What does a restricted stock discount measure? This discount measures the difference between two prices. We define the restricted stock discount (RSD) in Exhibit 8.1 of Business Valuation: An Integrated Theory Third Edition, which Amazon.com says you can take delivery October 13th. I don’t think anyone will disagree with the definition.
The purchase price per share for the restricted shares is the price at which the restricted shares were issued. The market price for the issuer’s unrestricted shares is observed for the same day.
In this example, a closed-end fund made an investment in restricted shares of PubliCo at $15.00 per share. The freely traded price on the day of the transaction was reported at $20.00 per share. As we see in the exhibit above, this transaction would have been recorded as showing a restricted stock discount (RSD) of 25.0%.
This 25.0% discount measures the difference between two prices, and nothing more. The primary inferences we can draw based on the available information are that:
- The restricted stock transaction occurred at a price of $15.00 per share
- PubliCo’s unrestricted shares traded at $20.00 per share at the time of the transaction
- The restricted stock transaction price was $5.00 per share lower than the freely traded price
- The restricted stock transaction price was 25.0% lower than the price of PubliCo’s otherwise identical but freely tradable shares on that date
- Publico’s unrestricted shares closed at a price $5.00 per share higher than the transaction price in its restricted shares on that date
- PubliCo’s unrestricted shares closed at a 33.3% premium to the restricted stock transaction on that date
The bottom line is that any restricted stock discount measures the difference between two prices. There is no economic evidence in any one or any average of discounts that provides direct economoic evidence of why any transaction was priced as it was.
Given the hypothetical transaction in Exhibit 8.1 above, what information was available to public market participants and to investors in restricted shares? Exhibit 8.2 provides a summary.
Except for the restrictions on trading imposed by SEC Rule 144, restricted shares of publicly traded companies are identical to their freely-traded counterparts. Exhibit 8.2 focuses on the similarities between the shares from the viewpoint of market participants and valuation analysts. What is clear about the restricted shares is that, on transaction dates, investors had access to all information available to public investors in each company’s publicly traded shares.
To understand why restricted shares were usually traded at discounts (and often steep discounts, to their freely traded counterparts) we have to understand how restricted shares differ. The answer lies in the information available to the managers of issuing public companies and to investors purchasing their restricted shares, as summarized in Exhibit 8.3.
Like all transactions, restricted share issuances were the product of negotiation between two or more parties with adverse interests. The issuer of restricted shares is motivated to receive the higher issuance price possible (i.e., to negotiate the smallest possible discount). Buyers of restricted shares, on the other hand, were motivated to achieve the lowest possible issuance price (i.e., the highest possible discount). As the text in Exhibit 8.3 indicates, the observed discounts reflect the relative negotiating leverage of the parties.
We engage in a bit of simple logic here. There is little doubt that in the early restricted stock studies, significant discounts to publicly traded prices of issuers were observed. The difference in prices is referred to as the restricted stock discount (RSD). So, the restricted stock price can be described as in Exhibit 8.8.
The question to be answered is this: what causes restricted stock discounts? The answer flows from the analysis above. The expected cash flows and expected growth for restricted shares of the same public company on the same day of issuance are the same. The only thing that could be different is the perception of risk over the required expected holding period of illiquidity for the restricted shares.
We employ the Gordon Model in Exhibit 3.10 to illustrate.
We see that if Vrsd is less than the freely traded price, the only explanation is that the discount rate must be higher for the restricted shares than for the freely-traded shares. This is fairly obvious from this brief analysis.
We call the difference in discount rates between the freely traded pricing (which would be r) and the restricted share pricing the expected holding period premium to the discount rate, or HPP. In Business Valuation: An Integrated Theory Third Edition, we illustrate this symbolically as in Exhibit 3.11. The book will be available on Amazon.com on October 13th.
We discussed the Silber Study, which was published in 1991, in the previous post in this series. That study showed many years ago that more attractive companies (i.e., those with less risk) issued restricted shares at lower discounts than less attractive companies (with more risk). As a profession, we should have clued into this fact some three decades ago.
In the next post in this series, we will examine the mechanics and math of the restricted stock discount and the cause of the expected holding period premium.
In the meantime, pre-order your copy of Business Valuation: An Integrated Theory Third Edition. You will want to read it for your self as soon as it is available.