Page 56 - FINAL CFA II SLIDES JUNE 2019 DAY 8

LOS 33.k: Explain and evaluate the effects on READING 33: PRIVATE COMPANYVALUATION
private company valuations of discounts and
premiums based on control and marketability.
MODULE 33.4: VALUATION DISCOUNTS

The Discount for Lack of Marketability
If an interest in a firm cannot be easily sold, discounts for lack of marketability (DLOM) would be applied (sometimes termed a discount
for lack of liquidity). It is often the case that if a DLOC is applied, a DLOM will also be applied. For example, if a controlling shareholder
believes that a private firm should not be sold, minority shareholders both lack control and lack the ability to sell their position.

The DLOM varies with the following:
• An impending IPO or firm sale would decrease the DLOM.
• The payment of dividends would decrease the DLOM. Because they are applied in a sequential process, the DLOC
• Earlier, higher payments (i.e., shorter duration) would decrease the DLOM. and DLOM are multiplicative, not additive. So if the DLOC is
• Contractual restrictions on selling stock would increase the DLOM. 20%, and the DLOM is 13%, the total discount is:
• A greater pool of buyers would decrease the DLOM. total discount = 1 − [(1 − DLOC)(1 − DLOM)]
• Greater risk and value uncertainty would increase the DLOM. total discount = 1 − [(1 − 0.20)(1 − 0.13)] = 30.4%
This is not the 33% found when using an additive calculation.
To estimate the DLOM, an analyst can use one of 3 methods:

Method 1: Use the price of restricted shares is used. As an example, SEC Rule 144 may restrict the sale of shares acquired in a firm prior to
its IPO. In this case, the price of the restricted shares is compared to the price of the publicly traded shares.

Method 2: The price of pre-IPO shares is compared to that of post-IPO shares. One complicating factor is that post-IPO firms are generally
thought to have more certain cash flows and lower risk, so the estimated DLOM may not purely reflect changes in marketability.

Method 3: Estimate as the price of a put option divided by the stock price, where the put used is at-the-money. The time to maturity of the
valued option could be the time to the IPO. The volatility used could be based on the historical volatility of publicly traded stock or the implied
volatility of publicly traded options. The advantage of this approach over the other two DLOM estimation methods is that the estimated risk of
the firm can be factored into the option price. The drawback of this approach is that a put provides a certain selling price, not actual liquidity.

Although these methods provide a basis for calculating the DLOM, it is often challenging to implement them. The data may be limited, the
interpretation of the data will vary, and the magnitude of the DLOM applied to a company will vary by analyst. In addition to the DLOC and
DLOM, other discounts could be applied, such as key person discount.