New Detailed Cost of Capital Case Study: Step-by-Step Comparison of the Kroll Cost of Capital Navigator, BVR Cost of Capital Pro, Damodaran Data, and Surveys

VPS StraightTalk Webinar, October 20, 2022

This summer and fall 2022, within the business valuation profession, one of the most contentious issues has been “which cost of capital should business valuation professionals use when valuing a small business?” First, Dr. Damodaran advocated the implied equity risk premium with the capital asset pricing model without adding a size premium or company specific risk. He adjusts for other risk factors (size and company specific risks) by adjusting the forecasted cash flows. Next, James Hitchner, CPA, ABV, CFF, responded to Dr. Damodaran’s criticism. Shortly thereafter, Eric Nath, founder of Eri Nath & Associates, wrote an article, “Hitcher Rebuts Damodaran’s Attacks on Cost of Capital Inputs”, written for BVR, where he voiced support for Dr. Damodaran’s “forward-looking approach.” On October 20, 2022, James Hitchner hosted a webinar, “New Detailed Cost of Capital Case Study: Step-by-Step Comparison of the Kroll Cost of Capital Navigator, BVR Cost of Capital Pro, Damodaran Data, and Surveys.” This article summarizes points made during this webinar.

This summer and fall 2022, within the business valuation profession, one of the most contentious issues has been “which cost of capital should business valuation professionals use when valuing a small business?” First, Dr. Damodaran advocated the implied equity risk premium with the capital asset pricing model (CAPM) without adding a size premium or company specific risk. He adjusts for other risk factors (size and company specific risks) by adjusting the forecasted cash flows. Next, James Hitchner, CPA, ABV, CFF, responded to Dr. Damodaran’s criticism. Shortly thereafter, Eric Nath, founder of Eri Nath  & Associates, wrote an article, “Hitcher Rebuts Damodaran’s Attacks on Cost of Capital Inputs”, written for BVR, where he voiced support for Dr. Damodaran’s “forward-looking approach.” On October 20, 2022, James Hitchner hosted a VPS StraightTalk webinar, “New Detailed Cost of Capital Case Study: Step-by-Step Comparison of the Kroll Cost of Capital Navigator, BVR Cost of Capital Pro, Damodaran Data, and Surveys.” This article summarizes points made during this webinar.

Readers interested in more granularity can purchase a recording from VPS by going to CPE – Valuation Products and Services and following the tab for Webinars.

Dr. Aswath Damodaran’s View on Cost of Equity

Dr. Aswath Damodaran (Dr. Damodaran) criticizes the use of historical risk premiums, the concept of a “normalized” risk-free rate, and the use of a size premium and company specific risk premium. He deems the build-up method is a “recipe for disaster.”

Dr. Damodaran believes in using the implied equity risk premium with the capital asset pricing model, not using a size premium or company specific risk. Readers interested in this subject matter can follow this link to download a paper on this subject and the underlying assumptions made by Dr. Damodaran. Damodaran Online: Home Page for Aswath Damodaran (nyu.edu) and pvtfirmval.pdf (nyu.edu).

Kroll Cost of Capital Navigator

Kroll has an extensive library; there are multiple pdf available for download in the Resource Library section (note: subscription required) of the supporting documents for Kroll Cost of Capital Navigator. Compared to Dr. Damodaran, Kroll espouses a different approach. First, Kroll states that “one common method for estimating the ERP is to examine the historical differences between equity returns and risk-free returns, and make an assumption that this historical relationship will hold in the future.” Kroll acknowledges this relationship is not guaranteed to hold since the underlying premise is that history repeats itself. Second, “the cost of capital is a function of the investment, not the investor.” (Here too, there are some differences with positions taken in the paper Dr. Damodaran wrote about valuing closely held companies.) Third, Kroll critiques “discounting expected future cash flows for non-publicly traded investments using an ‘as if publicly-traded’ cost of capital may not provide an accurate estimate of value to the extent that market participants would consider other risks associated with non-publicly traded investments.” 

Kroll also criticizes underlying assumptions regarding the capital structure assumptions noting that:

As the proportion of debt is increased in the capital structure, the formulas commonly used for leveraging equity betas are linear, and therefore likely to understate the cost of equity capital at amounts of leverage. Similarly, the traditional depiction of the cost of capital fails to consider the gradually increasing cost of debt as debt is added to the capital structure due to a potential decrease in ability to service.

Kroll further states that “[i]n practice, the build-up method and CAPM are the most frequently use methods to estimate the cost of equity capital. The risk premia and size premia in the cost of capital module can be used to develop cost of equity capital estimates using build-up and CAPM, and so we focus on these two methods here.” “The size premium represents the difference between actual historical excess return and the excess return predicted by beta.” It further adds, “[d]espite its many criticisms, the CAPM is still one of the most widely used models for estimating the cost of equity capital, especially for larger companies in its pure textbook form, and even for smaller companies and closely held companies in its expanded or adjusted form (a.k.a. modified CAPM).”

Regarding the size premium, Kroll opines that “despite many criticisms of the size effect, it continues to be observed in data sources. Further, observation of the size effect is consistent with a modification of the pure CAPM. Studies have shown the limitations of beta as a sole measure of risk. The size premium is an empirically derived correction to the pure CAPM.”

Finally, regarding the company specific risk premium (CSRP), which Kroll acknowledges is “one of the most controversial and elusive areas of business valuation. It is an adjustment common to both the build-up method and CAPM.” The addition of a CSRP to the discount rate is “a commonly applied method to account for the overly optimistic forecasts” when the guideline public companies provide poor or even meaningless estimates of the market risk that the subject company would experience were it public.

BVResources Cost of Capital Professional

BVResources provides valuation professionals with a host of data sources, one of those is the cost of capital. See Cost of Capital Professional FAQs | Business Valuation Resources (bvresources.com). Practitioners using this data source can choose between using Damodaran’s Implied ERP. Damodaran’s Implied ERP with Sustainable Payout, Damodaran—Historical ERP, using a Size Premium (Beta Adjusted) or Size Premium (using a reference portfolio over the S&P 500), Industry Risk Premium, and a risk-free rate based on a spot yield 10- or 20-year rate.

There is a fair amount of choices that a practitioner can use and the rate derived may well not match that derived using Kroll and almost certainly not match what is derived using Damodaran’s approach.

Pepperdine Surveys—Projecting the Cost of Capital

Pepperdine produces results from a survey returned by investment bankers, private equity groups, business appraisers, brokers, and business owners; the 2021 Survey results were based on the responses of roughly 1,100 professionals. This is a small sample size.

The results produced suggest that:

1. Appraisers rely on the Treasury spot rate and not a normalized risk-free rate;
2. The equity risk premium is within what Hitchner finds is “a reasonable range … that could be a little high;
3. The long-term risk rate is only slightly above inflation;
4. Over one-half of the businesses have revenue below $10 million; and
5. DLOMs for a controlling interest is 10.1% to 16.5%. Many appraisers do not believe there should be a DLOM for a controlling interest, especially under 100%.

Hitchner suggests practitioners using this source as their basis for the cost of equity exercise “caution.”

Conclusion

This webinar will not settle or answer the question that is raised here. Ultimately, the choice made requires that the professional be well-informed of the choices made and not just select a method because it is used by a highly regarded academic or business professional appraiser. The choice of cost of capital must be defended. While the bulk of legal professionals have not honed on the controversy here, business valuation professionals can anticipate soon—especially where costs are not an issue—the need to defend their choice and use of cost of capital.

Beware, learn, and prepare to defend your opinion on this point (and many others).

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Roberto H Castro, JD, MBA, MST, CVA, is a retired attorney now focusing on litigation support. He is also Technical Editor of QuickRead and a member of NACVA’s CUV team.

Mr. Castro can be contacted at (509) 679-3668 or by e-mail to rcastro@rcastrolaw.com.