Common valuation methodologies for minority interests

A DCF valuation is based on the generally accepted theory that the value of an asset depends on the future net cash flows discounted back to a present value at an appropriate discounted rate.

Discounted cash flow valuations are the most technically accurate method of valuing an asset or business. They are particularly suitable to valuing discrete assets with finite lives. However, they suffer from the practical impediment that few companies have prepared cash flow forecasts of sufficient reliability over the necessary time frame to apply a DCF.

They involve the calculation in current dollar terms of the present value of the future net cash flows which are forecast to be derived from the asset in question by discounting those cash flows at a discount rate which reflects both the “time value of money” and the specific investment risk. When the cash flows to be discounted are “ungeared”, or before deducting the cost of debt finance, the discount rate is referred to as the weighted average cost of capital or “WACC”. 

The Discounted Cash Flow method is based on the principle that the value of any asset is the present value of the future cash flow stream from that asset. The risk associated with the future achievability of that cash flow is reflected in the discount rate that is used to convert the future cash flows to a present value.

In assessing the value of minority investor’s interest in a company, the DCF method can be used by assessing the future net cash flows of dividends paid to the investor, discounted back to a present value at an appropriate discounted rate.

However, in situations where we are valuing a minority interest in a profitable company which has not paid a dividend(s) in recent years, it may be assessed as “the present value of the eventual return such shares might offer to a prospective purchaser.”[1]

The valuation of the minority interest under a DCF methodology requires the following:

• an assessment of future maintainable profits;
• consideration of the factors influencing dividend policy;
• an assessment of the proportion of the profits that might be distributed; and
• an assessment of the length of time that can be expected to elapse before such a distribution is made.[2]

 
[1] Wayne Lonergan, The Valuation of Businesses, Shares and Other Equity, Page 143 – 144

[2] Wayne Lonergan, The Valuation of Businesses, Shares and Other Equity, Page 144

The capitalisation of future maintainable dividends seeks to represent the net present value of the future income stream available to a minority shareholder(s) (i.e. their return on investment), whereby “the value of such a shareholding generally ultimately lies in its right to receive dividends.”[1]

This valuation methodology applies particularly to minority interest holdings in private companies[2] and is commonly applied in situations where:

• the minority shareholder(s) have a limited / no ability to impact the key operational or financial decision(s) of a business such as the payment of dividends or sale of the business and/or its assets; and/or
• there is a restriction in the ability of the minority shareholder(s) to realise their interest in the company by way of a share sale.

This valuation methodology requires:

• the determination of a future maintainable distribution of a business, usually net profit after tax being the taxable surplus available for distribution to the shareholder(s); and 
• an appropriate dividend payout ratio.

The proportionate future maintainable dividend(s) available to a minority shareholder(s) are capitalised at a rate (dividend yield) considered appropriate for the particular business, taking into account internal and external factors such as risk, competition, prevailing returns and the nature of the industry in which the business operates.

 
[1] Wayne Lonergan, The Valuation of Businesses, Shares and Other Equity, Page 119

[2] Wayne Lonergan, The Valuation of Businesses, Shares and Other Equity, Page 123

Where an entity actively trades, it may be appropriate to value the entity on the basis of capitalised earnings and a comparison of results obtained with assets utilised in generating that income.

Under this method of valuation, it is necessary to determine the future maintainable earnings of a business. Such determination is generally made by reference to the past earning capacity of a business as disclosed in the financial statements, including the elimination or adjustment of items of an exceptional or non-recurring nature.

The future maintainable earnings are then capitalised at a rate considered appropriate for a business of that nature, taking into account factors such as risk, competition, prevailing returns the nature of the industry in which the business operates.

The result obtained by the capitalisation of future maintainable earnings is then compared with the net assets employed by a business and utilised in the generation of those earnings (“Net Business Assets”). Where the capitalised value of a business exceeds those net business assets, the difference is generally referred to as intangible, including goodwill.

Where an entity does not actively trade or the value of the net operating assets is greater than the Enterprise Value calculated using an income based approach (such as the capitalisation of future maintainable earnings approach), it is usually appropriate to value the entity using the adjusted book value method. This method utilises the book value of assets and liabilities, with adjustments as necessary to show those assets and liabilities at their fair market value.