                          T.C. Memo. 1999-177



                        UNITED STATES TAX COURT



                   MAY T. RAKOW, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 18975-96.                         Filed May 27, 1999.



     Glen T. Dobosz and Marios N. Karayannis, for petitioner.

     Karen P. Wright, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     GALE, Judge:     Respondent determined a deficiency in

petitioner’s Federal gift tax for the 1992 taxable year in the

amount of $170,885.    The issue for decision is the fair market

value of stock given by petitioner to her children and

grandchildren.
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     Unless otherwise indicated, all section references are to

the Internal Revenue Code as in effect for the year in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

                         FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.

The stipulation of facts and the attached exhibits are

incorporated by this reference.   Petitioner resided in Elgin,

Illinois, at the time the petition was filed.

     Illinois Hydraulic Construction Co. (IHC) has been owned by

the Rakow family since 1970.   During 1992, IHC had outstanding

6,340 shares of common stock and no preferred stock.   On

October 1, 1992, petitioner gave a total of 1,780 shares of IHC

common stock to her children and grandchildren.   Petitioner

reported the gifts of the 1,780 shares of IHC stock on a 1992

Form 709, United States Gift (and Generation-Skipping Transfer)

Tax Return.   Petitioner’s 1992 gift tax return valued the 6,340

shares of IHC common stock at $2,250,000, or $354.89 per share,

on a minority basis.   Respondent determined the value of the

6,340 shares of IHC to be $3,846,161, or $606.65 per share, on a

minority basis.

     IHC is a general contractor engaged in the construction of

industrial and commercial buildings, sewage and water treatment

plants, and underground utilities, primarily in Northern
                                   - 3 -


Illinois.    IHC obtained its work through bids.       Some requests for

bids, such as those for public or municipal jobs, were

advertised.       In contrast, the utilities, that is, the power and

telephone companies, would send invitations to bid to IHC and

other preselected companies.       IHC performed most of its contracts

alone, without subcontracting significant portions of the work.

     IHC has done work for the utilities for about 50 years.         Two

of its major clients were Ameritech, a telephone company, and

Commonwealth Edison, a power company.         In the 5-year period

spanning fiscal years ended April 30, 1988 through 1992, these

two major clients contributed from 33 to 49 percent of its

revenues.

     Thomas Rakow (Mr. Rakow), petitioner’s son, has been

president of IHC since the early 1980’s.         Petitioner also was a

full-time officer of IHC.      IHC paid Mr. Rakow and petitioner as

follows:

            Year Ended             Mr. Rakow         Petitioner

           Apr.   30,   1988       $106,600           $52,000
           Apr.   30,   1989        158,700            70,800
           Apr.   30,   1990        233,350            77,600
           Apr.   30,   1991        307,400            91,600
           Apr.   30,   1992        312,590            91,600

     IHC’s income statement for its fiscal year ended April 30,

1992, prepared by independent auditors, reports the following:
                                - 4 -


          Revenues                       $24,519,021
          Cost of revenue                (21,574,516)

          Gross profit from operations       2,944,505

          Operating expenses             (2,539,992)

          Income from operations               404,513

          Interest expense                     (50,430)
          Other income (net of other
            expense)                            59,995

          Income before taxes                  414,078

          Provision for income taxes          (134,413)

          Net income                           279,665

IHC’s fiscal 1992 revenues represent a 5-year compound growth of

9.57 percent and a 3-year compound growth of 5.1 percent.    IHC’s

balance sheet for April 30, 1992, prepared by independent

auditors, reflects assets of $7,624,578 and liabilities of

$4,539,091, for a net worth of $3,085,487.    As of April 30, 1992,

IHC had doubtful receivables of $19,109; this amount was excluded

from the assets reported on the balance sheet.    IHC had a line of

credit with a bank but had no outstanding long-term debt.

     An analysis of IHC’s income statements for its fiscal years

ended April 30, 1988 through 1992, reveals the following,

expressed in percentages of revenues (discrepancies in arithmetic

are due to rounding):
                                        - 5 -

                                                                 Average       Average
                         1992   1991    1990    1989   1988      1988-92       1990-92

Revenues                 100.0 100.0 100.0 100.0 100.0            100.0         100.0
-Direct costs             88.0 88.0 89.4 86.6 91.4                 88.7          88.5

Gross profit             12.0   12.0    10.6    13.4    8.6        11.3          11.5
-Operating expenses      10.4    9.8     8.5    10.9    7.5         9.4           9.6

Operating profit          1.6    2.2     2.2     2.4    1.1         1.9            2.0
-Interest expense         0.2    0.3     0.0     0.3    0.7         0.3            0.2
+Other income(expense)    0.2    0.4     0.4     0.3    0.7         0.4            0.3

Earnings before tax       1.7    2.3     2.6     2.5    1.1         2.0            2.2

                                       OPINION

      The issue for decision is the fair market value of the IHC

stock given by petitioner on October 1, 1992.                 Both parties rely

upon their respective experts’ opinions in attempting to

establish the correct fair market value.

      Fair market value is defined as “‘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 sell and

both having reasonable knowledge of relevant facts.’”                     United

States v. Cartwright, 411 U.S. 546, 551 (1973) (quoting sec.

20.2031-1(b), Estate Tax Regs.).           Expert opinion sometimes aids

the Court in determining valuation; other times, it does not.

See Laureys v. Commissioner, 92 T.C. 101, 129 (1989).                     We

evaluate such opinions in light of the demonstrated

qualifications of the expert and all other evidence of value in

the record.     See Estate of Newhouse v. Commissioner, 94 T.C. 193,

217 (1990).     We are not bound, however, by the opinion of any

expert witness when that opinion contravenes our judgment.                      See
                                - 6 -


id.   We may accept the opinion of an expert in its entirety, see

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

441, 452 (1980), or we may be selective in the use of any portion

thereof, see Parker v. Commissioner, 86 T.C. 547, 562 (1986).

      When valuing stock in the absence of arm’s-length sales, the

following factors are taken into consideration:    The company’s

net worth, prospective earning power and dividend-paying

capacity, and other relevant factors.    See sec. 25.2512-2(f),

Gift Tax Regs.   The other relevant factors include:

      the good will of the business; the economic outlook in
      the particular industry; the company’s position in the
      industry and its management; the degree of control of
      the business represented by the block of stock to be
      valued; and the values of securities of corporations
      engaged in the same or similar lines of business which
      are listed on a stock exchange. However, the weight to
      be accorded such comparisons or any other evidentiary
      factors considered in the determination of a value
      depends upon the facts of each case. * * * [Id.]

Petitioner’s Expert

      Petitioner presented the opinion of George H. Reddin of FMI

Corp., a management consulting firm to the construction industry

(petitioner’s expert).    Petitioner’s expert valued IHC on a

minority interest basis at $2,161,467, or $340.93 per share.

      Petitioner’s expert first valued IHC according to the cost

or asset approach.    Beginning with the book value of IHC on

September 30, 1992, of $3,397,339, he made downward adjustments

for taxes ($138,005) and a “doubtful” account receivable
                               - 7 -


($140,666) and an upward adjustment to bring the book value of

the depreciable assets to fair market value ($544,213).    He also

subtracted the cash value of insurance ($339,238), to be valued

as a nonoperating asset.   These adjustments resulted in an

adjusted book value of $3,323,643 for the operating assets.     In

determining the adjustment to the depreciable assets,

petitioner’s expert used information on book values and estimated

fair market values as of April 30, 1993, given to him by IHC’s

chief financial officer.   Petitioner’s expert believes the

estimated fair market values were based on quick sale auction

values.   He concluded that IHC had no goodwill apart from its

earnings capacity.

     Petitioner’s expert next valued IHC using a capitalization

of earnings method.   He adjusted IHC’s pretax earnings upwards in

some years and downwards in others to bring Mr. Rakow’s salary in

line with the industry average.   Over the fiscal years 1988

through 1992, this adjustment averaged 0.14 percent of revenues,

with a range of -0.5 to 0.5 percent of revenues.   He then

selected a capitalization rate, using the market comparable

approach, a buildup approach, and FMI’s experience.   For the

market comparable approach, petitioner’s expert chose 14 publicly

traded companies in construction or construction-related

businesses and focused on their price/earnings (P/E) ratios.     He

derived each company’s 1992 year range of P/E ratios from
                               - 8 -


Standard & Poor’s Stock Reports.   Ignoring those P/E ratios over

25 and those not calculable due to losses or zero profits (which

eliminated eight companies and truncated the range for one),

petitioner’s expert determined that the median of the midpoints

of the companies’ 1992 ranges of P/E ratios was a P/E ratio of

14.25.   Petitioner’s expert then considered the following factors

and made adjustments of unspecified quantities in the directions

indicated below for an end result of a pretax P/E ratio in the

range of 3 to 5:

                   Factor                     Adjustment

          Market diversification                 Down
          Product diversification                None
          Management depth                       Down
          Future earnings prospect               None
          Financial strength                     None
          Access to capital markets              Down
          Marketability                          Down
          Control                                 Up

            Net effect                           Down

     Petitioner’s expert also calculated a capitalization rate

using the buildup approach as follows:
                               - 9 -


          Risk-free rate                                  7.1
     +    Equity risk premium                             7.4
     =    Average market return                          14.5
     +    Risk premium for size                           5.1
     +    Other risk factors                              5.0
     =    Net cash-flow discount rate                    24.6
     +    Net earnings discount-net cash-flow discount    0.0
     =    Net earnings discount rate                     24.6
     -    Average growth rate                             5.0
     =    Net earnings cap rate for next year            19.6
     /    1 + growth rate                                1.05
     =    Net earnings cap rate for current year         18.7

Petitioner’s expert started with the risk-free rate of return for

the long-term Treasury bond on September 30, 1991.   He consulted

Ibbotson Associates 1992 Stocks, Bonds, Bills and Inflation

Yearbook, to obtain the historical equity risk premium for stocks

and the premium for small company stocks.   He determined an

additional premium of 5 percent was warranted when comparing IHC

to the public companies.   Petitioner’s expert considered IHC’s

net income and cash-flow to be the same because its capital

expenditures approximated depreciation.   He assumed a growth rate

of 5 percent.   Petitioner’s expert converted the after-tax

capitalization rate of 18.7 percent to 31.2 pretax, using a 40-

percent tax rate.   He then concluded that the buildup approach

yields a pretax earnings multiple of 3.2.

     Petitioner’s expert then stated that, in FMI’s experience

with actual transactions involving privately owned construction

companies, the pretax P/E ratios ranged from 3 to 5.   No data on

these transactions appear in his report or elsewhere in the
                               - 10 -


record.   Ultimately, petitioner’s expert concluded that a pretax

P/E ratio of 4 is appropriate in this case, as it implies a

pretax investment return in the absence of growth of nearly 25

percent, a return allegedly consistent with FMI’s experience.

     Petitioner’s expert then applied this P/E ratio of 4 to

various average and weighted average historic pretax earnings, to

current pretax earnings, and to projected 1993 pretax earnings as

estimated by IHC management.   As shown below, the results of the

earnings approach were lower than the value of the operation

derived through the asset approach.

                Method                                   Valuation

Book value (9-30-92)                                    $3,058,101
Adjusted book value (9-30-92)                            3,323,643
Capitalization of 5-yr. average adjusted earnings        1,820,712
Capitalization of 5-yr. weighted avg. adj. earnings      2,128,296
Capitalization of 3-yr. average adjusted earnings        2,408,588
Capitalization of 3-yr. weighted avg. adj. earnings      2,355,660
Capitalization of 1993 projected earnings                2,000,000

It was petitioner’s expert’s opinion that the fair market value

of IHC as an enterprise was $2,750,000.   When added to the

nonoperating assets of $339,238, this resulted in a total value

for IHC on a majority basis of $3,089,238.

     Petitioner’s expert determined a minority discount by

consulting market data.   Using the median premiums paid for

control for each year from 1980 to 1992 according to Mergerstat

Review, petitioner’s expert calculated the corresponding implied

minority interest discounts.   These discounts ranged in value
                               - 11 -


from 21.7 to 30.8.    The 1991 average control premium was 35.1,

the median premium was 29.4, and the minority discount

corresponding to the median premium was 22.7.    The 1992 figures

were 41.0, 34.7, and 25.8, respectively.    Petitioner’s expert

also looked at the Houlihan Lokey Howard & Zukin Control Premium

Study.   That study reflected an average control premium of 47.6

percent and a median control premium of 44.5 percent for the

third quarter of 1992, and average and median premiums of 51.2

and 43.5 percent, respectively, for the 12-month period ended

September 10, 1992.    The third quarter of 1992 included 17

transactions, and the 12-month period ended September 10, 1992,

involved 101 transactions.    Petitioner’s expert converted the

median premiums for these two periods to minority discounts of

31.5 and 30.0 percent, respectively.    Using the data from the two

sources, petitioner’s expert selected a minority discount of 30

percent.   He applied this discount to the value of IHC obtained

above, leading to a value on a minority basis of $2,161,467, or

$340.93 per share.

Respondent’s Expert

     Respondent relies on the opinion of Warren T. Jacobsen of

Horizon Capital Management (respondent’s expert).    Respondent’s

expert valued the IHC stock at $606.65 per share on a minority

basis.
                              - 12 -


     Respondent’s expert first valued IHC using the market

comparable approach.   He selected nine public companies, on the

basis of their products, markets, growth prospects, and risks,

from the companies listed under Standard Industrial

Classification (SIC) codes 1541/1542, general commercial

contractors; 1799, special trade contractors; 1623, water, sewer

and utility contractors; 1629, heavy construction; and 1791,

structural steel construction.    He determined the following

market ratios for the nine companies:    Price/revenue,

price/earnings before interest and taxes (EBIT), price/net, and

price/book value.   In a few cases, the ratios could not be

calculated because of deficit earnings.      Respondent’s expert

calculated an average of the comparable companies’ ratios for

each type of ratio; he then calculated another such average

eliminating the companies with the highest and lowest values for

each type ratio; lastly, he adjusted the latter averages to fit

IHC, the adjustments mainly representing the difference in size

between IHC and the comparable companies.      The resulting ratios

were as follows:

                          P/Rev      P/EBIT      P/Net     P/Book

Average                    0.44      12.55       29.72      1.30
Average excl. high/low     0.44      10.90       24.34      1.05
Conclusion (IHC)           0.30      10.00       20.00      1.00
                                       - 13 -


Respondent’s expert then calculated a value for IHC using these

ratios, weighting each of the four market comparison methods

equally as shown:
                                                Minority              Weighted
                         Base      Multiple       Value     Weight      Value

Price/revenue        $24,500,000    0.30       $7,350,000   0.25     $1,837,500
Price/earnings           300,000   20.00        6,000,000   0.25      1,500,000
Price/EBIT               500,000   10.00        5,000,000   0.25      1,250,000
Price/book             3,100,000    1.00        3,100,000   0.25        775,000

  Unadjusted value                                                    5,362,500

Because the market approach, based on individual shares, reflects

a marketable minority value, respondent’s expert applied a

control premium of 30 percent and then a marketability discount

of 25 percent, for a result of $5,228,438, which he rounded to

$5,200,000.      Respondent’s expert selected the 30-percent control

premium on the basis of the 1991 average premiums of 35 percent

for all companies, 28 percent for contractors and engineering

services, and 45 percent for construction companies.

      Respondent’s expert also valued IHC using the discounted

cash-flow approach.         This approach is based upon estimates of

future cash-flow discounted for the time value of money and

relative investment risks.           Relying on IHC’s 5-year and 3-year

averages and industry trends and forecasts, respondent’s expert

used the following growth rates:              Years 1 through 5, 5 percent;

years 6 through 10, 4 percent; post-year 10, 3 percent.                He

projected direct costs to be 88 percent of revenues based on

historical results, industry averages, and anticipated economic
                                - 14 -


conditions.   On the basis of IHC’s operating expenses (exclusive

of depreciation), which averaged 7.7 percent of revenues for the

last 5 years and 7.9 percent for the last 3 years, respondent’s

expert forecast operating expenses at 7.8 percent.    Depreciation

was forecast at 1.5 percent of revenues.    He assumed a 40-percent

tax rate for combined Federal and State income taxes.    For

working capital, respondent’s expert selected 5 percent of

revenue, the industry averages being 5 to 7 percent and IHC’s 5-

year average about 5 percent.    After a review of historical

results and discussion with management, he projected capital

expenditures to equal depreciation in the long term, at 1.5

percent of revenues.   Respondent’s expert developed a discount

rate using a weighted average cost of capital for a capital

structure of 80 percent equity and 20 percent debt, a structure

intended to be reflective of the capital structures of companies

in SIC codes 1541 and 1542; this resulted in a 13-percent

discount rate.   The end result of the discounted cash-flow

approach was a value for IHC of $4,800,000, rounded.

     Respondent’s expert then averaged the results of the

discounted cash-flow ($4,800,000) and the market comparable

approach ($5,200,000) for a value of $5 million, or $788.65 per

share, on a majority basis.   The 30-percent control premium

previously selected by respondent’s expert translates to a

minority discount of 23 percent.    Accordingly, on a minority
                                - 15 -


basis, respondent’s expert concluded that a share of IHC stock is

worth $606.65.

Court’s Analysis

     Not unexpectedly, each of the parties criticizes the opinion

of the other’s expert.     We have considered each of the criticisms

in our analysis.

     Petitioner has presented an asset-based value, but with

certain flaws in its methodology.     Respondent’s expert has not

presented us with a value based on the asset approach, reasoning

that because IHC is not a holding or investment company, the

approach is not as appropriate as one based on income or market

comparables.     Also, respondent’s expert opined that the asset

approach is not as reliable for going concerns because of the

difficulty of valuing intangibles.

     The company’s net worth is one of the factors to be

considered, see sec. 25.2512-2(f), Gift Tax Regs., and the asset-

based approach provides a value useful for comparison with the

results of other approaches.     Petitioner’s expert began with

IHC’s September 30, 1992, balance sheet.     However, there is

little support for his $140,666 downward adjustment for the

purportedly uncollectible receivable.     Also, the adjustment for

fair market value of the depreciable assets is based on the

representation of IHC’s management and quick sale values, rather

than on independent appraisals of value in an orderly disposition
                              - 16 -


or as part of a going concern.   Considering these weaknesses, we

believe that IHC’s value calculated on the basis of its assets is

greater than the $3.6 million postulated by petitioner’s expert

($3.3 million in operating assets, plus $0.3 million cash value

of life insurance).

     The usefulness of the market approach is dependent on the

comparables selected and the application of the variable chosen

to the appropriate data.   We find that petitioner’s expert’s

calculation of the P/E and price/book value ratios is flawed in

that it does not focus on the period of time close to the

valuation date but uses a median of the 1992 year ranges.    Also,

he ignored all high values of these ratios.   He used 14.25 as the

median P/E ratio of the comparables, but the exhibit in his

report gives the median as “nm”, or “not meaningful”.

Petitioner’s expert converted the after-tax P/E ratio derived

from the comparables’ P/E ratios to a pretax ratio and then

misapplied the adjusted P/E ratio to various average and weighted

average pretax earnings.   In a properly calculated market

comparable approach, the comparables’ P/E ratios are to be

calculated and the selected result to be applied to the subject

company on the same type of earnings; e.g., a P/E ratio

determined on the most recent year’s net earnings is to be

applied to the subject company’s most recent year’s net earnings;

a P/E ratio calculated on 5-year average earnings should be
                               - 17 -


applied to the subject’s 5-year average earnings.    See Zukin,

Financial Valuation:    Businesses and Business Interests, par.

2.8[2], at 2-30, par. 6.8[3], at 6-26 (1990).    Because we find

the P/E ratios and related computations employed by petitioner’s

expert to be unreliable, we disregard his conclusion that a P/E

ratio between 3 and 5 is appropriate for valuing IHC.1

     Petitioner’s expert also developed a capitalization rate

based on the buildup method.    To the risk-free rate and equity

premium, he added a small size risk premium and then 5 percent

for other risk factors.    Petitioner’s expert describes the other

risks as those factors which differentiate IHC from the public

companies he selected as comparables, factors such as smaller

geographical market, lack of management depth, and lesser access

to capital markets.    With the exception of control and

marketability, most of the factors presented by petitioner’s

expert are those which differentiate a small company from a large

one and already were taken into consideration by the small

company premium.   If we reduce petitioner’s expert’s

capitalization rate accordingly and follow the remainder of his

methodology, the resulting values are in the range of roughly



     1
        Petitioner’s expert also asserted that a pretax P/E ratio
ranging from 3 to 5 was consistent with FMI’s experience with
actual transactions, but because no supporting data with respect
to these transactions was provided in his report, we accord
little weight to the assertion.
                              - 18 -


$2.0 to $2.6 million, rather than $1.8 to $2.4 million, though

still substantially lower than the value of IHC’s assets.

     Petitioner attacks respondent’s expert’s use of a discounted

cash-flow approach to value on the grounds that that approach, or

any method based on a projection of future earnings, is not

feasible in the construction industry because of risks inherent

in the business, such as poor estimates, delays, litigation over

accidents, defects, and nonperformance, and cyclical demand.

Petitioner has not established that IHC suffers

disproportionately from any of the risks mentioned.    Earnings of

the company are a factor to be considered in valuing stock.    See

sec. 25.2512-2(f), Gift Tax Regs.   Careful selection of the input

into the cash-flow analysis takes into account industry risks.

Moreover, IHC’s earnings for the 5-year period ending in fiscal

1992 do not suggest volatility.   With the exception of a dip in

fiscal 1989, IHC’s earnings exhibited steady growth.

Consequently, the projected growth rates used by respondent’s

expert in his discounted cash-flow analysis are reasonable,

indeed, conservative.   Thus, we believe that a discounted cash-

flow analysis can be used appropriately to value IHC.   The weight

to be given to an earnings approach as opposed to an asset

approach depends in part on the degree to which the company is

actively engaged in the sale of goods or services, as opposed to

being a holding or investment company.   See Ward v. Commissioner,
                             - 19 -


87 T.C. 78, 102 (1986); Estate of Ford v. Commissioner, T.C.

Memo. 1993-580, affd. 53 F.3d 924 (8th Cir. 1995).    IHC was

clearly the former.

     Petitioner also attacks the methodology of respondent’s

expert’s discounted cash-flow analysis.   Specifically, petitioner

criticizes respondent’s expert’s assumption of a pretax profit

margin of 3.1 percent, when IHC’s actual pretax profit margin

averaged 2.0 percent for the 5-year period 1988-92.    Challenged

to explain the 1.1-percent discrepancy at trial, respondent’s

expert contended that the difference was attributable to the

upward adjustment in earnings he made to account for excessive

compensation paid to Mr. Rakow and petitioner during the period.

We believe respondent’s expert was mistaken in his testimony.

His report makes no mention of excessive compensation.    A review

of his report suggests that the 1.1-percent difference between

the 2.0 actual average pretax profit margin and the 3.1 pretax

profit margin assumed in the discounted cash-flow analysis is

attributable to--

          (i) respondent’s expert’s selection of a direct

     cost percentage of 88.0 percent, rather than the actual

     5-year average of 88.7 percent (for a difference of 0.7

     percent); plus

          (ii) respondent’s expert’s selection of a

     percentage for operating expenses (minus depreciation)
                               - 20 -


     of 7.8 percent, rather than the actual 5-year average

     of 7.9 percent (for a difference of 0.1 percent); plus

            (iii) the fact that (short-term) interest expense,

     which actually averaged 0.3 percent for the 5-year

     period, is disregarded in a discounted cash-flow

     analysis (for a difference of 0.3 percent).

These three factors appear to account for the difference between

the 3.1 percent pretax profit margin assumed in respondent’s

expert’s discounted cash-flow and IHC’s actual 5-year average

pretax profit margin of 2.0 percent.     Thus the maximum adjustment

that could have been attributable to excess compensation was 0.1

percent (i.e., the difference between the expert’s assumption

regarding operating expenses and the actual average), which is

within the range that petitioner’s own expert conceded that Mr.

Rakow may have been overcompensated.

     This is not to suggest that we believe respondent’s expert’s

use of a 3.1-percent assumption for pretax profit margins in the

cash-flow analysis is appropriate.      To the contrary, we believe

petitioner’s expert’s estimates understate direct costs, with the

result that cash-flow, and the indicated value based thereon, are

inflated.

     As noted above respondent’s expert assumed direct costs at

88.0 percent of revenues, notwithstanding the fact that IHC’s 5-

year average was 88.7 percent.    In his report, respondent’s
                              - 21 -


expert states that the 88.0-percent figure chosen was “based upon

historical results, industry averages, and anticipated economic

conditions”.   Yet historical results averaged 88.7 percent, and

the industry average, according to the report, was 90.2 percent.

If the assumed direct costs percentage is affected by the

industry average, it should go up in IHC’s case, not down.    We

find that respondent’s expert’s own data support an assumption of

a direct costs percentage higher than 88.0 percent.    If one were

to take the average of the most recent 3-year and 5-year average

direct costs (just as respondent’s expert did with respect to his

operating expenses assumption), the result would be a direct

costs assumption of 88.6, rather than 88.0, percent.

     We believe the record in this case supports the use of a

higher direct costs percentage, which more closely approximates

the historical averages experienced by IHC, than the one employed

by respondent’s expert.   If one substitutes a direct costs

percentage of 88.6 percent into respondent’s expert’s discounted

cash-flow analysis, the indicated value for IHC as a whole

becomes approximately $3.8 million, rather than the $4.8 million

calculated by respondent’s expert.

     As recalculated, the $3.8 million value indicated by a

discounted cash-flow analysis calls into question the other

valuation approach employed by respondent’s expert; namely, the

market comparable approach.   That approach indicated a value of
                               - 22 -


$5.2 million for IHC.    Respondent’s expert testified that a

material difference in the results produced by the market

comparable and discounted cash-flow approaches--which he defined

as a difference of approximately 25 to 30 percent--would suggest

that there was something “inherently wrong” that would cause him

to review his assumptions.    The difference between the values

indicated by the discounted cash-flow approach (as herein

adjusted) and the market comparable approach is $1.4 million, or

approximately 39 percent.    Respondent’s expert further testified

that as between the two valuation methods he used, the discounted

cash-flow analysis was “more significant” than market

comparables, based on his personal experience and his review of

industry literature.    In addition, we note that respondent’s

expert’s use of the market comparable approach required him to

make numerous adjustments to the ratios derived from the publicly

traded comparables, in an effort to account for the substantially

smaller size of IHC and certain Generally Accepted Accounting

Principles applied to the financial reports of public companies.

These adjustments appeared, in the end, somewhat arbitrary; in

any event, respondent’s expert conceded that they were based on

his subjective determinations.    In the Court’s view, the

adjustments necessitated by the size difference between IHC and

the publicly traded comparables render the market comparable

approach inherently more prone to error.    On the basis of these
                              - 23 -


considerations, and respondent’s expert’s own stated preference

for the discounted cash-flow analysis, we accord considerably

more weight to its results, than to the results indicated by the

market comparable approach.

     On the basis of the foregoing, we conclude that respondent’s

expert’s discounted cash-flow analysis, as adjusted to reflect

more closely IHC’s actual experience, provides the most reliable

indication of value; namely $3.8 million.    This figure is

sufficiently close to the adjusted book value of IHC’s assets

(i.e., $4 million plus) that the two indications of value are

reconcilable.   Conversely, we think the $2.0 to $2.6 million

value indicated by petitioner’s expert’s capitalization of

earnings method is so divergent from the asset-based value that

the former should be disregarded.   We accordingly find that the

value of IHC as a whole was $3.8 million on the valuation date.

     We now consider the appropriate minority discount to apply

in determining the value of petitioner’s shares of IHC stock.

The parties agree that the minority discount is the inverse of

the control premium.

     Respondent’s expert reviewed 1991 control premium figures

for the overall market (35 percent), general contractors (28

percent), and construction companies (45 percent), selected 30

percent as the appropriate control premium for IHC, and converted

this to a minority discount of 23 percent.    Petitioner’s expert
                               - 24 -


selected a minority discount rate of 30 percent using overall

market averages, one based on a survey of market activity recent

to the valuation date and another being the highest median

premium in the 12-year period including the valuation date.

Generally, the average of all companies is not a good indicator

of the subject company.    See Northern Trust Co. v. Commissioner,

87 T.C. 349, 384 (1986).   Although petitioner’s expert does not

present industry-specific control premium data, petitioner argues

for using the control premium of construction companies (45

percent, which converts to a minority discount of 31 percent).

As consistently reported in its audited financial statements, IHC

performed most of its jobs on a stand-alone basis.   Thus, it more

closely resembles a construction company than a general

contractor.   Consequently, we agree that the 45-percent control

premium that respondent’s expert reports for construction

companies is appropriately used for IHC.   Accordingly, an inverse

31-percent minority discount should be applied to petitioner’s

IHC stock.2

     Dividing the $3,800,000 value for IHC as a whole by the

6,340 shares outstanding results in a value of $599.40 per share.



     2
        Although the use of a 45-percent control premium would
affect the value computed by respondent’s expert under the market
comparable approach, we need not consider this because of our
conclusion that the market comparable approach is not reliable in
this case.
                             - 25 -


Applying the 31-percent minority discount rate to this share

value results in a value of $413.59 per share.   Accordingly, we

hold that petitioner’s shares were worth $413.59 each on the

valuation date.

     In keeping with our holding,

                                         Decision will be entered

                                    under Rule 155.
