Gift Cards and the Illiquidity Discount – A Valuation Perspective
03 December, 2015-
Ephraim Stulberg -
Canada
With the busiest season of the year for retail sales upon us, you are no doubt wondering what to buy for that special someone. If you’re reading this blog – and I have every reason to believe you are – then what you really want to know is what a Chartered Business Valuator has to say about gift giving. In this post I look at gift giving – and in particular, the silly practice of giving gift cards – from a business valuation perspective.
The Discount for Illiquidity and Jerry Seinfeld
Let us forget about gifts for a moment and think about equity valuation.
Suppose you had the ability to acquire one of two securities. Both securities are in companies that are exactly the same in every way (Company A and Company B) – they are in the same line of business, have the same assets and liabilities, and earn the same amount of income each year. Each company will pay the holder of the security $1,000 per year into perpetuity. The only difference between the two investments is that the holder of the shares of Company B is restricted from selling them for 2 years, while the holder of the shares of Company A has no such restrictions.
Clearly, you would rather own the shares of Company A than Company B, since those of Company A are identical to those of Company B, only they carry no restrictions. Precisely how much more you would pay for the more “liquid” shares of Company A has been a matter of debate within the valuation profession for a number of years, and I have written a lengthy article on the subject (here). In brief, the main sources of data on this discount are so-called “restricted stock” studies. These studies look at the price at which “restricted stock” is issued in private placements to accredited investors, relative to the current market price of that stock on the public exchanges. For example, if shares of a public company trade at $100 per share, and restricted stock are sold at $80 per share, then the illiquidity discount is $20, or 20%.
How useful are restricted stock studies? One analysis questions their validity. It shows [1] that the firms that issue restricted stock in private placements tend to be predominantly small firms listed “over-the-counter”. It concludes that much of the “discount” observed on these private placements is due to:
- The relatively poor financial position of the issuing company, and hence its poor bargaining position when it comes to issuing new equity; and,
- The fact that the observed market price for unrestricted shares of these companies (against which the restricted stock discount is calculated) is itself unrepresentative of the fair market value of those shares.
The Discount on Gift Cards
What does all this have to do with gift cards? It is many years since the great contemporary thinker and social critic, Dilbert, noted that gift certificates are “like money, only worse” (https://www.youtube.com/watch?v=OCvR9_W9osw/). Like money, they can be used to purchase goods and services; but unlike money, they can only be used to make purchases from the issuing business. Gift cards are illiquid; they are in many ways like restricted stock. If you recognize the value of liquidity, you will agree with Jerry Seinfeld that cash makes the perfect gift: (https://www.youtube.com/watch?v=aQlhrrqTQmU/). Elaine’s reaction betrays a basic unawareness of valuation theory.
So what is the discount for illiquidity on gift cards? How much would you be willing to sell a $100 gift certificate for? It will probably depend on a number of factors:
- If the card is for a store at which you regularly shop, you may not be willing to sell it for much less than $100.
- If the card is for a store at which you are likely to shop, but only irregularly, then you may be willing to accept a larger discount, in particular if you are short on cash.
For example, I buy my groceries at No Frills and my shoes at the Shoe Company. But I buy groceries every week, and shoes (very) infrequently. I would not sell a No Frills gift card for less than face value, since I can redeem the full face value in a very short period of time. But I would be glad to get rid of a Shoe Company gift card, which I may not use for a few years, for more of a discount. And if I needed to make a big purchase and was short of funds, I would be willing to take an ever steeper discount.
- If the card is for a large chain, it will require a smaller discount than a card for a small, speciality store.
- Cards for large chains are easy to use. Even if the seller does not regularly shop at the chain, many others do, and the card should be easier to unload.
In order to see this phenomenon in effect, you can look at some of the websites that buy and sell gift cards. At www.giftrescue.com, gift cards for gasoline sell at a discount of 3%, while cards for more specialized consumer goods such as clothing can be had for discounts of 35% to 40%. On http://www.cardswap.ca/buy/list/, it is grocery gift cards that trade closest to their face value.
How is this relevant for equity valuations? It suggests that the value of liquidity is investor-specific. The discount given by firms issuing illiquid stock will depend on how badly they need immediate cash. And the illiquidity discount that a purchaser or owner of that stock might apply in valuing it will depend on how much they require liquidity.
Conclusion
So how valuable is liquidity? The short answer is that, with investments as with gift cards: it depends.
The statements or comments contained within this article are based on the author’s own knowledge and experience and do not necessarily represent those of the firm, other partners, our clients, or other business partners.
Robert Comment, “Revisiting the Illiquidity Discount for Private Companies: A New (and “Skeptical”) Restricted Stock Study”, Journal of Applied Corporate Finance, 24:1 (Winter 2012);
Ephraim Stulberg
B.A, M.A, M.BA, CPA, CA, CBV, CFF, Partner/Senior Vice President
- +1 416.366.4968
- estulberg@mdd.com
- Toronto, ON, Canada
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