How Do Valuation Discounts Work in Business Valuation?
Updated: Feb 27
In brief, business valuation is a way that a company is assessed for its value. The worth of an individual business is based on its future prospects, expected profit, potential risk, and many other factors. All these elements are set up in order for the business to be assessed as a whole. Valuation discounts are the mechanism that a business valuation expert may use to adjust the value of your business for certain factors. Business valuation discounts are not inherent in any analytical methodology, and their use is at the expert's discretion, subject to professional guidance and appropriate consultation. This article will explain the concept of valuation discounts and their application in your business valuation.
Valuation discount and business valuation
The concept of valuation discount and its use in business valuation is based on the assumption or estimate of future business performance and therefore, the analyst may need to adjust the value of the business for various factors, known as valuation discounts. These adjustments may be applied on a case-by-case basis and at the expert's discretion.
Valuation discounts may be applied to calculate the business's fair market value. While business valuation is mainly concerned with the value of a business and its worth. The methodology used to assess the business value depends on the type of business, the sector, its size, and many other factors; hence, there are various standardized business valuation approaches.
What is a business valuation?
To better understand the basis of valuation discounts, it is necessary to first look at the concept of business valuation. A business valuation is an estimation of the value of a company. In order to come up with an accurate valuation of the company, many factors are taken into consideration, such as company performance, expected growth rate, financial performance, industry data, and other relevant information.
After completion of the analysis, whether it is projections, assumptions, or mathematical models, a valuation report is prepared, which includes the exact value of the company. A business valuation report can be used for various purposes, and below mentioned are some of them.
What is the purpose of a business valuation?
Well, business valuation serves as a basis for different decisions and helps in making various financial decisions, including raising capital, conducting mergers and acquisitions, implementing exit strategies, facilitating internal corporate decisions, and many other related things. Business valuation acts as a benchmark for determining a business's fair value, which is used to make strategic decisions.
It is important to note that the recommended valuation often needs to be reviewed and updated in order to obtain an overall understanding of the company's performance when compared to other companies in similar fields. As a result, this will effectively help the company to enhance its value and in return, create more value for the business.
What is a valuation discount?
Now that you have a basic understanding of business valuation, it's time to understand the concept of valuation discount. It is a factor that is used to adjust the value of a company and in some cases, it is also referred to as a discount rate. The objective of using valuation discounts is to adjust the estimated value of a company in order to get the actual fair market value.
Basically, after proper analysis and evaluation, a business valuation expert may apply the process of discounting on factors that may potentially impact the company's business performance, such as lack of marketability, control, dilution, and transferability. Therefore, the company's actual value is better understood by using valuation discounts as it will provide a better estimate of the real value.
Why is valuation discounting important in business valuation?
A valuation discount is mainly employed to achieve a company's optimum fair market value, assuming that all vital factors are considered and included in the analysis. Here are a few of the benefits of using a business valuation discount:
The analysis and valuation of a company are enhanced by using valuation discounts because it helps in giving the company an overall value that is genuine and realistic.
Private companies are often valued using valuation discounts because they lack various factors such as control, marketability, and transferability.
Business valuation can be conducted using discounted cash flow approach. To determine the present value of future cash flows of a company, it is often discounted using a discount rate.
Application of valuation discount in business valuation
Now that you know what a business valuation is and why it's important as well as the benefits of using a valuation discount in your business valuation, it's time to look at the actual application of valuation discount. Since this is a highly subjective area, experts often make assumptions on the level of discount to be used in the analysis, and based on that, they also choose the discount rate. Thus, the following list mentions some common discounts that may be applied to your business valuation.
Types of valuation discounts
There are various types of valuation discounts that are often used in business valuation. In the list below, we have included a few of the commonly used discount types in business valuation:
Discount for Lack of Marketability (DLOM) - In privately held companies, the lack of marketability refers to the fact that in these companies there is no access to public capital markets for them. As a result, there are restrictions on shares with no available market for their sale or trading. This reduces the value of these shares; hence, companies are valued lower than publicly traded companies. So, in order to overcome the loss of marketability in privately held companies, a discount for lack of marketability is employed. The discount rate is determined by a business valuation expert based on the facts and analysis of the business.
Discount for Restrictions on Transferability - As a matter of fact, private companies are structured in such a way that there are restrictions on the transferability of ownership. Essentially, ownership of private companies is governed by contracts and agreements which make the ownership transferable under certain conditions. Even though the ownership transfer may be possible, the sale or transactions of these shares cannot be performed in open markets. This phenomenon leads to lower valuations of private companies as compared to publicly traded companies because their shares are not freely transferable. To overcome this problem, a discount is applied and hence, the valuation is adjusted to account for restrictions on transferability.
Discount for Lack of Control (DLOC) - The lack of control is often associated with privately held companies. Non-controlling or non-voting shareholders do not have access to the decision-making process of the business and are often excluded from any important financial information. This reduces their power to influence certain business decisions and prevents them from exerting control over the company or carrying out any effective monitoring. Due to all these factors, the value of privately held companies is reduced and hence, they are valued lower. It is recommended to apply a discount for lack of control in your business valuation as it helps to achieve a realistic fair market value of the company.
Discount for Lack of Liquidity - In privately held companies, the actual ability to sell the shares in open markets is restricted as ownership is governed by private contracts and agreements. Since shareholders do not have the ability to freely transfer their shares, the value of these shares is reduced because the liquidity is restricted. When the value of these shares is reduced it leads to lower valuations of private companies. Therefore, a discount for lack of liquidity is recommended in the valuation process to adjust the business valuation to a realistic estimate of the value.
Discounted Cash Flow (DCF) - The discounted cash flow approach is often used for the valuation of businesses. It is a method that is widely used by various valuation experts and analysts to determine the fair market value of a company. Typically, the present value of a company is determined using the future expected cash flows and a discount rate is applied. Probably you may be wondering why is this discount rate applicable. Well, the cost of capital is the discount rate that is based on future assumptions and projections. As a result, it is an important input in the valuation and thus, a discount rate is applied to adjust the valuation.
How do you determine the discount rate?
As mentioned above, different discounts are used in business valuation, each of which has its own associated discount rate. Depending on the application of the discount, the appropriate discount rate is selected and thus, a discount rate is determined. The discount rates vary based on perception, assumptions, and calculations that are performed in the business valuation. Therefore, it may not be possible to list one universally applicable discount rate.
Valuing a business involves a series of inputs and calculations that determine the fair market value of a company. Are you confused about how to value your business? It is time to seek the help of a professional business valuation expert that can assist you in determining the fair market value of your company.