Firm Size Premium and Earnings Quality Discount – New Evidence

Firm Size Premium and Earnings Quality Discount – New Evidence

2 December 2013

Business Valuation Resources published a study by Valuation Advisors, LLC in their October 2013 BVWire newsletter called ‘The Increase of Initial Public Offerings (IPOs) in 2013 and the Impact on Lack of Marketability’. This study, which measures the discount between pre-IPO transactions and IPO price in US markets, shows that the median discount for lack of marketability (DLOM) has increased from 30% in 2012 to 39% in 2013 and median revenues of companies in the study decreased from $103 mln to $54 mln.

This increase coincides with the introduction of a new law, the Jumpstart Our Business Startups Act, which went into effect in 2012 that allows younger and smaller companies to IPO with less restrictions and reporting requirements. Indeed, the number of IPO’s (132) through Aug 2013 already exceeded the number of IPO’s (128) through all of 2012.

The increase in DLOM could have been due to higher discounts across the size spectrum. Also, the conclusion of higher DLOM due to the Jumpstart Our Business Startups Act was based on a simple comparison of DLOM to revenues rather than DLOM to companies qualifying for this Act.

Companies qualifying for listing under this Act are referred to as ‘emerging growth companies’ (“ECG”). A number of listing requirements, which are in place to protect investors, are relaxed for ECGs. This implicitly results in IPOs with lower earnings quality. The increase in DLOM mentioned by Valuation Advisors seems to result from additional firm size premium (higher discount rate for smaller companies) and earnings quality discount (higher discount rate due to relatively questionable financial statements).