Magazine article The CPA Journal

A Primer on the Quantitative Marketability Discount Model

Magazine article The CPA Journal

A Primer on the Quantitative Marketability Discount Model

Article excerpt

Note: Business valuation is relatively young as a formal process. New ideas are emerging every day that are aimed at revealing the true cost of capital. The following method, from an outspoken and creative valuation professional, adds much to the current discussion and experimentation in the world of valuations. Although considered controversial by some, the methodology below introduces new and valuable ideas and may stimulate others to take business valuation techniques to the next level.

The value of a business today is generally expressed as the present value of all expected future cash flows to be derived from the enterprise, discount-ed to the present, at an appropriate discount rate. This definition of enterprise value is grounded in the theory of finance, and can be expressed symbolically as shown in Equation 1.

Under the assumptions that all cash flows are reinvested in the enterprise at the discount rate, R (or are distributed and available for reinvestment at R), and that cash flow (CF) will grow at a constant rate, G, the basic valuation equation has been shown to be equivalent to the Gordon Model (the right-hand side of Equation 1). The Gordon Model is used almost universally to develop valuations under the income approach. It is generally thought that the Gordon Model develops valuation indications at the marketable minority, or as-if-freely-traded, level of value.

The Quantitative Marketability Discount Model (QMDM) was designed to employ the basic discounted cash flow model to value illiquid interests of closely held enterprises in the context of appraisals of the relevant business enterprises. The value of an illiquid interest in an enterprise can be similarly defined, where the cash flow received by shareholders (CF^sub sh^) is generally less than the total cash flows of the enterprise (CF^sub e^). This is expressed symbolically in Equation 2.

Conceptually, if the cash flow expected to be received by shareholders is less than all of the cash flows of an enterprise, and if minority shareholders experience risks in addition to the risks of the enterprise, then value to the shareholder (V^sub sh^) will be less than the freely traded value indicated by the Gordon Model. The questions are: How much less? How can appraisers reliably determine the difference?

The QMDM

Assume that the value of a closely held company has already been determined at the marketable minority level of value. The next objective is to determine the non-marketable minority level of value. On the basis of historical studies of restricted stock transactions involving public securities, many appraisers have agreed, based on benchmark analysis, that the appropriate marketability discount is approximately 35%. A significant problem with traditional benchmark analysis is that qualitative comparisons do not allow the appraiser to consider the wide variation of investment characteristics among closely held securities. The degree of the necessary marketability discount for a particular closely held security should be based on the economic characteristics of that security. The QMDM enables the appraiser to quantify marketability discounts based on the investment characteristics of each subject illiquid interest of a closely held enterprise.

The value of an illiquid security can be determined, relative to its marketable minority value, through an analysis of five key factors. These five factors are the basic assumptions of the QMDM:

* Expected growth in value. The expected growth in value at the marketable minority level provides the umbrella under which to consider the value of an illiquid security. The QMDM assumes that value will be realized at the marketable minority level at some point in the future (although this assumption can be modified to fit facts and circumstances). An investor wants to estimate the value to be achieved in the future: the terminal value of the QMDM's shareholder investment analysis. …

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