Last week, the BVWire™ included a follow-up to a Letter to the Editor authored by Ronald Seaman, FASA, of Tampa, Florida’s Southland Business Group. In his letter Seaman noted, “The costs of Long-Term Equity Anticipation Securities (LEAPS) put options are an excellent proxy for the discount for lack of marketability because the costs of LEAPS include most of the Mandelbaum factors and are obviously market-based. Because LEAPS are valuation-date specific and industry specific, the question about reduced liquidity can easily be answered by a study of their costs on whatever beginning and ending dates one chooses and for whatever industries or companies one chooses.”
Yet another ‘Wire reader, IRS analyst Harry Fuhrman, AVA, followed up with his thoughts on Seaman’s premise and took exception to his use of LEAPs in developing a discount for lack of marketability. What follows, are Fuhrman’s comments, which he offers solely as his own and not in the context of his position as a valuation analyst for the IRS. Indeed, he stresses that his opinions are not those of the Service in general. Fuhrman’s perspective:
“On Seaman’s Web site, [he] states, LEAPS can prove a significant DLOM. I believe Seaman’s comments are misleading and significantly overstate the range of discounts for the lack of marketability. [The] calculations exclude one-half of the equation, and by calculating only the cost for a put option (to “eliminate downside risk”), [he] disregards the related upside potential in an underlying security [to] which a hypothetical investor would have access. To ‘lock-in’ a security’s price today, an investor would undertake two courses of action: 1) purchase a put option to protect against any downside risk (as Seaman’s calculations do) or 2) 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. As a result, by including only the expense related with maintaining the current security price, the conclusions Seaman arrives at are overstated and cannot be used as anything more than the ceiling for potential discounts for lack of marketability.”
Fuhrman offers the following example: “AT&T closed at $25.02 on 1/20/2009. A January 2010 put at a $25.00 strike price traded for $5.00, and a January 2010 put, also at a $25.00 strike price, traded for $6.90. Based on these put options, the Seaman calculation would estimate discounts for lack of marketability ranging from 20-28 percent. This estimate would be significantly overstated as a holder of AT&T, in addition to purchasing a put to secure the downside risk, would also have the right to sell call options for 2010 and 2011, which were trading (for the same strike price) at $4.00 and $5.00, respectively. Taking into consideration the income from the sale of the call options, the vast majority of the cost of the put options would be offset. Rather the true ‘cost’ for securing the current AT&T stock price would be the net of the put cost and the call income, which would equate to a range for the discount of lack of marketability between 4.0 and 7.6 percent, significantly lower than the results based on Seaman’s calculations. Of course this would be a baseline indication reflecting the volatility inherent in the security over the time to market and would need to be adjusted for the specific interest at hand.”
Ronald Seaman’s response: "I understand Mr. Fuhrman’s arithmetic, but I don't understand his logic. A discount for lack of marketability does not attempt to 'lock-in a security’s price today,' which Mr. Fuhrman states as the objective in his example. A DLOM simply attempts to measure the investor's risk, a major part of which is the risk of loss in value over time. That is precisely the risk measured in an analysis using LEAPS put options. As an investor, I am interested in minimizing my risk and leaving open my opportunity for gain. If I could buy a put option on my stock at the value at which I bought it, I would be protected from downside risk. There is no loss of ‘upside potential’ because I can simply not exercise the option. Thus, there is no reason for me to purchase a call option.”
What do you think? Readers who want to join the discussion can drop us a line.