This post, the fourth in a series on restricted stock discounts, discusses the concepts of valuation premiums and discounts through the lens of the ASA Business Valuation Standards. The previous posts in the series can be referenced as follows:
- RED-3: Restricted Stock Discounts and the Guideline Transactions Method
- RSD-2: Why Are Illiquid Minority Values Always (Almost) Lower Than Marketable Minority Values?
- RSD-1: Background on Restricted Stock Discounts
According to BVS-VII Valuation Discounts and Premiums, of the ASA Business Valuation Standards, we learn the following about valuation discounts:
Para. II.A. A discount has no meaning until the conceptual basis underlying the base value to which it is applied is defined.
Para. II.C. A discount or premium is warranted when characteristics affecting the value of the subject interest differ sufficiently from those inherent in the base value to which the discount or premium is applied.
Para. II.D. A discount or premium quantifies an adjustment to account for differences in characteristics affecting the value of the subject interest relative to the base value to which it is compared.
There is no emphasis marked in the above because every word provides important guidance to valuation analysts. A discount has no meaning unless the valuation analyst specifies the base from which it is to be taken. Refer to the levels of value chart below. A marketability discount has no meaning until the base value, the marketable minority / financial control level of value, is specified.
A discount is warranted when valuation characteristics of a subject are sufficiently different from those of the relevant base value from which the discount is to be taken. In the context of the levels of value chart, the valuation analyst must determine the valuation characteristics of a subject company at the marketable minority / financial control level. Next, the valuation characteristics of the subject interest must be determined. If their respective valuation characteristics (expected cash flows, risk, and growth) are sufficiently different, a marketability discount will be warranted.
And, finally, a discount quantifies the adjustment necessitated by the differing valuation characteristics between the subject interest and the relevant base value.
We see familiar valuation discounts and premiums in the levels of value chart. Look at the chart and think about each of the discounts and premiums for a moment. Note that both premiums are related to a base value. And both discounts are related to a base value.
Students of the Integrated Theory of Business Valuation are aware that the differences in the levels of value are caused by differences in valuation characteristics (expected cash flows, risk and growth) at each of the conceptual levels.
Valuation ratio is defined in the Glossary of the ASA Business Valuation Standards 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. It does not relate enterprise value or market value of equity to financial, operating or physical data of any company. It shouldn’t be surprising that it is not good valuation methodology to apply an average of restricted stock discount studies as a valuation ratio to determine a marketability discount.
We will continue this series of posts on restricted stock discounts with a discussion of the similarities and differences between restricted shares and publicly-traded shares with “RSD-5 Freely Traded Shares Vs. Restricted Shares.”
In the meantime, Business Valuation: An Integrated Theory 3rd Edition (Travis Harms co-author) is available. Be the next to provide an honest review on Amazon.
Until next time, be safe and be well!