CHAPTER Issues and Challenges in Valuation 6.1 Issues and Challenges in Valuation We have discussed the valuation methodologies under the three broad valuation approaches (marker, income and asset based}. We now turn to some of the issues and challenges that are commonly encountered by valuers in practice. A number of issues are generic in nature, in that the valuer needs to consider them regardless of the valuation approaches adopted. Others are only applicable when the valuer adopts certain valuation approaches. Table 6.1 shows the list of common issues faced by valuers in practice that we will address in this chapter, 6.2 Selection of Comparable Companies One key challenge in valuation is how to determine appropriately a list of com- parable companies for valuation analysis. This is often required for drawing up the valuation parameters when deciding whether to adopt the income or mar! approach. A considerable amount of time and effort has to be spent in carrying out a proper and thorough research, To kick-start the process, it is imperative to have an understanding of the business of valuation and the industry within which it operates. If the subject company has a single line of business, finding comparable companies with a similar business is a narural ching to do. However, if the company has multi-business lines, for example, if it is a conglomerate, to find comparable companies with similar businesses may not be entirely possible.CHAPTER 6 © Issues and Challenges Valuation TABLE 6.1 Common Issues in Business Valuation CHALLENGING Issues cost of capital (WACC) computation? 6.5 What are the considerations in using multiples in an economic crisis? 6.6 Is there a value of gaining control of a company? If yes, how do we | All approaches account for this value of control? 6.7 If there is a lack of marketability of the shares, should we account —_Alll approaches for the lack in the valuation? 6.2 How do we select an appropriate set of comparable companies for | Market approach valuation analysis? Income approach 6.3 How much is the equity risk premium (or market risk premium)? Income approach 6.4 Which is the debt-equity mix ratio to use in the weighted average Income approach Market approach In such instances, comparable companies in all of the subject company’s business may need to be considered. The chain of events involving the identification, selection and shortlisting of comparable companies requires a filtering process, from a large group of compa- rable companies to an appropriate list, based on the most relevant selection cri- teria. The resources used may include business and financial databases, analysts? reports and industry surveys. A typical process is depicted as follows: © Use industry classification as a start te shortlist comparable companics oper- ating in a similar industry. © Study the business description and review the characte listed companies and climinate those that are different from the subj pany. This would include taking into account size, risks, growth potential and soon. * Collect detailed financial information for all comparable companies (and the subject company). © Perform a financial analysis on the companies to determine whether they are good comparables from the financial standpoint and make adjustments to the ics of the short- Tom companies where necessary. It is important to note that in determining the set of comparable companies, one has to bear in mind that sample size does matter. A larger group of comparable companies reduces the importance of any single guideline company, and given the fact that companies are complex in nature, no one er two companies can approximate all the characteristics of a subject company. Using a larger group of comparable companies increases the likelihood that more of the subject's char- teristics can be captured. Subject to the availability of data, a common sample size adopted by valuers can be from five ro ten comparable companies. Where6.3 Equity Risk Premium = 125 the sample size is small, the valuer will need to clearly articulate the reasons why it is so. A gaod discipline to have, and also a common practice, is for the valuer to discuss with the management of the subject company and seek their views on the comparable companies shortlisted. The management should pos sess good knowledge of the industry and the competitive landscape and should provide valuable input to this process, As a best practice, the valuer should iden- tify a well-thought-out, filtered list of comparable companies and document the filtering process as well as the reasons for the selection and/or elimination of comparable companies. 6.3 Equity Risk Premium As you would have recalled, equity risk premium, which is also often referred to as market risk premium, is a key component of cost of equity. The equity risk pre= mium is defined as the difference between the expected rate of return on the risk- free rate and the expected return of the market portfolio, It is a forward-looking expectation-driven figure; that is, itis the extra return investors expect to receive by putting their money in a market portfolio in preference to a risk-free invest- ment. As such, it is not dircetly observable. By and large, there are two ways to estimate the equity risk premium: by the historical or consensus approach, Fach of these methods has its pros and cons and has been used by valuers in their com- putation of valuation parameters. The Historical Approach The realised equity risk premium is computed based on the difference herween the long-term average return on a highly diversified market-weighted stock index and the return on a risk-free investment over a long enough period. It is often assumed that if the measurement period is long enough, the histori- cal equity risk premium will provide an unbiased estimate of the equity risk premium, However, there is no consensus on the length of the measurement period, Besides the length of the measurement period, there are sever: surement inputs and methodologies. First is the choice of risk-free investment, The two risk-free investments that are commonly employed are the long-term government bond and the short-term treasury bill. The argument for using long- term government bonds is thar it is commensurate with the concept of equity risk premium which is the extra return that investors expect to earn over a long, investment period. On the other hand, the argument in favour of using roll-over treasury bills is that long-term government bonds are not really risk-free as they face inflation risk. Second, the historical period used in the measurement can also lead to a different value. Third, the average historical return can be com- puted using either a geometric mean or an arithmetic mean, Calculating geo- ‘metric Mean requires computing the ath root of the product of 1 + first return unsettled mea-126 TABLE 6.2 Equity Risk Premium in the United States and Japan Jnited States apan E CHAPTER 6 * Issues and Challenges in Valuation multiplied by 1 + second return, and so on, up to the nth return, and minus 1. This is shown in Equation 6.1. Geometric mean = W(T + R,) X (1+ RX (1+ RX (1 +R) — 16.1) where R = the rate of return per period; and n= the number of periods. ‘The geometric mean is the annual compounded return of the investment, which equates the initial investment to the final value of the investment. The arithmetic mean is simply the sum of all annual returns divided by the number of years, as depicted in Equation 6.2. R,+ Ry + Ri+ OR, (6.2) Arithmetic mean = tn It ignores the compounding effect of investment returns made in the previ- ous years and assumes the beginning investment amount for each period to be the same. Conversely, the geometric mean incorporates the compounding effect. Hence, the geometric mean return is always lower than the arithmetic mean return. The higher the volatility of the returns, the larget is the difference between the two averaging methodologies, As such, the equity risk premium calculated using geometric mean returns is lower than that of arithmetic mean returns. There is no consensus among practitioners and academics on these issues. The choice of these measurement inputs and methodologies will affect the value, For example, Dimson, Marsh and Staunton used 111 years of data (1900 to 2010) in their study and found thar the historical equity tisk premiums differ because of the choice of risk-free investment assets and the return computation methods. The equity risk premiums also vary across countries.! Their findings for the United States and Japan markets are summarised in Table 6.2. We used data from 1999 ro 2015 and found that the historical market risk Premiums relative to Singapore government bonds for the Singapore market were as shown in Table 6.3. Lonc-rerm Government BOND Geometric Mean 4.4% 6.4% Arithmetic Mean 5.0% Paul Marsh and Mike Staunton (2011). Credit Suisse Global Investment Returns Sourcebook, Zurich, Credit Suisse Research Institute.6.4 Capital Structure—impact on Value 127? TABLE 6.3 Equity Risk Premium in Singapore Geometric Mean Animmenic MEAN Singapore 2.82% 4.69% The Singapore market risk premium figures must be interpreted with care as the time period is too short; hence the noise in the estimation is likely to be significant. We can see that the historical equity risk premiums vary across the definition and the historical period, and they also vary across countries. Another key criti cism for using the historical approach is that the past may not necessarily be a good guide for the future. The Consensus Approach ‘This approach uses a consensus estimate of the market participants. It is often based on surveys among investors and professionals for their views on the expected equity risk premium, Unlike the historical equity risk premium approach, which focuses on the past, this is forward-looking. One of the annual surveys is by Fernandez, Linares and Acin.2 They asked the participants about the market isk premium they used to calculate the required retum to equity, Their results show that the consensus estimate of equity risk premium for the United States is 5.4%; Japan, 5.3%; and Singapore, 5.7%, Supporters of the expert consensus approach often cite the abundance of information available as a key plus while its critics often argue that the quality of the output is highly dependent on the investors’ and professionals” forward- looking capabilities and that the potential bandwagon effect is always bee oning. A point ro note, however, is that in determining the forward-looking numbers, the ‘experts’ tend to apply a shorter length of time in their computa- tion, resulting in the equity risk premium being subject to frequent revisions, Conceptually, if the life of the asset to be valued has a long duration, then the equity risk premium to be adopted should also reflect the same tenure. So whar is currently practised in the market? Both the historical and consensus approaches are used. From observations, valucrs in the region would use a mix of the long-term historical premium and the forward-looking expert consensus methods. 6.4 Capital Structure—Impact on Value 2. Pablo Fernandez, Pablo Assurvey with 8,228 answers’. Available ar SSRN 2450452 201 In valuing a business, a required input is its capital structure. Should valuers use the current capital structure of the company? Before we discuss the correct capi- tal structure to be used in valuation, we should understand the link between the company value and its capital structure. pares and Isabel Fernndez Acin (2014).*Market risk premium used in 88 councries in128 = CHAPTER6 + Issues and Challenges in Valuation The discount rate used to compute the company value based on the forecasted free cash flow to the firm (FCFE) is WACC. It is computed using Equation (4.26 which we reproduce below. WACC = -t) (4.26 where WACC = the weighted average of the cost of capital; E = the market value of equity; D = the market value of debt; K, = the cost of equity; K,, = the cost of debt; and t= the marginal tax rate. We can see that when the company changes its mix of debt and equity, WAC also changes. Debt is cheaper than equity as the debtholders demand a lower expected return because they assume a risk lower than that of the sharchald- crs. Furthermore, the debt interest expense is tax deductible. As such, WACC can be lower by using more debt. Molding all clse constant, a smaller WACC will increase the value of the company. The company can increase its value by simply increasing the proportion of debr im its capital structure, However, debt puts pressure on the company because, unlike share divi dend, debt principal and interest payments are obligations. If these obli tions are not met, the company may risk some sort of financial distress and the ultimate distress is bankruptcy. The financial distress will increase the cost of equity, reduce the FCFF and also increase the cost of debt demanded by lend ers. These costs will reduce the advantages to debt. The financial distress cost will be small if the debt level is low but will inerease as the debr level rises Thus, the capital structure decisions of a company involve a trade-off between the benefits of debt and the financial distress cost. A company’s WACC can be lower and its value rises when it moves from all-equity to a small amount of debt. Here, the financial distress cost is almost nil, However, as more and more debt is added, the financial distress cost rises at an increasing rate. At some point, the increase in the financial distress cost of additional debt will outweigh the gain in debe benefits, The company’s WACC will creep up and its value will drop. The debe level at the turning point is the optimal mix of debt and equity for the company. There is an optimal mix of debt and equity, at least in theory, for any individual company that yields the lowest WACC and the highest com- pany value. ‘The determinants of the value of a company are not just the investments it makes but also the mix of debt and equity it uses to fund its investments, Hence, the capital structure used in computing WACC should be the optimal mix of equity and debt, if a controlling ownership interest is to be valued and the stan- dard of value is fair market value.6.5 Using Multiples in an Econamic Crisis 129 Determination of an Optimal Mix of Equity and Debt Unfortunately, financial theory has not yer developed a generally accepted theory for predicting a given company’s optimal capital structure as the financial distress costs arc not easy to measure. The current capital structure may not he a good proxy for the optimal capital structure. This is because a company’s capital struc ture generally changes over time and thus the current weight may not reflect the optimal mix expected to prevail over the life of the business, It may merely reflect a temporary increase in borrowing or a swing in share prices before the manage- ment rebalances the financing mix. As such, the following are often being uyed as proxy for the optimal capital strueture instead. © ‘The target capital structure of the company. A company usually attempts to determine what the best mix of financing should be, based on the assessment of its business risk, tax position and financial flexibility needs, and other con- siderations. This target capital structure is then used as a guide for raising funds in the future. If the abjective of the management is to maximise the company valve in the long run, the target weight can be a candidate for the capital structure in WACC computation, © The average capital structure af comparable companics. If the company does not have a targeted capital structure or the valuers do not agree that it is an optimal capital structure, the average capital structure of well-performing comparable companies may be used. Empirical studies have not found conclusive evidence that there is a single optimal industry capital structure, but generally agree that industries are important in the determination of a co y’s capital structure. There may be several optimal capital structures within an industry based upon risk and technology choices. Hence, a careful selection of well-performing com- parable companies is important in using the industry average capital structure, However, it would be important to understand how the industry-average capi tal structure is derived and whether or not it is reasonable to expect the subject company to achieve it, given (1) the current conditions of the company itself and (2) the current financial market conditions. There are circumstances where the use of the actual capital structure is more appropriate than the optimal capital structure. For example, if the valuer is val ing the minority interest of a publicly traded company, the use of an actual mix of debr and equity will be more appropriate as the buyer/holder has no influence on the capital structure policy. 6.5 Using Multiples in an Economic Crisis Immediately following the 2007-2008 global financial crisis, the world saw a reca libration of stock markets globally and a remarkable slow-down in the transactic activities in the market. The stock markets were volatile and at a time when the market exhibited a high degree of uncertainty, share prices were greatly aff by many factors resulting in historical multiples of quoted companies falling. |130. CHAPTER6 + Issues and Challenges in Valuation performing valuations, especially when using the market approach, multiples of comparable companies or transactions (trading and transaction multiples) are key valuation parameters. In analysing the data derived from comparable companies ‘or transactions, the valucr has to thoroughly analyse each of these comparable companies or transactions with a view to identifying any specific factors that impact only the comparable companies’ share price and/or the parties of the trans- action, but may not have a direct bearing, on the subject of valuation, Adjustments are then needed to be made accordingly. In addition, when looking at transaction multiples (especially during economic downturns), itis important for the valuer to be mindful chat some of these multiples do reflect the distressed sale nature of the disposal given the state of the economy, and that such data when used, is consis- tent with the premise of value that presides aver the valuation engagement. As multiples are derived from prices quored on share markets and/or from M&A transactions, the valuer will need to be conscious of the impact of the following, when coming up with appropriate multiples to be applied: © Prices are influenced by external factors, that is, a boom/panic which is tem- poral in nature; © Prices from the share market could potentially be illiquid and often only a few trades are made, sometimes even over an extended period of times * Trading on the share market (and the resulting price) can be influence high-pressure promotional campaigns; © Large blocks may be traded pursuant to a takeover bid; and © The market may be uninformed or misinformed, by 6.6 Value of Control: Control Premium and Minority Discount ‘The right co control the business is often regarded as an important factor in deter: mining, the value of the business, For example, in a dual class share structure, the shares that have voting rights command a higher value than those that have no or limited voting rights, or acquirers often pay a premium to gain control of a busi- ness, There appears to be a value of control. Before we discuss how to determine the value af control, it is important for us to understand why there is a perceived value of controlling a business. This value of control comes from the belief that the acquirer would, and could, operate the target business differently from its current way of operation and the change would generate a better performance. There are two important conditions here for the value of control to exist. First, the target company is not well run. Second, the acquirer is able to change the way the business is being operated. The more badly run the target business is, the higher is the value of control. On the other hand, an optimally run business will have a zero value of control, The easier it is for the acquirer to implement necessary changes to the business operation, the higher is the value of control. However, sometimes obstacles may stand in the way of a successful implementation of changes, leading to a reduction in the value of control. For example, there may be a strong hostile union, or there could be terms6.6 Value of Control: Control Premium and Minority Discount 1391 in the shareholders’ agreement or provisions in the company’s Memorandum and Articles of Association that make it difficult to change the management. The value of contcol may exist even for a very well-run company. This second source of value comes from the synergistic benefits an acquirer can achieve from combining two companies. The additional value can come from financial sources such as the lower cost of capital from increased debt capacity or deployment of cash slack by combining a company with excess cash and a company with high return projects and limited cash, It may also come from operational sources such as greater pricing power from higher market share, higher growth in new markers or greater cost efficiency due to economies of scale. In summary, the value of control is derived from the belief that © The company can be better run by changing the way it is operated; and/or reated by combining the operations of two companies, © Synergy can be ‘The value of control also depends on the probability of successfully implementing the changes and realising the perceived benefits. The value of control will vary across different companies and situations. There is no simple rule of thumb that can be used to determine what it is worth. Levels of Value ‘The concepts of value of control or discount due to lack of control, are often pre- sented in a level of value diagram similar to Figure 6.1. There are four basic levels of value in the figure. Discount Non-marketable Minority Interest Value FIGURE 6.1 Value of Contral and Discounts132 CHAPTER6 * Issues and Challenges in Valuation Marketable minority interest value The third level of valuc in the figure represents the value of a minority inter~ est that is freely traded in an active market (c.g., share listed on an exchange). Marketable minority interests in publicly traded companies lack control over the affairs of the company, but the holder does have contral over the ability to sell the investment at will. The marketable minority interest value can be the starting point for developing the value of control interest by adding a control premium, Marketable control interest value The second level of value reflects the value of controlling interests in a market- able business without any synergistic benefits from the acquirer, or it reflects the value to the existing control party. We move from the marketable minority inter- est value to the control interest value through the application of a conceptual pure control premium. Marketable control interest synergistic value The cop level represents the value ro an acquirer who gains control of a business that is freely traded in an active market and can achieve synergistic benefits from the transaction, We should note that this value uses a different standard of value from the other three levels of value. We move from the marketable minority inter- est value to the control interest value through the application of a conceptual pure control premium and synergy premium. The combination of pure control premium and synergy premium is often referred co as the control premium. Non-marketable minority interest value The lowest level of value represents the value of minority interests of non-publiely traded companies for which there is no active market. Holders of such invest ments lack control over the affairs of the business and market liquidity and do not have the ability to sell the shares owned at will. This results in a lower value than the marketable minority interest value. The difference is caused by the appli- cation of the marketability discount, which we will discuss in the next section. Control Premium The difference between the marketable control interest synergistic value and the marketable minority interest value is called the control premium, The control pre- mium can be segregated into two levels: a pure control premium and a synergy premium. The first is the difference between the marketable control interest value and the marketable minority interest value which reflects a pure control premium. The second is the difference between the synergistic value and the marketable control interest value and is called the synergy premium. The marketable control interest value can also be referred to as the stand- alone control interest value. Take, for example, an owner of a 100% interest in a company. The owner controls the composition of the board and management and all decision making and has access to all the business cash flows, amongst other things.6.6 Value of Control: Control Premium and Minority Discount 133 The top level of value, that is, the marketable control interest synergistic value, reflects situations that include synergistic benefits. In this instance, not only does the acquirer have the control of the company but the acquirer is also able to extract synergies or cost savings as a result of say, a business combination. How can we incorporate the value of control in the estimation of the business The market approach The application of a value of control can be based on a robust analysis ef multi- ples observed from comparable transactions that reflect actual change of control Comparable transactions are recent or pending acquisitions of similar companies in the industry. However, this approach is often hindered by either too few trans- actions or the lack of publicly available information. Under such circumstances, valuers are forced to look at alternative approaches which usually involve estimating the marketable minority interest value of the valuation subject using quoted trading multiples of comparable companies. A control premium figure is then added to the estimated marketable minority interest value to arrive at the marketable control interest value. How do we determine the size of the control premium? Unfortunately, there is no formula that has been developed for us to determine the magnitude of the con- trol premium of cach valuation subject at hand. Generally, the control premium used is based on observations of premiums paid for takeover transactions in the marketplace. Typically, it is calculated as follows: Acquisition price — Pr Pre-annoucement price nnougement price ap (6.3) Control premium The pre-announcement price is the target company’s stock price unaffected by quisition announcement. Typically, it was the share price, say, a month prior to the announcement. This is to ensure that the share price used to deter- mine the control premium does not include any element of speculation lead- ing to the announcement of the day the takeover is made, The average control premium of many acquisitions over a period of time is then used as the control premium adjustment. In the Asian region, based on our observation which is anecdotal, the control premium typically applied by practitioners is in the range of 15% to 35% Criticism of this approach includes the possibility that pre-announcement prices have incorporated the market expectation of acquisitions as markets often identify potential target companies well before they are targeted, In such cases, the difference between the acquisition price and the pre-announcement price will not reflect the true control premium paid. Furthermore, besides ereating synergy or running the companies differently and better, there are other motives of mak- ing acquisitions. The observed premiums paid may not be the control premium Furthermore, our earlier discussion on the sources of the value of control should convince us that the existence of a control premium and its magnitude vary with each specific situation. The problem of using these rules of thumb aver age figures is thar they are not based on an analysis of the current valuation sub ject at hand,134 CHAPTER 6 © Issues and Challenges in Valuation It is important to note that in determining the appropriate level of premium to apply, the valuer needs to consider the specific circumstances surrounding the valuation subject. For example, the valuer needs to give due regard to the level of control associated with the sharcholding being valued, the level of control assoct- ated with the remaining sharcholdings operating either in isolation or collectively, and the potential size of synergy benefits. The control premium to be used ean be cross-checked with the control premium estimated using the income approach discussed below, The income approach For the income approach, we can directly account for the value of control in the discounted cash flow (DCF) method. The stand-alone control interest value can be estimated by incorporating those planned changes in operation that will affect the expected future cash flow estimation and the discount rate, For exam- ple, WACC can be reduced by changing the debt and equity mix, or the expected growth rate in the cash flow can be increased by increasing the retention ratio and re-invested in the business. The discounted cash flow value of the company computed in this case is the stand-alone control interest value or the marketable control interest value. The difference between this calculated DCF value and the value based on the starus-quo operating model is the pure control premium, The synergistic benefits can also be incorporated into the DCE method to derive the highest level value, that is, the marketable control interest synergist value. The difference between this calculated DCF value and the value based on the status-quo operating model is the control premium, which includes synergy premium and pure control premium, Alternatively, the valuer can also use the DCF method to estimate the stand- alone control interest value based on the status-quo operating model, and then add on a control premium at the end. Minority Interest Discount A holder of a minority interest in the issued shares of a company generally has a passive investment and cannot, for example, initiate a sale of assets of the com- pany or change its dividend policy. Trading multiples derived from quoted com- panies reflect a marketable minority interest value, Alternatively, the value could also be obtained indirectly by applying a relevant minority interest discount to the control interest value or the contral interest synergistic value, No direct mar- ket evidence exists to support the quantum of a minority interest discount. Such discounts are often imputed from control premiums. 1 ~ 1 + Control premium Minority discount = 1 (6.4) For example, a control premium of 20% would be equivalent to a minority discount of 16.67%, Typically, based on our observations which are anecdotal, the quantum of the minority interest discount applied by valuers in the region is in the range of 15% to 25 % % (round off to the nearest 5%). However, the selection of an6.7 Lack 6.7 Lack of Marketability 135 appropriate discount is again based on specific circumstances surrounding the valuation. They include whether you are applying a discount to the stand-alone control interest value or the control interest synergistic value, and the level of influence (if any) associated with the shareholding being valued, and the level of control associated with the remaining shareholdings operating in iso- lation or, in some cases, collectively. In a setting involving unquoted shares, the terms of any shareholders’ agreement or the provisions in the company’s Memorandum and Articles of Association may be critical in considering the necessity and/or quantum of the discounts to be applied. For example, in the case of Chong Barbara v Commissioner of Estate Duties [2005] SGHC 1 a shareholding of 14.7% of issued capital can only have 3.5% of the voting rights as the articles of association ensure the founders’ control of the com- pany by granting the holder of the founder's shares 20 votes for each founder's share as compared to one vote for each ordinary share. In addition, the subject company is obliged to transfer the gains on the sale of investments in shares and properties to the capital reserve account and is not allowed to distrib- ute the gains by y of dividends to shareholders. Such disadvantages would further aggravate the value of a minority stake of ordinary share (‘which would effectively be at the mercy of the controlling shareholders’) and would ‘additionally be subjected to the whims of holders of founder's shares’ and therefore would expect a high discount for the value of such minority inter- est of ordinary share. In certain instances, the terms of restriction may place a cap on the quantum to be applied. Hence, the valuer will have to take this into account and consider the impact of such terms when doing the work. of Marketability The lack of marketability is often regarded as an important adjustment in derer- mining the value of business and asset that is not readily marketable, The term “marketability discount’ is used to describe the discount applied. Restricted shares, which are identical to freely traded shares except that they cannot be sold on the open market for a given period, often sell at a discount compared to freely traded shares. Privately owned business often takes months or even years to sell a controlling interest in the business, and it may be almost impossible to sell minority interest as the holders typically face restrictions that aftect their ability to transfer ownership interests. The longer time horizon to complete the sales and convert the business into cash creates risks and costs that should affect value. These risks and costs include the time value of money and the uncertainty as to the eventual sale price due ro unfavourable market-specific or business-specific events during the sale period, Hence, a marketability dis- count is often applied to the non-marketable minority interest value. However, there is no consensus among valuers an whether a marketability discount should be applied to a non-marketable controlling interest value. We will discuss this point later. If the lack of marketability affects value, how can thar be quant ation subject which is a non-marketable minority interest stak dina valu-136 CHAPTER 6 » Issues and Challenges in Valuation The Market Approach ‘The application of marketability discount is based on an analysis of multiples that are derived from the actual acquisition of minority holding in comparable private companies, However, this approach requires two things: the availability of an adequate number of transactions involving private companics that are similar in their characteristics to the valuation subject, and that these transactions are on public record. The alternative is to estimate the value from multiples based on ‘freely trade- able’ and publicly traded comparable companies, and discount that value by applying an estimated lack of marketability discount. Marketability Discount 4 Robert Reilly and Aaron Rotkowski (2007). “The discou vs of current conteowersies", The Tax Lawyer 61(1): 241-286, sncis A. Longstaff (1995), How much can marketabi 4 The marketability discount needs to be estimated either by the theoretical model or by the empirical method. The theoretical approach is to estimate the marketabilit iscount using the option pricing theory. Readers who are interested in the theoret- ical model can refer to Longstaff’s study.’ Although the theoretical approach may lack acceptance in the practitioner’s community, Longstaff’s study provides inter- esting insights: the marketability discount (or cost of illiquidity) increases with the length of the expected marketing/holding period and volatility of the business. For the empirical method, there are sve common approaches being used to estimate the marketability discount, One approach is to estimate the marketabil- ity discount using the price discount on the sales of restricted shares of publicly traded companies. There are many studies in the United States using the restricted shares approach. Using data from 1966 to 2006, 17 restricted stock studies have found discounts ranging from 13% to 45 Another approach is to quantify the discount by studying the price discount on private placement prices prior to an initial public offering (IPO). The two widely discussed studics are by John Emory (average discount rate found is 45% over the period 1980 to 2000) and Willamette Management Associates (average discount rate ranges from 23% ta 56% over the period 1975 to 2002). The major criticism of this approach is that the pre-IPO discounts are likely to reflect factors other than differences in marketability. For example, the discounts might reflect compensation given to insiders who provide services to the company. Reilly and Rotkowski provide a good summary of various restricted stock studies and pre-IPO studies.! In the Asian region, based on our observations, the marketability discount for minority interest typically applied by practitioners is in the range of 10% to 30% Given the wide range of discounts found in the empirical studies, the valu should not naively select a discount based on the average price discount from these studies. If the valuers decide to use a marketability discount from an empirical 1S affect yecurity values? Jourial of Finance 50, for lack of marketability: Update on current studies and6.7 Lack of Marketability 137 study to account for the lack of marketability in the valuation, they need to ha a thorough understanding of how the valuation subject compares to the intere analysed in the empirical study. A downward or upward adjustment relative to © selected benchmark may need to be made based on the unique company-specitic factors that would have an effect an the markerability discount. Below are se issues that are likely to have an impact on the adjustment, © Ifthe private company is planning to be listed or to be sold, the discount should be lower as the likelihood of converting to cash is higher. The higher the probability of listing, the lower should be the marketability discount. © The presence of contractual transferability restrietions that restriet the trans- fer of shares will increase the marketability discount. © Ifthe private company pays a high dividend regularly, the buyer of the minor stake does not need ro depend entirely on the prospect of selling the stake in the future to realise the return. The size of a marketability discount should be lower, © The size of the non-marketable minority interest will affect the discount rate. The larger the size of the minority interest, the harder it is to sell, This is, because fewer buyers can afford it. * The more volatile the operating cash Flow, ea pany, the harder it is to sell. A higher marketabi nings or revenue of the com ity discount is required, Non-Marketable Controlling Interest So far, our discussions on marketability discounts have been larg the valuation of a minority interest stake in a private company, What about the valuation of a 100% controlling interest of private companies? Do we still apply a marketability discount? There is no consensus amongst valuers, The opponents of marketability discounts argue that owners of private companies are free to sell their shares to a willing buyer unlike minority interest holders who often face rictions when they transfer ownership. Furthermore, they have no control over the cash flows and other benefits which determine the value of the business, during the expected holding period. The premise of the proponents of markerabilir owners are free to sell their shares, there is no readily a Furthermore, there exist uncertain- restricted to, discount is thar although ble market into which to sell their shares. There is a lack of liquidit tics as to the eventual sale price related to the marketing period Both arguments have their merits, and which argument is more valid will depend on the specific circumstances of each case under consideration. For exam- ple,a 100% controlling interest of a very profitable company in a mature indus- try during a strong economy period may justify a zero marketability discount ‘The valuers need to exercise their professional judgment. Generally, we can accept that a controlling stake in a private company will be more valuable than a minority stake, Hence, the size of marketability discount should vary with the size of ownership. The small minority holder suffers most from a lack of marketability and the discount is greater for the small uninfluen tial holdings. The marketability discount, if any, is applicable to the valuation of 100% controlling interest of private companies should be less than that applied valuing unlisted minority interests.138 © CHAPTERG * Issues and Challenges in Valuation The Income Approach The value of the non-marketable interest can be estimated using the DCF method as if it was readily marketable, and then adjusted for lack of marketability by applying a marketability discount. Another income approach is to increase the discount rate by adding a lack of marketability premium (or illiquidity premium) to the cost of equity. The premise of this approach is that buyers/holders of non-marketable assets require add tional return for bearing the illiquidity risk. The higher cost of capital will yield a lower estimated value for a non-marketable private company than the value of a comparable publicly traded company using the DCF method. However, similar to marketability discount, the estimation of illiquidity premium is challenging, Acharya and Pedersen,’ and Bekaert, Harvey and Lundblad® are two groups of theoretical researchers that studied the link between illiquidity risk and expected return, 6.8 Summary This chapter highlighted several common challenging and unsettled issues in valuation. The valucr, in performing his/her work, is constantly faced with com- plex issues that pose new challenges. Hence, it is of utmost importance that the valuer must keep abreast of developments in the valuation space, be continuously engaged in learning and development and upgrade his or her technical competen- cies, so as to be well equipped te deal with the ongoing challenges. 5. Viral V, Acharya and Lasse Heje Pedersen (2008). Asset pricing with liquic ): 375410. 6. Geert Heksaert, Campbell R. Harvey and Christian Lundblad (2007). Liquidiry and expected returns: Lessons fram emerging markets’, Review of Financial Studies 20(6): 1783-1831. risk’, Journal of Sinancia Economies