The objective of many business appraisals is to determine a valuation conclusion at the nonmarketable minority level of value. We saw in the first post in this series on discounts for lack of marketability that the marketability discount is a conceptual discount that moves value from an enterprise level to a shareholder level.
It is well and good to understand the conceptual nature of a marketability discount. However, business appraisers must normally reach an actual conclusion regarding the appropriate marketability discount in each business valuation report.
So the basic question is:
How can appraisers determine the appropriate marketability discount for each valuation situation?
This is a critical question since the discount for lack of marketability is the single largest valuation adjustment factor in most minority interest appraisals.
Marketability Discount Ratios
From the International Glossary and the ASA Business Valuation Standards:
Marketability Discount (Discount for Lack of Marketability). An amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability.
That’s a nice definition and suggests that a marketability discount is a discount from something. In the first post, we learned that it is a discount from the conceptual marketable minority, or as-if-freely-tradable, level of value. We see the conceptual discount in the levels of value chart below.
The marketability discount is normally expressed as a percentage to reflect the difference between two prices, the freely marketable price, which for closely held businesses is a hypothetical construct since by definition there is no market for their shares, and a nonmarketable price.
We can use a bit of math, where MD is the marketability discount, MM is a marketable minority value, and NMM is a nonmarketable minority value. And assume that the Value(MM) equals $1.00 and that the Value(NMM) equals $0.75. For the moment, let’s not worry about where the indicated values come from.
MD = (1 – Value(NMM) / Value(MM))
The reason we use the expression “one minus” is to express the discount in a positive light. The ratio of Value(NMM) to Value(MM), given the specified values, would be 75% (i.e., $0.75/$1.00). The discount in this case is 100% of the Value(MM), or $1.00, minus the 75% ratio of the two prices, or 25%.
If this seems obvious and so basic as to be trivial, it is not. The marketability discount is the result of a ratio between two prices. So the question becomes, does the marketability discount reflect a “valuation ratio,” which is also a defined term.
Valuation Ratio. A fraction in which a value or prices serves as the numerator and financial, operating, or physical data serves as the denominator.
Examples of valuation ratios include Market Value of Total Capital to Sales, or to EBITDA (earnings before interest, taxes, depreciation, and amortization), or Market Value of Equity to Net Income. These valuation ratios are expressed familiarly as:
MVTC / Sales
MVTC / EBITDA
MVE / Net Income
In each case, a value (MVTC or MVE) serves as the numerator of the fraction and a financial factor (Sales, EBITDA, or Net Income) serves as the denominator. Business appraisers and users of business appraisals are familiar with these ratios. For example, companies in an industry may be selling in a normal range of 6x to 8x EBITDA, or the price/earnings multiple of a public company may be 15x.
If we know a multiple, e.g., from the appropriate market, it means something when placed in relationship to a financial factor. If you know a financial factor, it means something when placed in relationship to a (market) multiple.
Marketability Discount Ratios Are Not Valuation Ratios
We can work with the basic equation of a marketability discount from above with a bit of simple algebra.
MD = (1 – Value(NMM) / Value(MM)
Switching the factors around,
Value(NMM) / Value(MM) = (1 – MD)
Value(NMM) = Value(MM) x (1 – MD)
The nonmarketable value, which is the desired result of many appraisals, is a function of the marketable value times a ratio, which is not a valuation ratio. The marketability discount reflects a ratio of two prices. In and of itself, a discount for lack of marketability provides no valuation information whatsoever.
Back to the Basic Question
So the question remains, given the central objective of arriving at credible nonmarketable minority values, how do we determine MD, or the marketability discount, or the discount for lack of marketability, or the DLOM (all interchangeable terms)? We will investigate this question in-depth as this series on marketability discounts continues.