In the fifth post in this series on “Understanding the Largest Valuation Discount,” a generalized overview of the use of the income approach was developed. This sixth post in the series addresses the market approach for developing marketability discounts, or discounts for lack of marketability (DLOM).
This post is developed in three parts:
- Background information precedent to the discussion of the market approach for developing DLOMs.
- The conceptual application of the market approach at enterprise levels of value.
- The conceptual application of the market approach for developing marketability discounts to derive value indications at the nonmarketable minority level of value.
The discussion in the first two parts is necessary to fully understand the conceptual overview developed in the third part.
Background Precedent to the Discussion
The market approach to valuing a business, business ownership interest, intangible asset or security is described in the ASA Business Valuation Standards (“the ASABVS”) as:
The market approach is 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 businesses, business ownership interests, securities or intangible assets that have been sold.
Too often in business valuation, we fail to specify precisely what we are talking about before engaging in debate. To be clear:
- This series of posts is addressing the marketability discount applicable to the value of businesses at the marketable minority level of value. The level of value from which the marketability discount is taken is an enterprise level of value based on 100% of the available cash flows of the enterprise. These cash flows are, by definition, normalized to that of a well-run, publicly traded equivalent. If it were not so, then the resulting value indication would not be at the marketable minority level (“as-if freely traded”) level of value.
- The resulting valuation indication is of an illiquid minority interest in the subject enterprise, which is described as the nonmarketable minority level of value.
The two bolded terms, marketable minority and nonmarketable minority, are not defined terms, but appraisers use them in virtually every appraisal. They are described conceptually in the levels of value charts.
The marketability discount is clearly shown, at least conceptually, in both charts above. It is, as indicated, the discount that takes an enterprise value indication at the marketable minority level of value to the shareholder level, or to the nonmarketable minority level of value.
We have discussed these concepts in earlier posts in the series. However, it is important to be crystal clear what we are talking about as we develop a conceptual background for the use of the market approach to developing marketability discounts.
The Market Approach: Marketable Minority and Above
The market approach to valuing businesses, business ownership interests, securities or intangible assets was defined above. The key to the market approach is that we look to “the markets” for similar business interests to develop “guidelines” for the valuation of particular subject interests.
BVS V of the ASABVS, “Market Approach to Business Valuation,” goes on to indicate examples of methods under the market approach such as the Guideline Public Company Method and the Guideline Transaction Method, which are the subject of two Statements on ASA Business Valuation Standards (of the same names).
When valuing businesses, the use of the market approach is straightforward, at least conceptually:
- Marketable Minority. At the marketable minority level, we examine transactions in the shares of “comparable” publicly traded companies to develop guideline valuation ratios for application to a subject business. After developing a group of publicly traded “guideline companies,” the analyst will make appropriate comparisons and adjustments and apply valuation ratios like Price/Net Income (the P/E ratio), Market Value of Total Capital (MVTC) to Sales, or to Earnings Before Taxes, Depreciation, and Amortization (EBITDA), or to another level of the income statement. The end result of the application of such ratios to the normalized earnings of a subject business is a value indication at the marketable minority level of value.
- Financial Control. At the financial control level of value, appraisers have a choice, depending on the availability of data. They can develop groups of “comparable” transactions in the sales of controlling interests of companies. Based on relevant comparisons with a subject controlling interest, the analyst may apply valuation ratios directly from the guideline group of transactions to the subject business. The result, if the transactions are considered to be “financial” transactions, is at the financial control level of value. In the alternative, analysts can make indirect comparisons of valuation ratios from publicly traded groups of guideline companies because there is a growing understanding that the financial control and marketable minority levels of value are conceptually similar in magnitude (hence their co-location in the chart on the right above).
- Strategic Control. Analysts can develop value indications under the market approach at the strategic control level of value either directly or indirectly. In the direct method, comparisons are made with comparable transactions which are deemed to have occurred at the strategic control level. In the indirect method, value indications are developed by the application of appropriate (strategic or synergistic) control premiums to value indications at the marketable minority level of value (or the financial control level of value). Appraisers should apply control premiums with great caution. Control premiums are not economic drivers and mask often widely different underlying economics (i.e., valuation ratios) for otherwise seemingly similar transactions.
The Market Approach: Nonmarketable Minority Level
The market approach is based on relevant comparisons of a subject entity’s valuation parameters with valuation ratios developed from transactions in the relevant markets for the interest. The previous two sections outline the application of the market approach at the enterprise levels of value, including the marketable minority, the financial control and the strategic control levels.
- Direct Application. Referring to the levels of value charts above, we can develop value indications at the nonmarketable minority level by making appropriate valuation comparisons with transactions in illiquid securities of the business being considered in the appraisal. Appraisers always inquire about transactions in shares of subject companies. However, transactions in illiquid interests of private companies do not reflect an active market and should be used with caution. Quite often these transactions may reflect a lack of information or compulsion on the part of sellers (or buyers), and may not therefore be reflective of fair market value, which is the standard of value applicable in many, if not most, valuation requirements.
- Indirect Application. Realizing the inadequacies of the direct application of the market approach for the valuation of illiquid securities, appraisers began to turn to indirect methods. Indirect methods include the examination of transactions of illiquid securities in the public markets. It was observed that shares of publicly traded companies bearing legal or other restrictions on marketability tended to transact at discounts to publicly traded shares of the same companies that bore no similar restrictions. Analysts can develop groups of transactions in the shares of similar (to the subject company), publicly traded (but otherwise illiquid) companies, and make appropriate comparisons with valuation ratios from those transactions with the subject interest.
The SEC Institutional Investor Study was published in the early 1970s and reflected transactions in restricted shares of public companies occurring in the latter 1960s. In the ensuing years, a number of other studies of restricted stock transactions were published. By the 1980s, appraisers were engaging in what is now called “benchmark analysis” to develop marketability discounts. Comparisons were made with the averages of restricted stock studies and averages from the studies, or selections of discounts around the averages, were often applied by appraisers to marketable minority indications of value in the development of nonmarketable minority indications of value.
Beginning in the 1980s, as studies of restricted stock transactions of public companies continued to be performed, analysts, including John Emory, then at Robert W. Baird & Co., began to investigate transactions in private companies occurring in the months prior to their initial public offerings. These studies came to be called “pre-IPO studies.” The pre-IPO studies were also used in the employment of benchmark analysis to develop marketability discounts indirectly.
Over time, a number of restricted stock studies were conducted and transactional data became available from them (here and here among others). In addition, the pre-IPO markets were analyzed in more depth and pre-IPO transactional data bases emerged. More recently, transactions in LEAPS, or long-term equity anticipation securities, have been examined. With the development of these transactional data bases, appraisers gained the ability to employ the market approach indirectly but with, hopefully, more precision than with benchmark analysis.
We will examine specific data bases and indirect market approach methods for developing marketability discounts in future posts in this series. We only mention them now to position them as methods under the market approach.
Wrapping Up and Looking Ahead
We have now developed a conceptual overview of the market approach for developing the largest valuation discount, the marketability discount. Post four in the series provided a roadmap calling for the conceptual discussion of the income approach in post five and the present conceptual discussion of the market approach.
The next post will, as promised, will address “Business Valuation Standards and the Marketability Discount.” In upcoming posts, we will consider the income approach and the market approach for developing DLOMs through the filter of prevailing business appraisal standards, including the Uniform Standards of Professional Appraisal Practice and the ASA Business Valuation Standards. References to other sets of business appraisal standards may also be considered.
Then, as indicated in the roadmap post:
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.
This series was just mentioned in the BVWire. I hope it continues to generate interest among users of appraisal reports as well as business appraisers. The series is designed to avoid piecemeal discussion of the largest valuation discount. It will, hopefully, develop into the most comprehensive examination of the marketability discount to date.