VALUATION DISCOUNTS AND PREMIUMS

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VALUATION DISCOUNTS AND PREMIUMSFundamentals, Techniques & Theorynon-marketable minority interest level. Mercer attempts to address two major issues regardingquantifying discounts for lack of marketability as he stated in his book.1. The fact is that the two largest adjustments in most business valuation reports often receive onlylimited support and documentation.2. The real issue is the absence of tools.The Quantitative Marketability Discount Model (QMDM) addresses the incremental returnrepresented by a marketability discount that is above the enterprise-level discount rate. Thisincremental return applicable to a non-marketable security is necessary to induce investors tomake the purchase rather than making an investment in a similar freely traded security. Thequantitative methodologies developed in Mercer’s book focus on the factors that influence theconcept of the incremental return.B. BASIC FRAMEWORK FOR THE QMDMMercer focuses on five categories of “the fundamental elements of value” used by investors inmaking their investment decisions.1. Capital AppreciationQuantifying a discount for lack of marketability requires consideration of the anticipatedgrowth in the value of the investment.2. Dividend YieldThe valuator must consider the expected dividend yield based on the marketable minorityinterest value (the dividends are the expected interim cash flows to the holder of theinvestment).3. Holding Period of InvestmentThe QMDM provides a means for the valuator to make an assessment of the expectedholding period of the investment.4. Prospects for LiquiditySince there is no ready market for investments in privately held securities, investors areconcerned with the prospects for liquidity while holding the investment.5. Investor’s Required Holding Period ReturnThe QMDM develops a means of assessing the required holding period rate of return for ahypothetical investor. The basis for estimating this discount is the equity discount rateused in the appraisal at the marketable minority discount level. Additional specific risks,which relate to investors in illiquid interests of the enterprise, are added. The requiredholding period return utilized in the QMDM is usually expressed in terms of anapproximate range.38 – Chapter Seven © 1995–2011 by National Association of Certified Valuators and Analysts (NACVA). All rights reserved.2012.v1 Used by Institute of Business Appraisers with permission of NACVA for limited purpose of collaborative training.
Fundamentals, Techniques & TheoryVALUATION DISCOUNTS AND PREMIUMSMercer explains:“Since the expected cash flows generated by the business are the source of the nonmarketableminority investor’s cash flows, the risks faced by the non-marketableminority investor encompass the risk of the business generating those cash flows, aswell as incremental risks arising from the illiquidity of the investment. Therefore, theembodiment of risk for valuation purposes, the relevant discount rate, must for nonmarketableminority investors be greater than or equal to, but cannot be less than, thediscount rate applicable to the valuation of the business.”C. UTILIZING THE QMDMIn developing a valuation utilizing the QMDM, the model assumes that any necessarynormalization adjustments, including those related to nonrecurring items and discretionaryowner compensation and/or benefits, have been made when arriving at the capitalizable benefitstream. There have been some challenges to this assumption under the model, as ownercompensation adjustments are generally an element of control and not considered in a valuationof a minority interest.Using the five elements discussed previously, the discount can be calculated using the followingequation:Marketing Discount (MD) = 1 – [Shareholder’s ValueEnterprise Value] %1 – [Value of Expected Cash Flows to Minority ShareholderValue of Expected Cash Flows in Context of Ongoing Business] %Source: Quantifying Marketability Discounts, Developing and Supporting, Marketability Discountsin the Appraisal of Closely Held Business Interests, Z. Christopher Mercer, ASA, CFAD. USING MERCER’S EQUATIONAssumptions:Discount rate25% Enterprise LevelAnticipated growth 5%Capitalization rate20% Enterprise LevelNet earnings multiple (1/cr)5 P/E MultipleAfter-tax earnings power$0.40 per ShareFreely tradable value$2.0 per ShareGrowth rate of value 5%Interim cash flows (earnings retained to growbusiness)0%Probable holding period10 YearsRequired holding period rate of return20% per YearBased on the above assumptions, the subject interest would be valued at $0.53 per share. Thisvalue is calculated by growing the freely tradable value ($2) at five percent for 10 years, and© 1995–2012 by National Association of Certified Valuators and Analysts (NACVA). All rights reserved. Chapter Seven – 39Used by Institute of Business Appraisers with permission of NACVA for limited purpose of collaborative training. 2012.v1
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