The Direct and Indirect Methods of Valuing Minority Interests by axe17204


									  FINANCIAL VALUATION - Income Approach

The Direct and Indirect Methods
of Valuing Minority Interests
Using the Income Approach
When valuing a minority interest            nority level value, a LOC discount
using the income approach, there are        must be deducted. The most common
two methods commonly used in prac-          source of the empirical data used to               HAROLD G. MARTIN JR.,
tice: the “direct method” and “indi-        determine the LOC discount when                     CPA/ABV, CFF, ASA, CFE
rect method.” As with many issues in        using an income approach is the
valuation, this is another area where       Mergerstat Control Premium Studies.                    Keiter, Stephens, Hurst,
there are differing schools of thought      This Mergerstat data presents the                       Gary & Shreaves. P.C.
on which method is more appropri-           control premiums paid by buyers to                         Richmond, VA
ate. However, for the reasons dis-          sellers in M&A transactions. This            
cussed below, the direct method is          premium is then converted to an LOC
more appropriate in most instances.         discount using a mathematical formu-        the controlling owners in the subject
         In using the direct method,        la.                                         company extract all cash such that
no control-type adjustments are                        However, there are potential     there is no cash flow available for dis-
made to the economic income, and the        problems in using the Mergerstat            tribution to the minority shareholder.
resulting cash flow is considered to be     data for this purpose. For example,         The value to the minority shareholder
on a minority level basis. The ration-      many of the transactions are syner-         is not $0, as the shareholder can bring
ale for this approach is that the minor-    gistic transactions. This means that in     a shareholder oppression suit and de-
ity shareholder does not have the at-       addition to the existence of a control      mand fair value. (Rights of sharehold-
tribute of control to determine com-        premium, there is also a synergistic        ers and the legal remedy available to
pensation policy; therefore, the cash       premium imbedded in the transaction         them will vary from state to state).3
flow available for distribution to the      price. Generally, the two types of pre-              While businesses can be val-
minority shareholder (the economic          miums cannot be segregated. It is           ued under both the direct and indirect
income stream to be valued) should          primarily for this reason, as well as       method for valuing minority interests
not be adjusted for compensation.           the fact that the direct method pro-        by the income approach, typically the
Use of this method eliminates the           duces a result specific to the subject      direct method requires less reliance
need to deduct a lack of control            company being valued, that the direct       on adjustments and imperfect control
(“LOC”) discount.1                          method is generally the more pre-           premium studies.
         Alternatively, if the “indirect    ferred approach.
method” is used, control adjustments                   Having said this, when valu-
are made to the economic income             ing a minority interest, the economic       1
                                                                                            James R. Hitchner, ed., Financial Valuation: Applica-
stream and the resulting cash flow is       income stream is often calculated on            tions and Models, 2nd ed. (New York: John Wiley &
                                                                                            Sons, Inc., 2006), p. 103.
considered to be on a control-level         both a control and minority level           2
                                                                                            Shannon P. Pratt, Valuing a Business - The Analysis
basis. If the subject interest is a mi-     basis. An example of when this may              and Appraisal of Closely Held Companies, 5th ed.
nority interest, in order to derive a mi-        be required is if you are using al-        (Chicago: Irwin Professional Publishing, 2008), p. 132.
                                                                                            Gary Trugman, Understanding Business Valuation, 3rd
                                                 ternative valuation approaches
                                                                                            ed. (New York: American Institute of Certified Public
                                                 (e.g. market approach) and for             Accountants, 2008) p. 190.
                                                 purposes of assessing comparabil-

                                                                                            expert TIP
                                                 ity, you need to present the subject
                                                 company’s income statement on a
                                                 control-level basis.2
                                                       There may also be certain in-
                                                                                            When valuing a minority interest
                                                 stances when, because of the facts
                                                 and circumstances, you must cal-           using the income approach,
                                                 culate a control level value and           there are two methods common-
                                                 then deduct an LOC discount                ly used in practice: the “direct
                                                 using the Mergerstat studies               method” and “indirect method.”
                                                 (warts and all). For example,
                                                 this may be appropriate where

  FVLE Issue 18                                        April/May 2009                                                           Page 11

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