Where Have We Been So Far in the Series?
The first three posts in this series on Understanding the Largest Valuation Discount have been as follows:
- #1: The Marketability Discount
- #2: What is a Marketability Discount (DLOM)?
- #3: Enterprise vs. Shareholder Level (After DLOM) Values
The third post might have been titled “Establishing the Base Value From Which the Marketability Discount is Taken.” At this point, we have a basic understanding of what the marketability discount is, at least in words. One primary objective of this series is to develop an appropriate perspective on the largest valuation discount so that we can examine the various valuation methods used by appraisers in their determination.
The Next Three Posts
Before we begin to study actual valuation methods, we need to examine the discount for lack of marketability in the context of the two major valuation approaches that are typically employed in developing them – the Income Approach and the Market Approach (the Asset Approach is almost never and used to estimate the value of illiquid interests). We will also discuss what prevailing business valuation standards suggest regarding DLOMs on a conceptual basis before we even begin to consider actual numbers, prices or discounts.
Therefore the next three posts will be:
- #5: The Income Approach for Developing Marketability Discounts
- #6: The Market Approach for Developing Marketability Discounts
- #7: Business Valuation Standards and the Marketability Discount
As background, there are three general approaches to valuation, the Income Approach, the Market Approach, and the Asset Approach. According to the International Glossary and the ASA Business Valuation Standards, these terms are defined as follows:
- Income (Income-Based) Approach. A general way of determining a value indication of a business, business ownership interest, security, or intangible asset by using one or more methods that convert anticipated economic benefits into a present single amount.
- Market (Market-Based) Approach. A general way of determining a value indication of a business, business ownership interest, security, or intangible asset by using one or more methods that compare the subject to similar business, business ownership interests, securities or intangible assets that have been sold.
- Asset (Asset-Based) Approach. A general way of determining a value indication of a business, business ownership interest, security, or intangible asset by using one or more methods based on the value of the assets net of liabilities.
The Income Approach includes methods like the capitalization of earnings or the discounted cash flow method, and mathematical models like the Black Scholes Option Pricing Model. The Market Approach includes methods like comparisons with guideline transactions such as restricted stock studies, pre-IPO studies and others.
Most appraisals of minority interests conducted by qualified appraisers and which might include consideration of marketability discounts are conducted under one or more sets of business valuation standards, including the Uniform Standards of Professional Appraisal Practice.
Where We Go From There
Lest any readers grow impatient, we will still not be ready to discuss specific methods for developing marketability discounts. Before beginning the discussion of DLOM valuation methods or studies related to such methods, we will provide an overview of a recent publication of the Internal Revenue Service, IRS DLOM Job Aid.
The IRS DLOM Job Aid provides an overview and discussion of numerous valuation methods. We will summarize this overview as a starting point. However, the IRS DLOM Job Aid also provides a listing and discussion of numerous “factors influencing marketability.”
The factors influencing marketability were developed based on a review of numerous articles and studies pertaining to marketability discounts and represent a consensus listing of many of the factors that influence the magnitude of marketability discounts in specific valuation situations. We will develop this list of factors for closer examination.
So there will be four or perhaps six more background posts before we begin to analyze and discuss specific valuation methods for determining marketability discounts. The wait will be worthwhile. Only if we have a framework within which to discuss and to compare and contrast the methods, including their relative strengths and weaknesses, can we hope for a productive dialogue. Mere opinions or wishes or preferences will not contribute to the discussion.
Marketability discounts applicable in the valuation of business interests and securities should be discussed in the context of the valuation approaches and methods within which they are developed and within the context of the business valuation standards that govern most business appraisals.