Why discount and cap rates for minority and controlling investments are the same

Valuing a business? Then the need to figure out the discount and cap rates for minority and controlling investments may be in the cards. Appraisers call this step in the valuation process assessing the cost of capital.

Reliable evidence you can use to figure out your cost of capital comes from the public capital markets. That’s where investors buy and sell ownership interests in the form of company stocks. What sets this market apart from private business sales? Most transactions involve small blocks of shares. In other words, investors trade in minority ownership interests.

But when it comes to private business sales, controlling shares of the company change hands. So you can ask this question: does this affect your discount and cap rates?

Discount and cap rates are the same for minority and controlling investments

In general, the cost of capital remains the same regardless of whether your ownership interest is minority or controlling. That’s because investors still insist on their required rates of return in either case.

So why do company acquirers tend to pay a control premium above the market share price?  Because they plan on using the control over the business in order to improve the cash flows.

For example, controlling the company gives you a chance to improve operations and synergize with other companies in your investment portfolio. If you don’t control the company, you can’t make these changes.

Sometimes savvy buyers get to enjoy a negative control premium when taking a struggling company off the seller’s hands. Why would they do this? Because they see the financial ‘light at the end of the tunnel’ that the current owners fail to spot.

Tread carefully when using control premiums or minority discounts

Before rushing into applying a control premium or minority discount, study your proposed investment carefully. Then decide if you should adjust your valuation results.

See Valuation Tour