Valuing Shares – A Minefield, Not A Science

By | 25 February 2016

An individual’s company’s shares may need to be valued for a variety of reasons. For example, a shareholder may wish to sell his shares to an unconnected individual, and the parties may wish to establish a ‘fair value’ for the shares; or an individual’s shareholding may need to be valued as part of a divorce settlement.

Share valuations are often necessary for tax purposes. This article concerns valuations of unquoted shares for capital gains tax (CGT) purposes. Of course, valuations may be required for other taxes, such as for inheritance tax purposes on a lifetime gift of shares or on death, or for income tax purposes when shares are awarded by company employers to employees as part of a share incentive arrangement.

The general CGT provisions dealing with valuations define the ‘market value’ of an asset as the price that might reasonably be expected to fetch on a sale in the open market (TCGA 1992, s 272(1)). There are specific provisions concerning unquoted shares (and securities), which state that in determining market value “there is available to any prospective purchaser of the asset in question all the information which a prudent prospective purchaser of the asset might reasonably require if he were proposing to purchase it from a willing vendor by private treaty and at arm’s length” (s 273(3)).

However, the tax legislation offers no guidance on the method of valuing unquoted shares. This has resulted in a number of court cases on share valuations. Various approaches and methodologies in valuing unquoted shares have evolved over many years. The practice of share valuation is a specialised one. However, even experts in that field can sometimes value the same shares in fundamentally different ways, resulting in substantially different valuations.

Difference of opinion

For example, in Foulser & Anor v Revenue & Customs [2015] UKFTT 220 (TC), the taxpayers, husband and wife (Mr and Mrs F), made gifts of their shareholdings on 24 November 1997, as part of a tax planning exercise. Mr F gifted 51%, and Mrs F gifted 9%. It was necessary to ascertain the market value of the shares for CGT purposes. However, there was a major difference of opinion between the taxpayers and HM Revenue and Customs (HMRC).

The First-tier Tribunal considered the evidence of share valuation experts on behalf of both sides. The experts differed fundamentally in methodology and approach, resulting in a huge difference in their valuations. The taxpayer’s expert valued Mr F’s shares at £6 million; HMRC’s expert valued them at £20,638,000. In addition, the taxpayer’s expert valued Mrs F’s shares at £243,750, whereas HMRC’s expert valued her shares at £2.5 million.

Expert valuation for the taxpayers

A detailed analysis of the valuation techniques adopted by the valuation experts is beyond the scope of this article. However, in broad terms the taxpayers’ expert’s valuation involved the following approach:

• The earnings component of the calculation was on the basis of ‘future maintainable earnings’ (i.e. adjusting pre-tax profits for items that are unlikely to recur under new management, to arrive at the underlying profits of the trade);
• This involved adjusting management accounts profits, e.g. additions for ‘increases in efficiency’ (i.e. adding the non-recurring cost of certain trading production difficulties), deductions for ‘foreign exchange profits’, reducing interest receivable (i.e. based on the fact that funds earning interest would instead be used as a deposit on a new factory), and increasing interest payable (i.e. based on interest on borrowings secured on the new factory);
• adding back royalties paid to a company under common control;
• deducting tax on profits, to arrive at a figure for post-tax future maintainable earnings;
• determining a capitalisation factor of between 8 and 10, to give a range of values for the entire company (the capitalisation factor was derived from the private company price index (PCPI) (which is published quarterly by BDO), as adjusted based on the expert valuer’s judgment for certain factors considered to be relevant in this case); and
• applying the capitalisation factor to the figure arrived at for future maintainable earnings.

This resulted in a range of values for the company as a whole. For Mr F’s 51% shareholding, the pro-rata value of his shareholding was then discounted by 20% to take account of the fact that he did not have total control of the company. The taxpayers’ expert then selected a figure of £6 million from the resulting range of values.

However, for Mrs F’s 9% shareholding, the expert considered that a rational investor would require a dividend yield of 24%, which was applied to an assumed dividend return on a 9% holding, giving a value for that holding of £243,750.

Expert valuation for HMRC

By contrast, the approach adopted by HMRC’s valuation expert broadly proceeded as follows:

• The starting point was the post-tax profit disclosed in the company’s latest accounts before the valuation date;
• The FTSE actuaries index for the company’s industry sector was used to select a number of quoted comparable companies, as a basis to arrive at (in the expert’s judgment) a suitable price earnings (PE) ratio of 15;
• A ‘bid premium’ of 40% was applied to the above PE ratio (i.e. to reflect that stock exchange PE ratios are applicable to small parcels of shares, whereas the bid price for an entire company would include a bid premium to the price per share);
• The resulting PE ratio of 21 was translated into a ‘prospective’ PE ratio of 15, based on the company’s projected earnings and a comparison of prospective PE ratios from bids for other companies in the same industry sector;
• HMRC’s expert identified a particular quoted company in the same sector (with an historic PE ratio of 22.2) that was most like the company being valued in terms of activity and size. He concluded that the quoted company’s acquisition price supported his entirety value of the company being valued.

Having arrived at an entirety value for the company, HMRC’s expert then valued Mr F’s 51% shareholding based on a pro-rata percentage of the company’s entirety value. He initially discounted that value at 15% for lack of full control, but subsequently eliminated that discount due to an indicative offer having been made for Mr and Mrs F’s shares in October 1997. This resulted in a value for Mr F’s 51% shareholding of £20,638,000.

HMRC’s expert valued Mrs F’s 9% shareholding based on a pro-rata percentage of the company’s entirety value. His view was that such a significant, though uninfluential, minority holding would normally attract a discount of 50% of the pro-rata entirety value, but in this case he initially considered that a discount of 40% would be appropriate (resulting in a valuation for Mrs F’s 9% shareholding of £2,185,000). However, based on the indicative offer in October 1997 and in the particular circumstances, he considered their market value to be £2.5 million.

Who’s right?

The First-tier Tribunal held that the difference between the valuations of the taxpayers’ and HMRC’s experts must mean that one of the methodologies adopted was “fundamentally flawed” and must be ruled out. The tribunal therefore considered in detail the valuation approaches of both experts.

The tribunal found that there were serious flaws in the methodology adopted by the taxpayers’ expert in the valuation of Mr F’s 51% shareholding, in relation to both the concept of future maintainable earnings, and his use of a capitalisation factor derived from the PCPI. Furthermore, the tribunal did not consider that a valuation of Mrs F’s 9% shareholding on a dividend yield basis was appropriate.

Based on the conclusions reached on the experts’ individual valuations, the tribunal preferred the approach of HMRC’s expert, in respect of both Mr F’s 51% shareholding and Mrs F’s 9% shareholding.

However, that was not the end of the matter. The tribunal reasoned that the HMRC expert’s ‘control premium’ of 40% used in the valuation of Mr F’s 51% shareholding was too high, and reduced it to 35%. This resulted in a PE ratio of 20.25, and a lower entirety value of the company. The tribunal also considered that the HMRC expert’s discount for lack of control was too low and increased it to 20%, and that there should be no uplift in value for the offer in October 1997.

Similarly, the tribunal held that the HMRC expert’s discount applied to Mrs F’s 9% shareholding for lack of control of 40% was too low, and increased it to 50%. Once again, there was no uplift in value for the October 1997 offer.

The tribunal concluded that the market value for CGT purposes in respect of Mr F’s 51% shareholding was £15,920,873, and that Mrs F’s 9% shareholding was worth £1,755,978, on 24 November 1997.

Thus the valuations of Mr and Mrs F’s shareholdings as determined by the tribunal were considerably different to the valuations of both experts, although they were much closer to the HMRC expert’s figures, as his valuation approach was preferred.

Practical point

The tribunal in Foulser described share valuation in the following terms: “Share valuation is not a science. There is no prescribed formula by which shares in a private company are to be valued”.

Share valuations are therefore something probably best left to a suitably experienced specialist share valuer, although as indicated above, even valuation experts can potentially get it wrong.

For CGT (or corporation tax on chargeable gains) valuations, consider using HMRC’s ‘post-transaction valuation checks’ procedure. This is a free service from HMRC to assist taxpayers in completing tax returns, by checking valuations after disposals have been made (including ‘deemed’ disposals, such as for negligible value claims) but before the return is submitted. The relevant application form (CG34) can be downloaded from the website:

The above article was first published by Tax Insider (October 2015) (