Implied Private Company Pricing Line Provides Cost of Capital Comfort

New private company cost of capital model delivers consistent and observable results

The Implied Private Company Pricing Line (IPCPL) Cost of Capital Model seeks to eliminate pitfalls for unsystematic risk, liquidity, small stock premium, PTE taxes, and cash/leverage by utilizing real transaction, market-clearing prices between buyers and sellers of comparable small private businesses.

The Implied Private Company Pricing Line (IPCPL) is a new model that is intended to estimate the cost of capital for a privately held firm whose revenues are less than $10 million. It is designed to eliminate the inherent problems in comparing public and private data and provide a more reliable estimate of the cost of capital. It was originally introduced in the Spring 2012 edition of Business Valuation Review (Volume 31, No. 1). IPCPL continues to evolve and improve. Most recently, it was featured in the September 2013 edition of Business Valuation Resources as a BV Update. Its authors and developers are no strangers to the valuation community. They include Robert Dohmeyer (Dohmeyer Valuation Corporation), Peter Butler (Valtrend, LLC), and Rod Burkert (Burkert Valuation Advisors). To their credit, the IPCPL model seeks to eliminate “pitfalls for unsystematic risk, liquidity, small stock premium, PTE taxes, and cash/leverage by utilizing real transaction, market-clearing prices between buyers and sellers of comparable small private businesses.” The authors go on to say:

The IPCPL aggregates 500 Pratt’s Stats private company transactions and directly estimates the aggregate IRR on free cash flows. This IRR aka “ex ante” approach is fundamentally the same as professor Damodaran’s calculation of the implied equity risk premium approach. By using prices paid (FMV) for small privately held companies, all of the above public security return extrapolation issues are rendered moot. Effects of liquidity, unsystematic risk, taxes etc. are reflected (‘baked-in’) in the (FMV) clearing prices paid for the businesses. We note when challenging appraisers on, for example, why they use decile 10 instead of the closer in size 10z, or why do they start with a company specific risk premium of 5% instead of 0% most admit that there is nothing scientifically sound about how they do it except:

‘If I use 10z instead of 10, I would get PV results that are probably too low compared to the comps and if I were to use a 0% company specific risk premium instead of 5%, I would get PV results that are probably too high compared to the comps.’

With this data and this model, we developed cost of capital estimates that are most consistent with the observable FMV prices paid for small privately held businesses. Employing cost of capital figures generally lower than IPCPL would yield fair market values in excess of the empirical FMV evidence and employing cost of capital figures generally higher than IPCPL would yield fair market values below the empirical FMV evidence.

Recently, State Chapter members of NACVA Texas were fortunate enough to have Bob Dohmeyer, ASA, personally present and explain the Implied Private Company Pricing Line Model and its current application in business valuation. Suffice to say, IPCPL is an exciting development and contribution to the cost of capital determination. Why? In short, IPCPL is based on actual market sale transactions of mainstream private businesses and, as Dohmeyer likes to point out, many of the unsystematic risk factors are “baked in” and minimize the need for subjective adjustments. The IPCPL Model is like comfort food; you can’t help but like it because it is simple on the surface, it’s what you want or crave, and you could fall victim to overindulgence. Every valuation analyst should take the time to read and explore the data and model that the authors have offered up to the valuation community. The IPCPL is not without resources.

Suggested Resources

• Business Valuation Resources IPCPL Center, http://www.bvmarketdata.com/defaulttextonly.asp?f=IPCP
• The Implied Private Company Pricing Line 2.0, Business Valuation Resources, LLC, http://www.bvresources.com/download.asp?DownloadID=503
• The Implied Private Company Pricing Line: Empirically Observing the Cost of Capital COC  =  FCFF/P + G, Business Valuation Review, Volume 31, Issue 1, Spring 2012
• http://biz-app-solutions.com
• http://biz-app-solutions.com/faqpdf.pdf

As indicated, the most current written presentation of the Implied Private Company Pricing Line is available from BV Resources as a complimentary download. The authors will take the reader through the development of the model, provide statistical support and evidence as to its accuracy and relevance, and offer suggestions as to its current application in the field of business valuation. For those analysts that like to start at the beginning, the model was first introduced in Spring 2012 in Business Valuation Review. The evolution or advancement in the model to date centers on an improvement of the private company returns where the developers now use a sample of 500 transactions, aggregate them, and estimate the aggregate unlevered internal rate of return (IRR). In both presentations, the valuation analyst will find that the authors know their subject. Dohmeyer is a regular contributor to cost of capital discussions and debates. Butler is well known for contributions and advancement of the use of total beta in the field of business valuation.

For those who feel a level of comfort after reading the IPCPL papers, they should head directly to the developers’ website. In a supposedly transparent era, the developers open up the IPCPL Model for review, use, and comment. What was not covered in their papers, the analyst is likely find it addressed in a frequently asked question (FAQ) section.

Key Observations • The IPCPL is not yet prime time, but, nevertheless, a valuable and relevant tool in every valuator’s toolbox. Its concept and principle are sound, but it is not yet vetted for litigation and peer acceptance. • Some company specific risk premium (adjustment) may be required; however, it will relate to a private market transaction data difference and not a public traded company/industry difference. • Although the database is updated monthly, the small change in cost of capital values is consistent with the conclusions reached by other authors and developers of private company transaction databases. • The IPCPL Model and results are similar to the cost of capital models and arguments advanced by Professor Damodaran of the Stern School of Business at New York University and John Paglia of the Pepperdine Private Capital Market Studies. • The IPCPL results suggest (with good reason) subjective build-ups under the Capital Asset Pricing Model (CAPM) that are frequently seen in small business valuations are too often excessive and mostly undervalue the subject company. • Based on the current work, results, and communication between the developers and the valuation community, the IPCPL Model will gain credibility and acceptance by valuators and users of business valuation in the near future. Any valuator that appreciates the market approach or has operational or transactional experience will be drawn to the Implied Private Company Pricing Line like comfort food. While the cost of capital debate continues and one resource transitions, many of us can look forward to future developments, advancements, and another helping of IPCPL.

Jeff Harwell, CVA, MAFF, CMEA, is principal of Harwell & Company, a Dallas/Fort Worth-area valuation analyst, economic damages, and litigation support firm. Mr. Harwell received his BBA from the University of Texas at Arlington and his MBA from the Neeley School at Texas Christian University. He currently serves on the National Association of Certified Valuators and Analysts’ (NACVA) Standards Committee, as well as NACVA’s State Chapter Committee. Mr. Harwell’s clients include attorneys, business owners, and CPAs. Mr. Harwell can be reached at jharwell@bfval.com.