Financial analysis

Financial analysis refers to an assessment of the viability, stability and profitability of a business, sub-business
or project.

It is performed by professionals who prepare reports using ratios that make use of information taken from
financial statements and other reports. These reports are usually presented to top management as one of their
bases in making business decisions. Based on these reports, management may:

 Continue or discontinue its main operation or part of its business;

 Make or purchase certain materials in the manufacture of its product;
 Acquire or rent/lease certain machineries and equipment in the production of its goods;
 Issue stocks or negotiate for a bank loan to increase its working capital;
 Make decisions regarding investing or lending capital;
 Other decisions that allow management to make an informed selection on various alternatives in the
conduct of its business.

Goals
Financial analysts often assess the firm's:

1. Profitability - its ability to earn income and sustain growth in both short-term and long-term. A company's
degree of profitability is usually based on the income statement, which reports on the company's results of
operations;

2. Solvency - its ability to pay its obligation to creditors and other third parties in the long-term;
3. Liquidity - its ability to maintain positive cash flow, while satisfying immediate obligations;

Both 2 and 3 are based on the company's balance sheet, which indicates the financial condition of a business as
of a given point in time.

4. Stability- the firm's ability to remain in business in the long run, without having to sustain significant losses
in the conduct of its business. Assessing a company's stability requires the use of both the income statement and
the balance sheet, as well as other financial and non-financial indicators.

Methods
Financial analysts often compare financial ratios (of solvency, profitability, growth, etc.):

 Past Performance - Across historical time periods for the same firm (the last 5 years for example),
 Future Performance - Using historical figures and certain mathematical and statistical techniques,
including present and future values, This extrapolation method is the main source of errors in financial
analysis as past statistics can be poor predictors of future prospects.
 Comparative Performance - Comparison between similar firms.

These ratios are calculated by dividing a (group of) account balance(s), taken from the balance sheet and / or the
income statement, by another, for example :

n / equity = return on equity

Net income / total assets = return on assets
 Stock price / earnings per share = P/E-ratio

Comparing financial ratios are merely one way of conducting financial analysis. Financial ratios face several
theoretical challenges:

 They say little about the firm's prospects in an absolute sense. Their insights about relative performance
require a reference point from other time periods or similar firms.
 One ratio holds little meaning. As indicators, ratios can be logically interpreted in at least two ways. One
can partially overcome this problem by combining several related ratios to paint a more comprehensive
picture of the firm's performance.
 Seasonal factors may prevent year-end values from being representative. A ratio's values may be
distorted as account balances change from the beginning to the end of an accounting period. Use average
values for such accounts whenever possible.
 Financial ratios are no more objective than the accounting methods employed. Changes in accounting
policies or choices can yield drastically different ratio values.
 They fail to account for exogenous factors like investor behavior that are not based upon economic
fundamentals of the firm or the general economy (fundamental analysis) [1].

Business valuation
Business valuation is a process and a set of procedures used to estimate the economic value of an owner’s
interest in a business. Valuation is used by financial market participants to determine the price they are willing
to pay or receive to consummate a sale of a business. In addition to estimating the selling price of a business,
the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift
taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for
estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal
purposes.

Standard and premise of value

Before the value of a business can be measured, the valuation assignment must specify the reason for and
circumstances surrounding the business valuation. These are formally known as the business value standard and
premise of value.[1] The standard of value is the hypothetical conditions under which the business will be
valued. The premise of value relates to the assumptions, such as assuming that the business will continue
forever in its current form (going concern), or that the value of the business lies in the proceeds from the sale of
all of its assets minus the related debt (sum of the parts or assemblage of business assets).

Business valuation results can vary considerably depending upon the choice of both the standard and premise of
value. In an actual business sale, it would be expected that the buyer and seller, each with an incentive to
achieve an optimal outcome, would determine the fair market value of a business asset that would compete in
the market for such an acquisition. If the synergies are specific to the company being valued, they may not be
considered. Fair value also does not incorporate discounts for lack of control or marketability.

Note, however, that it is possible to achieve the fair market value for a business asset that is being liquidated in
its secondary market. This underscores the difference between the standard and premise of value.
These assumptions might not, and probably do not, reflect the actual conditions of the market in which the
subject business might be sold. However, these conditions are assumed because they yield a uniform standard of
value, after applying generally-accepted valuation techniques, which allows meaningful comparison between
businesses which are similarly situated.

Elements of business valuation

Economic conditions

A business valuation report generally begins with a description of national, regional and local economic
conditions existing as of the valuation date, as well as the conditions of the industry in which the subject
business operates. A common source of economic information for the first section of the business valuation
report is the Federal Reserve Board’s Beige Book, published eight times a year by the Federal Reserve Bank.
State governments and industry associations often publish useful statistics describing regional and industry
conditions.

Financial Analysis

The financial statement analysis generally involves common size analysis, ratio analysis (liquidity, turnover,
profitability, etc.), trend analysis and industry comparative analysis. This permits the valuation analyst to
compare the subject company to other businesses in the same or similar industry, and to discover trends
affecting the company and/or the industry over time. By comparing a company’s financial statements in
different time periods, the valuation expert can view growth or decline in revenues or expenses, changes in
capital structure, or other financial trends. How the subject company compares to the industry will help with the
risk assessment and ultimately help determine the discount rate and the selection of market multiples.

Normalization of financial statements

The most common normalization adjustments fall into the following four categories:

 Comparability Adjustments. The valuer may adjust the subject company’s financial statements to facilitate a
comparison between the subject company and other businesses in the same industry or geographic location.
These adjustments are intended to eliminate differences between the way that published industry data is
presented and the way that the subject company’s data is presented in its financial statements.

 Non-operating Adjustments. It is reasonable to assume that if a business were sold in a hypothetical sales
transaction (which is the underlying premise of the fair market value standard), the seller would retain any
assets which were not related to the production of earnings or price those non-operating assets separately. For
this reason, non-operating assets (such as excess cash) are usually eliminated from the balance sheet.

 Non-recurring Adjustments. The subject company’s financial statements may be affected by events that are not
expected to recur, such as the purchase or sale of assets, a lawsuit, or an unusually large revenue or expense.
These non-recurring items are adjusted so that the financial statements will better reflect the management’s
expectations of future performance.

 Discretionary Adjustments. The owners of private companies may be paid at variance from the market level of
compensation that similar executives in the industry might command. In order to determine fair market value,
the owner’s compensation, benefits, perquisites and distributions must be adjusted to industry standards.
Similarly, the rent paid by the subject business for the use of property owned by the company’s owners
individually may be scrutinized.
Income, Asset and Market Approaches

Three different approaches are commonly used in business valuation: the income approach, the asset-based
approach, and the market approach[2]. Within each of these approaches, there are various techniques for
determining the value of a business using the definition of value appropriate for the appraisal assignment.
Generally, the income approaches determine value by calculating the net present value of the benefit stream
generated by the business (discounted cash flow); the asset-based approaches determine value by adding the
sum of the parts of the business (net asset value); and the market approaches determine value by comparing the
subject company to other companies in the same industry, of the same size, and/or within the same region.

A number of business valuation models can be constructed that utilize various methods under the three business
valuation approaches. Venture Capitalists and Private Equity professionals have long used the First chicago
method which essentially combines the income approach with the market approach.

In determining which of these approaches to use, the valuation professional must exercise discretion. Each
technique has advantages and drawbacks, which must be considered when applying those techniques to a
particular subject company. Most treatises and court decisions encourage the valuator to consider more than one
technique, which must be reconciled with each other to arrive at a value conclusion. A measure of common
sense and a good grasp of mathematics is helpful.

Income approaches
The income approaches determine fair market value by multiplying the benefit stream generated by the subject
or target company times a discount or capitalization rate. The discount or capitalization rate converts the stream
of benefits into present value. There are several different income approaches, including capitalization of
earnings or cash flows, discounted future cash flows (“DCF”), and the excess earnings method (which is a
hybrid of asset and income approaches). Most of the income approaches look to the company’s adjusted
historical financial data for a single period; only DCF requires data for multiple future periods. The discount or
capitalization rate must be matched to the type of benefit stream to which it is applied. The result of a value
calculation under the income approach is generally the fair market value of a controlling, marketable interest in
the subject company, since the entire benefit stream of the subject company is most often valued, and the
capitalization and discount rates are derived from statistics concerning public companies.

Discount or capitalization rates

A discount rate or capitalization rate is used to determine the present value of the expected returns of a business.
The discount rate and capitalization rate are closely related to each other, but distinguishable. Generally
speaking, the discount rate or capitalization rate may be defined as the yield necessary to attract investors to a
particular investment, given the risks associated with that investment.

 In DCF valuations, the discount rate, often an estimate of the cost of capital for the business are used to
calculate the net present value of a series of projected cash flows.

 On the other hand, a capitalization rate is applied in methods of business valuation that are based on business
data for a single period of time. For example, in real estate valuations for properties that generate cash flows, a
capitalization rate may be applied to the net operating income (NOI) (i.e., income before depreciation and
interest expenses) of the property for the trailing twelve months.

There are several different methods of determining the appropriate discount rates. The discount rate is
composed of two elements: (1) the risk-free rate, which is the return that an investor would expect from a
secure, practically risk-free investment, such as a high quality government bond; plus (2) a risk premium that
compensates an investor for the relative level of risk associated with a particular investment in excess of the
risk-free rate. Most importantly, the selected discount or capitalization rate must be consistent with stream of
benefits to which it is to be applied.

Capital Asset Pricing Model (“CAPM”)

The Capital Asset Pricing Model ( CAPM) is one method of determining the appropriate discount rate in
business valuations. The CAPM method originated from the Nobel Prize winning studies of Harry Markowitz,
James Tobin and William Sharpe. The CAPM method derives the discount rate by adding a risk premium to the
risk-free rate. In this instance, however, the risk premium is derived by multiplying the equity risk premium
times “beta,” which is a measure of stock price volatility. Beta is published by various sources for particular
industries and companies. Beta is associated with the systematic risks of an investment.

One of the criticisms of the CAPM method is that beta is derived from the volatility of prices of publicly-traded
companies, which are likely to differ from private companies in their capital structures, diversification of
products and markets, access to credit markets, size, management depth, and many other respects. Where
private companies can be shown to be sufficiently similar to public companies, however, the CAPM method
may be appropriate.

Weighted Average Cost of Capital (“WACC”)

The weighted average cost of capital is an approach to determining a discount rate. The WACC method
determines the subject company’s actual cost of capital by calculating the weighted average of the company’s
cost of debt and cost of equity. The WACC must be applied to the subject company’s net cash flow to total
invested capital.

One of the problems with this method is that the valuator may elect to calculate WACC according to the subject
company’s existing capital structure, the average industry capital structure, or the optimal capital structure.
Such discretion detracts from the objectivity of this approach, in the minds of some critics.

Indeed, since the WACC captures the risk of the subject business itself, the existing or contemplated capital
structures, rather than industry averages, are the appropriate choices for business valuation.

Once the capitalization rate or discount rate is determined, it must be applied to an appropriate economic
income streams: pretax cash flow, aftertax cash flow, pretax net income, after tax net income, excess earnings,
projected cash flow, etc. The result of this formula is the indicated value before discounts. Before moving on to
calculate discounts, however, the valuation professional must consider the indicated value under the asset and
market approaches.

Careful matching of the discount rate to the appropriate measure of economic income is critical to the accuracy
of the business valuation results. Net cash flow is a frequent choice in professionally conducted business
appraisals. The rationale behind this choice is that this earnings basis corresponds to the equity discount rate
derived from the Build-Up or CAPM models: the returns obtained from investments in publicly traded
companies can easily be represented in terms of net cash flows. At the same time, the discount rates are
generally also derived from the public capital markets data.

Build-Up Method

The Build-Up Method is a widely-recognized method of determining the after-tax net cash flow discount rate,
which in turn yields the capitalization rate. The figures used in the Build-Up Method are derived from various
sources. This method is called a “build-up” method because it is the sum of risks associated with various classes
of assets. It is based on the principle that investors would require a greater return on classes of assets that are
more risky. The first element of a Build-Up capitalization rate is the risk-free rate, which is the rate of return for
long-term government bonds. Investors who buy large-cap equity stocks, which are inherently more risky than
long-term government bonds, require a greater return, so the next element of the Build-Up method is the equity
risk premium. In determining a company’s value, the long-horizon equity risk premium is used because the
Company’s life is assumed to be infinite. The sum of the risk-free rate and the equity risk premium yields the
long-term average market rate of return on large public company stocks.

Similarly, investors who invest in small cap stocks, which are riskier than blue-chip stocks, require a greater
return, called the “size premium.” Size premium data is generally available from two sources: Morningstars'
(formerly Ibbotson & Associates') Stocks, Bonds, Bills & Inflation and Duff & Phelps' Risk Premium Report.

By adding the first three elements of a Build-Up discount rate, we can determine the rate of return that investors
would require on their investments in small public company stocks. These three elements of the Build-Up
discount rate are known collectively as the “systematic risks.”

In addition to systematic risks, the discount rate must include “unsystematic risks,” which fall into two
categories. One of those categories is the “industry risk premium.” Morningstar’s yearbooks contain empirical
data to quantify the risks associated with various industries, grouped by SIC industry code.

The other category of unsystematic risk is referred to as “specific company risk.” Historically, no published data
has been available to quantify specific company risks. However as of late 2006, new ground-breaking research
has been able to quantify, or isolate, this risk for publicly-traded stocks through the use of Total Beta
calculations. P. Butler and K. Pinkerton have outlined a procedure, known as the Butler Pinkerton Model
(BPM), using a modified Capital Asset Pricing Model ( CAPM) to calculate the company specific risk
premium. The model uses an equality between the standard CAPM which relies on the total beta on one side of
the equation; and the firm's beta, size premium and company specific risk premium on the other. The equality is
then solved for the company specific risk premium as the only unknown. The BPM is a relatively new concept
and is gaining acceptance in the business valuation community.

It is important to understand why this capitalization rate for small, privately-held companies is significantly
higher than the return that an investor might expect to receive from other common types of investments, such as
money market accounts, mutual funds, or even real estate. Those investments involve substantially lower levels
of risk than an investment in a closely-held company. Depository accounts are insured by the federal
government (up to certain limits); mutual funds are composed of publicly-traded stocks, for which risk can be
substantially minimized through portfolio diversification.

Closely-held companies, on the other hand, frequently fail for a variety of reasons too numerous to name.
Examples of the risk can be witnessed in the storefronts on every Main Street in America. There are no federal
guarantees. The risk of investing in a private company cannot be reduced through diversification, and most
businesses do not own the type of hard assets that can ensure capital appreciation over time. This is why
investors demand a much higher return on their investment in closely-held businesses; such investments are
inherently much more risky.

Asset-based approaches
The value of asset-based analysis of a business is equal to the sum of its parts. That is the theory underlying the
asset-based approaches to business valuation. The asset approach to business valuation is based on the principle
of substitution: no rational investor will pay more for the business assets than the cost of procuring assets of
similar economic utility. In contrast to the income-based approaches, which require the valuation professional to
make subjective judgments about capitalization or discount rates, the adjusted net book value method is
relatively objective. Pursuant to accounting convention, most assets are reported on the books of the subject
company at their acquisition value, net of depreciation where applicable. These values must be adjusted to fair
market value wherever possible. The value of a company’s intangible assets, such as goodwill, is generally
impossible to determine apart from the company’s overall enterprise value. For this reason, the asset-based
approach is not the most probative method of determining the value of going business concerns. In these cases,
the asset-based approach yields a result that is probably lesser than the fair market value of the business. In
considering an asset-based approach, the valuation professional must consider whether the shareholder whose
interest is being valued would have any authority to access the value of the assets directly. Shareholders own
shares in a corporation, but not its assets, which are owned by the corporation. A controlling shareholder may
have the authority to direct the corporation to sell all or part of the assets it owns and to distribute the proceeds
to the shareholder(s). The non-controlling shareholder, however, lacks this authority and cannot access the
value of the assets. As a result, the value of a corporation's assets is rarely the most relevant indicator of value to
a shareholder who cannot avail himself of that value. Adjusted net book value may be the most relevant
standard of value where liquidation is imminent or ongoing; where a company earnings or cash flow are
nominal, negative or worth less than its assets; or where net book value is standard in the industry in which the
company operates. None of these situations applies to the Company which is the subject of this valuation report.
However, the adjusted net book value may be used as a “sanity check” when compared to other methods of
valuation, such as the income and market approaches.

Market approaches
The market approach to business valuation is rooted in the economic principle of competition: that in a free
market the supply and demand forces will drive the price of business assets to a certain equilibrium. Buyers
would not pay more for the business, and the sellers will not accept less, than the price of a comparable business
enterprise. It is similar in many respects to the “comparable sales” method that is commonly used in real estate
appraisal. The market price of the stocks of publicly traded companies engaged in the same or a similar line of
business, whose shares are actively traded in a free and open market, can be a valid indicator of value when the
transactions in which stocks are traded are sufficiently similar to permit meaningful comparison.

The difficulty lies in identifying public companies that are sufficiently comparable to the subject company for
this purpose. Also, as for a private company, the equity is less liquid (in other words its stocks are less easy to
buy or sell) than for a public company, its value is considered to be slightly lower than such a market-based
valuation would give.

Guideline Public Company method

The Guideline Public Company method entails a comparison of the subject company to publicly traded
companies. The comparison is generally based on published data regarding the public companies’ stock price
and earnings, sales, or revenues, which is expressed as a fraction known as a “multiple.” If the guideline public
companies are sufficiently similar to each other and the subject company to permit a meaningful comparison,
then their multiples should be similar. The public companies identified for comparison purposes should be
similar to the subject company in terms of industry, product lines, market, growth, margins and risk.

Guideline Transaction Method or Direct Market Data Method

Using this method, the valuation analyst may determine market multiples by reviewing published data regarding
actual transactions involving either minority or controlling interests in either publicly traded or closely held
companies. In judging whether a reasonable basis for comparison exists, the valuation analysis must consider:
(1) the similarity of qualitative and quantitative investment and investor characteristics; (2) the extent to which
reliable data is known about the transactions in which interests in the guideline companies were bought and
sold; and (3) whether or not the price paid for the guideline companies was in an arms-length transaction, or a
forced or distressed sale.

Discounts and premiums

The valuation approaches yield the fair market value of the Company as a whole. In valuing a minority, non-
controlling interest in a business, however, the valuation professional must consider the applicability of
discounts that affect such interests. Discussions of discounts and premiums frequently begin with a review of
the “levels of value.” There are three common levels of value: controlling interest, marketable minority, and
non-marketable minority. The intermediate level, marketable minority interest, is lesser than the controlling
interest level and higher than the non-marketable minority interest level. The marketable minority interest level
represents the perceived value of equity interests that are freely traded without any restrictions. These interests
are generally traded on the New York Stock Exchange, AMEX, NASDAQ, and other exchanges where there is
a ready market for equity securities. These values represent a minority interest in the subject companies – small
blocks of stock that represent less than 50% of the company’s equity, and usually much less than 50%.
Controlling interest level is the value that an investor would be willing to pay to acquire more than 50% of a
company’s stock, thereby gaining the attendant prerogatives of control. Some of the prerogatives of control
include: electing directors, hiring and firing the company’s management and determining their compensation;
declaring dividends and distributions, determining the company’s strategy and line of business, and acquiring,
selling or liquidating the business. This level of value generally contains a control premium over the
intermediate level of value, which typically ranges from 25% to 50%. An additional premium may be paid by
strategic investors who are motivated by synergistic motives. Non-marketable, minority level is the lowest level
on the chart, representing the level at which non-controlling equity interests in private companies are generally
valued or traded. This level of value is discounted because no ready market exists in which to purchase or sell
interests. Private companies are less “liquid” than publicly-traded companies, and transactions in private
companies take longer and are more uncertain. Between the intermediate and lowest levels of the chart, there
are restricted shares of publicly-traded companies. Despite a growing inclination of the IRS and Tax Courts to
challenge valuation discounts , Shannon Pratt suggested in a scholarly presentation recently that valuation
discounts are actually increasing as the differences between public and private companies is widening .
Publicly-traded stocks have grown more liquid in the past decade due to rapid electronic trading, reduced
commissions, and governmental deregulation. These developments have not improved the liquidity of interests
in private companies, however. Valuation discounts are multiplicative, so they must be considered in order.
Control premiums and their inverse, minority interest discounts, are considered before marketability discounts
are applied.

Discount for lack of control

The first discount that must be considered is the discount for lack of control, which in this instance is also a
minority interest discount. Minority interest discounts are the inverse of control premiums, to which the
following mathematical relationship exists: MID = 1 – [1 / (1 + CP)] The most common source of data
regarding control premiums is the Control Premium Study, published annually by Mergerstat since 1972.
Mergerstat compiles data regarding publicly announced mergers, acquisitions and divestitures involving 10% or
more of the equity interests in public companies, where the purchase price is $1 million or more and at least one
of the parties to the transaction is a U.S. entity. Mergerstat defines the “control premium” as the percentage
difference between the acquisition price and the share price of the freely-traded public shares five days prior to
the announcement of the M&A transaction. While it is not without valid criticism, Mergerstat control premium
data (and the minority interest discount derived therefrom) is widely accepted within the valuation profession.
Discount for lack of marketability

Another factor to be considered in valuing closely held companies is the marketability of an interest in such
businesses. Marketability is defined as the ability to convert the business interest into cash quickly, with
minimum transaction and administrative costs, and with a high degree of certainty as to the amount of net
proceeds. There is usually a cost and a time lag associated with locating interested and capable buyers of
interests in privately-held companies, because there is no established market of readily-available buyers and
sellers. All other factors being equal, an interest in a publicly traded company is worth more because it is
readily marketable. Conversely, an interest in a private-held company is worth less because no established
market exists. The IRS Valuation Guide for Income, Estate and Gift Taxes, Valuation Training for Appeals
Officers acknowledges the relationship between value and marketability, stating: “Investors prefer an asset
which is easy to sell, that is, liquid.” The discount for lack of control is separate and distinguishable from the
discount for lack of marketability. It is the valuation professional’s task to quantify the lack of marketability of
an interest in a privately-held company. Because, in this case, the subject interest is not a controlling interest in
the Company, and the owner of that interest cannot compel liquidation to convert the subject interest to cash
quickly, and no established market exists on which that interest could be sold, the discount for lack of
marketability is appropriate. Several empirical studies have been published that attempt to quantify the discount
for lack of marketability. These studies include the restricted stock studies and the pre-IPO studies. The
aggregate of these studies indicate average discounts of 35% and 50%, respectively. Some experts believe the
Lack of Control and Marketability discounts can aggregate discounts for as much as ninety percent of a
Company's fair market value, specifically with family owned companies.

Restricted stock studies

Restricted stocks are equity securities of public companies that are similar in all respects to the freely traded
stocks of those companies except that they carry a restriction that prevents them from being traded on the open
market for a certain period of time, which is usually one year (two years prior to 1990). This restriction from
active trading, which amounts to a lack of marketability, is the only distinction between the restricted stock and
its freely-traded counterpart. Restricted stock can be traded in private transactions and usually do so at a
discount. The restricted stock studies attempt to verify the difference in price at which the restricted shares trade
versus the price at which the same unrestricted securities trade in the open market as of the same date. The
underlying data by which these studies arrived at their conclusions has not been made public. Consequently, it
is not possible when valuing a particular company to compare the characteristics of that company to the study
data. Still, the existence of a marketability discount has been recognized by valuation professionals and the
Courts, and the restricted stock studies are frequently cited as empirical evidence. Notably, the lowest average
discount reported by these studies was 26% and the highest average discount was 45%.

Option pricing

In addition to the restricted stock studies, U.S. publicly traded companies are able to sell stock to offshore
investors (SEC Regulation S, enacted in 1990) without registering the shares with the Securities and Exchange
Commission. The offshore buyers may resell these shares in the United States, still without having to register
the shares, after holding them for just 40 days. Typically, these shares are sold for 20% to 30% below the
publicly traded share price. Some of these transactions have been reported with discounts of more than 30%,
resulting from the lack of marketability. These discounts are similar to the marketability discounts inferred from
the restricted and pre-IPO studies, despite the holding period being just 40 days. Studies based on the prices
paid for options have also confirmed similar discounts. If one holds restricted stock and purchases an option to
sell that stock at the market price (a put), the holder has, in effect, purchased marketability for the shares. The
price of the put is equal to the marketability discount. The range of marketability discounts derived by this study
was 32% to 49%.
Pre-IPO studies

Another approach to measure the marketability discount is to compare the prices of stock offered in initial
public offerings (IPOs) to transactions in the same company’s stocks prior to the IPO. Companies that are going
public are required to disclose all transactions in their stocks for a period of three years prior to the IPO. The
pre-IPO studies are the leading alternative to the restricted stock stocks in quantifying the marketability
discount. The pre-IPO studies are sometimes criticized because the sample size is relatively small, the pre-IPO
transactions may not be arm’s length, and the financial structure and product lines of the studied companies may
have changed during the three year pre-IPO window.

Applying the studies

The studies confirm what the marketplace knows intuitively: Investors covet liquidity and loathe obstacles that
impair liquidity. Prudent investors buy illiquid investments only when there is a sufficient discount in the price
to increase the rate of return to a level which brings risk-reward back into balance. The referenced studies
establish a reasonable range of valuation discounts from the mid-30%s to the low 50%s. The more recent
studies appeared to yield a more conservative range of discounts than older studies, which may have suffered
from smaller sample sizes. Another method of quantifying the lack of marketability discount is the Quantifying
Marketability Discounts Model (QMDM).