January 2023
According to the International Glossary of Business Valuation Terms “Market Capitalization” (of equity) is the share price of a publicly-traded stock multiplied by the number of shares outstanding. This is usually assumed by business valuators and investors to equate to fair market value. P/E ratios, that are widely used by investors and business valuators to value businesses, are calculated by dividing the subject company’s market capitalization by its earnings. Likewise, other ratios are used to value businesses such as price to sales, price to cash flow and price to book value that assume that market capitalization equals fair market value.
The assumption that market capitalization represents fair market value is in turn based on the assumption that the publicly-traded price equates to fair market value. However, in some cases this isn’t a valid assumption. For instance, if the subject stock is thinly traded its share price may be below fair market value as there likely will be an inherent discount in the price due to illiquidity. Likewise, if a large block of stock is being sold in the public market there would be a downward pressure on the stock price. This is otherwise known as a “blockage discount”.
The publicly-traded price of a stock normally equates to a marketable minority interest. Or, in other words, an equity interest that is freely traded and doesn’t have the power to control the subject company. However, if a controlling interest in the company is being acquired, or if investors believe it might be acquired, the price could rise above fair market value on a minority interest basis.
There are a number of reasons that market capitalization may not equate to fair market value. The business valuator and the investor should be cognizant of this and should not blindly assume that market capitalization equals fair market value. The publicly-traded stock price utilized in a business valuation should be examined to make sure that it represents fair market value.
Relevant Court Cases
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Chase v. Chase,
Court of Appeals of Tennessee at Knoxville,
No. 19-D-1205,
filed December 9, 2022
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Goicochea v. Goicochea,
Court of Special Appeals of Maryland,
No. 0877,
filed December 6, 2022
Recent Business Valuation Articles
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“The Market Capitalization Illusion,”
by J.B. Heaton,
dated December 17, 2022
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“Pop & Perjury: the IRS Valuation War
with the Estate of Michael Jackson,”
by Beckett Cantley and Geoffrey Dietrich,
21 UNHL Rev. 93 (2022)
Recent Engagements
- Valuation of 100% of the member interests
in a specialty restaurant on a controlling interest
basis for potential purchase/sale purposes.
- Valuation of 100% of the common stock
of a real estate management and investment company
on a controlling interest basis for estate tax
reporting purposes.
- Valuation of a 25% member interest of a
real estate holding company on a minority
interest basis for gift tax reporting purposes.
- Consulting regarding 100% of the member interests
a niche retail and rental firm on a controlling
interest basis for planning purposes.
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