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With differences from entity to entity in corporate documentation (constitutions, shareholders’ agreements, etc.), returns to shareholders’ and the composition of assets and liabilities, there is no one-size-fits-all approach to the valuation of a minority interest.
The most obvious issue faced when assessing the value of a minority interest surrounds the discounts (if any) that should apply. To dive deeper into the minority interest discounts, you can view our previous article.
However, the valuation methodology is also crucial in the assessment of the value attached to a minority interest with some commonly adopted valuation methodologies including an implicit minority interest discount, a factor often overlooked by lawyers, advisors and even business valuation professionals.
The most common valuation methodologies for a minority interest is:
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:
[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:
This valuation methodology requires:
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.
Within the above valuation methodologies, the application of minority interest discounts (such as discounts for lack of control and marketability), are implied within the DCF and CFMD methodologies as opposed to the FME and ABV methodologies which require an additional assessment of the appropriate discount (if any) that should apply, discussed below.
The DCF that values the dividend stream and the CFMD methodologies calculate the value of an investor’s interest in a company having regards to the anticipated or expected cash flows or dividends to which the investor can reasonably expect to receive in the future.
On that basis, any discounts for lack of control or lack of marketability are already implied in the discount or capitalisation rate applied. As such, no separate discounts for lack of control or lack of marketability are required under these methodologies.
The CFME and ABV methodologies calculate the total value of an entity (100%) in the first instance ordinarily on a control basis unless otherwise stated. The investor’s interest in the entity is then calculated at first instance as a portion of the total value of the entity on a pro rata basis.
On that basis, in situations where the interest represents a holding of 50% or less, it is necessary to consider whether in determining the fair market value of the interest being valued a discount should be applied to recognise the lack of control and the lack of marketability of the shares held by the investor.
As with any valuation engagement, the type(s) of valuation methodologies available for experts is dependent on the information available, so not all of these methodologies may be able to be undertaken in a specific engagement. However, it is critical that the right advice is obtained in any valuation engagement, particularly those involving a minority interest.
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