Business valuation
Encyclopedia
Business valuation is a process and a set of procedures used to estimate the economic value
of an owner’s interest in a business. Valuation
is used by financial market participants to determine the price they are willing to pay or receive to consummate a sale of a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes.
The standard of value is the hypothetical conditions under which the business will be valued. The premise of value relates to the assumptions, such as assuming that the business will continue forever in its current form (going concern), or that the value of the business lies in the proceeds from the sale of all of its assets minus the related debt (sum of the parts or assemblage of business assets).
Business valuation results can vary considerably depending upon the choice of both the standard and premise of value. In an actual business sale, it would be expected that the buyer and seller, each with an incentive to achieve an optimal outcome, would determine the fair market value of a business asset that would compete in the market for such an acquisition. If the synergies are specific to the company being valued, they may not be considered. Fair value also does not incorporate discounts for lack of control or marketability.
Note, however, that it is possible to achieve the fair market value for a business asset that is being liquidated in its secondary market. This underscores the difference between the standard and premise of value.
These assumptions might not, and probably do not, reflect the actual conditions of the market in which the subject business might be sold. However, these conditions are assumed because they yield a uniform standard of value, after applying generally accepted valuation techniques, which allows meaningful comparison between businesses which are similarly situated.
A common source of economic information for the first section of the business valuation report is the Federal Reserve Board’s Beige Book
, published eight times a year by the Federal Reserve Bank
. State governments and industry associations also publish useful statistics describing regional and industry conditions.
in different time periods, the valuation expert can view growth or decline in revenues or expenses, changes in capital structure, or other financial trends. How the subject company compares to the industry will help with the risk assessment and ultimately help determine the discount rate and the selection of market multiples.
, the asset-based approach, and the market approach. Within each of these approaches, there are various techniques for determining the value of a business using the definition of value appropriate for the appraisal assignment. Generally, the income approaches determine value by calculating the net present value
of the benefit stream generated by the business (discounted cash flow
); the asset-based approaches determine value by adding the sum of the parts of the business (net asset value); and the market approaches determine value by comparing the subject company to other companies in the same industry, of the same size, and/or within the same region.
A number of business valuation models can be constructed that utilize various methods under the three business valuation approaches. Venture Capitalists and Private Equity professionals have long used the First chicago method
which essentially combines the income approach with the market approach.
In determining which of these approaches to use, the valuation professional must exercise discretion. Each technique has advantages and drawbacks, which must be considered when applying those techniques to a particular subject company. Most treatises and court decisions encourage the valuator to consider more than one technique, which must be reconciled with each other to arrive at a value conclusion. A measure of common sense and a good grasp of mathematics is helpful.
by multiplying the benefit stream generated by the subject or target company times a discount or capitalization rate. The discount or capitalization rate converts the stream of benefits into present value
. There are several different income approaches, including capitalization of earnings or cash flow
s, discounted future cash flows (“DCF
”), and the excess earnings method (which is a hybrid of asset and income apprope of benefit stream to which it is applied. The result of a value calculation under the income approach is generally the fair market value
of a controlling, marketable interest in the subject company, since the entire benefit stream of the subject company is most often valued, and the capitalization and discount rates are derived from statistics concerning public companies.
or capitalization rate
is used to determine the present value
of the expected return
s of a business. The discount rate
and capitalization rate
are closely related to each other, but distinguishable. Generally speaking, the discount rate
or capitalization rate
may be defined as the yield necessary to attract investors to a particular investment, given the risks associated with that investment.
There are several different methods of determining the appropriate discount rates. The discount rate is composed of two elements: (1) the risk-free rate
, which is the return that an investor would expect from a secure, practically risk-free investment, such as a high quality government bond; plus (2) a risk premium
that compensates an investor for the relative level of risk associated with a particular investment in excess of the risk-free rate. Most importantly, the selected discount or capitalization rate must be consistent with stream of benefits to which it is to be applied.
(CAPM
) is one method of determining the appropriate discount rate in business valuations. The CAPM
method originated from the Nobel Prize winning studies of Harry Markowitz, James Tobin and William Sharpe. The CAPM
method derives the discount rate by adding a risk premium to the risk-free rate. In this instance, however, the risk premium is derived by multiplying the equity risk premium times “beta,” which is a measure of stock price volatility. Beta is published by various sources for particular industries and companies. Beta is associated with the systematic risks of an investment.
One of the criticisms of the CAPM
method is that beta is derived from the volatility of prices of publicly traded companies, which are likely to differ from private companies in their capital structures, diversification of products and markets, access to credit markets, size, management depth, and many other respects. Where private companies can be shown to be sufficiently similar to public companies, however, the CAPM
method may be appropriate.
is an approach to determining a discount rate. The WACC
method determines the subject company’s actual cost of capital
by calculating the weighted average of the company’s cost of debt and cost of equity
. The WACC
must be applied to the subject company’s net cash flow
to total invested capital.
One of the problems with this method is that the valuator may elect to calculate WACC
according to the subject company’s existing capital structure
, the average industry capital structure
, or the optimal capital structure. Such discretion detracts from the objectivity of this approach, in the minds of some critics.
Indeed, since the WACC
captures the risk of the subject business itself, the existing or contemplated capital structures, rather than industry averages, are the appropriate choices for business valuation.
Once the capitalization rate
or discount rate
is determined, it must be applied to an appropriate economic income stream: pretax cash flow
, aftertax cash flow
, pretax net income
, after tax net income
, excess earnings, projected cash flow
, etc. The result of this formula is the indicated value before discounts. Before moving on to calculate discounts, however, the valuation professional must consider the indicated value under the asset and market approaches.
Careful matching of the discount rate
to the appropriate measure of economic income is critical to the accuracy of the business valuation results. Net cash flow
is a frequent choice in professionally conducted business appraisals. The rationale behind this choice is that this earnings basis corresponds to the equity discount rate derived from the Build-Up or CAPM
models: the returns obtained from investments in publicly traded companies can easily be represented in terms of net cash flows. At the same time, the discount rates are generally also derived from the public capital markets data.
Similarly, investors who invest in small cap stocks, which are riskier than blue-chip stocks, require a greater return, called the “size premium.” Size premium data is generally available from two sources: Morningstar
's (formerly Ibbotson
& Associates') Stocks, Bonds, Bills & Inflation and Duff & Phelps
' Risk Premium Report.
By adding the first three elements of a Build-Up discount rate, we can determine the rate of return that investors would require on their investments in small public company stocks. These three elements of the Build-Up discount rate are known collectively as the “systematic risks.”
In addition to systematic risks, the discount rate must include “unsystematic risks,” which fall into two categories. One of those categories is the “industry risk premium.” Morningstar’s yearbooks contain empirical data to quantify the risks associated with various industries, grouped by SIC industry code.
The other category of unsystematic risk is referred to as “specific company risk.” Historically, no published data has been available to quantify specific company risks. However as of late 2006, new research has been able to quantify, or isolate, this risk for publicly traded stocks through the use of Total Beta calculations. P. Butler and K. Pinkerton have outlined a procedure which sets the following two equations together:
Total Cost of Equity (TCOE) = risk-free rate + total beta*equity risk premium
TCOE = risk-free rate + beta*equity risk premium + size premium + company-specific risk premium
The only unknown in the two equations is the company specific risk premium.
While it is possible to isolate the company-specific risk premium as shown above, many appraisers just key in on the total cost of equity (TCOE) provided by the following equation: TCOE = risk-free rate + Total beta*equity risk premium.
It is similar to using the market approach in the income approach instead of adding separate (and potentially redundant) measures of risk in the build-up approach. The use of total beta (developed by Aswath Damodaran) is a relatively new concept. It is, however, gaining acceptance in the business valuation community since it is based on modern portfolio theory. Total beta can help appraisers develop a cost of capital who were content to use their intuition alone when previously adding a purely subjective company-specific risk premium in the build-up approach.
It is important to understand why this capitalization rate for small, privately held companies is significantly higher than the return that an investor might expect to receive from other common types of investments, such as money market accounts, mutual funds, or even real estate. Those investments involve substantially lower levels of risk than an investment in a closely held company. Depository accounts are insured by the federal government (up to certain limits); mutual funds are composed of publicly traded stocks, for which risk can be substantially minimized through portfolio diversification.
Closely held companies, on the other hand, frequently fail for a variety of reasons too numerous to name. Examples of the risk can be witnessed in the storefronts on every Main Street in America. There are no federal guarantees. The risk of investing in a private company cannot be reduced through diversification, and most businesses do not own the type of hard assets that can ensure capital appreciation over time. This is why investors demand a much higher return on their investment in closely held businesses; such investments are inherently much more risky. (This paragraph is biased, presuming that by the mere fact that a company is closely held, it is prone towards failure.)
method is relatively objective. Pursuant to accounting convention, most assets are reported on the books of the subject company at their acquisition value, net of depreciation where applicable. These values must be adjusted to fair market value
wherever possible.
The value of a company’s intangible assets, such as goodwill, is generally impossible to determine apart from the company’s overall enterprise value. For this reason, the asset-based approach is not the most probative method of determining the value of going business concerns. In these cases, the asset-based approach yields a result that is probably lesser than the fair market value
of the business.
In considering an asset-based approach, the valuation professional must consider whether the shareholder whose interest is being valued would have any authority to access the value of the assets directly. Shareholders own shares in a corporation, but not its assets, which are owned by the corporation. A controlling shareholder may have the authority to direct the corporation to sell all or part of the assets it owns and to distribute the proceeds to the shareholder(s). The non-controlling shareholder, however, lacks this authority and cannot access the value of the assets. As a result, the value of a corporation's assets is rarely the most relevant indicator of value to a shareholder who cannot avail himself of that value.
Adjusted net book value
may be the most relevant standard of value where liquidation is imminent or ongoing; where a company earnings or cash flow are nominal, negative or worth less than its assets; or where net book value
is standard in the industry in which the company operates. The adjusted net book value
may also be used as a “sanity check” when compared to other methods of valuation, such as the income and market approaches.
. The market price of the stocks of publicly traded companies engaged in the same or a similar line of business, whose shares are actively traded in a free and open market, can be a valid indicator of value when the transactions in which stocks are traded are sufficiently similar to permit meaningful comparison.
The difficulty lies in identifying public companies that are sufficiently comparable to the subject company for this purpose. Also, as for a private company, the equity is less liquid (in other words its stocks are less easy to buy or sell) than for a public company
, its value is considered to be slightly lower than such a market-based valuation
would give.
When there is a lack of comparison with direct competition, a meaningful alternative could be a vertical value-chain approach where the subject company is compared with, for example, a known downstream industry to have a good feel of its value by building useful correlations with its downstream companies. Such comparison often reveals useful insights which help business analysts better understand performance relationship between the subject company and its downstream industry. For example, if a growing subject company is in an industry more concentrated than its downstream industry with a high degree of interdependence, one should logically expect the subject company performs better than the downstream industry in terms of growth, margins and risk.
of the Company as a whole. In valuing a minority, non-controlling interest in a business, however, the valuation professional must consider the applicability of discounts that affect such interests.
Discussions of discounts and premiums frequently begin with a review of the “levels of value.” There are three common levels of value: controlling interest, marketable minority, and non-marketable minority.
The intermediate level, marketable minority interest, is less than the controlling interest level and higher than the non-marketable minority interest level. The marketable minority interest level represents the perceived value of equity interests that are freely traded without any restrictions. These interests are generally traded on the New York Stock Exchange, AMEX, NASDAQ, and other exchanges where there is a ready market for equity securities. These values represent a minority interest in the subject companies – small blocks of stock that represent less than 50% of the company’s equity, and usually much less than 50%.
Controlling interest level is the value that an investor would be willing to pay to acquire more than 50% of a company’s stock, thereby gaining the attendant prerogatives of control. Some of the prerogatives of control include: electing directors, hiring and firing the company’s management and determining their compensation; declaring dividends and distributions, determining the company’s strategy and line of business, and acquiring, selling or liquidating the business. This level of value generally contains a control premium
over the intermediate level of value, which typically ranges from 25% to 50%. An additional premium may be paid by strategic investors who are motivated by synergistic motives.
Non-marketable, minority level is the lowest level on the chart, representing the level at which non-controlling equity interests in private companies are generally valued or traded. This level of value is discounted because no ready market exists in which to purchase or sell interests. Private companies are less “liquid” than publicly traded companies, and transactions in private companies take longer and are more uncertain. Between the intermediate and lowest levels of the chart, there are restricted shares of publicly traded companies.
Despite a growing inclination of the IRS and Tax Courts to challenge valuation discounts, Shannon Pratt suggested in a scholarly presentation recently that valuation discounts are actually increasing as the differences between public and private companies is widening . Publicly traded stocks have grown more liquid in the past decade due to rapid electronic trading, reduced commissions, and governmental deregulation. These developments have not improved the liquidity of interests in private companies, however.
Valuation discounts are multiplicative, so they must be considered in order. Control premiums and their inverse, minority interest discounts, are considered before marketability discounts are applied.
MID = 1 – [1 / (1 + CP)]
The most common source of data regarding control premiums is the Control Premium Study, published annually by Mergerstat since 1972. Mergerstat compiles data regarding publicly announced mergers, acquisitions and divestitures involving 10% or more of the equity interests in public companies, where the purchase price is $1 million or more and at least one of the parties to the transaction is a U.S. entity
. Mergerstat defines the “control premium” as the percentage difference between the acquisition price and the share price of the freely traded public shares five days prior to the announcement of the M&A transaction.
While it is not without valid criticism, Mergerstat control premium data (and the minority interest discount derived therefrom) is widely accepted within the valuation profession.
All other factors being equal, an interest in a publicly traded company is worth more because it is readily marketable. Conversely, an interest in a private-held company is worth less because no established market exists. The IRS Valuation Guide for Income, Estate and Gift Taxes, Valuation Training for Appeals Officers acknowledges the relationship between value and marketability, stating: “Investors prefer an asset which is easy to sell, that is, liquid.”
The discount for lack of control is separate and distinguishable from the discount for lack of marketability. It is the valuation professional’s task to quantify the lack of marketability of an interest in a privately held company. Because, in this case, the subject interest is not a controlling interest in the Company, and the owner of that interest cannot compel liquidation to convert the subject interest to cash quickly, and no established market exists on which that interest could be sold, the discount for lack of marketability is appropriate.
Several empirical studies have been published that attempt to quantify the discount for lack of marketability. These studies include the restricted stock studies and the pre-IPO studies. The aggregate of these studies indicate average discounts of 35% and 50%, respectively. Some experts believe the Lack of Control and Marketability discounts can aggregate discounts for as much as ninety percent of a Company's fair market value, specifically with family-owned companies.
The underlying data by which these studies arrived at their conclusions has not been made public. Consequently, it is not possible when valuing a particular company to compare the characteristics of that company to the study data. Still, the existence of a marketability discount has been recognized by valuation professionals and the Courts, and the restricted stock studies are frequently cited as empirical evidence. Notably, the lowest average discount reported by these studies was 26% and the highest average discount was 40%.
Studies based on the prices paid for options have also confirmed similar discounts. If one holds restricted stock
and purchases an option to sell that stock at the market price (a put
), the holder has, in effect, purchased marketability for the shares. The price of the put
is equal to the marketability discount. The range of marketability discounts derived by this study was 32% to 49%. However, ascribing the entire value of a put option to marketability is misleading, because the primary source of put value comes from the downside price protection. A correct economic analysis would use deeply in-the-money puts or Single-stock futures
, demonstrating that marketability of restricted stock is of low value because it is easy to hedge using unrestricted stock or futures trades.
The pre-IPO studies are sometimes criticized because the sample size is relatively small, the pre-IPO transactions may not be arm’s length, and the financial structure and product lines of the studied companies may have changed during the three year pre-IPO window.
to a level which brings risk-reward back into balance.
The referenced studies establish a reasonable range of valuation discounts from the mid-30%s to the low 50%s. The more recent studies appeared to yield a more conservative range of discounts than older studies, which may have suffered from smaller sample sizes. Another method of quantifying the lack of marketability discount is the Quantifying Marketability Discounts Model (QMDM).
A number of stock market indicators in the United States and other countries provide an indication of the market value of publicly traded firms. The Survey of Consumer Finance in the US also includes an estimate of household ownership of stocks, including indirect ownership through mutual funds. The 2004 and 2007 SCF indicate a growing trend in stock ownership, with 51% of households indicating a direct or indirect ownership of stocks, with the majority of those respondents indicating indirect ownership through mutual funds. Few indications are available on the value of privately held firms. Anderson (2009) recently estimated the market value of U.S. privately held and publicly traded firms, using Internal Revenue Service and SCF data. He estimates that privately held firms produced more income for investors, and had more value than publicly held firms, in 2004.
Valuation (finance)
In finance, valuation is the process of estimating what something is worth. Items that are usually valued are a financial asset or liability. Valuations can be done on assets or on liabilities...
of an owner’s interest in a business. Valuation
Valuation (finance)
In finance, valuation is the process of estimating what something is worth. Items that are usually valued are a financial asset or liability. Valuations can be done on assets or on liabilities...
is used by financial market participants to determine the price they are willing to pay or receive to consummate a sale of a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes.
Standard and premise of value
Before the value of a business can be measured, the valuation assignment must specify the reason for and circumstances surrounding the business valuation. These are formally known as the business value standard and premise of value.The standard of value is the hypothetical conditions under which the business will be valued. The premise of value relates to the assumptions, such as assuming that the business will continue forever in its current form (going concern), or that the value of the business lies in the proceeds from the sale of all of its assets minus the related debt (sum of the parts or assemblage of business assets).
Business valuation results can vary considerably depending upon the choice of both the standard and premise of value. In an actual business sale, it would be expected that the buyer and seller, each with an incentive to achieve an optimal outcome, would determine the fair market value of a business asset that would compete in the market for such an acquisition. If the synergies are specific to the company being valued, they may not be considered. Fair value also does not incorporate discounts for lack of control or marketability.
Note, however, that it is possible to achieve the fair market value for a business asset that is being liquidated in its secondary market. This underscores the difference between the standard and premise of value.
These assumptions might not, and probably do not, reflect the actual conditions of the market in which the subject business might be sold. However, these conditions are assumed because they yield a uniform standard of value, after applying generally accepted valuation techniques, which allows meaningful comparison between businesses which are similarly situated.
Economic conditions
A business valuation report generally begins with a description of national, regional and local economic conditions existing as of the valuation date, as well as the conditions of the industry in which the subject business operates.A common source of economic information for the first section of the business valuation report is the Federal Reserve Board’s Beige Book
Beige Book
The Beige Book, more formally called the Summary of Commentary on Current Economic Conditions, is a report published by the United States Federal Reserve Board eight times a year. The report is published in advance of meetings of the Federal Open Market Committee...
, published eight times a year by the Federal Reserve Bank
Federal Reserve Bank
The twelve Federal Reserve Banks form a major part of the Federal Reserve System, the central banking system of the United States. The twelve federal reserve banks together divide the nation into twelve Federal Reserve Districts, the twelve banking districts created by the Federal Reserve Act of...
. State governments and industry associations also publish useful statistics describing regional and industry conditions.
Financial analysis
The financial statement analysis generally involves common size analysis, ratio analysis (liquidity, turnover, profitability, etc.), trend analysis and industry comparative analysis. This permits the valuation analyst to compare the subject company to other businesses in the same or similar industry, and to discover trends affecting the company and/or the industry over time. By comparing a company’s financial statementsFinancial statements
A financial statement is a formal record of the financial activities of a business, person, or other entity. In British English—including United Kingdom company law—a financial statement is often referred to as an account, although the term financial statement is also used, particularly by...
in different time periods, the valuation expert can view growth or decline in revenues or expenses, changes in capital structure, or other financial trends. How the subject company compares to the industry will help with the risk assessment and ultimately help determine the discount rate and the selection of market multiples.
Normalization of financial statements
The most common normalization adjustments fall into the following four categories:- Comparability Adjustments. The valuer may adjust the subject company’s financial statementsFinancial statementsA financial statement is a formal record of the financial activities of a business, person, or other entity. In British English—including United Kingdom company law—a financial statement is often referred to as an account, although the term financial statement is also used, particularly by...
to facilitate a comparison between the subject company and other businesses in the same industry or geographic location. These adjustments are intended to eliminate differences between the way that published industry data is presented and the way that the subject company’s data is presented in its financial statementsFinancial statementsA financial statement is a formal record of the financial activities of a business, person, or other entity. In British English—including United Kingdom company law—a financial statement is often referred to as an account, although the term financial statement is also used, particularly by...
.
- Non-operating Adjustments. It is reasonable to assume that if a business were sold in a hypothetical sales transaction (which is the underlying premise of the fair market valueFair market valueFair market value is an estimate of the market value of a property, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the market. An estimate of fair market value may be founded either on precedent or...
standard), the seller would retain any assets which were not related to the production of earnings or price those non-operating assets separately. For this reason, non-operating assets (such as excess cash) are usually eliminated from the balance sheet.
- Non-recurring Adjustments. The subject company’s financial statements may be affected by events that are not expected to recur, such as the purchase or sale of assets, a lawsuit, or an unusually large revenue or expense. These non-recurring items are adjusted so that the financial statementsFinancial statementsA financial statement is a formal record of the financial activities of a business, person, or other entity. In British English—including United Kingdom company law—a financial statement is often referred to as an account, although the term financial statement is also used, particularly by...
will better reflect the management’s expectations of future performance.
- Discretionary Adjustments. The owners of private companies may be paid at variance from the market level of compensation that similar executives in the industry might command. In order to determine fair market valueFair market valueFair market value is an estimate of the market value of a property, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the market. An estimate of fair market value may be founded either on precedent or...
, the owner’s compensation, benefits, perquisites and distributions must be adjusted to industry standards. Similarly, the rent paid by the subject business for the use of property owned by the company’s owners individually may be scrutinized.
Income, asset and market approaches
Three different approaches are commonly used in business valuation: the income approachIncome approach
The Income Approach is one of three major groups of methodologies, called valuation approaches, used by appraisers. It is particularly common in commercial real estate appraisal and in business appraisal. The fundamental math is similar to the methods used for financial valuation, securities...
, the asset-based approach, and the market approach. Within each of these approaches, there are various techniques for determining the value of a business using the definition of value appropriate for the appraisal assignment. Generally, the income approaches determine value by calculating the net present value
Net present value
In finance, the net present value or net present worth of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows of the same entity...
of the benefit stream generated by the business (discounted cash flow
Discounted cash flow
In finance, discounted cash flow analysis is a method of valuing a project, company, or asset using the concepts of the time value of money...
); the asset-based approaches determine value by adding the sum of the parts of the business (net asset value); and the market approaches determine value by comparing the subject company to other companies in the same industry, of the same size, and/or within the same region.
A number of business valuation models can be constructed that utilize various methods under the three business valuation approaches. Venture Capitalists and Private Equity professionals have long used the First chicago method
First Chicago Method
The First Chicago Method or Venture Capital Method is a context specific approach used by venture capital and private equity investors that combines elements of both a multiples-based valuation and a discounted cash flow valuation approach....
which essentially combines the income approach with the market approach.
In determining which of these approaches to use, the valuation professional must exercise discretion. Each technique has advantages and drawbacks, which must be considered when applying those techniques to a particular subject company. Most treatises and court decisions encourage the valuator to consider more than one technique, which must be reconciled with each other to arrive at a value conclusion. A measure of common sense and a good grasp of mathematics is helpful.
Income approaches
The income approaches determine fair market valueFair market value
Fair market value is an estimate of the market value of a property, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the market. An estimate of fair market value may be founded either on precedent or...
by multiplying the benefit stream generated by the subject or target company times a discount or capitalization rate. The discount or capitalization rate converts the stream of benefits into present value
Present value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
. There are several different income approaches, including capitalization of earnings or cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
s, discounted future cash flows (“DCF
Discounted cash flow
In finance, discounted cash flow analysis is a method of valuing a project, company, or asset using the concepts of the time value of money...
”), and the excess earnings method (which is a hybrid of asset and income apprope of benefit stream to which it is applied. The result of a value calculation under the income approach is generally the fair market value
Fair market value
Fair market value is an estimate of the market value of a property, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the market. An estimate of fair market value may be founded either on precedent or...
of a controlling, marketable interest in the subject company, since the entire benefit stream of the subject company is most often valued, and the capitalization and discount rates are derived from statistics concerning public companies.
Discount or capitalization rates
A discount rateDiscount rate
The discount rate can mean*an interest rate a central bank charges depository institutions that borrow reserves from it, for example for the use of the Federal Reserve's discount window....
or capitalization rate
Capitalization rate
Capitalization rate is the ratio between the net operating income produced by an asset and its capital cost or alternatively its current market value...
is used to determine the present value
Present value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
of the expected return
Expected return
The expected return is the weighted-average outcome in gambling, probability theory, economics or finance.It isthe average of a probability distribution of possible returns, calculated by using the following formula:...
s of a business. The discount rate
Discount rate
The discount rate can mean*an interest rate a central bank charges depository institutions that borrow reserves from it, for example for the use of the Federal Reserve's discount window....
and capitalization rate
Capitalization rate
Capitalization rate is the ratio between the net operating income produced by an asset and its capital cost or alternatively its current market value...
are closely related to each other, but distinguishable. Generally speaking, the discount rate
Discount rate
The discount rate can mean*an interest rate a central bank charges depository institutions that borrow reserves from it, for example for the use of the Federal Reserve's discount window....
or capitalization rate
Capitalization rate
Capitalization rate is the ratio between the net operating income produced by an asset and its capital cost or alternatively its current market value...
may be defined as the yield necessary to attract investors to a particular investment, given the risks associated with that investment.
- In DCFDiscounted cash flowIn finance, discounted cash flow analysis is a method of valuing a project, company, or asset using the concepts of the time value of money...
valuations, the discount rateDiscount rateThe discount rate can mean*an interest rate a central bank charges depository institutions that borrow reserves from it, for example for the use of the Federal Reserve's discount window....
, often an estimate of the cost of capitalCost of capitalThe cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds , or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities"...
for the business is used to calculate the net present valueNet present valueIn finance, the net present value or net present worth of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows of the same entity...
of a series of projected cash flowCash flowCash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
s.
- On the other hand, a capitalization rate is applied in methods of business valuation that are based on business data for a single period of time. For example, in real estate valuations for properties that generate cash flowCash flowCash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
s, a capitalization rateCapitalization rateCapitalization rate is the ratio between the net operating income produced by an asset and its capital cost or alternatively its current market value...
may be applied to the net operating income (NOI) (i.e., income before depreciation and interest expenses) of the property for the trailing twelve months.
There are several different methods of determining the appropriate discount rates. The discount rate is composed of two elements: (1) the risk-free rate
Risk-free interest rate
Risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss. The risk-free rate represents the interest that an investor would expect from an absolutely risk-free investment over a given period of time....
, which is the return that an investor would expect from a secure, practically risk-free investment, such as a high quality government bond; plus (2) a risk premium
Risk premium
A risk premium is the minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset, in order to induce an individual to hold the risky asset rather than the risk-free asset...
that compensates an investor for the relative level of risk associated with a particular investment in excess of the risk-free rate. Most importantly, the selected discount or capitalization rate must be consistent with stream of benefits to which it is to be applied.
Capital Asset Pricing Model (“CAPM”)
The Capital Asset Pricing ModelCapital asset pricing model
In finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...
(CAPM
Capital asset pricing model
In finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...
) is one method of determining the appropriate discount rate in business valuations. The CAPM
Capital asset pricing model
In finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...
method originated from the Nobel Prize winning studies of Harry Markowitz, James Tobin and William Sharpe. The CAPM
Capital asset pricing model
In finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...
method derives the discount rate by adding a risk premium to the risk-free rate. In this instance, however, the risk premium is derived by multiplying the equity risk premium times “beta,” which is a measure of stock price volatility. Beta is published by various sources for particular industries and companies. Beta is associated with the systematic risks of an investment.
One of the criticisms of the CAPM
Capital asset pricing model
In finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...
method is that beta is derived from the volatility of prices of publicly traded companies, which are likely to differ from private companies in their capital structures, diversification of products and markets, access to credit markets, size, management depth, and many other respects. Where private companies can be shown to be sufficiently similar to public companies, however, the CAPM
Capital asset pricing model
In finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...
method may be appropriate.
Weighted average cost of capital (“WACC”)
The weighted average cost of capitalWeighted average cost of capital
The weighted average cost of capital is the rate that a company is expected to pay on average to all its security holders to finance its assets....
is an approach to determining a discount rate. The WACC
Weighted average cost of capital
The weighted average cost of capital is the rate that a company is expected to pay on average to all its security holders to finance its assets....
method determines the subject company’s actual cost of capital
Cost of capital
The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds , or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities"...
by calculating the weighted average of the company’s cost of debt and cost of equity
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
. The WACC
Weighted average cost of capital
The weighted average cost of capital is the rate that a company is expected to pay on average to all its security holders to finance its assets....
must be applied to the subject company’s net cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
to total invested capital.
One of the problems with this method is that the valuator may elect to calculate WACC
Weighted average cost of capital
The weighted average cost of capital is the rate that a company is expected to pay on average to all its security holders to finance its assets....
according to the subject company’s existing capital structure
Capital structure
In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...
, the average industry capital structure
Capital structure
In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...
, or the optimal capital structure. Such discretion detracts from the objectivity of this approach, in the minds of some critics.
Indeed, since the WACC
Weighted average cost of capital
The weighted average cost of capital is the rate that a company is expected to pay on average to all its security holders to finance its assets....
captures the risk of the subject business itself, the existing or contemplated capital structures, rather than industry averages, are the appropriate choices for business valuation.
Once the capitalization rate
Capitalization rate
Capitalization rate is the ratio between the net operating income produced by an asset and its capital cost or alternatively its current market value...
or discount rate
Discount rate
The discount rate can mean*an interest rate a central bank charges depository institutions that borrow reserves from it, for example for the use of the Federal Reserve's discount window....
is determined, it must be applied to an appropriate economic income stream: pretax cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
, aftertax cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
, pretax net income
Net income
Net income is the residual income of a firm after adding total revenue and gains and subtracting all expenses and losses for the reporting period. Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings...
, after tax net income
Net income
Net income is the residual income of a firm after adding total revenue and gains and subtracting all expenses and losses for the reporting period. Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings...
, excess earnings, projected cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
, etc. The result of this formula is the indicated value before discounts. Before moving on to calculate discounts, however, the valuation professional must consider the indicated value under the asset and market approaches.
Careful matching of the discount rate
Discount rate
The discount rate can mean*an interest rate a central bank charges depository institutions that borrow reserves from it, for example for the use of the Federal Reserve's discount window....
to the appropriate measure of economic income is critical to the accuracy of the business valuation results. Net cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
is a frequent choice in professionally conducted business appraisals. The rationale behind this choice is that this earnings basis corresponds to the equity discount rate derived from the Build-Up or CAPM
Capital asset pricing model
In finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...
models: the returns obtained from investments in publicly traded companies can easily be represented in terms of net cash flows. At the same time, the discount rates are generally also derived from the public capital markets data.
Build-Up Method
The Build-Up Method is a widely recognized method of determining the after-tax net cash flow discount rate, which in turn yields the capitalization rate. The figures used in the Build-Up Method are derived from various sources. This method is called a “build-up” method because it is the sum of risks associated with various classes of assets. It is based on the principle that investors would require a greater return on classes of assets that are more risky. The first element of a Build-Up capitalization rate is the risk-free rate, which is the rate of return for long-term government bonds. Investors who buy large-cap equity stocks, which are inherently more risky than long-term government bonds, require a greater return, so the next element of the Build-Up method is the equity risk premium. In determining a company’s value, the long-horizon equity risk premium is used because the Company’s life is assumed to be infinite. The sum of the risk-free rate and the equity risk premium yields the long-term average market rate of return on large public company stocks.Similarly, investors who invest in small cap stocks, which are riskier than blue-chip stocks, require a greater return, called the “size premium.” Size premium data is generally available from two sources: Morningstar
Morningstar, Inc.
Morningstar, Inc. is an independent investment research company based in Chicago, Illinois, USA.-Businesses:Morningstar, Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. The company offers an extensive line of products and services for...
's (formerly Ibbotson
Roger G. Ibbotson
Roger G. Ibbotson is professor of finance at Yale School of Management and has written extensively on capital market returns, cost of capital, and international investment. He is the former chairman and founder of Ibbotson Associates, a financial research and information firm that was acquired by...
& Associates') Stocks, Bonds, Bills & Inflation and Duff & Phelps
Duff & Phelps
Duff & Phelps Corporation a publicly traded financial advisory and investment banking firm, providing services principally in the areas of valuation, transactions, financial restructuring, dispute and taxation...
' Risk Premium Report.
By adding the first three elements of a Build-Up discount rate, we can determine the rate of return that investors would require on their investments in small public company stocks. These three elements of the Build-Up discount rate are known collectively as the “systematic risks.”
In addition to systematic risks, the discount rate must include “unsystematic risks,” which fall into two categories. One of those categories is the “industry risk premium.” Morningstar’s yearbooks contain empirical data to quantify the risks associated with various industries, grouped by SIC industry code.
The other category of unsystematic risk is referred to as “specific company risk.” Historically, no published data has been available to quantify specific company risks. However as of late 2006, new research has been able to quantify, or isolate, this risk for publicly traded stocks through the use of Total Beta calculations. P. Butler and K. Pinkerton have outlined a procedure which sets the following two equations together:
Total Cost of Equity (TCOE) = risk-free rate + total beta*equity risk premium
TCOE = risk-free rate + beta*equity risk premium + size premium + company-specific risk premium
The only unknown in the two equations is the company specific risk premium.
While it is possible to isolate the company-specific risk premium as shown above, many appraisers just key in on the total cost of equity (TCOE) provided by the following equation: TCOE = risk-free rate + Total beta*equity risk premium.
It is similar to using the market approach in the income approach instead of adding separate (and potentially redundant) measures of risk in the build-up approach. The use of total beta (developed by Aswath Damodaran) is a relatively new concept. It is, however, gaining acceptance in the business valuation community since it is based on modern portfolio theory. Total beta can help appraisers develop a cost of capital who were content to use their intuition alone when previously adding a purely subjective company-specific risk premium in the build-up approach.
It is important to understand why this capitalization rate for small, privately held companies is significantly higher than the return that an investor might expect to receive from other common types of investments, such as money market accounts, mutual funds, or even real estate. Those investments involve substantially lower levels of risk than an investment in a closely held company. Depository accounts are insured by the federal government (up to certain limits); mutual funds are composed of publicly traded stocks, for which risk can be substantially minimized through portfolio diversification.
Closely held companies, on the other hand, frequently fail for a variety of reasons too numerous to name. Examples of the risk can be witnessed in the storefronts on every Main Street in America. There are no federal guarantees. The risk of investing in a private company cannot be reduced through diversification, and most businesses do not own the type of hard assets that can ensure capital appreciation over time. This is why investors demand a much higher return on their investment in closely held businesses; such investments are inherently much more risky. (This paragraph is biased, presuming that by the mere fact that a company is closely held, it is prone towards failure.)
Asset-based approaches
The value of asset-based analysis of a business is equal to the sum of its parts. That is the theory underlying the asset-based approaches to business valuation. The asset approach to business valuation is based on the principle of substitution: no rational investor will pay more for the business assets than the cost of procuring assets of similar economic utility. In contrast to the income-based approaches, which require the valuation professional to make subjective judgments about capitalization or discount rates, the adjusted net book valueBook value
In accounting, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or Impairment costs made against the asset. Traditionally, a company's book value...
method is relatively objective. Pursuant to accounting convention, most assets are reported on the books of the subject company at their acquisition value, net of depreciation where applicable. These values must be adjusted to fair market value
Fair market value
Fair market value is an estimate of the market value of a property, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the market. An estimate of fair market value may be founded either on precedent or...
wherever possible.
The value of a company’s intangible assets, such as goodwill, is generally impossible to determine apart from the company’s overall enterprise value. For this reason, the asset-based approach is not the most probative method of determining the value of going business concerns. In these cases, the asset-based approach yields a result that is probably lesser than the fair market value
Fair market value
Fair market value is an estimate of the market value of a property, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the market. An estimate of fair market value may be founded either on precedent or...
of the business.
In considering an asset-based approach, the valuation professional must consider whether the shareholder whose interest is being valued would have any authority to access the value of the assets directly. Shareholders own shares in a corporation, but not its assets, which are owned by the corporation. A controlling shareholder may have the authority to direct the corporation to sell all or part of the assets it owns and to distribute the proceeds to the shareholder(s). The non-controlling shareholder, however, lacks this authority and cannot access the value of the assets. As a result, the value of a corporation's assets is rarely the most relevant indicator of value to a shareholder who cannot avail himself of that value.
Adjusted net book value
Book value
In accounting, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or Impairment costs made against the asset. Traditionally, a company's book value...
may be the most relevant standard of value where liquidation is imminent or ongoing; where a company earnings or cash flow are nominal, negative or worth less than its assets; or where net book value
Book value
In accounting, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or Impairment costs made against the asset. Traditionally, a company's book value...
is standard in the industry in which the company operates. The adjusted net book value
Book value
In accounting, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or Impairment costs made against the asset. Traditionally, a company's book value...
may also be used as a “sanity check” when compared to other methods of valuation, such as the income and market approaches.
Market approaches
The market approach to business valuation is rooted in the economic principle of competition: that in a free market the supply and demand forces will drive the price of business assets to a certain equilibrium. Buyers would not pay more for the business, and the sellers will not accept less, than the price of a comparable business enterprise. It is similar in many respects to the “comparable sales” method that is commonly used in real estate appraisalReal estate appraisal
Real estate appraisal, property valuation or land valuation is the process of valuing real property. The value usually sought is the property's Market Value. Appraisals are needed because compared to, say, corporate stock, real estate transactions occur very infrequently...
. The market price of the stocks of publicly traded companies engaged in the same or a similar line of business, whose shares are actively traded in a free and open market, can be a valid indicator of value when the transactions in which stocks are traded are sufficiently similar to permit meaningful comparison.
The difficulty lies in identifying public companies that are sufficiently comparable to the subject company for this purpose. Also, as for a private company, the equity is less liquid (in other words its stocks are less easy to buy or sell) than for a public company
Public company
This is not the same as a Government-owned corporation.A public company or publicly traded company is a limited liability company that offers its securities for sale to the general public, typically through a stock exchange, or through market makers operating in over the counter markets...
, its value is considered to be slightly lower than such a market-based valuation
Market-based valuation
Market-based valuation is a form of stock valuation that refers to market indicators, also called "extrinsic" criteria .- Examples of market valuation methods :...
would give.
When there is a lack of comparison with direct competition, a meaningful alternative could be a vertical value-chain approach where the subject company is compared with, for example, a known downstream industry to have a good feel of its value by building useful correlations with its downstream companies. Such comparison often reveals useful insights which help business analysts better understand performance relationship between the subject company and its downstream industry. For example, if a growing subject company is in an industry more concentrated than its downstream industry with a high degree of interdependence, one should logically expect the subject company performs better than the downstream industry in terms of growth, margins and risk.
Guideline Public Company method
The Guideline Public Company method entails a comparison of the subject company to publicly traded companies. The comparison is generally based on published data regarding the public companies’ stock price and earnings, sales, or revenues, which is expressed as a fraction known as a “multiple.” If the guideline public companies are sufficiently similar to each other and the subject company to permit a meaningful comparison, then their multiples should be similar. The public companies identified for comparison purposes should be similar to the subject company in terms of industry, product lines, market, growth, margins and risk.Guideline Transaction Method or Direct Market Data Method
Using this method, the valuation analyst may determine market multiples by reviewing published data regarding actual transactions involving either minority or controlling interests in either publicly traded or closely held companies. In judging whether a reasonable basis for comparison exists, the valuation analysis must consider: (1) the similarity of qualitative and quantitative investment and investor characteristics; (2) the extent to which reliable data is known about the transactions in which interests in the guideline companies were bought and sold; and (3) whether or not the price paid for the guideline companies was in an arms-length transaction, or a forced or distressed sale. In regards to data reliability and both the guideline transaction method and the direct market data method, unlike real estate sales data, sales of privately held companies are neither actively traded or regularly reported to city or county recording offices, nor verified by these same local government offices. Sales of privately held companies are voluntarily reported by business brokers to data re-sellers or unscientifically accumulated by these same private, for profit data re-sellers. Consequently the data is considered, by the very nature of the data collection process, to be corrupted by sampling bias and nonsampling error, and of questionable reliability.Discounts and premiums
The valuation approaches yield the fair market valueFair market value
Fair market value is an estimate of the market value of a property, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the market. An estimate of fair market value may be founded either on precedent or...
of the Company as a whole. In valuing a minority, non-controlling interest in a business, however, the valuation professional must consider the applicability of discounts that affect such interests.
Discussions of discounts and premiums frequently begin with a review of the “levels of value.” There are three common levels of value: controlling interest, marketable minority, and non-marketable minority.
The intermediate level, marketable minority interest, is less than the controlling interest level and higher than the non-marketable minority interest level. The marketable minority interest level represents the perceived value of equity interests that are freely traded without any restrictions. These interests are generally traded on the New York Stock Exchange, AMEX, NASDAQ, and other exchanges where there is a ready market for equity securities. These values represent a minority interest in the subject companies – small blocks of stock that represent less than 50% of the company’s equity, and usually much less than 50%.
Controlling interest level is the value that an investor would be willing to pay to acquire more than 50% of a company’s stock, thereby gaining the attendant prerogatives of control. Some of the prerogatives of control include: electing directors, hiring and firing the company’s management and determining their compensation; declaring dividends and distributions, determining the company’s strategy and line of business, and acquiring, selling or liquidating the business. This level of value generally contains a control premium
Control premium
Control premium is an amount that a buyer is usually willing to pay over the current market price of a publicly traded company. Contrary to a widely held view, this premium is not justified by the expected synergies, such as the expected increase in cash flow resulting from cost savings and revenue...
over the intermediate level of value, which typically ranges from 25% to 50%. An additional premium may be paid by strategic investors who are motivated by synergistic motives.
Non-marketable, minority level is the lowest level on the chart, representing the level at which non-controlling equity interests in private companies are generally valued or traded. This level of value is discounted because no ready market exists in which to purchase or sell interests. Private companies are less “liquid” than publicly traded companies, and transactions in private companies take longer and are more uncertain. Between the intermediate and lowest levels of the chart, there are restricted shares of publicly traded companies.
Despite a growing inclination of the IRS and Tax Courts to challenge valuation discounts, Shannon Pratt suggested in a scholarly presentation recently that valuation discounts are actually increasing as the differences between public and private companies is widening . Publicly traded stocks have grown more liquid in the past decade due to rapid electronic trading, reduced commissions, and governmental deregulation. These developments have not improved the liquidity of interests in private companies, however.
Valuation discounts are multiplicative, so they must be considered in order. Control premiums and their inverse, minority interest discounts, are considered before marketability discounts are applied.
Discount for lack of control
The first discount that must be considered is the discount for lack of control, which in this instance is also a minority interest discount. Minority interest discounts are the inverse of control premiums, to which the following mathematical relationship exists:MID = 1 – [1 / (1 + CP)]
The most common source of data regarding control premiums is the Control Premium Study, published annually by Mergerstat since 1972. Mergerstat compiles data regarding publicly announced mergers, acquisitions and divestitures involving 10% or more of the equity interests in public companies, where the purchase price is $1 million or more and at least one of the parties to the transaction is a U.S. entity
United States entity
United States entity is a designation given to some entities , e.g. for International Traffic in Arms Regulations purposes:For purposes of the preceding paragraph, a U.S. entity is a firm incorporated in the United States that is controlled by U.S. citizens or by another U.S...
. Mergerstat defines the “control premium” as the percentage difference between the acquisition price and the share price of the freely traded public shares five days prior to the announcement of the M&A transaction.
While it is not without valid criticism, Mergerstat control premium data (and the minority interest discount derived therefrom) is widely accepted within the valuation profession.
Discount for lack of marketability
Another factor to be considered in valuing closely held companies is the marketability of an interest in such businesses. Marketability is defined as the ability to convert the business interest into cash quickly, with minimum transaction and administrative costs, and with a high degree of certainty as to the amount of net proceeds. There is usually a cost and a time lag associated with locating interested and capable buyers of interests in privately held companies, because there is no established market of readily available buyers and sellers.All other factors being equal, an interest in a publicly traded company is worth more because it is readily marketable. Conversely, an interest in a private-held company is worth less because no established market exists. The IRS Valuation Guide for Income, Estate and Gift Taxes, Valuation Training for Appeals Officers acknowledges the relationship between value and marketability, stating: “Investors prefer an asset which is easy to sell, that is, liquid.”
The discount for lack of control is separate and distinguishable from the discount for lack of marketability. It is the valuation professional’s task to quantify the lack of marketability of an interest in a privately held company. Because, in this case, the subject interest is not a controlling interest in the Company, and the owner of that interest cannot compel liquidation to convert the subject interest to cash quickly, and no established market exists on which that interest could be sold, the discount for lack of marketability is appropriate.
Several empirical studies have been published that attempt to quantify the discount for lack of marketability. These studies include the restricted stock studies and the pre-IPO studies. The aggregate of these studies indicate average discounts of 35% and 50%, respectively. Some experts believe the Lack of Control and Marketability discounts can aggregate discounts for as much as ninety percent of a Company's fair market value, specifically with family-owned companies.
Restricted stock studies
Restricted stocks are equity securities of public companies that are similar in all respects to the freely traded stocks of those companies except that they carry a restriction that prevents them from being traded on the open market for a certain period of time, which is usually one year (two years prior to 1990). This restriction from active trading, which amounts to a lack of marketability, is the only distinction between the restricted stock and its freely traded counterpart. Restricted stock can be traded in private transactions and usually do so at a discount. The restricted stock studies attempt to verify the difference in price at which the restricted shares trade versus the price at which the same unrestricted securities trade in the open market as of the same date.The underlying data by which these studies arrived at their conclusions has not been made public. Consequently, it is not possible when valuing a particular company to compare the characteristics of that company to the study data. Still, the existence of a marketability discount has been recognized by valuation professionals and the Courts, and the restricted stock studies are frequently cited as empirical evidence. Notably, the lowest average discount reported by these studies was 26% and the highest average discount was 40%.
Option pricing
In addition to the restricted stock studies, U.S. publicly traded companies are able to sell stock to offshore investors (SEC Regulation S, enacted in 1990) without registering the shares with the Securities and Exchange Commission. The offshore buyers may resell these shares in the United States, still without having to register the shares, after holding them for just 40 days. Typically, these shares are sold for 20% to 30% below the publicly traded share price. Some of these transactions have been reported with discounts of more than 30%, resulting from the lack of marketability. These discounts are similar to the marketability discounts inferred from the restricted and pre-IPO studies, despite the holding period being just 40 days.Studies based on the prices paid for options have also confirmed similar discounts. If one holds restricted stock
Restricted stock
Restricted stock, also known as letter stock or restricted securities, refers to stock of a company that is not fully transferable until certain conditions have been met. Upon satisfaction of those conditions, the stock becomes transferable by the person holding the award.One type of restricted...
and purchases an option to sell that stock at the market price (a put
Put
Put can refer to:* Put option, a financial contract between two parties, the buyer and the seller of the option* The Biblical Put, the son of Ham and the grandson of Noah...
), the holder has, in effect, purchased marketability for the shares. The price of the put
Put
Put can refer to:* Put option, a financial contract between two parties, the buyer and the seller of the option* The Biblical Put, the son of Ham and the grandson of Noah...
is equal to the marketability discount. The range of marketability discounts derived by this study was 32% to 49%. However, ascribing the entire value of a put option to marketability is misleading, because the primary source of put value comes from the downside price protection. A correct economic analysis would use deeply in-the-money puts or Single-stock futures
Single-stock futures
Single-stock futuresIn finance, a single-stock futures is a type of futures contracts between two parties to exchange a specified number of stocks in company for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
, demonstrating that marketability of restricted stock is of low value because it is easy to hedge using unrestricted stock or futures trades.
Pre-IPO studies
Another approach to measure the marketability discount is to compare the prices of stock offered in initial public offerings (IPOs) to transactions in the same company’s stocks prior to the IPO. Companies that are going public are required to disclose all transactions in their stocks for a period of three years prior to the IPO. The pre-IPO studies are the leading alternative to the restricted stock stocks in quantifying the marketability discount.The pre-IPO studies are sometimes criticized because the sample size is relatively small, the pre-IPO transactions may not be arm’s length, and the financial structure and product lines of the studied companies may have changed during the three year pre-IPO window.
Applying the studies
The studies confirm what the marketplace knows intuitively: Investors covet liquidity and loathe obstacles that impair liquidity. Prudent investors buy illiquid investments only when there is a sufficient discount in the price to increase the rate of returnRate of return
In finance, rate of return , also known as return on investment , rate of profit or sometimes just return, is the ratio of money gained or lost on an investment relative to the amount of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or...
to a level which brings risk-reward back into balance.
The referenced studies establish a reasonable range of valuation discounts from the mid-30%s to the low 50%s. The more recent studies appeared to yield a more conservative range of discounts than older studies, which may have suffered from smaller sample sizes. Another method of quantifying the lack of marketability discount is the Quantifying Marketability Discounts Model (QMDM).
Estimates of business value
The evidence on the market value of specific businesses varies widely, largely depending on reported market transactions in the equity of the firm. A fraction of businesses are "publicly traded," meaning that their equity can be purchased and sold by investors in stock markets available to the general public. Publicly traded companies on major stock markets have an easily calculated "market capitalization" that is a direct estimate of the market value of the firm's equity. Some publicly traded firms have relatively few recorded trades (including many firms traded "over the counter" or in "pink sheets"). A far larger number of firms are privately held. Normally, equity interests in these firms (which include corporations, partnerships, limited-liability companies, and some other organizational forms) are traded privately, and often irregularly.A number of stock market indicators in the United States and other countries provide an indication of the market value of publicly traded firms. The Survey of Consumer Finance in the US also includes an estimate of household ownership of stocks, including indirect ownership through mutual funds. The 2004 and 2007 SCF indicate a growing trend in stock ownership, with 51% of households indicating a direct or indirect ownership of stocks, with the majority of those respondents indicating indirect ownership through mutual funds. Few indications are available on the value of privately held firms. Anderson (2009) recently estimated the market value of U.S. privately held and publicly traded firms, using Internal Revenue Service and SCF data. He estimates that privately held firms produced more income for investors, and had more value than publicly held firms, in 2004.
See also
- Price/sales ratioPrice/sales ratioPrice-to-sales ratio, P/S ratio, or PSR, is a valuation metric for stocks. It is calculated by dividing the company's market cap by the company's revenue in the most recent year; or, equivalently, divide the per-share stock price by the per-share revenue.Unless otherwise stated, P/S is "trailing...
- P/E ratioP/E ratioThe P/E ratio of a stock is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share...
- Intangible assetIntangible assetIntangible assets are defined as identifiable non-monetary assets that cannot be seen, touched or physically measured, which are created through time and/or effort and that are identifiable as a separate asset...
- Consolidation (business)Consolidation (business)Consolidation or amalgamation is the act of merging many things into one. In business, it often refers to the mergers and acquisitions of many smaller companies into much larger ones. In the context of financial accounting, consolidation refers to the aggregation of financial statements of a group...
- Control premiumControl premiumControl premium is an amount that a buyer is usually willing to pay over the current market price of a publicly traded company. Contrary to a widely held view, this premium is not justified by the expected synergies, such as the expected increase in cash flow resulting from cost savings and revenue...
- DivestmentDivestmentIn finance and economics, divestment or divestiture is the reduction of some kind of asset for either financial or ethical objectives or sale of an existing business by a firm...
- Enterprise valueEnterprise valueEnterprise value , Total enterprise value , or Firm value is an economic measure reflecting the market value of a whole business. It is a sum of claims of all the security-holders: debtholders, preferred shareholders, minority shareholders, common equity holders, and others...
- Triple Accounting
- Mergers and acquisitionsMergers and acquisitionsMergers and acquisitions refers to the aspect of corporate strategy, corporate finance and management dealing with the buying, selling, dividing and combining of different companies and similar entities that can help an enterprise grow rapidly in its sector or location of origin, or a new field or...
- SubsidiarySubsidiaryA subsidiary company, subsidiary, or daughter company is a company that is completely or partly owned and wholly controlled by another company that owns more than half of the subsidiary's stock. The subsidiary can be a company, corporation, or limited liability company. In some cases it is a...
Further reading
- Anderson, Patrick L., Business Economics and Finance, Chapman & Hall/CRC, 2005. ISBN 1584883480.
- Anderson, Patrick L., “New Developments in Business Valuation.” Developments in Litigation Economics. Eds P.A. Gaughan and R.J. Thornton, Burlington: Elsevier, 2005. ISBN 076231270X.
- Brinig, Brian P., JD, CPA, Finance & Accounting for Lawyers, BV Resources, LLC, Portland, OR, 2011. ISBN 9781935081715.
- Campbell Ian R., and Johnson, Howard E., The Valuation of Business Interests, Canadian Institute of Chartered Accountants, 2001. ISBN 0888006144.
- Damodaran, Aswath. Investment Valuation, New York, Wiley, 1996. ISBN 0471112135.
- Fishman, Pratt, Morrison, Standards of Value: Theory and Applications, John Wiley & Sons, Inc., NJ, 2007.
- Gaughan, Patrick A., Measuring Business Interruption Losses, John Wiley & Sons, Inc., NJ, 2004.
- Hitchner, James R., ed., Financial Valuation, McGraw-Hill, 2003.
- Mercer, Christopher, “Fair Market Value vs. The Real World,” Valuation Strategies, March 1999; reprint
- Pratt, Shannon H. Valuing Small Businesses and Professional Practices. 3rd ed., New York, McGraw-Hill, 1998.
- Pratt, Reilly, and Schweihs, Valuing A Business, The Analysis and Appraisal of Closely Held Companies, 3rd ed., New York, McGraw-Hill, 1996, [4th ed., 2002] [5th ed., 2007]
- Pratt, Reilly, Cost of Capital, McGraw-Hill, 2002.
- Trout, Robert, “Business Valuations,” chapter 8 in Patrick Gaughan, ed., Measuring Commercial Damages, Wiley, 2000.
- Wolpin, Jeffrey; “Mythbusting – Discrediting Appraisal Myths Through Properly Applied Statistical Reasoning,” Valuation Strategies, Jan./Feb 2008