"Bang Bang" - The Tax Court Shot Him Down...

I never thought I would be mining Cher's back catalog for inspiration for an even more tenuous link for the title to these emails - but I may be getting desperate...


As promised, I return to the Tax Court's ruling in Estate of Richmond v. Commissioner handed down in February. You may recall that at her death, Mrs. Richmond owned 23% of PHC, a 76-year old investment holding C corporation which in turn held a portfolio of stocks worth over $52 million. Over the years, PHC had followed a strategy of maximizing dividend income and then paying it out to the shareholders. Dividends declared by PHC in the seven years prior to the date of death had averaged over $1 million and had been increasing at about 5% per year.


The valuation expert for the Estate relied primarily on an income approach to valuing the 23% interest based on the fact that PHC had a strong history of dividend payments. The method involved determining the present value of the expected future dividend stream based on the 2005 dividend paid to Mrs. Richmond of $252,000.


The Tax Court disagreed with this approach. They opined that:

"Dividend capitalization is one method for valuing a business; and this method may be entirely appropriate where a company's assets are difficult to value. For example, a company that does not hold a portfolio of publicly traded securities but instead operates a business."


However, in this case, the method ignored "the most concrete and reliable data of value that are available - i.e., the actual market prices of the publicly traded securities that constituted PHC's portfolio".


The Tax Court considered that this information would be highly relevant to a potential investor almost to the exclusion of the dividend yield and then went on to say:

"PHC's primary assets...are marketable securities, which have ascertainable market values. Moreover, those market values inherently reflect the market's judgement as to the projected income streams of each stock and therefore reflect the future income stream of PHC. For that reason, a properly discounted net asset valuation of PHC indirectly takes into account the expected dividend stream that underlies the estate's valuation method. We therefore follow this Court's consistent precedent of using net asset valuations for companies with holdings like PHC."


So while it was a nice try from the Estate's valuation expert, he was comprehensively shot down by the Court. The income approach was only potentially viable here because PHC had such a consistent policy of paying dividends. The income approach does not work since it only takes into account the annual dividend stream and fails to capture growth in the portfolio - which is reflected in the net asset value of the company.