An abridged version of this article was written for and originally published by Arizona Real Country Magazine in their June 2026 issue on page 55.

That happens because business valuation is not just a math problem. It is a judgment problem. When the number actually matters, in a sale, a buy-sell dispute, an estate matter, a divorce, or an IRS review, the easy shortcuts begin to show their cracks. “That is the multiple I found” may sound decisive, but it is usually just borrowed confidence wearing a necktie.

Many people still approach valuation by taking earnings and multiplying them by a market multiple. Sometimes that shortcut lands in the right neighborhood. Sometimes it does not. The trouble is that it often skips the questions that matter most. What does the business really earn once personal, unusual, and discretionary expenses are stripped out? What would it cost to replace the owner if the owner is essential to operations? How durable is the income stream? And how quickly should an investor recover capital before the business starts losing altitude?

A real CFO starts there. Not with a borrowed multiple, but with a disciplined framework. First, I look at what money could earn with little or no business risk. That is the return on investment. Then I ask how quickly I want the original capital returned. That is the return of investment. The higher the risk, the faster I want my money back. That is where the real valuation debate lives.

From there, the work becomes more honest. Earnings must be normalized. Add-backs have to be tested instead of blindly accepted. Officer compensation has to be leveled to market reality, whether that means increasing it because the owner is underpaid or reducing it because the owner has treated the business like a personal ATM. Only then can a buyer, a court, or the IRS begin to see what the business is actually worth, rather than what someone hopes it is worth.

The Sprint-Lap Overview

Here is the process in plain English:

That approach fits the IRS’s broader valuation guidance, which calls for defining the issue, identifying relevant factors, documenting the facts, and using the valuation approaches and methods that best indicate value in the case at hand.

What the Owner Sees vs. What the CFO Tests

Why Valuators Often Review Five Years of History

When valuing a business, I usually begin by reviewing about five years of financial history. That does not mean the business is worth five years of earnings. It means I want enough history to see whether the company is stable, improving, declining, or being dressed up for the prom right before a sale. Five years of financial data often shows me whether the business is:

The IRS’s valuation guidance, through Revenue Ruling 59-60, says detailed profit-and-loss statements should be obtained for a representative period, preferably five or more years. The same guidance also warns that using an arbitrary five- or ten-year average, without regard to current trends or future prospects, will not produce a realistic valuation. If earnings are rising or falling, more weight may be given to more recent years.

That is why weighting is judgment, not a canned formula.

If one year was distorted by COVID, supply chain chaos, a one-time contract, a key employee departure, or the owner finally deciding to run fewer personal expenses through the business, that year may need to be normalized or weighted differently. But you do not simply throw out bad years and hug the good year like it is the only honest child in the family. You explain the facts and weight the history accordingly.

What Might a Typical Return OF Period Look Like?

These are illustrative judgment ranges, not IRS tables and not universal rules. Local market conditions, contracts, competition, debt load, lease terms, customer concentration, and succession depth can shift them.

Still, this is the kind of thinking a CFO should be doing:

A useful caution here: for agriculture and land-heavy businesses, the operating business and the underlying real estate may deserve separate thought. The operating return period may be one thing. The land value may be another. Dirt has a way of surviving longer than management.

A Simple Example of How Value Changes

Now let’s show why professionals spend so much time on the return OF period.

To recover capital, I add a recovery component that answers this question:

How much principal must come back each year so the investor gets capital back within the chosen time period?

• 3 years means more risk, so capital must come back faster, and value drops.
• 5 years means moderate durability, so value rises.
• 7 years means greater stability, so value rises further.

That is why this section is where professionals earn their fee. The real valuation debate often is not whether the business made money. It is whether those earnings are durable enough to justify a 3-year, 5-year, or 7-year recovery period.

Where Multiples Fit, and Where They Mislead

A properly derived multiple can land in the same neighborhood as this method, because a multiple is often just the inverse of a capitalization rate.

That is why you can sometimes back into a 2.8x multiple, a 4.5x multiple, or a 6.0x multiple from the return ON / return OF framework above.

So I am not saying multiples are useless.

I am saying they are often a quick-and-dirty shorthand for assumptions that were never explained.

That is the problem.

When someone says, “This business trades at 4x EBITDA,” my next questions are:

Revenue Ruling 59-60 is explicit that there is no general formula for valuing closely held stock, and it also warns against mechanically averaging factors or applying formulaic weights without realistic consideration of the facts.

So yes, multiples can be a useful cross-check. But if you do not know where the multiple came from, you are at the mercy of someone else’s assumptions. That is not analysis. That is outsourcing your judgment.

Add-Backs: Cleaning the Books Until They Resemble Reality

Small business financial statements are often built for taxes, cash flow, convenience, and survival. They are not always built for valuation clarity.

That is why we normalize earnings.

What is an add-back?

An add-back is an adjustment to reported earnings that removes an expense or loss item that is not representative of ongoing, maintainable business operations.

What does this business really earn once the noise is stripped out?

Those items may not represent ongoing economic costs of the business.

But not every “add-back” increases value. This is where bad seller-side valuations get a little theatrical. Normalization also works in the other direction.

Missing economic costs are not value-boosting add-backs. They are costs that should have been there all along. The IRS’s valuation guidance emphasizes separating recurrent from non-recurring items and focusing on what is actually predictive of future earnings. That is the entire point of normalization.

Leveling Officer Compensation: One of the Most Important Adjustments in Small Business Valuation

This deserves its own section because it causes more valuation nonsense than almost anything else.

In many owner-operated businesses, the owner is:

• underpaid,
• overpaid,
• or paid in a tax-driven mix of wages and distributions that makes economic analysis messy.

A proper valuation should not blindly accept that compensation number. It should level it to market reality.

This is especially important when the owner is the key person and is leaving. Revenue Ruling 59-60 specifically says the loss of the manager in a “one-man” business may have a depressing effect on value and that the absence of management succession is a relevant factor.

The IRS’s reasonable compensation guidance for S corporations focuses on what the shareholder-employee actually did for the company and points to factors such as services provided, the role of non-shareholder employees, and the contribution of capital and equipment. In other words, the IRS already lives in the same neighborhood as this valuation adjustment.

So when I level officer compensation, I am not inventing a theory. I am trying to convert tax-driven compensation into economic reality.

Discounts: Minority Ownership and Lack of Marketability

After valuing the business, you still may have to value the specific ownership interest.

That is where discounts enter the track.

The IRS has a dedicated DLOM job aid and makes clear that marketability discounts can materially reduce value, but also that DLOM is a fact-intensive issue, not a cookbook percentage. The same job aid also says it is not official IRS legal authority, which is important to remember.

One caution here: not every valuation requires discounts. If you are valuing 100% of a company for a sale, minority discounts may not belong. If you are valuing a partial interest in a divorce, estate, gift, or shareholder dispute, the discount analysis may become central.

Why This Method Matters

This is why I like the return ON / return OF framework.

It forces the analyst to answer real questions:

That is a much cleaner process than grabbing a multiple off the shelf and hoping it fits.

A multiple may still appear in the final conversation. Fine. But now it is a result of analysis, not a substitute for it.

Final Lap