Discounts and Premiums in Valuation

Challenges in Valuation

Often value of a share depends on the holder

A share is worth more in the hands of a controlling shareholder Shareholder types effectively have different rights

Rights are priced in capital markets

Control is valuable and priced at premium

Challenges in Valuation

Value of a share may also differ for large and small shareholders
Absent control considerations, a larger stake may be more difficult to monetize Liquidity and control are seldom

independent

Exit option for minority is limited

Hence share held by a large, controlling

shareholder is often more liquid

Challenges in Valuation

Share value may also differ for institutional vs. individual shareholders
Tax treatments are different, which affects the liquidity

A share can also be more valuable for a founding interest family due to emotional

Challenges in Valuation

Share value may also differ for strategic reasons

It is worth more for a strategic investor than for a financial investor Also be worth more to a diversified than to an undiversified shareholder because of exposure to idiosyncratic risk

Levels of value &ownership characteristics

What if to apply both discounts????

Application of the discounts is multiplicative, not additive

Discount for control is applied first

Value of Control

Range of Control
100 % Equity Ownership Position

Control Interest with Liquidating Control

51% Operating Control

Two equity holders, each with 50% interest

Minority with largest block of equity interest Minority with swing vote attributes Minority with cumulative voting rights Pure minority interest no control features

Value of Control

Value of controlling a firm derives from the fact that

you or someone else would operate the firm differently from the way it is operated currently

Find out status quo value Revalue the company with a hypothetical optimal management team Difference is value of controlling

Value of Changing Management

SAP is a business software manufacturing company, headquartered in Germany. It has a well-deserved reputation for good management, especially when it comes to new investments; it reinvested 57.42% of its after-tax operating income back into the company and generated a return on capital of 19.93%. On both dimensions, it did considerably better than its peer group. The management is, however, extremely conservative When it comes to the use of debt and has a debt ratio of 14%; its resulting cost of capital is 8.68%.

Contd..
An aggressive management can change the financing mix and move the firm to its optimal debt ratio of 30% At a 30% debt ratio, the cost of capital is minimized at 7.95% Restructured Valuation with this change and arrive at a value of 118.70 Euros per share Value of control 12.6 Euros/share (12%)

Probability of control change

Status Quo $ 955 million $ 5.13 per share Optimally managed $2,323 million $12.47 per share The market price per share at the time of the valuation is currently $9.50 Ascertain the probability of control changing

Solution
Expected value per share = Status Quo Value + Probability of control changing * (Optimal Value Status Quo Value) $ 9.50 = $ 5.13 + Probability of control changing ($12.47 - $5.13) The market is attaching a probability of 59.5% that management policies can be changed.

Valuing voting and non-voting shares

With existing management in place, the value of a firm12.5 billion $ for the equity With aggressive debt policy the firm is revalued at 14.7 billion $ There are 242.5 million voting shares and 476.7 non-voting shares in the company Probability of management change is 20%

Solution
Value per non-voting share = Status Quo Value/ (# voting shares + # nonvoting shares) = 12,500/(242.5+476.7) = 17.38 $/ share Value per voting share = Status Quo value/sh + Probability of management change * (Optimal value Status Quo Value) = 17.38 + 0.2* (14,700-12,500)/242.5 = 19.19 $/ share

Quantification of VP

In Dual class Shares

Voting Premium A variation

Estimates of the voting premium have been found to range widely across countries:
510% in the U.S. (Zingales, 1995), 80% in Italy (Zingales, 1994).

Factors that explain this variation include

the degree of shareholder protection (Nenova, 2003) and the likelihood of a change in control in the company (Zingales, 1995)

How big is the value of control?

Assume that the status quo value for the firm is $ 100 million and the optimal value is $150 million, You would be willing to pay 51% of optimal value ($150 million) for a controlling stake and 49% of the status quo value ($ 100 million) for a minority stake. 2% in voting rights translates into a difference of $26.5 million in value

Sources of Empirical Data

Mergerstat Review published annually and quarterly Houlihan, Lokey, Howard and Zukin, Inc. (HLHZ) Control Premium Study Quarterly SEC

Control Premium Mergerstat data

Minority Discount

Valuing Minority interest

Horizontal computed by comparison with other minority interest transactions Top Down control value less applicable discounts Bottom Up start with minority value and add premiums for control interest valuations Most practitioners prefer horizontal and/or top down

Quantification of MD

Example from Mergerstat

Control Premium Vs SENSEX

Source: CFO Connect

Use of Mercers Equation

Value of Liquidity

Effect of Liquidity on Value

Less liquid Investments should trade for less than more liquid similar investments

Size of illiquidity discount depend upon

Type of Assets owned by the Firm Size of the Firm: Health of the Firm Cash Flow Generating Capacity Size of the Block

Empirical Evidences

Restricted Stock Private Placements Bid Ask Spread

Pre-IPO studies

Studies on Restricted Stock

Cross Sectional Differences : Restricted Stock

Siber (1991)

Illiquid Discounts

Johnson Study 1999

Total Sale $00 10 M $10 50 M $50 200 M Average Discount 23.5% 19.4% 17.7%

Over $200 M
Total Net Income Negative $0-1M $1-10 M Over $10M

13.0%
Average Discount 22.5% 26.0% 18.1% 06.3%

Johnson Study 1999

Transaction Size 0-5 $M 5-10 $M 10-25 $M Over 25 $M Average Discount 26.7% 20.9% 17.0% 10.8%

Net Income Margin Negative 0-5 % 5-10 %

10-25 %

Average Discount 22.5% 23.7% 15.2%

11.6%

Private Placements

Bajaj et al,

Bid Ask Spread

Damodaran (2000) regressed the bid-ask spread against annual revenues, with a dummy variable for positive earnings (DERN: 0 if negative and 1 if positive), cash as a percent of firm value and trading volume. Spread = 0.145 0.0022 ln (Annual Revenues) -0.015 (DERN) 0.016 (Cash/Firm Value) 0.11 ($ Monthly trading volume/ Firm Value) Plugging in the corresponding values with a trading volume of zero for a private firm should yield an estimate of the synthetic bid-ask spread for the firm. This synthetic spread can be used as a measure of the illiquidity discount on the firm.

Other Discounts

Other Discounts in valuation

Small company risk discount Key person/thin management discounts Lack of diversification discount Non-homogenous assets discount Specific company risk discount Market absorption and blockage discounts Investment company discount Information access and reliability discount Restrictive agreement discount Liquidation costs discount

Thank You