Introduction
The Discount for Lack of Marketability (DLOM) reflects the reduction in value attributable to the inability to quickly sell an ownership interest. Since shares in private companies cannot generally be sold as easily as publicly traded securities, investors typically require compensation for this illiquidity.
Valutico estimates DLOM using a weighted combination of three option pricing models:
Finnerty Model
Protective Put Model
Asian Put Model
Each model estimates the economic cost of illiquidity using a different option pricing framework. By default, Valutico combines the results of all three models to produce a balanced estimate, while allowing the weighting assigned to each model to be adjusted.
What are Option Pricing Models?
An option pricing model estimates the fair value of a financial option i.e. a contract giving the holder the right, but not the obligation, to buy or sell an asset at a predetermined price within a specified period, based on factors such as volatility, time to maturity, interest rates, and dividend yield.
The application of option pricing models to DLOM was first proposed by David B. Chaffe III, who argued that the inability to sell a private investment is economically equivalent to the absence of a protective put option. The cost of purchasing such a hypothetical option therefore represents the value of marketability, with the option premium serving as an estimate of the marketability discount.
Shared Inputs
All three models use the following assumptions:
Volatility – Derived from the median volatility of the selected peer group. Higher volatility increases the estimated DLOM, while lower volatility decreases it.
Risk-free Rate – Imported from the Cost of Capital assumptions. Higher risk-free rates generally reduce the estimated DLOM, while lower rates increase it.
Dividend Yield – Assumed to be 0% by default. Higher dividend yields generally reduce the estimated DLOM, while lower dividend yields increase it.
Holding Period (Time to Liquidity) – By default, this is set equal to the forecast period defined in the Forecast module. Longer expected holding periods generally increase the estimated DLOM, while shorter holding periods reduce it.
Finnerty Model
Developed by John D. Finnerty, the Finnerty Model estimates DLOM using an average-strike European put option.
Unlike a standard put option, where the strike price is fixed at inception, the Finnerty Model assumes the strike price equals the average share price over the holding period. This reflects the assumption that investors cannot systematically choose the optimal time to sell an illiquid investment.
By averaging the strike price, the model reduces the influence of short-term price fluctuations and generally produces more stable discount estimates across different volatility and holding period assumptions.
Protective Put Model
Developed by David B. Chaffe III, the Protective Put Model estimates DLOM using a standard at-the-money European put option valued using the Black-Scholes option pricing model.
The model assumes that an investor could protect the value of a freely tradable security by purchasing a put option with a maturity equal to the expected holding period. The cost of that protection is interpreted as the cost of illiquidity.
Because the strike price is fixed rather than averaged, the Protective Put Model is generally more sensitive to changes in volatility and holding period than the Finnerty Model.
Asian Put Model
The Asian Put Model estimates DLOM using an Asian-style put option, where the underlying share price is averaged over the holding period rather than using a single point-in-time price.
Unlike the Finnerty Model, which averages the strike price, the Asian Put Model keeps the strike price fixed and instead averages the underlying share price used to determine the option payoff.
This averaging mechanism reduces the impact of short-term price fluctuations and generally produces discount estimates that are less sensitive to volatility than the Protective Put Model.
Why Use a Weighted Combination?
By default, Valutico assigns an equal weighting of 33.3% to each model to produce a balanced DLOM estimate. If required, you can adjust these weightings, including allocating 100% to a single model, to reflect the specific facts and circumstances of the valuation engagement or your preferred valuation methodology.