Discounts For Lack Of Marketability (DLOM): Role in Valuation

Introduction

When it comes to valuing a company or an asset, one of the key factors to consider is its marketability. Marketability refers to the ease with which an asset can be bought or sold in the market. However, not all assets are easily marketable, and this lack of marketability can have a significant impact on their value. In this article, we will explore the concept of Discounts for Lack of Marketability (DLOM) and their role in valuation.

Understanding Discounts for Lack of Marketability (DLOM)

Discounts for Lack of Marketability (DLOM) are adjustments made to the value of an asset to account for its illiquidity or lack of marketability. Illiquid assets are those that cannot be easily converted into cash without a significant loss in value or a lengthy time period. Examples of illiquid assets include privately held companies, restricted stock, and certain types of real estate.

When valuing illiquid assets, it is important to consider the fact that potential buyers may require a discount to compensate for the risks and costs associated with holding such assets. This discount is known as the Discount for Lack of Marketability (DLOM).

Factors Affecting DLOM

Several factors can influence the magnitude of the DLOM applied to an asset. These factors include:

• Company Size: Smaller companies are generally considered to be less marketable than larger companies. This is because smaller companies often have a limited number of potential buyers, making it more difficult to find a willing buyer at a fair price.
• Company Performance: The financial performance of a company can also impact its marketability. A company with a strong track record of profitability and growth is likely to be more marketable than a company with inconsistent or poor financial performance.
• Industry and Market Conditions: The industry in which a company operates and the overall market conditions can also affect its marketability. For example, a company operating in a declining industry may be less marketable than a company operating in a growing industry.
• Ownership Structure: The ownership structure of a company can also impact its marketability. Companies with a large number of shareholders or complex ownership arrangements may be less marketable than companies with a simple ownership structure.

Methods for Determining DLOM

There are several methods that can be used to determine the appropriate DLOM for an asset. These methods include:

• Restricted Stock Studies: Restricted stock studies involve analyzing the prices at which restricted stock is sold in private transactions. By comparing the prices of restricted stock to the prices of freely tradable stock, an estimate of the DLOM can be derived.
• Option Pricing Models: Option pricing models, such as the Black-Scholes model, can also be used to estimate the DLOM. These models calculate the value of an option to purchase or sell an asset, taking into account factors such as the asset's volatility and the time remaining until the option expires.
• Pre-IPO Studies: Pre-IPO studies involve analyzing the prices at which shares of companies are sold in private transactions prior to their initial public offering (IPO). By comparing the prices of these shares to the prices at which the shares are sold in the IPO, an estimate of the DLOM can be derived.

Case Study: DLOM in Valuing a Privately Held Company

To illustrate the role of DLOM in valuation, let's consider a case study of a privately held company. Company XYZ is a small technology startup that is not publicly traded. The company has been growing rapidly and has a strong customer base, but it is still in the early stages of development.

To determine the value of Company XYZ, an appraiser considers various factors, including the company's financial performance, industry conditions, and ownership structure. Based on these factors, the appraiser determines that a DLOM of 20% is appropriate.

Without the DLOM, the appraiser would value Company XYZ at $10 million. However, with the DLOM applied, the value of the company is reduced to $8 million. This reduction in value reflects the illiquidity and lack of marketability associated with privately held companies.

The Importance of DLOM in Valuation

DLOM plays a crucial role in valuation, especially for illiquid assets. By applying a discount to account for the lack of marketability, valuations can more accurately reflect the risks and costs associated with holding such assets.

Without considering DLOM, valuations may overstate the true value of illiquid assets, leading to potential mispricing and inaccurate investment decisions. Incorporating DLOM into the valuation process helps investors and appraisers make more informed decisions and ensures that the value assigned to an asset is realistic and reflective of its marketability.

Conclusion

Discounts for Lack of Marketability (DLOM) are an essential component of the valuation process for illiquid assets. By accounting for the illiquidity and lack of marketability associated with certain assets, DLOM helps ensure that valuations accurately reflect the risks and costs involved in holding such assets.

Factors such as company size, performance, industry conditions, and ownership structure can influence the magnitude of the DLOM applied to an asset. Various methods, including restricted stock studies, option pricing models, and pre-IPO studies, can be used to determine the appropriate DLOM.

Understanding and incorporating DLOM into the valuation process is crucial for investors, appraisers, and other financial professionals. By doing so, they can make more informed decisions and ensure that the value assigned to an asset is realistic and reflective of its marketability.