The Conceptual Valuation “Spaces”
The levels of value chart is one of the most important descriptive figures for business valuation. In the following chart, we provide five numbers for the conceptual “spaces” on the levels of value chart. We previously gave names to these spaces and they are the familiar valuation discounts and premiums used by business appraisers. In this post, we refer to the “spaces” on the chart to focus on why they exist and the economic factors that create the familiar discounts and premiums.
A preliminary discussion of these valuation premiums and discounts was provided in Appraisal Review #3: The Levels of Value and Appraisal Review.
I believe that absent a clear understanding of these “spaces” and the underlying causes of the familiar valuation discounts and premiums, business appraisers cannot adequately prepare or review a business appraisal.
We now describe these “spaces” and name them:
- The space between the Financial Control Value and the Strategic Control Value (moving up). This space is called the Strategic Control Premium.
- The space between the Strategic Control Value and the Financial Control Value (moving down). This space has no name because it is not a recognized valuation discount.
- The space between the Marketable Minority Value and the Financial Control Value (moving up). This space is called the Financial Control Premium.
- The space between the Financial Control Value and the Marketable Minority Value (moving down). This space is called the Minority Interest Discount.
- The space between the Marketable Minority Value and the Nonmarketable Minority Value. This space is called the Marketability Discount or the Discount for Lack of Marketability (or DLOM).
Some readers may think that I am pointing out the obvious and everyone knows all this. Many valuation disputes are the result of differing interpretations regarding what these “spaces” mean and how to measure the premiums and discounts that are used to define them. However, understanding these valuation “spaces” and the named premiums and discounts is essential if appraisers desire to prepare reasonable appraisals, to review their own work and the work of others in their firms, and to review the work of other appraisers in a formal sense. We now discuss these important valuation spaces by number in the levels of value chart above.
1. The Strategic Control Premium (from Marketable Minority/Financial Control Levels)
The space between the financial and strategic control levels is called the strategic control premium. For many years in the public securities markets, it was observed that public companies, when acquired, often received premiums in pricing relative to their previously unaffected share prices. And the observed premiums were often substantial, averaging on the order of 40% for years.
The premiums came to be called “control premiums” and were studied by market participants. These premiums began to be used by business appraisers to adjust marketable minority pricing to the control level. Prior to the mid-1990s, the levels of value chart used by appraisers had only three levels, and there was no distinction between the financial control and strategic control levels.
For a discussion of the previous understanding of the levels of value with three levels, see The Traditional Levels of Value Chart in a post from 2017.
In the sixth post in this series, we discussed the levels of value and the conceptual math that defines them. It is now time to examine the premiums and discounts that are used by business appraisers to move between them.
Observed control premiums relay differences in unaffected prices of public companies and the strategic control price paid by acquirers. These premiums reflect the expected present value of future synergies or strategic benefits. Unfortunately, observed control premiums do not provide any economic evidence for appraisers, reflecting as they do only the differences between two prices, strategic control and unaffected public pricing. Strategic control premiums may also reflect the value added to a transaction when strategic acquirers utilize their own, likely lower (relative to smaller companies), costs of capital in their pricing.
1a. Review: Restricted Stock Discounts are Not Valuation Ratios (or Multiples)
We now take what may seem like a side-step to discuss that restricted stock discounts are neither valuation multiples that express economic information, nor valuation ratios, to use a similar name.
In a previous series on this blog on restricted stock studies and restricted stock discounts, we noted:
Multiple is defined in the recently published International Valuation Glossary – Business Valuation as:
a ratio calculated as the value of a business or security divided by Economic Income or a non-financial metric. Also known as market multiple, pricing multiple, or valuation ratio (second emphasis added).
Valuation ratio was previously defined in the Glossary of the ASA Business Valuation Standards, prior to its removal and the adoption of the International Valuation Glossary – Business Valuation, as:
A fraction in which a value or price serves as the numerator and financial, operating, or physical data serves as the denominator.
Examples of valuation ratios include price/earnings multiples, enterprise value to EBITDA multiples, enterprise value to gross profit multiples, and enterprise value per case (e.g., for a wholesale beer distributor). The following exhibit provides examples of valuation ratios.
Note that a restricted stock discount is not a valuation ratio or a valuation multiple. It does not relate enterprise value or market value of equity to any company’s financial, operating, or physical data. It shouldn’t be surprising that it is not a good valuation methodology to apply an average of restricted stock discount studies as a valuation ratio to determine a marketability discount.
1b. Similarly, Strategic Control Premiums are Not Valuation Ratios (or Multiples)
A strategic control premium observed when a public company is acquired has no economic meaning. It measures only the difference between two prices, the announced transaction price and the previously unaffected public price of the acquired company. As I have said, there is no economic information in any single control premium, and there is no economic information in an average of several or hundreds of control premiums.
The last post, Appraisal Review #8: A Story of Review from the Archives, provided an example where an appraiser applied an average control premium to guideline public company multiples to yield a noneconomic result. The valuation ratios from the actual transactions giving rise to the average control premium of 60% had EBITDA multiples with an average of about 11x, or close to the average guideline public company multiple giving rise to the marketable minority value (before the control premium). After application of the control premium of 60%, the effective EBITDA multiple was 16x. Clearly, premiums from transactions where the valuation ratios are in the range of 11x EBITDA cannot be used to achieve a conclusion of 16x EBITDA.
1c. What Fills the “Space” Between the Financial Control and Strategic Control Levels?
We introduced the conceptual math of the levels of value in Appraisal Review #6: Fair Market Value and the Integrated Theory. A summary table follows for ease of reference as we examine the reason for the “space” between financial control/marketable minority and strategic control.
For now, assume there is little or no difference between marketable minority and financial control values. The conceptual math of value at financial and strategic control in the first column above shows us the conceptual math of value. In the middle column for “Relationships,” as we have noted before, there are three reasons that strategic control value might exceed financial control.
- Cash flow, as perceived by a strategic acquirer, may exceed stand-alone cash flow at the financial control level. This perception of greater cash flow could come from expected synergies or strategic benefits available to the acquirer but not available on a stand-alone (i.e., going concern) basis. The present value of those incremental cash flows could provide greater expected value to the strategic acquirer than is available to the stand-alone company.
- The expected growth in earnings, as perceived by a strategic acquirer, may exceed the expected earnings growth on a stand-alone basis. The expectation of faster growth means more future cash flows than available on a stand-alone basis. The greater expected growth could come from selling the acquirer’s products into the target’s customer base, from selling the target’s products into the acquirer’s customer base, or from other strategic benefits. The present value of those greater future cash flows from faster growth could provide greater expected value than is available on a stand-alone basis.
- Many strategic acquirers are larger than their targets and may have lower discount rates (both equity discount rates and weighted average costs of capital) than their smaller, stand-alone targets. If an acquirer applies its lower discount rate to the expected cash flows or the target and to the expected greater cash flows from synergies and faster growth, then value from the perspective of a strategic buyer may be greater, even significantly greater, than the stand-alone financial control value of the target.
What we have shown in this discussion is that observed control premiums are not some “magic thing” that acquirers pay. Observed control premiums are the result of economic forces at work. Value to the strategic acquirer is greater than stand-alone financial control/marketable minority value because of different expectations regarding expected cash flow, risk and growth. The “space” between financial control and strategic control is created by differing economic perceptions regarding those expectations.
2. The “Space” Moving from Strategic Control to Marketable Minority/Financial Control
The second “space” in the levels of value chart above is the space, moving downward from strategic control to financial control. Appraisers give no name to the downward movement. In the original levels of value figure with three levels, this downward movement was called the minority interest discount. That was at a time when appraisers generally believed that the value of control flowed from certain “prerogatives of control.” I wrote about this in a previous post titled The Case for the Disappearing Minority Interest Discount (and also in Business Valuation: An Integrated Theory Third Edition).
The reduction in value was often attributed to certain prerogatives of control, like the ability to run a company, to pick who to do business with, to determine dividend policy, and more. The implication was that buyers of companies were paying substantial control premiums to obtain these prerogatives of control. The minority interest discount accounted for this premium by taking it away, since minority shares lack control.
However, we have seen that buyers pay for the economic benefits of enhanced cash flow, growth and perhaps risk reduction, and not for the prerogatives of control. So this second “space” is not the minority interest discount.
The second space is just that, an empty space. I have never had a valuation engagement that began with an observed strategic acquisition of a company and with the objective of determining what the financial control/marketable minority value would have been pre-acquisition? With public company acquisitions, we observe both prices, the unaffected market price, and the acquisition price. That space simply represents the difference between those two numbers.
3 and 4. The Financial Control Premium and the Minority Interest Discount
To the extent it exists, the financial control premium reflects any difference between the marketable minority value of a business and its financial control value. The financial control premium would be created by incremental benefits financial buyers might expect to gain from increasing cash flow and growth relative to the marketable minority value. However, there is a caveat. To the extent there are perceived benefits, the financial buyer must be willing to give them to or share them with the sellers of a stand-alone company.
Keep in mind that the beginning point for valuing an interest at the nonmarketable minority level is the normalized cash flows of the business. Normalization includes adjusting earnings for unusual and non-recurring items as well as for excess owner compensation and other perquisites and benefits. I have written a number of posts on this blog regarding normalizing adjustments, the most recent of which can is Normalizing for Excess Owner Compensation in Minority Interest Appraisals.
There is no available market evidence supporting the existence of a financial control premium. To the extent that appraisers develop them, they must be the result of incremental differences in expected cash flow and growth (or reduced risk) relative to the marketable minority level.
We leave conceptual space for a financial control premium in the levels of value chart, but there is not much space, which is why the charts are touching.
If the financial control premium is minimal or nonexistent, conceptual equivalency suggests that the minority interest discount is minimal or nonexistent.
There is no market evidence reflecting minority interest discounts for operating companies. We will address the issue for asset holding entities in a future post.
“Spaces” three and four on the levels of value chart are there for conceptual reasons. However, there is little or no market evidence observable by appraisers to define the financial control premium or the minority interest discount.
An important implication of these observations is that in developing a nonmarketable minority value, the beginning point is to develop value at the marketable minority/financial control level and then to develop a single discount, i.e., the marketability discount or DLOM, to arrive at the nonmarketable minority level. That discount is the fifth “space” in the levels of value chart above.
5. The “Space” Between the Marketable Minority/Financial Control and Nonmarketable Minority Levels
The space between the marketable minority/financial control level and the nonmarketable minority level is given the name of the marketability discount, or the DLOM. The marketability discount reflects the difference in pricing of minority interests of closely held businesses and their corresponding financial control/marketability minority values. Value at the financial control/marketable minority level is based on 100% of expected, normalized cash flows for business entities, discount rates reflective of the risks of the businesses, and expected growth in cash flows for the businesses.
Value at the nonmarketable minority level is based on expected cash flows to the interests, which are often less than, or much less than, the cash flows of the enterprise. The growth of minority interest cash flows is impacted by excess owner compensation and by dividend and reinvestment policies of controlling shareholders and may be less than for the businesses. Cash flows are considered over a reasonable range of expected holding periods, rather than in perpetuity as for the businesses. Finally, the risks associated with owning an illiquid minority interest are likely greater than the risks at the level of the business. So lower expected cash flows and growth and higher risks of illiquid minority interests create the differential from the marketable minority/financial control level known as the marketability discount (or discount for lack of marketability).
This discussion should suffice for this post. There is parallel development relative to the strategic control premium, so we will not go further at this time.
To read more on this issue, see RSD-2: Why are Illiquid Minority Values Always (Almost) Lower Than Marketable Minority Values?
I have used the idea of valuation “spaces” between the levels of value to focus attention on the fact that there are economic reasons for the spaces and for the valuation discounts and premiums we commonly consider in business appraisal. The two discounts (minority interest and marketability) and the two premiums (financial control and strategic control) exist because of differing perceptions of expected cash flow, growth and risk among hypothetical or real market participants.
When you next “apply” a valuation discount, ask yourself whether the amount or extent of the difference between the base level (either marketable minority or financial control) and the resulting level (either marketable minority or nonmarketable minority) is based on differences in expectations regarding cash flow, growth and risk by investors at each of the respective levels.
When you next “apply” a valuation premium, ask yourself whether the amount or extent of the difference between the base level (either marketable minority or financial control) and the resulting level (either financial control or strategic control) is based on differences in expectations regarding cash flow, growth and risk by investors at each of the respective levels.
I hope this review of the “spaces” on the levels of value chart has been helpful.
Please do comment in the space below. These issues warrant wide discussion.