Company Specific Risk

Alleged Best Practices to Whom?

Peter J. Butler, CFA, ASA, MBA, founder of Valtrend, LLC and inventor of the Total Cost of Equity Calculator (TCOE), responds to comments made by Robert Reilly and Connor Thurman regarding best practices used to arrive at the company specific risk; the latter article did not discuss the TCOE and here he “key[s] in on Part III—the section which addresses empirical evidence in the selection of the company specific risk premium (CSRP)” and merits of the TCOE.

Introduction

I read all four parts of the “Best Practices for Estimating the Company-Specific Risk Premium” in NACVA’s QuickRead written by Robert Reilly and Connor Thurman (the “Article”). I want to key in on Part III—the section which addresses empirical evidence in the selection of the company specific risk premium (CSRP). With due respect to the authors, I was surprised not to see total beta and the resultant total cost of equity (TCOE) equation included in this section; especially after reading about the other alleged “best” practices.

Let’s look at the recommendations from the Article first before highlighting total beta’s advantages over them.

Quantum of Risk in Modified Capital Asset Pricing Model (MCAPM) and Build-up Method (BUM)

We all are aware that in these methods, we build-up the rate from a risk-free rate all the way to an investment in private equity, with the last premium being the CSRP.

The range of the quantum of risk (prior to selection of the CSRP) runs from, in the example provided in the Article, 3% – 6% (MCAPM) or 3% – 7% (BUM), by looking at each risk-premium:

• 3% for the risk-free rate (the lower end of the range);
• 6%–7% for the equity risk premium (the upper end of the range); and
• 5% for the (alleged and dubious) size premium.

Then, this alleged best practice model selects 4% for the CSRP for both the MCAPM and the BUM. But how?

The Article states that the 4% selection was dependent upon the “Analyst’s Estimated Company-Specific Risk Premium—Based on an Assessment of the Previous Levels of Risk.” (Emphasis added)

What do the first three levels of risk have to do with the last level? Nothing, unfortunately. As if the CSRP could not be greater than 3%–6%. I have certainly applied a CSRP above this range for my subject company, if appropriate.

By admission, this alleged best practice offers no pertinent empirical evidence for this last portion of the TCOE.

Considering the CSRP Deciles Size Premia Studies Data as a Proxy for CSRP

The Article states that “While the CRSP Decile Size Premia Studies data are typically relied upon to quantify S_p, these data may also provide some guidance about developing the CSRP range.” The obvious question is how exactly does a size premium provide guidance for a completely different risk premium?

The (alleged and dubious) size premium is separate and distinct from the CSRP. Otherwise, why have we as a profession always separated the two? Why are we again using other data (which does not capture the CSRP) to allegedly quantify the CSRP?

Moreover, most academics (possibly all academics?) believe that the (alleged and dubious) size premium has not existed since the early 1980s—despite what influential appraisers tell us—some of whom have an obvious conflict of interest on the topic.

The Article keys in on sub-deciles 10w, 10x, 10y and 10z to allegedly apply empirical S_p evidence to CSRPs; despite recognizing that the 10^th decile “is comprised of financially troubled and financially distressed companies” and whose individual use in the size premium selection is generally discouraged. What happens if your subject company is not financially troubled or financially distressed?

Moreover, we have been taught that company-specific risk is not priced in the publicly-traded markets since investors can easily diversify the risk away. Thus, how does looking at the (alleged and dubious) size premium help us in quantifying this risk? Thus, as controversial as the (alleged and dubious) size premium is, let’s not also drag its use into the CSRP and double-down on the potentially faulty data.

Analysis of Relative Bond Ratings and Bond Yields

The theme continues and it goes like this: Let’s look at other data—rather than data in the appropriate domain.

In this approach, the Article looks to the high-yield bond spread as guidance to develop the CSRP. The Article states the spread is “the incremental return that debt investors expect as compensation for the factors that pertain to company-specific risk—such as financial distress, liquidity risk, and so-forth.” (Emphasis added)

Again, is your subject company financially distressed? Most of the companies that I value—at least as of late—have not been close to financially-distressed.

Moreover, they are two different types of securities. Are you valuing equity or a fixed income instrument? The future cash flows and risks to those cash flows are obviously different; particularly if you are not dealing with a financially struggling company.

Finally, if you believe that you have accounted for liquidity risk in the development of your cost of equity, how does that impact your conclusion of value; either for a controlling equity interest (where most do not apply a discount for lack of marketability [DLOM]) or for a minority equity interest? Do you apply a lower DLOM for a minority equity interest than you would have otherwise, or not at all?

Which brings us to the last alleged best practice.

Analysis of Illiquidity Studies (Restricted Stock Studies)

The theme continues of looking for alleged evidence of company-specific risk in incorrect places, and ignoring the pertinent domain. In this case, the Article looks to restricted stock studies and the selection of an appropriate DLOM (assuming we even need to select a DLOM, which is controversial for a 100% equity interest) for assistance in the selection of the appropriate CSRP.

The Article mentions that this approach captures “illiquidity issues that private companies experience (and that public companies do not experience).” Thus, does this method capture CSRP or a DLOM or a combination? See above comments regarding potential double-dipping between the cost of equity and an appropriate DLOM.

Summary

Apparently, alleged “best” practices are in the eye of the beholder. For the above reasons, I have never used any of the alleged “empirical” evidence above to help select an appropriate CSRP.

There is simply no need to “muddy the waters” and use data[1] which captures other risks—to use (again) as any type of guide for the CSRP. Why? We have total beta and have had it at least for three decades now.

Total beta is the “Occam’s Razor” for the development of a TCOE for a privately-held company. Occam’s Razor indicates that the simplest explanation (that is, the solution that requires the fewest assumptions) is preferable. As you will see below, total beta, by far, requires far fewer assumptions than the leaps of faith required to use the Article’s alleged “best” practices.

Total Beta

Total beta is the pertinent statistic in the pertinent domain to mitigate the subjectivity of selection of an appropriate CSRP, or even eliminate the need to select the CSRP altogether.

Total beta’s “origin” can be traced to 1981. Professor Damodaran used it to develop the TCOE in the 1990s. I have written extensively about total beta since 2006; invented and co-developed the Butler Pinkerton Calculator (BPC) in 2007 (which has received numerous testimonials from PhDs in finance and other well-respected appraisers); and has had happy subscribers ever since.

In my opinion, I have very successfully and confidently used the BPC over that time period (while recognizing nothing is perfect in the development of the cost of equity) rather than completely guessing at a CSRP or using the alleged best practices described in the Article. Thus, to not see total beta mentioned in the list of alleged best practices was a big surprise.

In any event, I will not repeat in grand detail everything total beta here, other than to address the above criticisms and juxtapose them with total beta.

Total beta is 100% based on the CAPM,[2] and does not have to rely upon other potentially faulty risk premiums as a guide. “Simply” select the appropriate total beta (or private company beta) to replace beta in the CAPM equation: TCOE = r_f + TB*ERP, since total beta captures total risk (priced systematic [beta] and un-priced company-specific risk), which is what either the MCAPM or BUM attempts to do—just with many steps. Total beta simply assumes that the un-priced company-specific risk for the public guidelines is a good proxy for the priced company-specific risk of privately-held companies.

Since I believe the academic research and the elimination of the size premium, the fact that I may use specific public companies as potential guidelines for smaller, privately-held companies, does not concern me—nor should it concern you. After all, any analyst uses publicly-traded stocks when selecting the equity risk premium, the industry risk premium, beta, and the (alleged and dubious) size premium. Simply stated, total beta is a market approach to selecting the TCOE; similar to selecting a multiple in the market approach.

Thus, the selection of total beta is not reliant upon any alleged quantum of risk of previous components of risk in the BUM or MCAPM (which do not capture CSRP), and specifically, not the (alleged and dubious) size premium.

Moreover, since total beta is calculated from publicly-traded stocks (often times from the same industry or guidelines used to calculate beta), there is no risk of capturing illiquidity risk (if using efficiently traded stocks) and double-dipping between risk and lack of marketability/liquidity.

Additionally, the analyst can be selective in selecting potential guidelines (rather than somehow relying upon financially-distressed high yield bonds, a completely different [fixed income] security with a different risk profile, than an equity security) in capturing CSRP.

In addition to comparing various total betas in the subject company’s industry, you can look outside the industry for specific risk factors with total beta. For example, I am valuing a company with significant customer concentration. So, I recently searched the sec.gov website and searched for the specific words, “customer concentration,” and found some interesting publicly-traded stocks which suffer from such—like my subject company. This kind of flexibility is simply impossible with the above alleged generic “empirical” data in the Article—all risk components which capture other risks, but not company-specific equity risks.

Thus, as you can see, my idea of best practice for the selection of a CSRP (or TCOE) is completely different than that presented in the Article.

What’s yours?

[1] Questionable or otherwise.

[2] We can debate the merits of the CAPM (or any other model or survey). However, the Article appears to be a supporter of the CAPM.

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Mr. Butler is the founder of Valtrend, LLC, and is the inventor of the Total Cost of Equity Calculator (aka the Butler Pinkerton Calculator) to better quantify discount rates for privately-held companies. This Calculator helps Valtrend and other leading appraisal companies form opinions that are more empirical: less subjective™. Mr. Butler is also a co-developer of the Implied Private Company Pricing Line/Model (IPCPL)—another useful tool for business appraisers to use to help select a cost of capital in the income approach to valuation.

Mr. Butler can be contacted at (208) 371-7267 or by e-mail to pete@valtrend.com.