The Interconnectedness of Control, Returns, and Valuation in Discount for Lack of Control

Today's post is by Roger Loh Kit Seng, the Director at Mazars Malaysia, providing firm-wide technical guidance on various financial modelling, valuation and financial reporting issues. Roger was involved in multiple valuation assignments for various industries, including consumer, energy, financial services, healthcare, infrastructure, luxury, real estate, technology, and transport & logistics.

A discount for lack of control (DLOC) has been considered a fundamental principle in business valuation, especially in cases of minority interest valuation. Some intricacies, exceptions, and untold stories, however, complicate this concept. In this article, we aim to challenge the automatic concept application of DLOC on minority interests and explore how our understanding of control, or the lack thereof, can significantly impact the valuation process.

Rethinking the Fundamentals of Control and Value

Is having control always valuable? Many believe that having control over business operations, making strategic decisions, and influencing financial policies will automatically increase the value of ownership. However, is this assumption valid? Does control really increase the value of an ownership interest? These are essential questions worth considering.

Control is a complex concept that goes beyond decision-making power. It also involves strategic alignment of interests, distribution of financial benefits, and risk management. Hitchner argues that control has the advantage of reducing the return on investment for minority shareholders.[1] On the other hand, Damodaran opines that control premium is derived from the belief that a participant can operate the business differently from how it is currently being run.[2]

Hence, the control premium may reflect:

• the transfer of wealth from minority to majority shareholders; and/or

• the value difference between the ones run by competent managers and the status quo.

Revisiting the Level of Value and Control Premium

The level of value characteristics have long been used by valuation professionals to determine the value of a company. However, ambiguous situations whether or not someone has control may arise. For instance, having a 50% shareholding interest does not necessarily imply control, nor is the shareholder a minority.

According to Pratt, a 50% shareholding interest is insufficient to take action but can be enough to block others from doing so, resulting in a deadlock. On the other hand, if a holder has majority voting shares, regardless of how small the block is, the holder has control.[3]

Control Premium Using a One-Size-Fits-All Approach

Valuation professionals commonly refer to control premium databases to determine control adjustments. These databases rely on the acquisition prices of public companies compared to their previous public trading prices. However, there may be instances where the acquisition price data indicates that the transactions under a controlling basis were completed at a price lower than the market value.[4]

For example, in Q4 2023, about 15% of 158 deals had negative control premiums.[5] Valuation professionals should reconsider their methodology if they rely solely on the average control premium as the valuation adjustment.

Quantifying DLOC Using the Income Approach

Valuing minority interests requires a critical re-evaluation of how control is quantified. Conventionally, valuations rely on broad assumptions, but a more nuanced approach is needed, especially within the income approach framework.

A way to achieve this is by developing two cash flow projections—one optimised and the other reflecting the status quo. The optimised projection assumes assets are operating at optimum efficiency, embodying an optimum return on invested capital, an ideal reinvestment rate, and minimised financing costs. On the other hand, the status quo projection anchors itself in the current operational and financial realities.

The differential between these two projections unveils the true value of control, or the lack thereof,[6] which essentially captures the DLOC.[7] This method does not merely apply a generic discount, but assesses how applying control could realistically alter financial outcomes.

By anchoring the valuation in the lack of potential for value enhancement, this method aligns better with the economic realities faced by minority shareholders. It offers a more reasonable reflection of the true value of minority interests.

The Case of an Optimally Managed Company

That said, optimally managed companies have minimal room for further enhancement. In such scenarios, the DLOC approaches zero, which challenges the traditional application of DLOC and its relevance to companies that are already leveraging their assets and resources to their fullest potential.

This nuanced understanding prompts a significant shift in how valuation professionals approach DLOC for minority interests, especially in the valuation of companies already performing at optimum. It suggests that the value attributed to control needs a more refined analysis that appreciates the full spectrum of what control entails and its actual impact on value.

Summing Up

We need to reconsider the conventional norms surrounding DLOC to ensure a discerning valuation practice. By analysing the interplay between optimal management and control premiums, we can gain valuable insights that lead to a more nuanced and evidence-based approach to valuing control.

In the case of optimally managed companies, we shall challenge our understanding of value and move away from automatic discounting. This paradigm shift is necessary to reflect the true essence of a business value and aligns closer to the economic realities of minority interests.

An evidence-based approach enriches our professional acumen and ensures our valuations are reasonable. As we continue to explore, we must carry the torch of inquiry, lighting the way to a future where the valuation of control and minority interests is as dynamic and multifaceted as the businesses we value.

[1] James R. Hitchner, Financial Valuation

[2] Aswath Damodaran, The Value of Control: Implications for Control Premia, Minority Discounts and Voting Share Differentials

[3] Shannon P. Pratt, Valuing a Business: The Analysis and Appraisal of Closely Held Companies

[4] Shannon P. Pratt, Valuing a Business: The Analysis and Appraisal of Closely Held Companies

[5] Control Premium Study Quarterly – 4th Quarter 2023

[6] Aswath Damodaran, The Value of Control: Implications for Control Premia, Minority Discounts and Voting Share Differentials

[7] International Valuation Standards, Effective 31 January 2022