Marketability Misconception

January 1, 2012

Marketability = Liquidity. The notion of a discount to value based on the marketability of the subject property has been around for a long time, and is based in the fundamental proposition that the market craves liquidity and loathes the absence of it. All else equal, a liquid (marketable, as if freely traded) investment should be worth more than an illiquid (less marketable, not freely traded) one. Actual performance of the market clearly demonstrates this phenomenon.

Marketability = Risk. The concept of a marketability discount seems to suggest the value of the subject business should be less because no one would want to buy it. The managing spouse often protests that the business should have a marketability discount because it’s not making money. But technically, this is incorrect: the desirability of the subject business as an investment should be addressed in the required rate of return (i.e., the capitalization rate or the discount rate). Less desirable businesses are riskier investments, so investors would require a higher rate of return on the expected income stream, irrespective of the size or velocity of the marketplace.

Discount Always Relative. For the business appraiser, marketability discounts, (more properly, adjustments for lack of liquidity or for difference of marketability) are critical to the accuracy of the valuation result. But the key thing to remember is that the marketability discounts are always relative to some reference point of value. For example, if the appraiser relies on transactions of public stock (a common benchmark for liquidity) as a source for the development of the discount rate, then the resulting value of the subject business is its value as if were as liquid as publicly traded stocks (which it is not). Without an adjustment to match the marketability (liquidity) of the subject business to the publicly traded stocks that were used as the basis for the discount rate, the value of the subject business may be significantly overstated.

Marketability Discount is Internal. In this sense, the marketability discount may be said to be internal to the methodology selected by the appraiser, and not closely related to the characteristics of the subject business except insofar as it is less liquid (i.e., would take longer to convert to cash than publicly traded stocks). In the conventional sense, the marketability adjustment only arises because the appraiser uses the rate of return obtained by investors in publicly traded stocks as the source for the benchmark rate of return in his discount-rate development. Were he to use a rate of return obtained by investors in privately-held entities - for example buyers/holders of shares in private corporations - as the benchmark rate of return, no such marketability adjustment would be required because the liquidity of the source for the benchmark rate is the same as the liquidity of the subject ownership interest. This is a watershed change in thinking (though not a new concept by any means) for many lay-thinkers.

Measuring the Discount. Once the decision has been made to rely on trades of publicly traded stocks as the source for the benchmark rate of return, the appraiser must next take steps to measure the extent of discount from the “as if freely traded” value that results from the application of the benchmark-based discount rate. There are a couple of good ways to measure the size of the discount to apply, and we’ll address these in a future issue.

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