It is axiomatic that no business operates in a vacuum. General industry conditions are perhaps the biggest part of systematic risk a company faces. The reason it is called systematic is that you cannot avoid it by diversifying your business investment. The entire economy is affected, so you have to ride out the rough spots as best you can.
Every time you see a business valuation report, the appraiser has made a set of assumptions about the economy going forward. In fact, professional valuation reports contain a section dealing with the economic conditions. This discussion forms the basis of earnings and expenses forecasts that you see further down in the report.
On occasion, you may run across the economic discussion that seems too lengthy or complicated. Indeed, what future holds is anyone’s guess. Looking into the future beyond a couple of years is fraught with potential errors. Overall market indicators such as the national or regional economic growth prospects are probably more important than tactical decisions made by the Federal Reserve.
Remember that historic performance is just that – a point in history. It will never be repeated so the economic conditions and business outlook will differ from years past. If your business appraisal dwells exclusively on the past, it is likely to miss significant developments that could substantially change your business prospects.
Business value is about risk and returns. As such, business valuation is a forward looking exercise. History is a guide, but accurate business valuation depends on how well you can envision what the business will be able to accomplish in the future.
If you take a look at the highly efficient capital markets such as the NYSE or NASDAQ exchanges, the prices per share of public company stock are actually the minority share prices. What this means is that the buyers and sellers typically trade a small number of shares. Each block of shares sold does not represent control of the entire company.
If, on the other hand, someone wants to buy a controlling share of the company, they would need to pay a premium over the current share market price. This is usually done in the form of a tender offer.
Controlling ownership interest is valuable
Why is a controlling block of shares more expensive? First, because the acquirer needs to induce many small shareholders to sell their stock. Second, because the acquirer gets to control the company, including making such momentous decisions as hiring and firing executives, distributing dividends, raising capital, merging with other companies, or selling the business.
In the public market, there is plenty of data on such tender offers. The premium paid over the market price is reported in regulatory disclosures. As a rule, the control premium typically falls somewhere in the 30% – 40% range. Put another way, to buy the entire company you would need to pay up to 40% more per share than if you just bought a single share of stock in the firm.
From control premium to minority discount
The opposite side of this is the minority discount. This discount usually arises in the context of valuing private companies. The reason is that private businesses do not sell their stock to the public, so their valuation is typically done on the business enterprise basis. The value of the whole company is determined. If you want to know what a partner’s ownership interest is worth, you first figure out the value of the pro rata share, then apply the minority discount.
Why is this discount important? Since there is no public market for ownership of private companies, there is no way to observe the price per share for a privately owned business. Think about it – how valuable would a 10% ownership of a small company be to an outside investor? You cannot make any decisions in a business controlled by the owners of the remaining 90%.
All you can hope for is an occasional dividend payout by the board. If the board is controlled by the same 90% owners, you should be lucky to see any money. More often than not, the controlling owners pay themselves in salaries and generous perks, and minimize the taxable income. If you object to the board, you are out of luck.
Adjusting for DLOM
If you use guideline public company comparables to figure out the value of a private firm, you would need to make the adjustments for lack of marketability (DLOM) first. Assuming your comparable companies are close enough to the target firm financially and operationally, you can work out the valuation multiples and determine the value of the private company on a per share basis. But remember that this guideline public company approach prices in the minority discount! In other words, your private company value could actually be 30% – 40% higher than this calculation shows.
On the other hand, you can use a set of valuation methods directly to value the entire private company. The business enterprise value you come up with is on a controlling ownership basis. If you want to figure out the value of minority ownership interests, you can apply the minority discount to the per share price you calculated.
