Appraisal Review #3: Levels of Value and the Appraisal Review

The levels of value chart for business valuation relates the various “levels” of value to one another on a conceptual basis. It was first published in 1990, as noted below. This chart recognized what the markets and business valuation analysts had roughly understood for some time about “levels” of value of businesses. So what do the conceptual levels of value have to do with fair market value, and what does all this have to do with appraisal review? We will see two levels of value charts containing three and four conceptual levels, respectively. In an appraisal, it is critical to specify the appropriate level of value. In appraisal review, it is perhaps even more critical to understand appraisal assignments and reach reasonable conclusions regarding the appropriate level of value. How else can a reviewer reach a valid opinion regarding the quality and appropriateness of another appraiser’s work? How else can a reviewer reach a valid opinion regarding the reasonableness of the conclusion of a report under review? And we have not yet attempted to define fair market value.

Initial Levels of Value Chart – Three Levels

The initial levels of value chart had three conceptual levels, as indicated in the figure below.[1]  The three levels actually represent four conceptual values.

  • Trading prices of public companies, referred to as the marketable minority level of value (middle level), provide a base from which to analyze value at the other levels.
  • Public companies that are sold in change of control transactions tend to trade at prices higher than their previously unaffected market prices, i.e., at the control level of value (upper level);
  • Restricted shares of public companies tend to trade at prices lower than the price of otherwise identical shares that are not restricted, (i.e., marketable minority) or at the nonmarketable minority level (lower level).
  • Illiquid minority interests of private companies tend to trade at prices lower than their hypothetical pricing at the marketable minority level or at the nonmarketable minority level of value (lower level).

The lowest level of value, then, encompassed both the value of restricted shares of public companies and illiquid minority interests of private companies. In fact, the initial studies referenced by appraisers to estimate marketability discounts for illiquid minority interests were the restricted stock studies.

While the levels of value chart was new in 1990, the concepts embodied in the chart were roughly accepted by valuation analysts (and courts) prior to that time based on the observations outlined above.

The levels of value chart is important in a discussion of fair market value in the context of appraisal review because there is no direct reference to these conceptual levels in Revenue Ruling 59-60. In fact, neither the minority interest discount nor the marketability discount is mentioned in the ruling.

The levels of value chart is so important to an understanding of valuation concepts that analysts at Mercer Capital have included versions of it in virtually every valuation report since about 1992.

Like most valuation analysts, we initially assumed the existence of the conceptual adjustments referred to as the control premium, the minority interest discount, and the marketability discount as shown in the first figure below.

  • We relied on market evidence from control premium studies to help ascertain the magnitude of control premiums (and the related, or so we thought, minority interest discounts); and,
  • We relied on certain benchmark studies, the various pre-IPO and restricted stock studies, as the basis for estimating marketability discounts.

What we, like most valuation analysts, did not begin to realize until the early 1990s was that the three-level chart is descriptive only. In other words, the discounts and premiums in the chart provided no guidance regarding the how or the why of observed levels of value, and merely described what business valuation analysts and market participants had observed to that point.

As the 1990s progressed, we had become increasingly uncomfortable with the prevailing methodologies for developing marketability discounts. The Quantitative Marketability Discount Model (QMDM), which is based on our early development of the Integrated Theory, was introduced in speeches beginning in 1994 and in a book in 1997. [2]

And the levels of value evolved to include four distinct levels.

Revised Levels of Value Chart – Four Levels

The ASA Business Valuation Standards require that the level of value be specified in any appraisal. The level of value is defined by illustration in BVS-I General Requirements for Developing a Business Valuation at its Para. II.11 as:

The level of value (e.g., strategic control, financial control, marketable minority, or nonmarketable minority) in the context of the standard of value, the premise of value, and the relevant characteristics of the interest.

Note the change in the definition of levels of value from the concept in the 1990 chart. Four conceptual levels are mentioned in the illustration of the definition. The levels of value are conceptual in nature and have been developed by business appraisers to explain why the value of businesses and interests in them may differ in value based on the context of an appraisal. The conceptual levels of value in the definition above are shown in the following chart:[3]

To adequately specify an appraisal under the fair market value standard (or any other standard), the appropriate premise of value, likely going concern, and the level of value must be defined. Differing specifications of these critical definitional elements can create significant differences in appraisal conclusions.[4]  From the viewpoint of appraisal review, it is critical that both the initial appraiser and any review appraiser have an understanding of the differences between the initial levels of value chart and the more current chart.

The conceptual levels of value exist because of differing perspectives regarding the expected cash flow, growth, and risks of market participants (and hypothetical investors). Consider the following:

  • A strategic investor looks at the cash flows of a business through a lens that considers potential strategic or synergistic elements not available to financial investors. And because of the size of a strategic investor and its likely portfolio of assets, its risk profile may be relatively low. This viewpoint defines the strategic control level of value above. We will discuss the implications for fair market value and the strategic level of value in a future post.
  • Financial control investors look at the normalized expected cash flows of a business and have access to or control over 100% of business cash flows and face the risks of the business. There is growing recognition that the financial control and marketable minority (as-if-freely trading in public markets) are synonymous, or virtually so. We show why this relationship normally exists in Chapter 2 of Business Valuation: An Integrated Theory Third Edition. These cash flows and risks define the middle levels in the chart above. This realization also suggests that the minority interest discount, to the extent that it might exist, would be small, and not the bold adjustment used by appraisers in prior decades.
  • In the alternative, investors in illiquid minority interests (nonmarketable minority) of a business may have access to only a portion of business cash flows, or none, if no dividends are paid. Certainly, the risks associated with illiquidity are greater than the risks of the business. These expected cash flows and risks define value from the viewpoint of the investors at the nonmarketable minority level of value.

If the levels of value are defined by expected cash flow, risk, and growth, the premiums and discounts in the chart above are defined by differences in expected cash flow, risk, and growth at each level. We discuss these concepts in a bit more depth in the section “Fair Market Value and the Integrated Theory.”

Implications for Appraisal Review

With this discussion of standards of value, premise of value, and levels of value in hand, we can begin a more detailed review of the standard of value known as fair market value. Before moving forward, however, we conclude that review appraisers must have a clear understanding of the conceptual levels of value to be prepared to review any fair market value appraisal report. I will say that differences in opinion regarding the appropriate level of value are often the most significant contributor to differences in appraisal conclusions.

  • This observation is particularly true in the buy-sell agreement arena where shareholder and operating agreements seldom define the appropriate level of value with clarity when using fair market value as the appropriate standard of value.
  • In the gift and estate tax arena, it may be clear that a subject interest is an illiquid minority interest; however, appraisers and review appraisers may disagree about the relative importance of the hypothetical willing buyers and hypothetical willing sellers of fair market value, with wide differentials often the result.

In the next post, we examine the most common definitions of fair market value and discuss the implications of the definitions for appraisal and appraisal review.

In the meantime, be well. And if these posts strike a responsive or an unresponsive chord with you, I welcome your comments on this blog.



[1]      Z. Christopher Mercer, ‘‘Do Public Company (Minority) Transactions Yield Controlling Interest or Minority Interest Pricing Data?,’’ Business Valuation Review Vol. 9, No. 4 (1990). This article was written in response to an insightful article by Eric Nath, published earlier that year. See Eric W. Nath, ‘‘Control Premiums and Minority Interest Discounts in Private Companies,’’ Business Valuation Review, Vol. 9, No. 2 (1990). See also James H. Zukin, Financial Valuation: Business and Business Interests (New York: Maxwell MacMillan, 1990), pp. 2– 3. While the concepts of the levels of value had been around for some time prior to 1990, to the best of our knowledge, the levels of value chart was not published until the Mercer article in 1990 and in the Zukin text that same year.
[2]      See Z. Christopher Mercer, Quantifying Marketability Discounts (Memphis: Peabody Publishing, LP, 1997). This book is out of print. See the book referenced in the next note, which discusses the QMDM in current terms.
[3]      Mercer, Z. Christopher and Harms, Travis W., Business Valuation: An Integrated Theory Third Edition (Hoboken, NJ, John Wiley & Sons, Inc., 2021), p. 52.
[4]      There are, of course, other definitional elements in defining a fair market value engagement. These include naming the client, the specific interest to be valued, the valuation date, and others.

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