The stock market is essentially a marketplace where the buyers and sellers of stocks and other derivative products interact with each other and transact under certain rules and regulations that safeguard the interest of all parties. The market is supposed to function in an "efficient" way that leads to price discovery, negating arbitrage opportunities as the price adjustments take place based on demand and supply while providing free information to one and all. Whether the markets are actually efficient and the prices are not manipulated with synthetic demand and supply is a topic of discussion for another day! But one can’t deny the fact that the market provides "liquidity" to the investor. Liquidity is defined as the efficiency or ease with which an asset or security can be converted into ready cash without affecting its market price.
One can easily buy or sell the listed stocks on an exchange without having to worry about finding a seller or a buyer. What happens when you own stocks of a private company? You can’t sell them on an exchange as those are not listed and moreover, the stocks will have restrictions of their own in terms of transferability. Suppose you know a stock whose value is $50 and it is publicly traded, we can easily sell it for $50 (or close to $50 depending on the market depth and the bid-ask spread). Now imagine you hold a stock whose fair value is $50 and it is a private entity. Firstly, note that we have added the word "fair" as the stock is not traded, the price has to be computed using valuation techniques and fair value is defined as the price agreed upon by a willing buyer and seller, assuming both parties are knowledgeable and enter the transaction freely. Secondly, as the stock is of a private entity’s do you think we will get the same $50 amount when we try to sell it?
Definitely No! The buyer will argue that the stock is a hard sell and he will ask for a discount and you will end up getting say around $40. This difference of $10 (fair value of $50 minus the consideration received of $40) is nothing but the Discount for Lack of Marketability. A discount for lack of marketability ("DLOM") reflects the lack of a ready market for an interest in a privately-held enterprise. A marketability discount is applied to compensate an investor for the limited ability to readily convert an illiquid asset to cash. The marketability of an interest in a publicly-traded stock has added value over the interest in a privately-held entity because it may be converted into cash quickly with less risk of loss of value. The net difference in price attributable to a lack of liquidity is typically expressed as a percentage discount from the gross value and is referred to as a lack of marketability discount.
A discount for lack of marketability is commonly applied to the stock of a company to reflect the lack of a recognized market for the stock and the fact that such stock is not readily transferable. Investors typically prefer investments that have quick access to a liquid secondary market and that can be readily and efficiently converted into cash. All other factors being equal, shares of stock without such marketability characteristics would sell at a discount when compared to shares that do possess such marketability characteristics.
Some of the common methodologies of computing the DLOM is:
Protective Put*
The method was first described by David Chaffe in 1993, and it serves as the foundation for other option-based methods. In this method, the discount is estimated as the value of an at-the-money put with a life equal to the period of the restriction, divided by the marketable stock value. Intuitively, by purchasing an at the-money put option, the buyer guarantees a price at least equal to today’s stock price, thus creating liquidity.
Longstaff*
In 1995, Francis Longstaff published an article in the Journal of Finance that describes an upper bound on the discount for lack of marketability based on a lookback option. Intuitively, in liquid security, an investor with perfect market timing ability would sell the security when the value is highest. Longstaff also correlated his results to restricted stock studies using a volatility input of 10 percent for low volatility companies and 30 percent for high volatility companies. The Longstaff model provides a wide upper bound because an average investor will possess imperfect market timing ability, and, therefore, the investor is unlikely to attain the maximum value of the security. Thus, it is generally believed not a reasonable method for estimating discounts when used with observed market volatilities, because the upper bounds do not correlate well with observed market discounts and in fact rise in excess of 100 percent for high volatility securities with long restriction periods.
Finnerty*
In 2001, John Finnerty proposed a model that assumes the investor does not possess special market timing ability and would be equally likely to exercise the hypothetical liquid security at any given point of time. The value of marketability is modeled as the present value of cash flows. The Finnerty method addresses the issue of assuming perfect market timing in the Longstaff method (see below) and the issue of assuming protection on the downside while still realizing appreciation on the upside in the protective put method (see below). Finnerty also performed a regression analysis to restricted stock studies, adjusting to remove other significant factors such as concentration of ownership and information effects, and found that after isolating the marketability-related factors, the discounts predicted by his method are consistent with the data. Finnerty presented an updated version of his model at the American Society of Appraisers Advanced Business Valuation Conference in October 2009.
Asian Put*
The Asian protective put is a variant of the protective put method that is preferred by some practitioners because it estimates the discount based on the average price over the restriction period rather than based on the final price. This method is conceptually similar to the Finnerty method but is estimated as an average price Asian put (which measures the difference between the current price and the average price over the holding period), rather than an average strike Asian put (which measures the difference between the average price over the holding period and the final price). The discounts predicted by this method are uniformly lower than those for the protective put, are lower than the Finnerty method for low volatility stocks, and are higher than the Finnerty method for high volatility stocks.
There are many studies as to what should be the actual DLOM that reflects the true discount that the market offers, however, there is not a single shoe that fits all. The purpose of this article is to give a general idea as to what DLOM is and the standard procedures described by the guide. Until next time..
*Source: AICPA Accounting and Valuation Guide - Valuation of Privately-Held-Company Equity Securities Issued as Compensation.
The author is a CA, MBA, FRM L1 working in the field of business valuation. He is also pursuing MScFE and has experience in pricing private equities using OPM, PWERM etc.
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