Definition and Importance
The Discount for Lack of Marketability (DLOM) is a reduction applied to the valuation of securities or investments that are not readily marketable. This discount reflects the diminished liquidity and the additional risks associated with selling a stake that cannot be quickly or easily converted to cash in the marketplace. DLOM is particularly significant in the valuation of noncontrolling, nonmarketable business interests.
Calculation Methods
Comparative Approach
One common method to estimate DLOM is the Comparative Approach. This involves comparing the subject company to publicly traded companies with similar characteristics and determining an appropriate discount based on differences in marketability.
Restricted Stock Studies
Another method is analyzing Restricted Stock Studies, which examine the price differences between restricted shares (which cannot be sold for a certain period) and their freely traded counterparts. The gap in prices represents the DLOM.
Key Considerations
Liquidity
Liquidity, or the ability to quickly sell an asset at its fair market value, is a major factor in determining DLOM. Assets that lack liquidity generally warrant a higher marketability discount.
Holding Period
The expected holding period for the investment is also crucial. Longer holding periods typically lead to higher DLOMs because the investor must wait longer to realize their return on the investment.
Market Conditions
Prevailing market conditions can influence DLOM. In bullish markets, the demand for less liquid investments tends to increase, potentially reducing the required discount. Conversely, bearish markets can increase the discount due to heightened risk and reduced liquidity.
Historical Context
Development of DLOM
The concept of DLOM has evolved significantly over the past few decades. Initial studies in the mid-20th century began to address the impact of liquidity on asset prices, leading to formal recognition and development of empirical methods to quantify DLOM.
Influential Studies
Pivotal studies, such as the SEC’s Rule 144 study and the Mandelbaum case, have shaped the understanding and application of DLOM in financial valuations. These studies provided foundational evidence on the price discounts associated with restricted stock and the factors influencing marketability.
Applications in Valuation
Business Valuation
In business valuations, particularly for family-owned or closely-held businesses, DLOM adjustments are critical. The lack of a public market for these shares means an investor requires a higher return, achieved by purchasing at a discounted price.
Estate and Gift Tax
For estate and gift tax purposes, applying DLOM to nonmarketable minority interests can significantly reduce the tax liability. This is because the value of the gifted or inherited interest is reduced by the marketability discount, resulting in a lower taxable value.
Related Terms
- Noncontrolling Interest: A noncontrolling interest is a minority stake in a company that does not provide the investor with control over the business’s operations or decisions. Noncontrolling interests often encounter higher marketability discounts.
- Minority Discount: While DLOM focuses on marketability, a Minority Discount (or lack of control discount) reflects the reduction in value due to the inability to influence the business’s management.
FAQs
Why is DLOM important in valuation?
How is DLOM different from a minority discount?
Can DLOM vary over time?
Summary
The Discount for Lack of Marketability (DLOM) plays a crucial role in accurately valuing noncontrolling, nonmarketable ownership interests. By understanding and applying various methods to estimate DLOM, investors and valuators can better assess the true value of securities and investments. This practice not only reflects the risks and liquidity constraints inherent in such investments but also ensures a fair and realistic valuation.
References
- Pratt, S. P., & Niculita, A. (2008). Valuing a Business: The Analysis and Appraisal of Closely Held Companies. McGraw-Hill.
- Mandelbaum v. Commissioner, 69 T.C.M. 2852 (1995).
- SEC Rule 144 - Selling Restricted and Control Securities.
By understanding and appropriately applying DLOM, you ensure more accurate and fair valuations that reflect the unique characteristics and risks of nonmarketable investments.
