Valuation: When the quoted share price is not the value
This article originally appeared on The Lawyer’s Daily website published by LexisNexis Canada Inc.
Valuation of investments in publicly traded companies are often required by lawyers working with clients involved in shareholder disputes, various tax issues and matrimonial property division purposes.
It is important to understand that the quoted share price is not always the value. There are two common situations giving rise to discounts from the quoted price:
- Difficulties arise when attempting to liquidate a large ownership position in a thinly traded public company. In these cases, it is often appropriate to discount the quoted price to arrive at the value. We refer to this as a blockage discount.
- The holder of certain publicly traded shares may be under a legal restriction, disallowing the sale of shares for a period of time. We refer to this as a restriction discount.
What is a blockage discount?
A blockage discount is the discount required from the quoted price of a share where a subject block of shares is larger than the typical trading volume, such that liquidating the block would require an unreasonable length of time or depress the trading price of the shares.
Consider Ms. Smith, who owns one million shares in PublicCo. The average trading volume of PublicCo shares is 10,000 per day. Assuming Ms. Smith could utilize 100 per cent of the volume, she would need a minimum of 100 days to sell her PublicCo shares. The possibility of using 100 per cent of the daily trading volume is impractical, as these transactions would result in an oversupply of shares and cause downward pressure on the trading price. Ms. Smith would be unable to immediately sell her holdings at the current quoted price, and therefore her shares would be subject to a blockage discount.
How do we quantify the blockage discount?
There is no single commonly accepted methodology or practice to determine a blockage discount. Typically, blockage discounts range from zero per cent to 30 per cent. We receive some guidance in determining the appropriate discount from court cases. Court cases involving blockage discounts have opined on discounts ranging from zero per cent to 30 per cent.
By purchasing a notional put option, a holder of a block of shares could notionally hedge against downside risk during the gradual disposal period of the block. The cost of the notional put option may be a proxy for the blockage discount. In reality, there may not be an active options market from which to purchase a large quantity of put options.
There are several identified factors that increase the blockage discount, including:
- A large block size relative to the daily trading volume and to the trading float;
- Concentrated share ownership with a limited group of owners (less widely held);
- High volatility (share price movement / fluctuations);
- Poor historical performance as well as a weak current outlook for the company;
- A current downward price trend for the shares;
- A lack of dividend payments;
- A low percentage of institutional ownership; and
- No previous history of the market absorbing similar block trades.
What is a restriction discount?
A restriction discount is the discount required from the quoted price where particular shares are subject to a trading constraint for a limited period, during which the restricted shares are not freely tradable.
Consider Mr. Apple, who also owns shares in PublicCo; however, his shares are subject to a 120-day trading restriction. Unlike regular publicly traded PublicCo shares, he is unable to sell his shares until the restriction period ends. Mr. Apple would be unable to immediately sell his holdings at the current quoted price, and therefore his shares would be subject to a restriction discount.
How do we quantify the restriction discount?
Similar to blockage discount, there is no single objective methodology. The concept of a restriction discount has been studied extensively, with a wide range of discount conclusions; most studies fall within the range of 20 per cent to 30 per cent.
Notional options strategies may also be used to provide guidance on the quantum of the restriction discount. For example, a notional put option allows the current trading price to be locked in, removing the downside risk of holding the security until the end of the restricted trading period.
Some identified factors that increase the restriction discount include:
- A longer restriction period;
- A relatively small market capitalization of the company;
- High volatility (share price movement / fluctuations); and
- Lower revenues and earnings for the company.
For both blockage discounts and restriction discounts, valuators must consider company and share trading characteristics, case-specific circumstances, notional option calculations, court precedents, restricted share studies, and professional judgment to arrive at the appropriate discounts.