In a tax environment where significant gifts need to be made and substantial value needs to be transferred, the topic of valuation discounts rises to the forefront.

Valuation discounts are not magical or mysterious. They relate to differences between businesses at the level of the enterprise and interests in those businesses from the viewpoint of shareholders, owners or investors.

In this continuing series, we are investigating the marketability discount, or discount for lack of marketability (DLOM), which is typically the largest valuation discount in most minority interest appraisals.

What is the Value of a Business?

There is little disagreement that the value of a business enterprise, today, is represented by the (present) value of all future benefits (cash flows) to be derived from that business, into perpetuity, discounted to the present at a discount rate reflective of the risks associated with achieving them. The discounted cash flow model (DCF) is summarized in the first value expression below and is used to describe this definition conceptually.

The value of a business assumes that the business will exist and generate cash flows into perpetuity.

The DCF model can be summarized in the form of the Gordon Model, which is shown at the right side of the figure above.  This summary form of the DCF model holds true if all expected cash flows are reinvested in the business at the discount rate, r, or alternatively, are distributed to shareholders, and those expected cash flows grow into perpetuity at the (long-term) growth rate, g.

The discounted cash flow model can be expressed in a two stage form, where the analyst develops a forecast for a finite period of years, and then determines a terminal value, which represents the present value of all remaining cash flows of the business at the end of the finite forecast period. The algebraic expression for this model can be shown as:

The two-stage DCF model is helpful when companies are starting up, when they are experiencing significant change at the valuation date, or when they are cyclical in nature. The basic idea of this model is that the analyst can capture the value-impact of near-term cash flows, which may vary significantly from longer-term cash flows, and then determine a terminal value at the end of the finite forecast period when cash flows are expected to have stabilized.

Normalized Cash Flows and the Base Value for Marketability Discounts

The cash flows employed in the DCF model (or the Gordon Model) are typically assumed to be the normalized cash flows of the business enterprise. Normalization adjustments are made to account for non-recurring items impacting the income statement, the impact of balance sheet adjustments on the income statement, and discretionary expenses of controlling shareholders. Discretionary expenses would include above-market owner compensation, preferential charitable gifts, and compensation paid to non-working owners.

For a more detailed discussion of normalization adjustments and the rationale for their use, see this post or Chapter 4 of Business Valuation: An Integrated Theory Second Edition (Mercer and Harms.)

The normalized cash flows of a business, when capitalized using the Gordon Model or when the DCF method is employed, are generally assumed to produce value indications at the marketable minority or financial control level of value. In other words, theses methods develop base values at the enterprise level of value, and they are appropriate base values for which to deduct, or to consider, appropriate marketability discounts. Remember the Standards guidance in previous posts suggesting that no discount has any meaning unless the base value from which it is to be taken has been clearly specified.

The base value from which marketability discounts are considered is the marketable minority level of value, which is reflected in the charts above. This level of value is an enterprise level of value. By enterprise level, we mean that the cash flows of the enterprise have been considered in arriving at this level.

The discount for lack of marketability (DLOM) is the adjustment that appraisers use to “move” from this enterprise level of value to the nonmarketable minority level of value.

Next Steps in the Series

In the next post in this series on understanding the largest valuation discount, we will examine the conceptual nature of the nonmarketable minority level of value, which is a shareholder level of value. By shareholder level, we mean that only the portion of enterprise cash flows that can reasonably be expected to be received by an owner or potential investor will be considered.  For a variety of reasons that we will discuss in more detail, the shareholder-level cash flows may be less than those attributable to the enterprise.  They may also be subject to certain risks that are in addition to the risks of the enterprise.

When we understand the relationships between enterprise level base values and shareholder level values, we can begin to analyze the factors that might cause those values to be different. The term introduced in the IRS Job Aid is “factors influencing marketability.”

When we understand the differences between enterprise and shareholder level values and the reasons for those differences, we can then look at specific factors in individual valuation situations and assess which factors are important and, hopefully, their valuation impact through the development of the appropriate marketability discount in each case.