Chapter 9 Flashcards
What are the four types of models to identify and quantify valuation adjustments?
1) Theoretical models - top down and horizontal
2) Original empirical models - similar ownership rights
3) Inferential models - premiums paid for control
4) Precedential models - court decisions
What do investors require as a result of being generally risk averse?
Higher returns in exchange for accepting higher levels of risk
What are the levels of value?
Control strategic (public or private) Minority/control standalone liquid (public) Control liquid (private) Control standalone (private) Minority, nonmarketable (private)
What level of value result from the GPC method of the market approach?
Control or minority, marketable
What level of value result from the M&A method with public company transaction of the market approach?
Control, marketable
What level of value result from the M&A method with private company transaction of the market approach?
Control, nonmarketable
What level of value result from the adjusted book value method of the asset approach?
Control, marketable
What level of value result from the liquidation method of the asset approach?
Control, marketable
What level of value result from the cost to create method of the asset approach?
Control, marketable
What level of value result from the capitalization of benefits method of the income approach?
Control or minority, marketable or nonmarketable
What level of value result from the discounted future benefits method of the income approach?
Control or minority, marketable or nonmarketable
What level of value result from the excess earnings method of the income approach?
Control, marketable or nonmarketable
What does marketable refer to?
Values derived from public marketplace and assumes that a certain amount of liquidity is embedded in the value
What does nonmarketable refer to?
Values derived from the closely held marketplace and that a certain amount of lack of liquidity is built into the value
What are the levels of ownership?
Control interests
1) 100 percent ownership
2) Ownership sufficient to liquidate or merge
3) 51 percent operating control
Minority interests
4) 50-50 ownership
5) Less than 50 percent, but the largest block of stock ownership
6) Less than 50 percent, but with swing vote powers
7) Less than 50 percent, but with cumulative voting powers
8) Pure minority interests
What 10 facts and circumstances affect adjustments?
1) Purpose of the valuation
2) Ownership interest being valued
3) Ownership structure of the entity
4) Size of block of stock being valued
5) Financial condition and structure of the subject
6) Stock related issues such as dividend policy and history, stock redemption policies, and restrictions on sale of stock
7) State statutes
8) Desirability of and potential market or lack thereof for subject
9) Potential synergies or lack thereof with potential buyers
10) Prospect of an IPO or sale
The concept of minority interest addresses what?
The degree of control or lack of control
The concept of marketability addresses what?
The ability to liquidate an investment in a timely and certain manner
What is addressed first, control or marketability issues and why?
Control and then and only then marketability because the size of the block being valued should be considered in determining the marketability discount
Does the sum of the parts of minority blocks equal the value of the whole enterprise?
No, often minority blocks in the absence of a swing vote are usually less due to lack of control and other factors
What is the definition of control?
Generally the ownership of more than 50 percent of the voting stock or other ownership interest in a business enterprise
What source provides information about the definition of control which may override the terms of an agreement?
State statutes
What 6 abilities of the controlling ownership interest result in a premium for control?
1) Implement business and operational changes
2) Appoint and remove management, appoint self to BOD
3) Control the timing and amount of cash distributions
4) Purchase, sell, convey, exchange, pledge, hypothecate, encumber, and lease the property (tangible and intangible) of the business
5) Enter into, and abrogate, agreements on behalf of the business
6) In general, cause the company to do whatever subject to the law and public policy
What are the two methods to discount for lack of control?
1) Estimate the value of the equity of the total enterprise on a controlling basis (cash flows adjusted for controlling items), compute the minority pro rata interest in the total, and estimate the amount of discount for lack of control applicable
2) use cash flows available to the minority owner
What are the main sources to quantify a control premium?
Control premium study (quarterly - difference between per share price paid for controlling interest in public companies and per share price prior to acquisition which is presumably minority)
FacSet Mergerstat Review (annual - overall M&A including private, public, and cross-border transactions and premiums offered)
Mergerstat/BVR Control Premium Study (annual subscription and includes Control premium study report - searchable database of transactions used to quantify control premiums and minority discounts)
How is a control premium converted into an implied discount for lack of control?
Lack of Control discount = 1 - (1/(1+average control premium paid))
What is the controversary regarding control premiums and discounts?
Whether acquisition premiums represent synergistic premiums versus premiums paid for control
What are additional sources of discount for lack of control information?
- Direct Investments Spectrum (previously The Partnership Spectrum) - bi-monthly since 1990 which provides price to value discounts in the secondary partnership market - doesn’t break down difference between DLOM and DLOC but indicates a large portion relates to DLOC. Divides partnerships into equity distributing with low to no debt, equity distributing moderate to high debt, equity non-distributing, undeveloped land, triple-net lease, and insured mortgages. Same company provides access to a database that is searchable with information on partnership metrics.
- Morningstar Principia Closed-End Funds - monthly CDROM with closed-end funds searchable by type (equity, bonds, specialized, international), Price/NAV multiple is a proxy for DLOC when valuing holding companies whose primary asset is marketable securities
Prior to Revenue Ruling 93-12, what did the IRS follow?
Revenue Ruling 81-253 which stated the family attribution doctrine
What is the family attribution doctrine?
Individual minority stockholder interests should not be valued by applying a DLOC due to the familial relationship of the stockholders, instead the interests should be aggregated for gift tax.
For what purpose did Revenue Ruling 93-12 arise?
Gift tax
What does Revenue Ruling 93-12 state?
In the case of a corporation with a single class of stock, notwithstanding a family relationship of the donor, donee, and other shareholders, the share of other family members will not be aggregated with the transferred shares to determine whether the transferred shares should be valued as part of the controlling interest.
How are normalization adjustments handled when valuing control versus non-controlling interests?
Normalization adjustments related to control (not non-recurring items) can only be made when valuing a controlling interest
What is the definition of marketability?
The ability to quickly convert property to cash at a minimal cost
What is the definition of a discount for lack of marketability?
An amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability
How many methods are there to determine DLOM?
More than 75
What are two traditional sources of data to derive a DLOM?
Restricted stock studies and pre-IPO studies
What are interest are the restricted stock studies and pre-IPO studies based on?
Minority interests
Between the restricted stock studies and pre-IPO studies, which is preferred when deriving a DLOM?
Recent restricted stock studies
What controversy exists with respect to DLOM?
Whether DLOM applies to controlling interests
How are restricted stock studies conducted?
Comparing the price of private placements of restricted securities with publicly traded securities of the same company
What is restricted stock?
Shares of publicly traded companies that are subject to transfer restrictions
What is Rule 144 of the Securities Exchange Act of 1934?
Corporate insiders and other deemed control shareholders must comply with this rule with respect to when, in what quantity and over what period of time they may liquidate their restricted shares
How does restricted stock compare to publicly traded stock of the same company?
They are identical except the restriction on transferability
What do the restricted stock studies indicate?
That restricted shares trade at significant discounts
What should be considered when using restricted stock studies for a DLOM on a privately held business?
Restricted stock will become fully marketable at some point in time whereas no such expectation exists for a privately held business
What are the most well-known restricted stock studies?
SEC Institutional Investor (1971) Gelman Study (1972) Trout Study (1977) Moroney Study (1973) Maher Study (1976) Standard Research Consultants' Study (1983) Willamette Management Associates (?) Silber Study (1991) FMV Opinions Inc Study (1995) Management Planning Study (1980) Johnson Study (1991) Columbia Financial Advisors Study (2000) Trugman Valuation Associates Inc (2009)
What is the median or average discount range in the well-known restricted stock studies?
25-35% with discounts decreasing during the 1990s as restrictions eased and SEC reduced the holding period from 2 years to 1 year in 1997
What is the history of holding periods required under Rule 144?
Reduced from 2 years to 1 year in 1997 and to 6 months in November 2007
What is a piggyback registration right?
When a private company seller negotiates a provision in the sale of their private company stock in exchange for restricted shares of the public company that the public buyer attempt to register the restricted shares with the next public registration statement the buying company makes
What can a private company seller do if they are unable to negotiate a registration right?
Attempt to sell the shares in a private placement under SEC Rule 144
What if the private seller is an affiliate of the public buyer?
The private seller’s eventual liquidation of his or her registered public shares must be done in accordance with SEC Rule 144
What are the holding period requirements under SEC Rule 144 after December 2007?
Resale without limitation after 6 months for issuers that are reporting companies that comply with current information requirements under Rule 144(c) or after one year in the case of non-compliance for reporting
What resources are available to help value securities that are restricted from immediate resale?
Revenue Ruling 77-287 which sets forth guidelines and the SEC Institutional Investor Study assists in the determination of a DLOM
What should be considered when using restricted stock studies?
Discounts may require adjustments based on newer holding period regulations
Consider option pricing methodology to replicate the likely holding period of the shares
What is a pre-IPO study?
Comparison of sales of closely held stock with their prices at the subsequent IPO
What common pre-IPO studies are there?
Emory Studies (1995-1997)
Willamette Management Associates Study
Valuation Advisors LLC Study (2000-2001)
Hitchner Studies
What are the concerns with using pre-IPO studies to calculate a DLOM?
Selection bias because it only includes successful IPOs
Growth prospects are often high-growth businesses between the time of purchase and the IPO
Not arms length since it is a purchase by insiders
Tax Court has echoed these concerns
What 7 additional items should be considered when quantifying a DLOM?
1) put rights
2) dividends, distributions, or withdrawals
3) pool of buyers
4) potential for IPO/sale
5) size of block
6) buy and sell agreement
7) prior sales of stock
What are some of the quantitative methods in calculating a DLOM
1) using databases such as the FMV restricted stock study and valuation advisors’ lack of marketability discount study
2) quantitative marketability discount model (QMDM)
3) option pricing model
4) LEAPS (long-term equity anticipation securities)
What is the FMV restricted stock study?
A searchable database by BVR containing more than 700 restricted stock transactions
What is the valuation advisors’ lack of marketability discount study?
A searchable database by BVR with almost 9,000 pre-IPO transactions
What is QMDM?
Quantitative marketability discount model which was developed by Mercer Capital and is a DCF at the shareholder level to calculate DLOM
What is an option pricing model?
Models to calculate a DLOM under the premise that a put option is a cost to guarantee the price - Black Scholes
What is LEAPS?
Long-term equity anticipation securities - long-term put option and is used in a market approach type analysis to determine DLOM
What are 6 common situations where stock options must be valued?
1) upon grant, exchange, or termination
2) proxy statement disclosures
3) financial statement purposes under FASB ASC 718 and footnote disclosure
4) executive compensation or income tax reporting
5) ownership transfer
7) breach of contract matters
What are the two types of models that exist for the valuation of stock options?
Econometric (empirical) and theoretical
What is an econometric model for valuing stock options?
Developed by studying historical relationships of various economic factors thought to influence the option value and actual market price - most common are Shelton, Kassouf
What is a theoretical model for valuing stock options?
Statistical or probability model which is forward-looking and considers the option terms and characteristics of the underlying stock to determine what it should sell for in the market - most common are black-Scholes, Noreen-WOlfson, and lattice models
What was the Black-Scholes option pricing model originally applicable to?
European (cannot exercise before maturity), simple put and call options on equities
What were the original five inputs related to stock option prices under the original Black-Scholes?
1) current value of underlying stock
2) implied volatility (std deviation)
3) risk-free interest rate
4) exercise price
5) time to maturity
What were the 7 assumptions under Black-Scholes originally?
1) price of the underlying stock is normally distributed with constant mean and volatility
2) no transaction costs
3) markets trade continuously, no sudden jumps in price
4) risk-free rate is constant and same for all maturities
5) stock pays no dividends during option life and no other shareholder distributions
6) option only exercised at maturity
7) tax rate if any is identical for all transactions/market participants
What is required under the Shelton, Kassouf, and Noreen-Wolfson models?
Estimate the volatility of the stock price and re-estimate the coefficients of the regression relationship which is difficult for closely held businesses where historical pricing data is unavailable or scarce
What is a lattice model?
A system that calculates fair value of a share option or similar instrument using assumptions to estimate share value and post-vesting behavior of option holders during the option term
How does a lattice model arrive at the value of an option?
Estimates future share price and estimates the intrinsic future value of the option. This is then discounted back to grant date using probability weighted averaging techniques
What is a binomial lattice used for?
Valuing employee options
What are 5 unique factors that a lattice model takes into account?
1) changing dividend, interest, or volatility rates
2) post-vesting exercise behavior
3) stock price barriers
4) vesting tranches (percentage becomes vested each year)
5) forfeitures (leaving or termination before/after vesting period)
What are 6 situations that require the valuation of preferred stock?
1) purchase or sale for cash
2) exchange of common equity/debt for preferred stock
3) gift/estate taxes
4) allocating total enterprise value among classes of securities
5) adjusting a balance sheet for preferred stock owned or outstanding
6) divorce
What are 5 factors to be considered when valuing preferred stock?
1) yield
2) dividend coverage
3) liquidation protection and preference
4) voting rights
5) redemption privilege
Whether the yield of the preferred stock supports a valuation of stock at par depends on what?
The adequacy of the dividend rate and whether the dividend is cumulative or noncumulative
What should be considered regarding liquidation preference with respect to valuing preferred stock?
Whether the issuing company will be able to pay the full liquidation preference at liquidation
Do voting rights for preferred shares impact the value of the preferred stock?
Yes
Does the redemption privilege impact the value of the preferred stock?
Yes
What are other discounts should be considered?
1) key person or thin management
2) blockage
3) built-in capital gains
4) voting versus nonvoting
How should other discounts be incorporated into a valuation?
When developing the discount rate, market multiple, or DLOM
When should a key person discount be taken?
When the subject interest’s future earnings level could be adversely affected by the loss of a key individual
When should a blockage discount be taken?
Applies only to thinly traded publicly traded stock when a large block of stock is placed on the market at one time this may cause the price per share to decline
Does a blockage discount apply to closely held shares?
No, only public shares that are thinly traded
The larger the block of shares in relation to ________, the larger the impact on the current market price?
Average daily trading volume of the security
What factors should be considered for arriving at a blockage discount?
1) the period that might be required to liquidate the position based on average daily trading volume and the size of the block of stock
2) historical impact on stock price of larger blocks of shares that were traded
3) expected growth rate of stock
4) required rate of return of stock
Blockage discounts are allowed for _____ reporting purposes but not allowed for ______ reporting purposes?
Tax, financial
What is the combined or effective discount formula?
1 - ((1-DLOC) * (1-DLOM))
What are three questions to ask to reconcile the indicated values at the end of a valuation?
1) did I value the right thing?
2) did I value it the right way?
3) did I conclude the right value?
