Understanding business valuation is like navigating a financial labyrinth. This blog post sheds light on a crucial aspect: valuation adjustments –– specifically premiums, discounts, and control premiums.
Why Adjustments?
Imagine valuing a rare painting. You might consider various factors like similar paintings that have sold (market approach) or the cost of materials and the artist’s time (asset approach). However, these derived values might not perfectly reflect the artwork’s true worth in the market. Similarly, valuation methods might yield values that require adjustments to reflect the specific circumstances of a business. This is where premiums and discounts come in.
The Foundation
Before applying adjustments, the appraiser needs to determine the “standard of value” –– the specific type of value being sought. Think of it as the destination on your valuation journey. Is it fair market value, or something else entirely? Knowing the destination helps determine the appropriate adjustments.
Discounts vs Premiums
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Discounts: These reflect a decrease in value due to limitations associated with the ownership interest being valued. Think of them as tolls you encounter on your valuation journey. Common examples include:
- Marketability Discount: Imagine a beautiful painting locked away in a vault –– it’s valuable, but not readily available for purchase. Similarly, a private company’s shares might be difficult to sell quickly, hence a marketability discount reflects this lack of liquidity.
- Minority Discount: Minority shareholders might have less control and influence compared to majority shareholders. This lack of control might warrant a discount.
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Premiums: These represent an increase in value due to certain advantages associated with ownership. Think of them as shortcuts on your valuation journey. A common example is:
- Control Premium: Imagine owning a majority stake in a company, giving you significant control over its direction. This control might justify a premium on the value of your ownership interest.
Determining the Right Amount
While the theories behind premiums and discounts are sound, determining the exact amount can be subjective and often becomes a point of contention. Appraisers consider various factors to quantify these adjustments, including:
- Type of ownership interest: Is it a controlling or minority stake?
- Cash flow distribution: Does the ownership receive regular dividends or distributions?
- Transfer restrictions: Are there limitations on selling the ownership interest?
- Holding period: How long is the owner expected to hold onto the interest?
The Valuation Journey
Valuation adjustments are typically applied to individual values derived from different valuation approaches (income, market, asset) rather than a final averaged value. By understanding these adjustments and the appraiser’s thought process, you gain valuable insights into the intricacies of business valuation.
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