Definition
Discounts for Lack of Marketability (DLOM) refers to the reduction in a company’s valuation or stock price due to the inability to easily sell or convert the asset into cash. This usually occurs in the context of private companies where shares are not publicly traded, making them harder to sell. Therefore, the DLOM plays a key role in business valuation by adjusting the value to account for potential risks and the challenges with liquidity.
Phonetic
The phonetics of “Discounts For Lack Of Marketability (DLOM): Role in Valuation” would be:Discounts – /ˈdisˌkounts/For – /fɔːr/Lack – /lak/Of – /əv/Marketability – /ˌmɑːrkɪtəˈbɪlɪti/ (DLOM) – /diː ɛl oʊ ɛm/Role – /roʊl/ in – /ɪn/ Valuation – /ˌvæljuˈeɪʃən/.Collectively: “ˈdisˌkounts fɔːr lak əv ˌmɑːrkɪtəˈbɪlɪti (diː ɛl oʊ ɛm): roʊl in ˌvæljuˈeɪʃən”.
Key Takeaways
1. Significance of DLOM: The Discount for Lack of Marketability (DLOM) is a crucial concept in the field of business valuation. It serves as a discount applied to the valuation of a company’s equity due to the relative lack of liquidity in the market. The value of a business can be significantly influenced based on its illiquidity and inability to be speedily converted into cash which DLOM estimates.
2. Determining factors of DLOM: The computation of DLOM is highly subjective and depends on several factors – risk associated with the asset or security, the period of restriction or holding period for the security, and the perceived market conditions. Valuation experts must scrutinize all aspects meticulously to accurately calculate DLOM.
3. Methods used for estimating DLOM: Various techniques are used to estimate DLOM, among them are Option Pricing Models, Benchmark Study Data, Discounted Cash Flow methods and the Quantitative Marketability Discount Model. The use of any specific method would depend on the nature of the business, available data, and the expert’s professional judgment.
Importance
Discounts for Lack of Marketability (DLOM) plays a critical role in business and finance valuation, largely impacting the perceived value of an asset or a business, typically in private company valuations. DLOM accounts for the reduced liquidity of assets that can’t be easily or rapidly sold in the market at fair market value, such as shares in a privately-held company or in a real estate property. This discount thus reflects the higher risk associated with such assets due to their lack of marketability. Incorporating DLOM into valuation models allows investors, analysts, and other valuation professionals to present a more realistic and accurate value of an asset or enterprise, providing crucial information for decision-making in investment, taxation, litigation, and merger and acquisition scenarios.
Explanation
Discounts for Lack of Marketability (DLOM) play a significant role in financial valuation, particularly in relation to privately owned companies and non-liquid investments. The purpose of DLOM is to provide a quantifiable measure for the inability to quickly buy or sell an asset at fair value, taking into account the risks associated with the asset’s lack of liquidity. It provides a compensating factor for potential investors or buyers because non-liquid assets like privately held shares or real estate properties typically take more time and effort to sell at a fair price compared to liquid assets that are tradable on open markets.In valuation, DLOM is seen as a critical factor in accurately determining the value of a business or an investment and mitigating potential investment risks. For instance, when valuing a privately held company, a DLOM would typically be applied to account for the difficulties in offloading shares in comparison to public companies. It serves as a hedge for potential buyers against the additional time, expense, and uncertainty tied to realizing the value of an illiquid asset. Thus, DLOM can impact both the attractiveness of an investment opportunity and the negotiation of the acquisition price.
Examples
Discount for Lack of Marketability (DLOM) refers to the reduction in the value of an investment because the investment is not readily marketable. It is commonly used in business valuation.1. Private Company Stocks: Private company shares usually have a lack of marketability compared to public companies. As these shares cannot be easily sold or transferred, there is a larger risk associated with holding these types of investments. So, if an investor is considering purchasing shares in a private corporation, they may request a discount on the price per share due to the difficulty they might encounter trying to resell the shares in the future.2. Restricted Stocks: Investors who hold restricted stocks (stocks of public companies that are not fully transferable until certain conditions are met) might need to apply a DLOM when valuing their shares. Because these stocks cannot be readily sold in the stock market until certain conditions have been fulfilled, they lack the liquidity that comes with unrestricted, freely tradable stocks. Therefore, an investor might value them less than unrestricted shares from the same company.3. Minority Interest in a Business: A minority interest in a business carries with it a lack of control over business decisions and can often be hard to sell. For example, an investor holding a small percentage of shares in a publicly-traded company might encounter some difficulty trying to resell these shares, especially if the majority of the shares are held by a single entity. Therefore, the minority shareholder may value their stake in the company less due to the potential difficulty in reselling their shares, thus applying a DLOM in their valuation.
Frequently Asked Questions(FAQ)
What is a Discount for Lack of Marketability (DLOM)?
A Discount for Lack of Marketability (DLOM) is a reduction in a company’s valuation, often used in valuing closely held, non-publicly traded companies, reflecting the relative absence or lower degree of marketability.
Why is DLOM important in business valuation?
DLOM plays a vital role in adjusting the fair value of a business, especially when the value of the business’s shares could be adversely affected by restrictions or limitations on their transferability or sale. DLOM accounts for these limitations, providing a more accurate assessment of a business’s value.
How is DLOM calculated?
The calculation of the DLOM varies depending on the specific circumstances of the company being valued. Several methods can be used, such as the Restricted Stock Method, Pre-IPO Studies, Option Pricing Models, and Quantitative Models. The choice depends on the specific variables present in the company’s situation.
Does DLOM apply to all businesses?
No, DLOM primarily applies to closely-held and private companies where there is no established market for buying and selling ownership interests.
Can DLOM affect a company’s selling price?
Yes, a high DLOM can reduce a company’s value, and thus, the selling price of its shares. This can occur when the shares or the company’s assets are not readily marketable or when there are significant restrictions on their transfer.
When is DLOM used in financial reporting?
DLOM is commonly used in financial reporting when fair valuing equity securities held by an entity that in most cases cannot be readily sold or if there are significant restrictions on the transfer of these securities.
How is DLOM different from a marketability discount?
The terms are often used interchangeably, but they focus on slightly different concepts. Both refer to the decrease in value due to a lack of marketability. However, DLOM focuses more on the limitations or difficulties in selling an ownership interest or asset, while the marketability discount can refer to the price difference between identical securities in different markets due primarily to the lack of liquidity in one of the markets.
Related Finance Terms
- Valuation Discount: This refers to the reduction in a company’s value due to various factors, one of which could be the lack of marketability.
- Restricted Stock Studies: These are frequently used in evaluating DLOM. They compare the prices of restricted shares (not readily marketable) with their fully marketable counterparts.
- Pre-IPO Studies: This refers to the studies of companies before they are publicly listed. These studies often include the consideration of DLOM as the shares aren’t marketable yet.
- Fair Market Value: DLOM plays a big role in determining a business’s fair market value – the price at which a property would change hands between a willing buyer and a willing seller.
- Liquidity Risk: The risk associated with the difficulty of selling an investment, or the discount a seller needs to apply to the investment for it to sell quickly. It greatly relates to DLOM in the valuation process.
