Valuation of closely-held businesses requires estimating future cash flows and then discounting those cash flows at an appropriate rate. Historical financial information is only important in so far as it suggests what to expect in the future. Historical information is never by itself sufficient—business conditions are constantly changing. Estimating future cash flows requires an in-depth understanding of the strengths and weaknesses of the firm being valued and trends in the industry and larger economy. According to IRS Revenue Ruling 59-60, “Valuation of securities is, in essence, a prophecy as to the future and must be based on facts available at the required date of appraisal.”
Accounting, actuarial, architecture, dental, engineering, financial planning/asset management, marketing, and specialized consulting firms are very similar from a valuation perspective. [Law firms are a special case which we addressed in a separate article in the July 2015 edition. Medical practices are also a special case because they are subject to a high degree of government regulation and price controls.] The following is a discussion of some of the major issues that need to be investigated to understand the future cash flow of professional service firms.
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