Valuation and liquidity discounts
September 2017 | PROFESSIONAL INSIGHT | FINANCE & INVESTMENT
Financier Worldwide Magazine
September 2017 Issue
In financial markets, asset liquidity is a key and active consideration. Liquidity refers to the ease in which an asset can be converted into cash, with cash being fully liquid and other securities liquid, to varying degrees. Investors value liquidity and would pay more for an asset that is fully liquid than for an otherwise identical asset that is not fully liquid. Liquidity and marketability are often confused. Liquidity risk is an aspect of the secondary market. Liquidity involves both speed of the transaction and visibility around its selling price. Sometimes the word ‘liquidity’ is applied to assets that are simply convertible to cash, for example, savings accounts, bank CDs and money market accounts, as opposed to assets that are sold on the secondary market. Marketability, on the other hand, is linked to transaction velocity. For example, the promptness of an asset’s conversion into cash – not the certainty of its selling or conversion price.
Regardless of whether you are doing valuation based on intrinsic economic value, comparing against how similar assets are priced (multiples) or pricing via real options (contingent claim valuation), illiquidity impacts value, both in terms of cash flow considerations and asset allocation decisions. After all, valuation is a process used to determine what a business is worth. Determining a private company’s worth and knowing “what drives its value is a prerequisite for deciding on the appropriate price to pay or receive in an acquisition, merger transaction, corporate restructuring, sale of securities, and other taxable events”, according to PrivCo.
In publicly traded equity markets, liquidity factors may be minimal and simpler, even though they still exist. Nonetheless, it is in private markets where liquidity is a key issue in asset valuation and can significantly affect value, or more specifically ‘pricing’. Indeed, such ‘liquidity discounts’ can reach up to 50 percent of estimated fundamental value. How large should a liquidity discount be for any given company? This is a technical challenge given that the discount itself is not explicit. Obtaining valuable insight around comparable company transactions is notoriously difficult, but if such information is available, it will be the final transaction price rather than current fundamental value that is reported. The delta between intrinsic valuation and pricing is, after all, a function of liquidity, not to mention potentially a number of other qualitative and quantitative factors (that in turn help increase or decrease liquidity). In other words, liquidity can be conceptualised as impacting pricing and not necessarily intrinsic value.
One challenge for many business valuation reports is therefore how to effectively communicate the value of a nonmarketable equity interest, particularly the rationale for the selected discount for lack of marketability (DLOM). Although, conversely, it is also reasonably intuitive to business owners and investors that private companies typically sell at a price discount compared to otherwise comparative public companies. However, it is still an engagement challenge given that you are essentially subtracting a potentially huge chunk of company or asset value (or at the very least pointing out that such a discount exists), especially as often, such discounts are calculated subjectively or via ‘rules of thumb’. This is a non-optimal approach as levels of liquidity and therefore the subsequent illiquidity discounts applied should vary between markets, sectors, assets, investor profiles and even over timeframes employed. According to Aswath Damodaran, there are macro factors that impact liquidity, as outlined below.
Liquidity of assets owned by the firm. The fact that a private firm is difficult to sell may be rendered moot if its assets are liquid and can be sold with no significant loss in value. A private firm with significant holdings of cash and marketable securities should have a lower illiquidity discount than one with factories or other assets for which there are relatively few buyers.
Financial health and cash flows of the firm. A private firm that is financially healthy should be easier to sell than one that is not healthy. In particular, a firm with strong income and positive cash flows should be subject to a smaller illiquidity discount than one with negative income and cash flows.
Possibility of going public in the future. The greater the likelihood that a private firm can go public in the future, the lower should be the illiquidity discount attached to its value. In effect, the probability of going public is built into the valuation of the private firm. Think internet companies going public during the dotcom boom.
Size of the firm. If we state the illiquidity discount as a percent of the value of the firm, it should become smaller as the size of the firm increases.
Operating history, business models and control should also be considered. The key issue at hand is how we can integrate liquidity factors into valuations. For DCF valuations there are two key approaches: “The first is to estimate the risk adjusted value, using the conventional approach, and to then reduce this value by an illiquidity discount. That discount can be estimated by looking at how the market prices illiquid assets,” says Aswath Damodaran. The most common method is based on analysis of restricted stock which are pre-IPO transactions with lock-down periods (for example, rule 144 stipulates six months for public equity) and by looking at discounts of different stock classes traded in different markets with different liquidity profiles and also bid-spread margins of public stocks, basically the ease with which you can sell a security and immediately recover your capital). These studies generally flag up large discounts (25-50 percent) for illiquid assets – with 35 percent being given as a common median data point – and, as such, valuations of private assets have generally used such ‘off the shelf’ fixed estimates.
Mr Damodaran sums up these studies. First, Maher (1976) examined restricted stock purchases made by four mutual funds in the period 1969-1973 and concluded that they traded an average discount of 35.43 percent on publicly traded stock in the same companies. Second, Moroney reported a mean discount of 35 percent for acquisitions of 146 restricted stock issues by 10 investment companies, using data from 1970. Third, Silber examined restricted stock issues from 1984 to 1989 and found that the median discount for restricted stock is 33.75 percent. Finally, other studies confirm these findings of a substantial discount, with discounts ranging from 30-35 percent. One recent study by Johnson did find a smaller discount of 20 percent.
The second main approach is via direct adjustments in cost of capital calculations, for instance, a build-up approach to CAPM. At the most simple level we look at the return profile of our asset class (for instance, small-caps) against the broader market or look in a bit more detail against a basket of factors, such as turnover ratio, trading volume and the aforementioned bid-ask spread. For relative valuation, we can either apply a fixed discount to the multiple or final economic value estimate or, where possible, filter the comparative universe not only on sector and risk and return characteristics but also liquidity variables such as high floats, trading volumes and low bid-ask prices. Liquidity discounts can also be quantified via regression analysis on a series of factors (such as Silber’s restricted stock study).
In all cases, lower liquidity should affect asset pricing. However, the liquidity needs of both the seller and the buyer should also be factored into appraisal analysis and investment decisions. The concept of illiquidity is, therefore, an essential consideration for valuation professionals – and business owners – who value assets that do not have readily-available market quotations to draw upon. To close out, according to the IRS, “In considering the discount for lack of marketability, you will be presented with an approach and be concerned with judging its reasonableness, its reliability, its adherence to the prevailing facts and circumstances of the valuation problem at hand, its general acceptance within the valuation community and the treatment that the approach has received at the hands of the courts”.
Adam Paul Patterson is a partner at ALFA Valuation & Advisory. He can be contacted on +55 41 99107 0765 or by email: email@example.com.
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Adam Paul Patterson
ALFA Valuation & Advisory