Question #1: The cost of a put option can be offset by the sale of a call option on the same stock, thus isn’t the discount for lack of marketability the difference between the two?
This argument was put forward in a January 2009 “Letter To The Editor” of BVResources’ BVWire publication by Harry J. Fuhrman, a valuation analyst for the IRS, in this manner: “I believe that Mr. Seaman’s comments are misleading and significantly overstate the range of discounts for the lack of marketability. Mr. Seaman’s calculations exclude one-half of the equation, and by calculating only the cost for a put option (in order to ‘eliminate downside risk’), Mr. Seaman disregards the related upside potential in an underlying security which a hypothetical investor would have access to.
“In order to ‘lock-in’ a security’s price today an investor would undertake two courses of action: (i) purchasing a put option to protect against any downside risk…but that investor would also (ii) have the ability to sell a call option related to any upside potential in the stock. The netting of the put-expense with the call-income would truly demonstrate the relevant position an investor would be confronted with when attempting to ‘lock-in’ the current security price.” (Emphasis in the original.)
Answer: Shades of Dr. Bajaj and his rationale for minuscule discounts!
First, no investor in closely-held stock wants to “lock-in a security’s price today.” He expects to make a return on his investment! That return may be in dividends, but the investor hopes his return will include growth in value of the stock. He certainly doesn’t want to sell a call option “related to any upside potential…” The upside potential is a major portion of the return on his investment he is looking for.
What an investor does want to do is to minimize his possibility of loss. That’s one of the major things measured by any discount for lack of marketability (see Mandelbaum). That risk of loss in value over time is precisely what is measured in the cost of a put option. And, the market proves to us that the risk of loss is valuation-date specific and industry-specific.
Question #2: Aren’t some of the Mandelbaum factors already included in the company-specific portion of the capitalization rate? Thus, aren’t you double-dipping by using an industry-specific LEAPS basis for the discount for lack of marketability?
Answer: Some of the factors considered are the same, but the use or purpose of the factors is different. The market shows us this. We consider company-specific risk factors in determining a discount rate for the purpose of estimating the stock price, just as investors in public companies consider company-specific factors in valuing publicly traded stocks.
But, we must consider company-specific risk factors again for the purpose of measuring an investor’s ability to sell his closely-held stock quickly; i.e., the discount for lack of marketability. Company-specific factors (and others) determine a reasonable size for the discount for lack of marketability of closely-held stock.
Comparisons of LEAPS and stock prices in August 2006 and November 2008 show that discounts (or the costs of price protection) in 2008 were more than double those in 2006, while, at the same time, the underlying stock prices had declined dramatically. (See article, “The Effects of Current Economic Troubles On Discounts For Lack of Marketability.”)
Finally, court decisions (like Mandelbaum) require consideration of these factors. Commonly used measures of marketability, such as restricted stock studies, require the use of data from companies as close in nature as possible to the company being appraised.
Question #3: Where can I find historical prices of LEAPS?
Answer: At www.marketdataexpress.com. They are available for $3.00 per stock symbol and per trading date (as of December 2010). A more detailed description of the procedure is in the article "How To Use LEAPS" in this website.
Question #4: How do you calculate the LEAPS discounts?
Answer: The discount is the relationship between the actual stock price and the next higher and lower strike prices. For example, a stock trading at $36.06 per share on your valuation date has put options at $35.00 at a cost of $5.10 and at $40.00 at a cost of $7.90. The "Distance Weighted Option Cost." of a put option for $36.06 is a straight-line percentage increase in the actual option cost difference between $35.00 and $40.00. Thus, the stock price, $36.05, is $1.06 above the $35.00 strike price, or 21.2% of the $5.00 difference in strike prices ( $1.06 ÷ $5.00). The difference in put option costs is $2.80 ($7.90 - $5.10). So we add 21.2% of the difference ($2.80 x .212 = $0.59) to the lower option cost ($5.10) to arrive at a "Distance Weighted Option Cost" of $5.69. Dividing that by the stock price results in a percentage cost of 15.8% ($5.69 ÷ $36.06).
Described in a mathematic formula, the calculation is:
| Step 1: | Share Price - Strike 1 Price | = a decimal number |
|
|
| Strike 2 Price - Strike 1 Price |
| |
| Step 2: | Option 2 Cost - Option 1 Cost * the decimal number from Step 1 + Option 1 Cost | = Adjusted Put Option Cost |
| |
| Step 3: |
Adjusted Put Option Cost |
= Discount |
|
|
| Share Price |
|