3.20: “Premium” as used in valuators’ reports
Some of the terminology used in valuators’ reports (and other documents in the financial industry) can be confusing. “Premium” is a prime example.
Various premiums are added together to determine the discount rate.
In developing a capitalization rate or a discount rate many CBVs use the build up method. This involves starting with a risk-free rate, such as long-term government bonds, to which is added an “equity risk premium” to represent the additional risk associated with investing in a broad basket of publicly traded equities. Thereafter the CBV will add an industry premium (to reflect the risks associated with that industry, it can be negative if its a generally low risk industry), a size premium (to reflect the risks associated with investing in a company that is notably smaller than the public company base) and a specific company premium (which will be developed by recognizing several individual risk factors).
Simplistically, the total of all the premiums provides the cap rate or the discount rate. More detailed work, including the interest rates paid on debt, lead to the weighted average cost of capital which is used in the capitalized cashflow valuation method.
The term “premium” may also be used to referred to the additional value that attaches to a block of shares that provides its owner with control or other privileges. This usually happens where the value of some of the shares are discounted for lack of control.
For example, assume 100 common shares have an en-bloc value of $1,000. The controlling block of 60 shares (whose en-bloc value = $600) may end up with a fair market value of $750 (i.e. the CBV recognizes a control premium of 25%) while the 40 shares that lack control may be discounted to $250.
Contact MVI if you need help with any of the terminology you don’t understand in a valuator’s report. Not much is rocket science but quite a lot of terminology has a specific meaning within the industry.