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Introduction where the risk-free rate (i) is the payback from the
One of the main problems in business valuation when investor when he or she invests in treasury debt issued by
we apply the Discounted Cash Flow Model (DCFM) is solvent countries, and the risk premium (P) is the
how to include risk from the uncertainty associated with difference between the average return on capital markets
future cash flows (CFs). It could be done, either in the CF and the risk-free rate and represents the extra return
or in the discount rate (ke). When it is included in the CF, required for investing in risky equity rather than investing
we are dealing with the certainty equivalent method (Cea in risk-free assets. Generally, higher risk commands a
higher premium, and therefore the required return has to
1979) or approach of the expected CF. However, if risk is
be higher.
included in the discount rate, then it is assumed that only
As risk is a relative concept (Holton 2004) associated
one rate exists that must be accepted by investors or
with each investor as a function of the uncertainty of the
shareholders, representing the risk assumed by the
expected CF (Mascareñas 2004), each one has a different
company (Cea 1979). This method is known as ‘‘discount
discount rate, although, statistically, the existence of a
rate method with risk’’ or ‘‘traditional approach.’’
single accepted rate. <
Although the use of the first method is suggested by
Research on the discount rate has been focused on
the IASB 36 (2004) and AECA (1981), nearly all of the
publicly traded companies, with a wide theoretical
research works and professional developments have been framework around them, which considers that the
focused on the latter. investor can diversify their investment and he or she
According to this process, the minimum return required make it liquid through the market. The investors want to
by an owner or investor when investing resources on a achieve a minimum return acting as a Purely Financial
publicly traded firm is the sum of two elements: a risk- Investor (PFI), without risk in a particular company (one
free rate (i) plus a risk premium (P): share) and with the maximum liquidity through the
ke ~izP, ð1Þ market. Thus, a rational PFI diversifies his or her
investment, looking for a portfolio that includes all
securities in proportion to their market participation.
Juana Alonso Cañadas holds a PhD in Financial
However, a ‘‘completely diversified’’ portfolio will not
Economics and Accounting from the Universidad de
eliminate risk entirely. The risk that cannot be eliminated
Almeria. She is a Lecturer in Financial Economics and
Accounting at the University of Almeria. by portfolio diversification is called ‘‘undiversifiable
Alfonso A. Rojo Ramirez holds a PhD in Economic risk’’ or ‘‘systematic risk,’’ since it is the risk that is
Sciences and Business from the Universidad Autón- associated with the market.
oma de Madrid. He is a Professor in Financial So risk premium could be broken down into two risk
Economics and Accounting at the University of factors: a market factor that cannot be eliminated (market
Almeria. risk premium, PM) and another specific factor of the
company that can be eliminated by means of diversifi- same nest’’ (Damodaran 2002). In other words, if the
cation (specific risk premium, Pe): market had perfect liquidity and all investors diversify
P~PM zPe : ð2Þ their investments, companies would not focus on a
specific activity, because as financial theory shows, they
According to Bruner et al. (1998), Welch (2000), and would act in an inefficient way.
Graham and Harvey (2001), the most commonly used Because of this nonfinancial behavior of some
method in practice to estimate the risk for an investor is the investors and company owners (economics risk investors
CAPM (Sharpe 1964), where the expected return of a PFI [ERIs]), they fall into a high-risk position and must be
(ke) is the sum of the risk-free rate (i) and the risk premium rewarded with an extra return, as they are assuming a role
(P). P depends on the total market risk and the volatility of that a PFI does not. In particular, this is true in the case of
an asset, but not on the specific risks, because these can be PHC, for which there is no market that gives them
eliminated throughout the investor’s diversification: ‘‘good’’ liquidity (Damodaran 2002).
k ~Rf zbi :ðRM {Rf Þ:
e ð3Þ As a consequence, the CAPM model, even being used
in practice, cannot be appropriate for ERI, as it is
The expression RM 5 Rf is the market risk premium
necessary to find a new approach to estimate the discount
(PM) or systematic risk, and b can be described as a
rate that allows us to include the lack of liquidity and the
measure of responsiveness of the returns on a company’s
risk derived from nondiversification in order to make a
shares compared to the returns on the market as a whole; correct valuation in the case of PHC or, in general, in
that is, the risk that a specific investment adds to a valuing nontraded companies.
diversified portfolio. PM is calculated by using the The aim of this paper is to examine whether the
historical prices of shares of quoted companies and b Spanish AECA’s proposal allows us to solve the discount
by the following expression: rate calculation problem for PHC, including a premium
Cov(i,R M ) due to illiquidity as well as nondiversification. This paper
b~ : ð4Þ
Var(R M ) is organized as follows: the next section reviews previous
literature; the third section lays out the AECA model
This model has been tested empirically concluding the
framework; the following section explains the goal and
existence of a positive linear relationship between an
shows the data, and the last section summarizes the main
asset’s return and beta (Fama and MacBeth 1973).
conclusions.
Nonetheless, it has been criticized recently, for two
reasons in particular: first, the difficulty in obtaining the Literature Review
single risk of a share and, second, the fact that the model Researchers have studied the illiquidity or the lack of
is based on past data to estimate the future capital cost marketability1 from two different fields, which we discuss
(Fernández and Carabias 2007; Gebhart, Lee, and separately.
Swaminathan 1999). Consequently, alternative models
have arisen such as the Arbitrage Pricing Theory (APT) Illiquidity and microstructure of
(Ross 1976), the multifactorial models (Chen, Roll, and financial markets
Ross 1986; Nieto and Rubio 2002), ‘‘proxy’’ models On the one hand, from the point of view of the market
(Fama and French 1992), extended models of CAPM and the CAPM model, investments can be commercialized
(Godfrey and Espinosa 1996; Solnik 1974), models based in a continuous way and to an unlimited amount, although
on accounting data (Beaver, Kettler, and Scholes 1970; it recognizes that investors face liquidity constraints in
Gebhart, Lee, and Swaminathan 1999; Miralles and virtually all financial markets (Longstaff 2001). Previous
Miralles 2002; Moya 1996; O’Hanlon and Steele 2000; studies show that the illiquidity problem makes investors
Rosenberg and Guy 1976), or models based on demand an extra return, which depending on the portfolio
professional opinions (Farrelly, Ferris, and Reichenstein can be approximately 7% to 18%, which is included to
1985; Welch 2000). compensate for the extra risk-premium (Lonsgstaff 2001).
Certainly, the CAPM model works for PFI who have Some researchers try to prove the existence of a FX
the opportunity to diversify their investments through a relation between the market liquidity, measured on the
liquid market, although neither markets are completely
liquid, nor have investors always had the opportunity to 1
For purposes of this article, we will use the terms illiquidity and lack of
diversify their investments, particularly if we are talking marketability as synonyms, although some authors make a distinction. For
about privately held companies (PHCs) whose owners example, Pratt (2001, 00) says ‘‘illiquidity and lack of marketability are
related but distinct. As with all valuation adjustments, it is important to
=
often focus on their business ‘‘putting all its eggs in the identify the base of comparison to which the adjustment relates.’’
Table 1
Studies about Illiquidity in Financial Markets
Source: Authors.
Note: This table shows a classification of relevant studies about market illiquidity according to the main goal of the various works. Four
groups exist: the first analyzes the relation between two variables: return and illiquidity; the second, the seasonal behavior of that
relation; the third, possible causes of illiquidity; and the fourth, the common determinants of liquidity.
holding period. Previous studies indicate that the values of business valuation by DCFM that includes, inter alia,
DLOM range between 20% and 50% (Hood, Mylan, and nondiversifiable risk and the effect of lack of liquidity.
O’Sullivan 1997; Kania 2001) in spite of the findings of The discount rate is based on aggregation of the risk-
Kania (2000), who points out that neither appraisers nor free rate (i) plus two premiums: one for market risk (PM)
researchers have made any definitive conclusions. and the other to reflect a specific business risk (Pe):
On the other hand, three authors have chosen the
ke min ~izPM zPe : ð5Þ
theoretical foundations underlying in the DCF model in
order to include the illiquidity discount. First, Tabak The idea underlying expression 5 is that an ERI who
(2002) suggests a model based on the CAPM and the invests his or her resources in a PHC requires a higher
equity risk premium. Second, Mercer (2003) designs the risk than a PFI who operates in the financial market,
Quantitative Marketability Discount Model (QMDM) to according to the degree of diversification and liquidity.
employ the basic discounted cash flow model to value Therefore, an ERI will demand at least a minimum return
illiquid interests of PHC in the context of appraisals of the such as the PFI plus a premium Pe (AECA 2005, 38)
relevant business companies. Finally, we can find the whose estimation, under AECA proposal, requires that it
proposal of AECA (2005) that suggests an alternative starts from the premise that economic and financial risk of
discount rate instead of CAPM to value PHC by DCF, the company is reflected in its profitability (Penman
which is explained and tested in the following sections. 2007, 693). Taking this hypothesis as a starting point, Pe
AECA’s Discount Rate could be calculated by the following expression:
si
AECA2 (2005) issued a standard about PHC valuation Pe ~u:PM ~ (RM {i), ð6Þ
sM
that suggests a discount rate (ke) for owner-investors that
could be extended to nonpublicly traded companies. This where
standard proposes a discount rate that should be used in u is the coefficient of variability of returns or total beta (bT)
si is the standard deviation of financial profitability of the
2
The Spanish Accounting and Business Administration Association is a
privately independent standard setter in accounting, finance, and manage-
company after interest and taxes
ment (http://aeca.es/queesaecaingles.htm). sM is the standard deviation of market return.
Table 2 Table 4
Summary of RSE Studies Summary of VM Studies ?
Years Average Empirical Study Years Covered Average DLOM (%)
Empirical Study Covered Transactions DLOM (%)
Koeplin, Sarin, and
SEC* 1966–1969 398 25.8 Shapiro 2000 1984–1998 22.28–53.85
SEC{ 1966–1969 338 32.6 Block 2007 1984–2006 16.25–27.10
Gelman 1972 1968–1970 89 33.0
Trout 2003 1968–1972 60 33.5 Source: Authors.
Moroney 1973 1969–1972 146 35.6 Note: The third group of studies attempts to estimate the
Maher 1976 1969–1973 — 35.4 DLOM comparing acquisition prices for public and private
SRC 1978–1982 28 45.0{ companies; that is, for each private company is identified the
WMA 1981–1984 33 31.2{ acquisition of a public one in the same country are identified.
Silber 1991 1981–1988 69 33.8 We show the main authors who have used that approach. The
FMV Opinions 1979–1992 100 23.0 table is composed of the period covered and the range of
FMV Opinions 1980–1997 243 22.1 variation for the DLOM.
Management
Planning 1980–1996 53 27.1
Wruck 1989 1979–1985 — 17.5 Thus, expression 7 would be an alternative discount
Hertzel and rate valid for including, inter alia, the effect of illiquidity
Smith 1993 1980–1987 106 13.5
Johnson 1999 1991–1995 72 200 and nondiversification on the business value:
Bajaj et al. 2001 1990–1995 88 22.2 ke ~izPM zPe ~iz(RM {i)zu:(RM {i)
Columbia Financial ð7Þ
Advisors 1996–1997 23 21.0 ~iz(RM {i):(1zu):
LiquiStat 2005–2006 61 32.8
The theoretical approach of this discount rate is
Source: Authors, based on Pratt, Reilly and Schweihs (2000). consistent with the foundations of the CAPM and the
Note: One body of empirical evidence has analyzed the DLOM existence of nondiversification and an illiquidity pre-
under the RSE approach. We present a list of the studies
mium. As Rojo, Cruz, and Alonso (2011) have
indicating for each one: the period covered, the number of
transactions tested, and the estimated DLOM expressed in demonstrated, the ERI could be considered as he or she
percent. The lower DLOM is calculated by Johnson (1999), and has a mixed portfolio composed of a benchmark market
the highest is estimated by SRC, but we can observe an average index whose profitability is RM and a risky asset that
of nearly 30%. yields Re financed by debt at risk-free interest rate Rf.
* Including reporting OTC companies.
{ Including no reporting OTC companies.
Therefore, the total return (ke) obtained by an ERI is the
{ Median discounts. sum of the returns of two investments: an index market
portfolio and the risk portfolio minus the cost of its debt
portfolio:
se
ke ~RM zRe {Rf ~RM z(RM {Rf ) : ð8Þ
sM
Table 3 As RM 5 Rf + PM, equation 8 can be rewritten as follows:
Summary of IPO Studies si
ke ~Rf zPM zPM , ð9Þ
sM
Years Average
Empirical Study Covered DLOM (%) where the specific premium (Pe) is the term PM?(si/sM).
Emory 1980–2000 45.0 This article considers that the AECA proposal
Valuation Advisors 1999–2001 40.0 contributes to avoiding subjective posterior discounts,
Willamette Management associated in most cases with the process of negotiation.
Associates 1975–1995 51.6 This is also a direct way of valuing the company that is
Source: Authors. not quoted, taking into account its particular risk.
Note: Some authors and institutions estimate the DLOM under Note that this discount rate requires empirical support
the IPO approach, quantifying the discount by comparing post- to justify its use in practice. Rojo and Alonso (2006) have
IPO share prices with transaction prices in the same shares explored how the company value changes in replacing the
before the IPO. This table shows a selection of these, indicating
which study; the period covered and the estimated DLOM are discount rate of the CAPM with the AECA in the DFC
expressed in percent. This study has been developed for several model. Using a sample of ninety-four Spanish public
periods, the percent shown in the table being an average of all. companies they conclude that the business value
decreases around 20%. However, since the AECA’s To calculate the value in sample A, the DCFM method
discount rate is designed for PHC, it is necessary to test it has been applied as in expression 9 (see appendix 1):
in this kind of company. Xn
FLTPj VEn
VE0 ~ j
z n, ð9Þ
Testing AECA’s Discount Rate in PHC j~1 (1zke )
(1zk e)
Table 5
Statistical Results
Source: Authors.
Note: Summary statistics to show the values of the discount rates calculated by AECA and CAPM model (keAECA and keCAPM) and
company value derived from applying the rates in expression 9 (VEAECA and VECAPM). Also shown is the difference between both,
expressed in euros and in percent. For each variable, the mean, median, variance, and standard deviation are shown.
A comparison is then made of the DLOM obtained estimate ke is the CAPM. However, when we value PHC,
with samples A and B, considering that companies from we need an alternative method since there is a specific
panel A are companies less liquid than those from panel risk associated with venture capitalists (ERI) that is not
B, given that PHC are less liquid investments than the considered by CAPM. Therefore, an alternative method
public companies, which have the financial market to to estimate the discount rate for valuing PHC that
provide liquidity. Under this assumption, the DLOM includes the lack of marketability in particular is required.
observed in sample A should be higher than the one in This research tests whether the proposal of AECA
sample B. provides an efficient model for valuators when faced with
After overcoming the constraints for estimating the estimating the discount rate to use for company valuation
company value in both samples using different valuation when applying the DCFM.
methods, the results obtained show that the DLOM in Our results, after applying the AECA model in two
sample A is nearly 21% higher than that of sample B. different sets of companies, permit us to conclude that as
This means the DLOM is greater for PHC, inter alia, ke by CAPM is lower than ke by AECA, the company
because they do not have a financial market that provides value drops when we use the latter. The main component
liquidity. of the reduction is the DLOM, which varies between 20%
and 50% depending on the sample and the level of
Conclusion
liquidity. This decrease in value is a direct consequence
One of the most debated questions in company of an increase of the discount rate that includes a specific
valuation is that of the discount rate in the DCF model. risk premium that primarily provides for an investment’s
When we value public companies, although there are lack of marketability. For this reason it can confidently be
different opinions about this, in general, the model to stated that the decline in value can be assimilated with the
DLOM.
Table 6
Summary of Statistical Significance
Table 7
Sample Variables Significance Summary of Main Results by Liquidity Level
Panel A .keCAPM {keAECA .Yes
Variable Sample B Mean Median
.VECAPM 2 VEAECA .Yes
Panel B .keCAPM {keAECA .Yes DLOM .Illiquid Company 0.3213 0.3212
.VECAPM 2 VEAECA .Yes .Liquid Company 0.2508 0.2057
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Appendix 1
Table A1
Business Value Estimation for Sample A
Source: Authors.
Appendix 2
Table A2
Business Value Estimation for Sample B
Source: Authors.
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Title: The Discount Rate in Valuing Privately Held Companies
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