The market share price of a listed public company represents the portfolio interest price. That is to say, the price an investor is prepared to buy or sell a small parcel of shares, typically less than 5% of the company.
In takeovers of listed companies, an acquirer is sometimes observed offering a premium above the market share price.
On this basis, some business valuers assume that the Equity Risk Premium and listed stock prices reflect minority interests and so a premium for control should be applied when valuing a controlling stake.
These are the views of a few experts:
According to Trugman (1)
“The ERP does not represent a minority or control position. I continue to see valuation reports that state because the rates of return come from the public market, the results are on a minority basis. This has been a consistent error by those uninitiated in the field of business valuation.”
According to Duff and Phelps (1)
“Some valuation analysts argue that the income approach always produces a publicly-traded minority basis of value because the capital asset pricing model and the build-up method develop discount and capitalization rates from minority transaction data in the public markets. This is not correct.”, “There is little or no difference in the rate of return that most investors require for investing in a public, freely tradable minority interest versus a controlling interest”
According to Pratt (2):
“More than anything else, when the cost of capital is used in the context of valuation, the question of whether the result of discounting or capitalizing represents a minority or a control value depends primarily on the nature of the cash flows being discounted or capitalized rather than on the discount or capitalization rate”, (2, page 151)
“Generally speaking, investors will not accept a lower expected rate of return for purchase of a controlling interest than for purchase of a minority interest. Control buyers pay premiums because they expect to do something to increase the cash flows, not because they are willing to accept a lower expected rate of return.” (2, page 153)
“If company cash flows are already maximized and the returns are already distributed pro rata to all shareholders, then there may be no difference between a control value and a minority value.”, (2, page 155)
According to Roger Ibbotson (3):
“When you are purchasing a company, you are acquiring the ability to potentially control future cash flows. To acquire this option to exercise control, you must pay a premium. Holding all else constant, it should not impact the discount rate”
And finally according to Eric Nath (4)
“Many valuation analysts believe that public company stocks trade at a “marketable noncontrolling”, or “marketable minority” interest level of value. In my opinion, this is simply not true.”
“Public stocks are non-controlling interests, but they do not trade as if they are. One of the simplest ways to test this assertion is as follows. Next time you are buying or selling public stocks, stop and ask yourself if you have adequately discounted the price because you personally were not able to appoint management, change the board of directors, set operational or strategic policy, change the course of the business, liquidate, dissolve, sell out, etc., etc., etc.”
“This basic mental exercise should suffice to illustrate how ludicrous it is to regard publicly-traded guideline company prices as reflecting “marketable minority” or “non-controlling” levels of value”
References
1. Gary Trugman, Understanding Business Valuation — a practical guide to valuing small to medium businesses (2018)
2. Shannon Pratt, Cost of Capital — Estimation and Applications (2002), Wiley & Sons
3. Roger Ibbotson, Ibbotson Associates Cost of Capital Workshop, Chapter 1, p 12
4. Eric Nath, Views on Control Premiums (2013), American Society of Appraisers (2013)
Simon Cook is a Chartered Accountant Accredited Business Valuer and Accredited Forensic Accountant.
