The Problem with Premiums and Discounts in Business Valuations
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June 18, 2024
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For decades, academics have researched and published data on premiums and discounts in valuations. Despite many valuers relying on this data, it is now considered dated and irrelevant. Some valuers use a ‘standard’ premium or discount, say 30%, regardless of the circumstances. However, a shift is underway as valuers prioritise relevance over tradition. Recognising the complexity, valuers stress the need for technical skill and professional judgment. There’s not a one-size-fits-all solution, fostering lively debate within the valuation community.
I recently participated in a panel discussion on ‘Discounts and Premiums: How averaging makes for average valuations’, hosted by the Chartered Accountants Australia and New Zealand (“CAANZ”), to discuss the challenges and shortcomings of applying premiums and discounts when preparing business valuations.
The panel included other business valuation specialists, including PwC’s Richard Stewart, Grant Thornton’s Jannaya James and the moderator, PwC’s James Moulton.
Some of the key takeaways from the discussion included:
Control Premiums
Applying Discounts and Premiums Is Tricky and There Isn’t a Mathematical ‘Right’ Answer
- There needs to be a thorough analysis of the specifics of the subject and the circumstances at hand.
- The term ‘control’ refers to the power to direct the management and policies of a business enterprise to enhance ‘value’.
- There is a wide body of case law on control premiums and a number of empirical studies in the United States and Australia. These studies generally involve public takeover offers where control has passed to the offeror.
- If analysing transactions in the industry, apply careful examination of:
— the motivation of the seller and the buyer
— the negotiation abilities of the parties
— the timing of the transaction
— the type of the buyer: financial or industry market participant
— whether there is an upward bias and if synergies and special value are included
— the stage of the industry and the competitive landscape
— other factors which are typically overlayed on top of the pure premium for control.
- A standard premium (such as ‘premiums for control are commonly around 30% in Australia’) should never be used.
- Question whether ‘minority’ shareholders will benefit to the same extent as the controlling shareholders in all respects — there may be a case for no control premium at all.
- Minority interest discounts are calculated as the inverse of the control premium. There is no direct market evidence to support the selection of a minority interest discount, except indirectly through observed control premiums.
Marketability Discounts
The Ability to Convert an Asset, Business or Investment Quickly or Readily to Cash at Minimal Cost
- The term ‘discount for lack of marketability’ (“DLOM”) relates to:
— discount for illiquidity
— risk and uncertainty to realise an asset in the future (timing and price risks)
— opportunity cost — benefit that could have been received, but has been given up to take another course of action (the cost of a foregone alternative).
- Marketability discounts are typically applicable to shares in privately held companies. For example, there is generally no ready market in which an investor can sell their shares if they require cash or become dissatisfied with the investment.
- A DLOM would also apply if an investor in a listed company wanted to sell a large block of shares compared to the trading volume or the size of the company (i.e., a blockage factor). The size of the appropriate DLOM increases with the size of the block.
- The DLOM is not a black-and-white issue or mathematical, and there is no definite and single formula to calculate such discounts. The degrees of discounts applied in any situation are largely dependent on the circumstances. The valuer should consider the Mandelbaum factors.
Illiquidity Discounts
There Are Differences in an Asset’s Degree of Illiquidity
- Aswath Damodaran, Professor of Finance at New York University, states that ‘All assets are illiquid, but there are differences in the degree of illiquidity. Illiquidity matters to investors. They pay lower prices and demand higher returns from less liquid assets than from otherwise similar more liquid assets’.1
Overall, the discussion highlighted the complexity and subjectivity of using premiums and discounts in valuations. It recognised that there is no mathematical ‘right’ answer, standard premium or discount that can be applied in every case.
Instead, it reinforced the need for thorough, nuanced and case-specific analysis to arrive at the most relevant and appropriate set of factors to consider and apply to achieve a robust, supportable and reliable valuation.
Footnotes:
1: Damodaran, A (2006), ‘The Cost of Illiquidity’, NYU Stern School of Business
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Published
June 18, 2024
Key Contacts
Senior Managing Director, Head of Australia Valuations Advisory