In the last post, we talked about the traditional levels of value chart. The chart has three conceptual levels and is reproduced below.
After discussing the chart briefly, and how appraisers initially “moved” between the three conceptual levels, the post concluded as follows:
What we have described thus far is the general state of knowledge of business appraisers regarding the levels of value as of the early 1990s. Unfortunately, that state of knowledge has not improved much on the part of many appraisers since then.
Four Levels of Value
By the mid to latter 1990s, many business appraisers began to realize that there were problems with using control premium data (used to “move” from the marketable minority level to the controlling interest level) to estimate minority interest discounts. The main issue was that most transactions involving the change of control of public companies, from which this data was developed, involved strategic control or synergistic acquisitions. The thinking led to the development of a new levels of value chart which is compared to the traditional chart below.
It was easy to add an additional level of value to the conceptual chart, which was done in the expanded chart on the right side above. Appraisers recognized that the control premiums typically studied reflected strategic or synergistic transactions, and that there must be a financial control level somewhere between the marketable minority level and the strategic control level. We understood that it was inappropriate to use strategic control premiums to estimate minority interest discounts, although many appraisers continued (and still do!) to do so. But there was no evidence in the market for the financial control premium (FCP) on the right above, and no evidence, therefore, for minority interest discounts.
Business appraisers had a decent idea about the conceptual levels of value, but had not yet developed a realistic understanding of how they related to each other from a valuation perspective. In fact, the two levels of value charts in the most recently published valuation text I have in my library, James Hitchner’s Financial Valuation Applications and Models Fourth Edition, published in 2017, reflects charts like shown immediately above (at pages 382-383).
During the 1990s, as I struggled with issues related to the levels of value, and the appropriateness of market evidence to develop minority interest discounts and marketability discounts, I remembered an article written by Eric Nath, which was published in the June 1990 issue of Business Valuation Review. The article was titled “Control Premiums and Minority Interest Discounts in Private Companies.” (purchase required). Nath wrote:
In the context of the public market, what does a control premium really mean? It means simply that a company is worth more to another individual or entity that to the current public shareholders. What has puzzled me for some time is if public stocks always trade at a discount to their controlling interest value, then why aren’t they taken over? If they truly are intrinsically worth more to someone else, surely that someone else will step forward and offer at least some premium for the privilege of owning the whole company. The fact that there are hundreds of billions, and perhaps trillions of dollars scouring the market for acquisition targets (LBO funds, domestic and foreign strategic buyers, and the bankers who fund them) makes it inconceivable that any good takeover opportunity will remain unmolested for long. As blood attracts sharks, a significant difference between the current price of a stock and its value to a controlling owner should trigger some form of takeover attack. (italics added)
Despite the fact that I initially wrote a dissenting article in the December 1990 issue of Business Valuation Review titled “Do Public Company (Minority) Transactions Yield Controlling Interest or Minority Interest Pricing Data?”, the Nath article triggered my thinking for a long time. That thinking led to an understanding that valuation at all conceptual levels is a function of expected cash flow, risk and growth. It also led to the realization that the “levels of value” represented differing views of expected cash flow, risks and growth, and that each level should be defined in those terms.
What is Valuation All About?
The value of a business is the value of all expected future benefits to be derived from it and discounted to the present at a discount rate appropriate for the riskiness of receiving the expected benefits. No one disagrees with this definition. The conceptual discounted cash flow model (DCF) can be summarized as follows.
The value of a business is expressed in terms of three variables, expected cash flow (CF1), the discount rate (r), and the expected growth in cash flows (g). The present values of all expected cash flows — to infinity — are discounted to the present at the discount rate (r).
Professor Myron Gordon proved that the basic DCF model can be summarized in a single expression if two assumptions are met. First, the expected growth must be constant into perpetuity, and second, all expected cash flows are either distributed to owners or reinvested in the business at the discount rate (r). The single expression of business value is shown at the right side of the equation above, and is often called the Gordon Model.
Different individuals or entities may look at the same business and have different expectations regarding its expected cash flows, risks and growth. That was the kernel of Nath’s idea in his 1990 article. Why are most public companies not taken over in any given year? Because there is not sufficient diversity of expectation regarding future benefits under separate ownership for most companies at a given point in time. Otherwise, “as blood attracts sharks,” these differences would foster more takeover activity.
This would suggest the public market pricing for most public companies represents a controlling interest value. It is not strategic control, so it must be financial control. The implication is that, for most public companies most of the time, their public market pricing would translate into financial control values if used by appraisers in guideline public company analyses.
Marketable Minority Value
There are a number of important implications about the discounted cash flow model and the Gordon Model as developed above. The Gordon Model is used by appraisers to determine “public equivalent” values. Look at the following chart.
The chart begins with the Gordon Model, with the expression, CFmm, substituted for CF1. The marketable minority level of value is defined by a relationship between expected cash flow, risk and growth.
The cash flow being examined is the expected cash flow of a public company, which gives rise to marketable minority value. Note that there is a lighter shaded financial control value box sitting on top of the marketable minority value box. We will address this level shortly.
We know that the public markets “normalize” pricing based on expectations for future earnings. For example, if a public company encounters a one-time, non-recurring event that significantly lowers reported earnings, but market participants know this and expect earnings to return to their normal levels, the markets’ pricing of its shares will reflect this expectation.
When appraisers normalize earnings of a private business, there is an implicit standard or benchmark for normalization. That benchmark is reflective of earnings “as if” the subject business were a public company. We normalize earnings to that of well-run public company equivalents. That is why the marketable minority level of value is also called the “as-if freely traded” level.
With public companies, the market “normalizes” pricing based on expected cash flows. So appraisers normalize earnings of private companies to achieve the marketable minority level of value. For public companies, market scrutiny is assumed to create normal earnings (and compensation) for their managements.
Discount rates, or the r above, are developed using the build-up model or other versions of the Capital Asset Pricing Model, with appropriate adjustments made for relative size and for company specific risks not typically found in public companies.
The ASA Business Valuation Standards define “normalized earnings” as:
Economic benefits adjusted for nonrecurring, non-economic, or other unusual items to eliminate anomalies and/or facilitate comparisons.
The comparisons that are facilitated are with guideline public companies with which a private company may be compared. Unfortunately, the concept of normalizing adjustments is one that is confusing for many appraisers. In our book, Business Valuation: An Integrated Theory Second Edition, Travis Harms and I talk about two kinds of normalizing adjustments, as shown conceptually in the following chart.
Type 1 normalizing adjustments account for non-recurring and unusual items, the income and expenses of non-operating assets, discontinued operations and other adjustments that might be relevant. All appraisers make these adjustments in the ordinary course of their valuation processes. Type 1 normalizing adjustments may be positive (increasing adjusted earnings) or negative (decreasing adjusted earnings). All such earnings adjustments are designed to reveal a public company equivalent earnings stream.
Type 2 normalizing adjustments account for adjustments to normalize owner compensation to market levels, for owner discretionary expenses, and any other relevant owner-related expenses (or income) items. Most normalizing adjustments tend to increase adjusted earnings, but this need not be the case. Again, the goal of Type 2 normalizing adjustments is to reveal a well-run equivalent earnings stream for comparison with guideline public companies or other relevant comparisons.
Many of my colleagues want the “flexibility” of not making Type 2 adjustments, arguing that they are “control adjustments” and that minority shareholders don’t have the ability to make these adjustments. If the goal of an initial valuation procedure is to develop a value indication at the marketable minority level, then it is simply incorrect not to make owner compensation and other Type 2 adjustments.
If appraisers do not make appropriate Type 2 normalizing adjustments, they will not develop the indicated benchmark value indications at that of “as-if freely traded,” or at the marketable minority level. Market evidence from public company restricted stock transactions, which are based relative to public market transaction pricing, would, therefore, be irrelevant.
From the base of well-run public equivalent values, appraisers can develop indications of value at the nonmarketable minority level of value. We will address this level shortly.
The Financial Control Level of Value
In the two immediately preceding figures, we have shown the financial control value sitting on top of the marketable minority value. We now examine the development of value at the financial control level.
We show both Type 1 and Type 2 normalizing adjustments on the figure above for reference. These are appropriate in deriving the appropriate level of earnings or cash flow, which is CFmm. We show four numbers in the figure.
- Financial control adjustments result from expected efficiencies of potential acquirers that may be shared with sellers. Financial control adjustments are generally the result of expectations to run a company better than at present (as opposed to differently in the case of strategic or synergistic control). Keep in mind the quote from Eric Nath above. The great majority of public companies do not trade in change of control transactions in any period, suggesting that financial control adjustments from the viewpoint of potential acquirers are nil or minimal.
- The financial control premium (FCP) would reflect any difference in value between marketable minority and financial control. It would be based on CFfc, or expected financial control earnings.
- Financial control adjustments are made from the viewpoint of potential investors in an enterprise, because the beginning point of any valuation, even a minority interest valuation, is at the enterprise level. The adjustments are made irrespective of the existing ownership of the business, whether minority or control.
- If no financial control adjustments are appropriate, then financial control earnings and the marketable minority earnings will be equal, or CFmm equals CFfc. Note that if CFmm equals CFfc, then financial control value will be equal to marketable minority value.
It is for these reasons that we place the financial control box immediately on top of the marketable minority box. Unless there are expected financial control benefits, then the two levels will sit on top of each other, and be of equivalent value. The financial control premium (FCP) will be zero and any implied minority interest discount will also be zero.
The day of large minority interest discounts in private company valuation should be over.
This idea is difficult for many appraisers who are accustomed to applying large and judgmental minority interest discounts in minority interest appraisals. They are, however, not warranted. This discussion should make clear that buyers of enterprises pay for the expected cash flows on a risk adjusted basis. They do not pay for the so-called prerogatives of control, which are granted by corporate charters and other agreements that accompany changes of control.
The Strategic (or Synergistic) Level of Value
The strategic control level of value corresponds to the top level of value in all of the charts above. It is the most common level at which public company acquisitions occur. Conceptually, the strategic control level looks as follows.
We show five numbers in the chart above, which help to follow the logic of strategic control.
- Strategic or synergistic control adjustments are the result of cash flow enhancements that potential acquirers may expect from a potential acquisition. They include things like the consolidation of overhead expenses or selling expenses, expected efficiencies in lower cost of goods sold or manufacturing, integration benefits with distribution and others. Strategic benefits also include benefits from expected vertical or horizontal integration and others.
- In combination, strategic benefits generate strategic control earnings, or CFss, which are earnings from the viewpoint of strategic or synergistic buyers of a business.
- The various strategic benefits are the result of the ability of acquirers to run a company differently than it is currently being run (as result of the benefits).
- Strategic control value is the result of capitalizing CFss or of discounting such benefits that have been forecasted into the future.
- The strategic control premium (SCP) reflects the difference between strategic control value and marketable minority value. Note that this premium is not based at all on the so-called prerogatives of control but on the expected risk-adjusted cash flow benefits from the perspective of potential acquirers.
We have not shown an equation, but there can be differences between the discount rates of financial control investors and strategic investors. A lower discount rate for a strategic or synergistic investor can create a further gap between the marketable minority or financial control levels and the strategic control level of value.
The strategic control level of value is not normally a concept that is appropriate in fair market value determinations. Fair market value is generally a financial standard calling for hypothetical negotiations between hypothetical buyers and sellers. Strategic control is an investment value concept and looks at value from the viewpoint of specific, strategic, buyers.
Nonmarketable Minority Level of Value
The last conceptual level of value is that of the nonmarketable minority level of value. This is the level of value based on the value of illiquid, minority interests in private businesses.
It is important to understand that investors approach the value of minority interests in the same fashion that they approach the value of entire businesses. The value of a minority interest in a business is the value of all expected benefits from the interest over a finite expected holding period and discounted to the present at a rate reflective of the risks of receiving the expected benefits.
In the case of most minority interest investments, the goal is the realization of a marketable minority value or financial control value at the end of the expected holding period for the investment. We show the nonmarketable minority level of value in relationship to the marketable minority level in the next chart.
In the chart above, we once again show that the marketable minority value is achieved after making both Type 1 and Type 2 adjustments and reflects a well-run public company equivalent value. The marketable minority value sets the context for valuing illiquid minority interests.
What are the expected benefits of an illiquid minority investment in a business? They are any interim dividends or distributions over the expected holding period for the investment plus the expected terminal value of the investment upon ultimate disposition at the end of the holding period.
From the base level of earnings at the marketable minority level (CFmm), the appraiser would eliminate any expected ongoing excess owner compensation and other discretionary expenses. These expenses do not impact the value of the entire enterprise because they have been normalized. However, they are not available for distribution or reinvestment.
The actual expected level of cash flow can be defined as CFnmm, or cash flow available after expected owner expenses and other suboptimal reinvestments by owners, e.g., in accumulating cash or other non-operating investments.
The discount rate at the nonmarketable minority level is designated as rhp, or the discount rate of the expected holding period. Note that rhp will exceed r, or the discount rate of an enterprise, in virtually all circumstances. Illiquid minority interests are worth less than the marketable minority level because CFnmm is often less than CFnmm and because rhp is greater than r.
The level of CFnmm and the net of distributions and expected reinvestments determine the level of potential growth in value for the enterprise. Note that the expected growth in value (gv) may be less (or more) than the expected growth in value of the enterprise at the marketable minority level.
For a more in-depth discussion of the nonmarketable minority level of value, see materials on the Quantitative Marketability Discount Model (QMDM).
Summary and Conclusions
Recall the traditional levels of value chart. Appraisers “moved” from one level to the next using control premiums, minority interest discounts, and marketability discounts. These discounts and premium were based on control premium studies and restricted stock studies (and pre-IPO studies).
We have seen that the control premium studies are not a reasonable basis for estimating minority interest discounts. Such discounts, to the extent they exist, are small or minimal in most private company minority interest valuations.
Restricted stock studies do not measure expected cash flows available to minority investors in illiquid minority interests of businesses, and as such, do not provide direct or indirect evidence of appropriate discounts in specific situations.
The conceptual levels of value are based on differences in expected cash flows, risks and growth from the viewpoint of different investors. Appraisers who do not focus on these elements in their valuations cannot mirror the thinking of hypothetical or real investors.
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