Even the most experienced business appraisers get confused on occasion. Do the discount or cap rates apply to valuing minority or controlling business ownership interests?
One share of company stock – a classical minority ownership interest
Why should you care? Because values of controlling shares of business ownership can be a lot higher than the typical ‘aunt Millie’s’ per-share price quoted by her friendly broker. Company per-share prices you see in the public capital markets are the classic minority ownership examples.
Control premia are paid when entire companies are acquired
The price per-share goes up if you decide to make a tender offer in order to acquire a controlling interest in the company. The prices paid by a synergistic or strategic business buyer can go through the roof. At least in the opinion of a prudent, conservative investor.
What affects the value of a company most? Its cash flows that you discount or capitalize to figure out its value. And all income based valuation methods use a measure of business cash flows in their numerator. The discount and capitalization rates enter into the denominator of the calculations.
Control over the company comes at a premium
As many financial gurus would attest, when you consider buying a business, you ultimately focus on acquiring control over its future cash flows. To do this, you need to pay a premium, regardless of the business risk captured by the discount rate.
Ask a savvy investor and you will hear that few buyers would accept a lower rate of return for buying a controlling slice of equities in a company rather than just a few shares. Business risk remains the same.
But if investors want control, they are probably looking to make some changes. For instance, shaking out non-performing members of the management team, changing the product mix and pricing strategy, eliminating a pesky competitor. Worth the extra premium on top of the street per-share price, to be sure.
Don’t be fooled by some spectacular tumbles in stock prices post-acquisition. Company purchases can and do go south on occasion. The market sees such failures as the reason to adjust the business valuation downwards. After all, strong headwinds indicate that business risk is increasing, so the rate of return goes up.