What is the Impact of the COVID-19 Crisis on Marketability Discounts (DLOMs)?

I spoke this morning at the New York Society of Certified Public Accountants’ Business Valuation Conference. Unlike previous years when I’ve spoken at this conference, my participation was virtual, and all attendees were virtual as well. A sign of the pandemic times we are in.

My presentation was titled “The Highs and Lows of the Integrated Theory of Business Valuation: Tackling the Market Participant Acquisition Premium (MPAP) and the Marketability Discount (or DLOM).” The two primary insights of the session, both of which may seem obvious, are important for business appraisers to focus on. We will see why as we address the question posed in the title of this post below.

The value of a business is a function of three things: the expected cash flows from the business, their expected growth, and the risks associated with achieving those cash flows. The expected cash flows are into perpetuity.
The value of an interest in a business (assume illiquid and minority) is a function of three things: the expected cash flows to the interest, which are derivative from the expected cash flows of the business, the growth of those cash flows, and the risks associated with the achievement of those cash flows over the finite expected holding period of the investment.

These concepts are at the heart of the Integrated Theory of Business Valuation, which is the topic of the second edition of the book Business Valuation: An Integrated Theory Second Edition. Travis Harms, my coauthor, and I are finalizing the third edition with John Wiley and Sons, Inc., and it will be available in September.

A question was raised following my NYSCPA session regarding the impact of the COVID-19 pandemic on the marketability discount using the Quantitative Marketability Discount Model, or QMDM. There is no simple or straightforward answer to the question, but I’ll try to address it briefly.

At the level of the business, value is a function of expected cash flows, their growth and the risks associated with achieving them. The COVID-19 pandemic will impact the expected cash flows and growth of each business uniquely. We are focusing on projections with managements in current valuations to develop the best possible expectations in light of where we are.

We believe that the overall riskiness is, hopefully temporarily, increased and are adding 1% of “COVID risk” premium in discount rate development for the time being. That decision was made after considerable slicing and dicing of public market performance and multiples. We attempt to focus on cash flow rather than attempting to “solve” the pandemic issues with a large dose of incremental risk discount rates. We will revisit this issue frequently.

Now, how do we address the COVID-19 pandemic in the context of valuing illiquid minority interests? The QMDM is a discounted cash flow model at the shareholder level. The QMDM develops value indications at the non-marketable minority level. These values are compared to the marketable minority values developed by appraisers. From my presentation, we compared the DCF assumptions for business with the assumptions for the shareholder level QMDM.

The assumptions included:

Range of Expected Holding Periods (Risk and Cash Flow). The impact of the pandemic on the expected holding periods of minority investments is not obvious. Depending on circumstances, the pandemic could accelerate a liquidity event at the business level or lengthen the expected holding period. Business appraisers must examine this assumption carefully, including discussions with management regarding their expectations for the future.
Expected Distribution/Dividend Yield (Cash Flow). Appraisers must focus on the outlook for distributions in minority appraisals in light of the COVID-19 crisis. Lower expected dividends (relative to the past) might lower value and increase the marketability discount. On the other hand, lower marketable minority values would tend to increase the yield, which could increase value and lower the discount if actual distributions were unchanged. Of course, if the expectation is for an elimination of future distributions, then value would be negatively impacted and DLOMs increased
Expected Growth in Distributions/Dividends (Growth, Cash Flow). The expectation for lower growth in dividends during the pandemic could lower minority values and tend to increase marketability discounts a bit.
Timing (Mid-Year or End of Year). Any change in the timing of distributions as result of the pandemic could have a modest impact on the marketability discounts calculated using the QMDM.
Growth in Value Over the Holding Period (Growth, Cash Flow). To the extent that the pandemic negatively impacts expected growth in value at the business level that translates to the interest, the business interest value would be adversely impacted and DLOMs increased.
Premium of Discount to Expected Enterprise Value (Terminal Value Cash Flow). This assumption would not appear to be likely to change.
Range of Required Holding Period Returns (Risk). The impact of our 1% “COVID risk” premium or any other risk premium used by other appraisers would tend to lower values by raising the base equity risk rate. However, with treasuries at historic lows, this impact could be mitigated somewhat.

It should be clear that there is no obvious answer to the question of the impact the COVID-19 pandemic on marketability discounts developed using the QMDM. As always, appraisers must examine the economic characteristics of businesses or business interests being valued in light of their expected cash flows, growth and risk. We are just having to look a bit more closely during these early weeks of the pandemic in light of the uncertainties it creates.

It should be obvious, but the use of averages of restricted stock studies from many years ago will shed no light on the appropriate level of marketability discounts during this current pandemic. To put a fine point on this observation, consider this table summarizing restricted stock studies that many appraisers still reference when developing marketability discounts.

The big red oval highlights the few studies that most appraisers reference. Note that the latest study was performed in 1997, and the studies used transactions that occurred between 1966 and 1995. All of this happened a long time ago. There were about a thousand transactions in all of the studies assuming there was no duplication of transactions in the various studies (unlikely).

We can stare at this information for hours and never gain any insight into the impact of the COVID-19 crisis on minority interest investments values or marketability discounts.

The QMDM is a tool to help appraisers address these important questions at any time, and especially during the pandemic. It is available at www.ChrisMercer.net/store .