) times (.6) times (.95) divided by (13,200) equals
($212.20 per share).
 - 23 -

measures, Ms. Walker concluded that the publicly traded

equivalent value of Demco’s equity was $4,900,000. This is not

materially different from the $4,914,000 value Ms. Walker

determined using historical performance measures.

Conclusion of Ms. Walker’s Original Report

Giving great weight to the two guideline company approaches

(historical performance and 1992 forecasted earnings), and giving

very little weight to a capitalized distributions approach,15 Ms.

Walker concluded that the publicly traded equivalent value of

Demco’s equity was $4,890,000. After applying the 40-percent

lack of marketability and 5-percent nonvoting discounts, Ms.

Walker concluded that the fair market value of the Demco

nonvoting common stock on the date of the gifts was $211.20 per

share.16

Ms. Walker’s Revised Report

In February 1999, Ms. Walker prepared a revised report

appraising the value of the Demco stock. This report was

prepared in response to respondent’s criticism that Ms. Walker’s

original report had failed to include an income-based

determination of Demco’s value. In response to respondent’s

15
See supra note 10.
16
The calculation is ($4,890,000) times (.6) times (.95)
divided by (13,200) equals ($211.16) per share, which Ms. Walker
rounded to $211.20.
 - 24 -

criticism, Ms. Walker’s revised report combined an income-based

approach with the market-based approach of her original report.

Ms. Walker’s Income-Based Approach

In general, a market-based appraisal concentrates on a

company’s historical performance measures and, by reference to

guideline public company multiples, attempts to determine the

price at which the stock of a company with those performance

measures would trade. An income-based appraisal, by contrast, is

more forward looking; it attempts to predict, and then determine

the present value of, all future returns an investor could expect

to receive from an investment in the subject company. See Pratt

et al., Valuing Small Businesses and Professional Practices 236-

240 (3d ed. 1998).17

Because an income-based approach attempts to value directly

the future cash-flows that will be generated by an investment in

the subject company, it will produce accurate results only if an

accurate forecast of the company’s future earnings is available.

See id. at 257. It appears from the record that at the time of

17
As Ms. Walker’s reports and testimony made clear, no
bright line separates market-based appraisal methods from income-
based methods. For example, Ms. Walker’s market-based appraisal
used some performance measures derived from Demco’s forecasted
income for 1992. Also, both Ms. Walker and respondent’s expert
Mr. Schroeder determined the discount (or capitalization) rates
used in their income-based appraisals by reference to the actual
rates of return available on publicly traded investments. See
infra pp. 28-29 and pp. 35-36.
 - 25 -

the gifts, Demco’s management had only predicted 1 year (1992) of

future results. Ms. Walker stated in her revised report that she

normally would have a 3- to 5-year forecast available when

performing an income-based appraisal.

It is important to note that because Ms. Walker did not have

a long-term forecast, she did not attempt to predict Demco’s

future cash-flows for use in her income-based analysis.

Moreover, because Demco’s historical cash-flow varied greatly

from year to year, Ms. Walker did not use Demco’s historical

cash-flows in her analysis either. Instead, Ms. Walker used

Demco’s historical results to develop what she called Demco’s

“normalized” free cash-flow; she then simply assumed that this

cash-flow would grow 5 percent per year indefinitely after 1992.

More particularly, in her income-based appraisal Ms. Walker:

(1) Examined Demco’s operating results for 1987-91 and its

forecasted results for 1992; (2) used those results to derive

what she called Demco’s “normalized free cash-flow”, or “dividend

paying capacity”; (3) assumed this normalized cash-flow would

continue indefinitely after 1992 and grow 5 percent per year; and

(4) determined the present value of that indefinite cash-flow

using a 22.75-percent capitalization rate.18 As the preceding

18
Ms. Walker described this method as a form of the
“constant growth dividend discount model”. Ms. Walker stated
that she typically used this method when she did not have a long-
(continued...)
 - 26 -

sentence makes clear, the two key variables in this approach are

Demco’s normalized free cash-flow and the appropriate discount or

capitalization rate to be used to determine the present value of

that cash-flow.

In order to determine Demco’s normalized free cash-flow, Ms.

Walker began by adding Demco’s 1987 to 1991 pretax income to its

forecasted 1992 pretax income; she then divided that sum by the

number of years in the period (6) to arrive at an average annual

pretax income of $1,097,381. Ms. Walker then made the following

adjustments to this average to arrive at normalized free cash-

flow:

1. She subtracted hypothetical income taxes at a 34-
percent rate.19

18
(...continued)
term forecast for the subject company.
19
Because Demco is an S corporation, it is not subject to
Federal income tax and pays only a small amount of State income
tax. Nevertheless, Ms. Walker computed Demco’s normalized free
cash-flow by subtracting a hypothetical income tax, at a 34-
percent rate, from Demco’s average income for 1987-92. This is
referred to as “tax-effecting” Demco’s income.

As Ms. Walker acknowledged in her testimony, appraisers
disagree on whether it is appropriate to tax-effect the income of
an S corporation. The argument in favor of tax-effecting
stresses that many potential buyers of S corporations are C
corporations. Because a C corporation would be unable to
maintain a target company’s S corporation status following an
acquisition, the C corporation would tax-effect the S
corporation’s income (at C corporation rates) in deciding how
much it would pay for the S corporation. See Trugman,
Understanding Business Valuation: A Practical Guide to Valuing
(continued...)
 - 27 -

2. She subtracted an amount equal to 5 percent of
Demco’s working capital in 1991, because she assumed working
capital would grow from that level at a 5-percent rate.

3. She added an amount equal to 5 percent of Demco’s
indebtedness in 1991, because she assumed debt would
increase from that amount at a 5-percent rate.

4. She subtracted an amount equal to the excess of
Demco’s average capital expenditures for 1987-91 over its
average depreciation and amortization for that period.

5. She increased the overall result by 5 percent,
because she assumed Demco would grow 5 percent from 1991 to
1992.

On the basis of all these calculations and assumptions, Ms.

Walker determined that Demco’s normalized free cash-flow for 1992

would be $720,317.

19
(...continued)
Small to Medium-Sized Businesses, at 198-199 (1998). By
contrast, the argument against tax-effecting stresses that
although an S corporation’s stockholders are subject to tax on
the corporation’s income, they are generally not subject to a
second level of tax when that income is distributed to them.
This could make an S corporation at least somewhat more valuable
than an equivalent C corporation. However, tax-effecting an S
corporation’s income, and then determining the value of that
income by reference to the rates of return on taxable
investments, means that an appraisal will give no value to S
corporation status.

In her revised report, Ms. Walker computed the present value
of Demco’s tax-effected cash-flow using a capitalization rate
determined by reference to the market rates of return on Treasury
securities and common stocks. See infra pp. 28-29. The interest
and dividends on such investments are fully taxable to their
holders. Because this methodology attributes no value to Demco’s
S corporation status, we believe it is likely to result in an
undervaluation of Demco’s stock. See Gross v. Commissioner, T.C.
Memo. 1999-254.
 - 28 -

Ms. Walker developed her capitalization rate in part by

reference to two sources: (1) The 1991 yield on long-term

Treasury securities, as set forth in the report of respondent’s

expert; and (2) the rates of return on publicly traded stocks

(the Ibbotson data) as set forth in Ibbotson Associates, Stocks,

Bonds, Bills, & Inflation, 1992 Yearbook.

As Ms. Walker correctly noted, respondent’s expert stated in

his report that in December 1991, the rate of return on a risk-

free investment (long-term Treasury securities) was 7.7

percent.20 According to Ms. Walker, the Ibbotson data revealed

that historically, the annual return on the Standard & Poors 500

Composite Common Stock Index (S & P 500) was 7.4 percentage

points higher than a risk-free return; it also revealed that the

annual return on stocks of smaller companies was 5.1 percentage

points higher than the overall S & P 500 return.

Ms. Walker was of the opinion that because Demco was

significantly smaller than the average small public company,

investors would demand an additional risk premium of 2.55

percentage points (one-half the 5.1 percentage point additional

return on small company stocks) on any investment in Demco stock.

20
We note that in her original report Ms. Walker stated
that at the end of 1991, the yield on 30-year Treasury bonds was
only 7.39 percent; she also stated that this yield was expected
to be 7.30 percent in June 1992 and 7.49 percent at the end of
1992.
 - 29 -

Therefore, on the basis of the Ibbotson data and her opinion, Ms.

Walker concluded that an appropriate capitalization rate for

Demco was 22.75 percent, calculated as follows: (1) A 7.7-

percent risk-free rate; plus (2) a 7.4-percent equity-risk

premium; plus (3) a 5.1-percent small company risk premium; and

plus (4) an additional 2.55-percent premium to reflect Demco’s

exceptionally small size.

Taking her normalized free cash-flow of $720,317, and

capitalizing this at a net rate of 17.75 percent (i.e., 22.75

percent capitalization rate, less 5-percent assumed growth rate),

Ms. Walker concluded that under her income-based method the value

of Demco’s equity would be $4,058,124.

Ms. Walker also concluded in her revised report, as she had

in her original report, that a 40-percent lack-of-marketability

discount and a 5-percent nonvoting discount should be applied.

After applying these discounts, the value of the nonvoting Demco

common stock on the date of the gifts, under Ms. Walker’s income-

based analysis, was $175.24 per share.

Conclusion of Ms. Walker’s Revised Report

Ms. Walker’s original report concluded that the fair market

value of the Demco nonvoting common stock, as of the date of the

gifts, was $211.20 per share. As noted, under Ms. Walker’s

income-based analysis the stock’s value was $175.24 per share.
 - 30 -

In her revised report, Ms. Walker relied on both her market-

based and her income-based results to arrive at her final opinion

on the value of the Demco stock. Giving these methods equal

weight (and after rounding), Ms. Walker stated in her revised

report that in her opinion, the value of the Demco nonvoting

common stock was $192.20 per share on the date of the gifts.

Ms. Walker’s Testimony

Although Ms. Walker’s revised report was more recent than,

and incorporated the conclusions of, her original report, Ms.

Walker did not disavow her original report at trial. To the

contrary, Ms. Walker testified that it remained her opinion that

her original report’s $211.20 conclusion was a reasonable

indication of fair market value. She further observed that

valuation is not an exact science; as she saw it, her revised

report simply indicated that one could justify a lower value than

her original report’s $211.20 value, if one chose to do so.

Respondent’s Expert’s Report

Respondent primarily relies on the February 1999 report of

Gary L. Schroeder to support respondent’s position.21 Mr.

21
Mr. Schroeder had prepared an earlier version of his
report in January 1996; respondent relied on that report to
prepare the statutory notices. Mr. Schroeder’s 1996 report had
concluded that the overall value of the gifts was $260.13 per
share, the same amount asserted in the statutory notices. Mr.
Schroeder’s February 1999 report concluded that the overall value
was $273.99 per share.
(continued...)
 - 31 -

Schroeder is associated with the St. Louis area office of Mentor

Valuations, Inc. Like Ms. Walker, Mr. Schroeder is a member of

the American Society of Appraisers and holds the Accredited

Senior Appraiser (business valuation) designation. Mr.

Schroeder’s report employed both a guideline public company

approach and an income-based approach to appraise the value of

the Demco stock.

Mr. Schroeder’s Guideline Company Approach

Except for its treatment of the media note (discussed

immediately below) and its conclusion as to value, Mr.

Schroeder’s guideline company approach was quite similar to Ms.

Walker’s. In fact, Mr. Schroeder used Ms. Walker’s calculations

of Demco’s net revenues and net income as the starting point for

the derivation of his performance measures. He also used two of

the guideline companies chosen by Ms. Walker, Educational

Development Corporation and Library Bureau, Inc. However, Mr.

Schroeder used only four performance measures and three guideline

companies to derive Demco’s value; this is far fewer than the 12

21
(...continued)
There are only two material differences in methodology
between the two versions of Mr. Schroeder’s report. First, in
his 1999 report, Mr. Schroeder treated the media note as a
nonoperating asset (see infra p. 32); he had not been able to do
this in his 1996 report due to a lack of financial data. Second,
in his 1999 report Mr. Schroeder gave his income-based value for
Demco’s stock approximately twice the weight of his market-based
value; he had given his income and market-based values
approximately equal weight in his 1996 report.
 - 32 -

measures and seven companies used by Ms. Walker.22 In addition,

the multiples chosen by Mr. Schroeder appeared to vary more from

one guideline company to another than the multiples chosen by Ms.

Walker.

Notwithstanding these distinctions, the major methodological

difference between the guideline company approaches of Mr.

Schroeder and Ms. Walker is that Mr. Schroeder treated the media

note as a separate, “nonoperating” asset. As a result, Mr.

Schroeder used a three-step procedure to derive his market-based

value for Demco. First, he developed four historical performance

measures for Demco that completely excluded the media division’s

operating results and the interest payable on the media note.

Second, he applied the guideline company multiples he developed

to those measures. Third, he added the media note’s $1,080,000

face amount to his guideline company value.

Having performed these steps, Mr. Schroeder concluded that

the value of Demco’s equity, before any discounts, was

22
The four measures used by Mr. Schroeder were: “adjusted
net income” for 1991 and for 1987 to 1991, and “revenues” for
1991 and for 1987 to 1991. Mr. Schroeder’s revenues were equal
to Demco’s net revenues as calculated by Ms. Walker. Mr.
Schroeder’s “adjusted net income” was equal to Demco’s net income
as calculated by Ms. Walker, less: (1) The 6 months of interest
on the media note included in Ms. Walker’s net income for 1991;
(2) a few nonrecurring items; and (3) a provision for income tax
at 34 percent.

The third guideline company used by Mr. Schroeder was Viking
Office Products, Inc.
 - 33 -

$6,800,000. On the basis of his review of studies similar to

those cited by Ms. Walker, Mr. Schroeder concluded that both lack

of marketability and nonvoting stock discounts should be applied.

Like Ms. Walker, Mr. Schroeder concluded that the lack of

marketability discount should be 40 percent. However, he

concluded that the nonvoting stock discount should be only 2

percent as opposed to the 5-percent discount proposed by Ms.

Walker.

Applying these discounts to his total equity value, Mr.

Schroeder concluded that under his market-based method the value

of the Demco nonvoting common stock on the date of the gifts was

approximately $2,840,000, or $303.03 per share. This is

approximately $92 per share more than Ms. Walker’s $211.20

market-based value. It is also approximately $33 per share more

than the $269.70 market-based value (and approximately $43 more

than the $260.13 overall value) determined in the earlier version

of Mr. Schroeder’s report, on which respondent relied in

preparing the statutory notices. See supra note 21.

Mr. Schroeder’s Income-Based Approach

Mr. Schroeder’s income-based approach differs from Ms.

Walker’s income-based approach in several important respects.

First, in his income-based approach Mr. Schroeder again treated

the media note as a nonoperating asset whose value should be

added to the present value of Demco’s predicted future income
 - 34 -

from sources other than the note. Second, Mr. Schroeder

expressly stated that his approach was designed to produce a

“control” value for Demco, rather than a minority value; he

therefore applied a 17-percent minority discount to the present

value of Demco’s future income. Third, Mr. Schroeder’s

determinations of both Demco’s future income and the appropriate

discount rate to apply to that income were quite different from

Ms. Walker’s.

With respect to his estimation of Demco’s future income, Mr.

Schroeder, unlike Ms. Walker, did attempt to predict Demco’s

operating results for 1992-96. Of course, because Demco’s

management had not made any long-term forecasts, Mr. Schroeder’s

predictions, like Ms. Walker’s extrapolations, necessarily were

based to a considerable extent on Demco’s historical operating

results. Nevertheless, Mr. Schroeder did specifically predict

that Demco’s distribution, marketing, and administrative expenses

would decline from their 1991 levels. He also predicted that

management’s forecasted 1992 net income was too high.23

With respect to the appropriate discount rate, Mr. Schroeder

chose a rate of 15 percent for 1992, the first year of his

23
We note that Mr. Schroeder, like Ms. Walker, tax effected
Demco’s future cash-flows by subtracting hypothetical income tax
from Demco’s projected net income (Mr. Schroeder used a 40-
percent rate, while Ms. Walker used a 34-percent rate). We
believe this is likely to result in an undervaluation of Demco
because Demco is an S corporation. See supra note 19.
 - 35 -

forecast; he then increased that rate by 0.5 percentage points

for each of the next 4 years, to arrive at a terminal rate of 17

percent. By contrast, Ms. Walker chose a 22.75-percent rate, as

discussed above.

Mr. Schroeder’s explanation for his choice of rates was not

very clear. Mr. Schroeder claimed that at the time of the gifts

long-term BAA rated corporate bonds were yielding approximately 9

percent. Mr. Schroeder then asserted that because an investment

in Demco was riskier than an investment in BAA bonds, a 6-

percentage point risk premium would be appropriate. However, he

did not explain why this was an appropriate premium.

Mr. Schroeder also attempted to justify his rates by

reference to the Ibbotson data. According to Mr. Schroeder, the

Ibbotson data showed that the average historical return on small

company stocks was 17.5 percent. Mr. Schroeder then asserted

that a lower rate than this would be appropriate for his

analysis, because controlling investors would accept a lower rate

of return than minority investors would; once again, Mr.

Schroeder did not offer any support for this assertion.

Moreover, Mr. Schroeder did not contest Ms. Walker’s observations

that 7.7 percent was an applicable risk-free rate at the time of

the gifts and that small company stocks have historically yielded

12.5 percentage points more than risk-free investments.
 - 36 -

Setting these objections aside for the moment, Mr. Schroeder

calculated his income-based value of Demco as follows. First, he

calculated the present value of Demco’s 1992-96 projected net

income, by discounting it at his 15- to 17-percent rates.

Second, he computed a 1997 residual value for Demco, by assuming

that Demco’s 1996 projected net income would grow at 3 percent

per year in perpetuity and capitalizing that income at his 17-

percent rate; he then discounted that terminal value back to a

present value as of the date of the gifts. Third, he added the

foregoing values together and applied his 17-percent minority

discount, to arrive at an income-based minority equity value of

$4,770,010. Fourth, he added the face amount of the media note

to arrive at a total equity value of $5,850,010. Fifth and

finally, he applied his 40-percent lack-of-marketability and 2-

percent nonvoting discounts, to arrive at rounded values of

$2,440,000 or $260.61 per share. This is approximately $85 per

share higher than Ms. Walker’s $175.24 per share income-based

value.

Mr. Schroeder’s Conclusion

Mr. Schroeder made his overall appraisal of Demco’s value by

combining his income-based and market-based values and giving the

income-based value approximately twice as much weight. In Mr.

Schroeder’s overall opinion, the fair market value of the Demco
 - 37 -

nonvoting common stock Mr. Wall gave to his children, as of the

date of the gifts, was $2,570,000 or $273.99 per share.

Various Positions as to Value

The following table sets forth the various positions as to

value taken by the parties or their experts:

Event or Report Value per Share
Gift Tax Returns $221.75
Statutory Notices $260.13
Ms. Walker’s Original $211.20
Report
Ms. Walker’s Revised $211.20 (original report’s market-based
Report value)

$175.24 (new income-based value)

$192.20 (overall value conclusion)
Mr. Schroeder’s Report $303.03 (market-based value)

$260.61 (income-based value)

$273.99 (overall value conclusion)

Discussion

As we observed at the outset, the parties’ original

positions on the value of the gifts were quite close; this

litigation has driven the parties further apart. The overall

value asserted in Ms. Walker’s revised report is less than the

value asserted in her original report and the value claimed by

petitioners on their gift tax returns. Similarly, the value

asserted in Mr. Schroeder’s report is greater than the value
 - 38 -

determined in his prior report that was used to prepare the

statutory notices.

Notwithstanding their differing conclusions as to value,

Ms. Walker and Mr. Schroeder agree on the following important

points.

1. Both accept the same data as an accurate
representation of Demco’s financial performance.

2. Both agree that the guideline companies used in the
market-based approaches are in fact comparable to Demco; two
of the three companies used by Mr. Schroeder were included
in the seven companies used by Ms. Walker.

3. Ms. Walker used a capitalization rate of 22.75
percent in her income-based analysis, while Mr. Schroeder
used rates varying from 15 to 17 percent. However, Ms.
Walker assumed that Demco would grow 5 percent per year,
while Mr. Schroeder assumed 3-percent growth. The
difference between the experts’ positions (17.75-percent
effective or net capitalization rate for Ms. Walker, 12-to-
14-percent net rate for Mr. Schroeder) is therefore less
than first appears.

4. Both Ms. Walker and Mr. Schroeder agreed that a 40-
percent lack of marketability discount was appropriate.

5. Both Ms. Walker and Mr. Schroeder agreed that a
nonvoting stock discount should also be applied; Ms. Walker
asserted that the discount should be 5 percent while Mr.
Schroeder contended that a 2-percent discount was more
appropriate.

Despite the closeness of the parties’ original positions and the

large areas of agreement between the experts that existed even at

time of trial, the parties have been unable to settle their

differences, and we are now required to value the Demco stock.
 - 39 -

Respondent determined in the statutory notices that the

value of the gifts was $260.13 per share. This determination is

presumed to be correct; petitioners have the burden of proving it

to be incorrect. See Rule 142(a); Welch v. Helvering, 290 U.S.

111 (1933); Estate of Jung v. Commissioner, 101 T.C. 412, 423

(1993).

Ms. Walker’s and Mr. Schroeder’s reports were generally

thoughtful and professional, and their testimony was responsive

and helpful. Nevertheless, for the reasons set forth below, we

conclude that Ms. Walker’s guideline company approach

significantly understated Demco’s value, while Mr. Schroeder’s

guideline approach somewhat overstated value and has other flaws

that limit its reliability. We also conclude that the experts’

income-based approaches are entitled to little weight, in part

because it was very difficult to predict Demco’s future income as

of the time of the gifts.

As a result, we conclude petitioners have not shown that the

value of the gifts was less than the $260.13 per share determined

in the statutory notices. To the contrary, the record

establishes to our satisfaction that the value lay between the

experts’ guideline company values and was at least $260.13 per

share.
 - 40 -

Problems With the Guideline Company Approaches

Although Ms. Walker’s guideline company approach was

thorough and clear, deserves careful consideration, and is

entitled to some weight, we believe it systematically understated

Demco’s value. First, it did not adequately take account of the

value of the $1,080,000 media note. Second, it used erroneous

measures of Demco’s projected income for 1992. Third, it did not

use all the guideline company multiples but instead picked and

chose among the lowest.

Treatment of Media Note

As noted above, Ms. Walker adjusted Demco’s historical

performance and forecasted earnings measures to eliminate income

attributable to the media division; that division was sold on

June 1, 1991, in exchange for cash and the media note. However,

Ms. Walker did not then readjust Demco’s measures to include pro

forma interest amounts on the media note, or any other amounts

reflecting the media division’s income from 1987 until the date

of sale. As a result, the only income attributable to the media

note reflected in the measures calculated by Ms. Walker was the 6

months’ worth of interest that accrued on the note from the sale

date to the end of 1991 and the interest projected to be received

in 1992.

Demco’s performance measures, as calculated by Ms. Walker,
 - 41 -

therefore understated Demco’s earning power and value. In fact,

Ms. Walker testified that under her analysis, Demco’s ownership

of the media note–-a $1,080,000 face amount, fully

collateralized, interest bearing asset--did not materially

increase the value of the Demco stock. By contrast, the

nonoperating asset method used by Mr. Schroeder took the value of

the media note into account, by adding it to the guideline value

based on his performance measures, and we believe it is

preferable to Ms. Walker’s approach in that respect.

In her testimony, Ms. Walker admitted that Mr. Schroeder’s

treatment of the media note was a reasonable approach. However,

Ms. Walker also stated that in her opinion, a minority discount

should be applied to the value of the media note under that

approach, because a minority stockholder could not require

liquidation of Demco and thus could not realize the note’s full

value.

We agree with Ms. Walker on this point. We conclude that

although Mr. Schroeder’s treatment of the media note is

preferable because it recognizes the note’s value, it somewhat

overstates that value to a minority stockholder. However, even

if the 25-percent minority discount Ms. Walker proposed at trial

were applied to the value of the media note, in addition to her

40-percent lack of marketability and 5-percent nonvoting stock
 - 42 -

discounts, then treating the media note as a nonoperating asset

would add approximately $35 per share to Ms. Walker’s values.

Erroneous Income Amount

The forecasted earnings measures Ms. Walker used in her

guideline company approach were significantly less than the

measures actually projected by Demco’s management. For example,

Ms. Walker’s original report stated that Demco was projecting

1992 EBIT of $1,372,000 and 1992 earnings of $1,034,615.

However, Demco was actually projecting that its earnings would be

approximately $400,000 higher; i.e., 1992 EBIT of $1,774,306 and

earnings of $1,434,198. We conclude that Ms. Walker simply made

a few transcription errors; nevertheless, these errors mean that

Ms. Walker’s appraisals significantly understated Demco’s value.

If the 1992 EBIT and earnings actually projected by Demco

were substituted for the erroneous amounts used by Ms. Walker,

then Ms. Walker’s appraisal of the Demco stock under her

forecasted earnings approach would have been approximately $289

per share, approximately $77 per share higher than the forecasted

earnings value set forth in her original report. The record does

not disclose Demco’s projected EBDIT for 1992. However, based on

Demco’s historical depreciation, we conclude that the measure of

1992 EBDIT used by Ms. Walker was, like her 1992 EBIT and

earnings measures, also approximately $400,000 too low. If Ms.

Walker’s measure of Demco’s 1992 EBDIT were also increased by
 - 43 -

$400,000, then Ms. Walker’s forecasted earnings value would have

been approximately $315 per share, approximately $103 per share

higher than the value in her original report. We note that these

values are quite close to the $303 guideline company value set

forth in Mr. Schroeder’s report.

Choice of Multiples

When Ms. Walker applied the guideline public company method

to Demco’s historical performance measures, she did not use the

multiples of all seven companies she had identified as

comparable. Instead, she consistently chose a multiple

determined by reference to the two or three companies with the

lowest multiples, as shown in the following table.

Mean Multiple of
the Comparable Multiple Used by
Measure Companies Ms. Walker
1991 EBIT 10.1 8.2
1987-91 EBIT 7.3 6.5
1991 EBDIT 7.7 5.0
1987-91 EBDIT 7.5 4.7
1991 DFNI 13.6 13.0
1987-91 DFNI 11.7 9.5
1991 DFCF 8.8 6.5
1987-91 DFCF 7.0 6.4
BVIC 1.19 1.25

Ms. Walker justified her disregard of most of the comparable

companies’ multiples by referring to the decline in Demco’s
 - 44 -

earnings from 1990-92. According to Ms. Walker, three of the

seven comparable companies had also suffered recent earnings

declines; it therefore made more sense to determine the

applicable multiples by reference to those companies, rather than

by reference to the comparable companies as a whole.

Ms. Walker’s use of the two or three lower multiple

companies is inconsistent with the conclusion expressed elsewhere

in her report that, even after the decline in Demco’s earnings

had been taken into account, Demco’s profitability and risk

levels were close to or at the industry norm. It also may be

inconsistent with her conclusion that the seven companies she

identified as comparable were in fact comparable to Demco. For

these reasons we believe that the multiples used by Ms. Walker

resulted in an understatement of the value of the Demco stock.

See Pratt et al., Valuing Small Businesses and Professional

Practices 276 (3d ed. 1998) (warning the analyst that she should

be cautious and careful, when using the guideline public company

method, to ensure that the use of certain companies for some

measures but not for others does not introduce bias or distortion

into the value indications).

If the mean multiples of the comparable companies had been

applied to Demco’s historical performance measures instead of the

multiples used by Ms. Walker, then the value of the Demco stock

under Ms. Walker’s historical performance measures approach would
 - 45 -

have been approximately $300 per share, approximately $88 per

share higher than the historical performance measures value in

Ms. Walker’s original report.24

We have similar concerns with Ms. Walker’s choice of

multiples in her forecasted earnings approach. Ms. Walker’s

original report discussed the forecasted earnings multiples of

only two of the seven comparable companies. Moreover, the

multiples Ms. Walker used were lower than even those two

companies’ multiples; the stated reason for this was that Demco

was predicting higher earnings growth.

Mr. Schroeder’s Guideline Company Approach

Notwithstanding the foregoing criticisms of Ms. Walker’s

guideline company approach, we do not believe Mr. Schroeder’s

guideline public company approach deserves controlling weight.

As noted above, Ms. Walker’s guideline analysis was thorough and

well explained; it is still entitled to some weight. In

addition, Mr. Schroeder’s approach somewhat overstates the media

note’s effect on value, because it does not apply a minority

discount. We also accept Ms. Walker’s criticism that it would

have been preferable if Mr. Schroeder had used more than three

guideline companies. Moreover, we note that Mr. Schroeder used

24
The statement in the text assumes that each performance
measure is equally weighted. Ms. Walker stated that she gave the
earnings-based measures greater weight, but we are unable to
determine the weighting she used.
 - 46 -

only four performance measures; the multiples he used seemed to

vary greatly from company to company, and his choice of multiples

was not very well explained.

Problems With the Income-Based Approaches

Ms. Walker testified that in theory, income-based approaches

should produce more accurate determinations of value, because

they attempt to value directly the future income streams flowing

from an investment. She also testified, however, that many

assumptions must be made to employ such approaches and the

results are highly sensitive to the assumptions used. Most

importantly, if the subject company’s future income is

unpredictable, then income-based methods will produce inaccurate

appraisals of the company’s value. See Pratt et al., supra at

257.

We conclude that as of the date of the gifts, it was very

difficult to predict Demco’s future income. It appears that as

of that date Demco’s management had predicted only 1 year of

future results. Due to the lack of a long-range forecast, Ms.

Walker did not even attempt to predict Demco’s future revenues.

Instead, she used an average of Demco’s historical and forecasted

results to create a measure she described as Demco’s “normalized”

free cash-flow, and assumed this would grow at a constant rate.

In this connection, we note that one of the leading treatises on

business valuations cautions that historical averages or pure
 - 47 -

extrapolations from those averages are usually inadequate bases

for an income-based analysis; an analyst should use such averages

only if she can explain why they are a reasonable proxy for

future expectations. See Pratt et al., supra at 240, 254. Given

the fluctuations in Demco’s net income, the difficulties being

experienced by Demco’s major customer groups, and the unsettled

economic conditions around the time of the gifts, it appears less

likely than usual that Demco’s past results could have served to

predict its future results. We also note that Ms. Walker’s

original report relied entirely on a market-based approach; her

revised report added an income-based approach only in response to

respondent’s criticism of her original report. For all these

reasons, we conclude that Ms. Walker’s income-based approach is

entitled to little weight.

Although Mr. Schroeder at least attempted to predict Demco’s

future income, his income-based analysis suffers from the same

flaws as Ms. Walker’s. Mr. Schroeder’s predictions, like Ms.

Walker’s extrapolations, were based to a great extent on Demco’s

average past performance. In addition, Mr. Schroeder did not

explain or justify very well either his assumptions about future

changes in Demco’s performance or his choice of discount rates.

We also note that although Ms. Walker had little criticism of Mr.

Schroeder’s guideline company approach–-or couched that criticism

in terms of reasonable professional differences--she identified
 - 48 -

several more serious problems with Mr. Schroeder’s income-based

approach. For all these reasons, we conclude that Mr.

Schroeder’s income-based analysis, like Ms. Walker’s, is entitled

to little weight.

Conclusion

Ms. Walker’s market-based appraisal of the Demco nonvoting

common stock was $211.20 per share; Mr. Schroeder’s market-based

appraisal was $303.03 per share. For the reasons set forth

above, Ms. Walker’s market-based appraisal significantly

understated Demco’s value. As we have explained, treating the

media note as a nonoperating asset would have increased Ms.

Walker’s market-based values by approximately $35 per share, even

after applying the 25-percent minority discount Ms. Walker

suggested. Similarly, using the correct projections for Demco’s

1992 earnings would have added approximately $103 per share to

Ms. Walker’s forecasted earnings based valuation, while using the

mean multiples of the comparable companies, instead of the lower

multiples chosen by Ms. Walker, would have added approximately

$88 per share to Ms. Walker’s historical performance measures

based valuation. Nevertheless, we still conclude that Mr.

Schroeder’s market-based appraisal somewhat overstated Demco’s

value, in part because it did not apply a minority discount to

the media note; we also conclude that it does not deserve

controlling weight because it used very few performance measures

and comparable companies.
 - 49 -

Ms. Walker’s and Mr. Schroeder’s income-based appraisals

were lower than their market-based appraisals, at $175.24 per

share and $260.61 per share, respectively. However, we conclude

that those income-based appraisals are entitled to little weight

for the reasons set forth above.25

On the basis of the foregoing and all the other facts and

circumstances, we conclude petitioners have not shown that the

value of the Demco nonvoting common stock, as of the date of the

gifts, was less than $260.13 per share. To the contrary, the

record establishes that it was at least equal to that amount.

To reflect all the foregoing,

Decisions will be entered

for respondent.

25
We also note that both experts’ income-based analyses
probably understated Demco’s value, because they determined
Demco’s future cash-flows on a hypothetical after tax basis, and
then used market rates of return on taxable investments to
determine the present value of those cash-flows. See supra notes
19, 23.