The theory and practice of the valuation of business gained prominence during the period of prohibition in the 1920’s. Between 1860 and 1880 the population of the United States grew from 6 million to 14 million people. Many of these people were recent immigrants. They found themselves working long hard hours in factories in abominable conditions. For many getting drunk was their only respite from this life. There was a concern that a “culture of drink” was beginning to form in American society. Due to technological processes like the telegraph, the railroad, and refrigeration, “big business” was able to grow. Pabst of Milwaukee and Anheuser Busch of St. Louis greatly expanded their operations.
The 18th amendment to the Constitution became effective on January 16, 1920. Many companies who sold alcohol were forced to close their doors. The U.S. Government allowed these companies tax breaks or compensated the company for its lost sales and profits. Up until this time, the value of a company was thought to be its equity or its assets minus its liabilities. Valuation theory developed the idea that the value of a company is measured by its goodwill and its ability to generate cash flow. Goodwill can be comprised of different components such as a trained work force, customer base, trade names, and reputation in the community.
The Internal Revenue Service has been a major contributor to the principles and practice of valuation. One such official pronouncement, the Appeals and Revenue Memorandum (ARM 34) established two important ideas. First, if a business has earnings in excess of another “like business”, goodwill exists; and second the “current value” of those excess earnings is the value of goodwill. Since the 1920’s and the end of prohibition, the practice and theory of valuation of business has been greatly developed. The Internal Revenue Service and the court system has continued to be a major contributor to the art and science of valuation. A comprehensive industry has grown comprised of writers, professionals, organizations, and supporting agencies.