For What It’s Worth: Dirty Harry and Business Valuation

Valuators Must be More Than “Lucky Punks”

How can appraisers best figure the cost of equity capital? Rand M. Curtiss argues that using standard tools including Ibbottson, Duff & Phelps, CAPM, or the Butler-Pinkerton model aren’t enough. What to use instead? Curtiss suggests starting with a look at the rate of return on mezzanine money and the rate of return on later-stage VC investments. Find out why.

Remember the movie in which Clint Eastwood told two cornered suspects, “This is a Magnum .357, the most powerful handgun in the world. You’ve got to ask yourself just one question: did I fire six shots or only five?”

Dirty Harry’s immortal question applies to business appraisers, too, although we are not held at gunpoint. (Some think being cross-examined is similar, though!) We have the most powerful technology in the world to estimate the cost of equity capital—Ibbotson and Duff & Phelps data, build-ups, CAPM and its variations, and the Butler-Pinkerton Model come to mind, but we still have to ask ourselves just one question: is our cost of equity capital estimate reasonable?

We cannot cite the above data and technology as justification for our estimate. That is equivalent to assuming the answer, saying it is so because it is so. There has to be another way to test our cost of equity capital conclusion.

My way is to take a big-picture look at the cost of equity capital, which contrasts with the piece-by-piece approach using the cited data and technology. I explain it in my mini-speech called “The Fastest Minute in Business Appraisal.” It goes like this, and it applies to going-concern businesses that are not in distress or in early stages of development.

As I see it, the lowest the cost of equity capital could be is the rate of return on mezzanine money, subordinated debt that usually comes with an equity kicker in the form of warrants. That is usually about 20%. The highest it could be is the rate of return on later-stage venture capital investments. That is usually about 40%. Both of these numbers are backed up by the Private Capital Markets studies furnished by Pepperdine University. 

That gives me a range of 20 to 40% for the cost of equity capital. Now, I ask myself whether the subject business is of medium risk, in which case it ought to have a cost of equity capital of around 30%, the midpoint of the range. 

If it is of lower risk, the cost of equity capital should be about 25%, and if it is higher, the cost of equity capital should be about 35%. My risk level assessment comes from my economic and industry outlooks, as well as my company qualitative and quantitative analyses.

I re-state the risks in my report and use them to estimate where my subject should fall in the 20 to 40% range, in multiples of 5%. I think I can distinguish between low, medium, and high risk, but I am not confident that I can make even finer judgments (like low-medium or medium-high risk levels). The rest is easy. If I built up a 33% discount rate and my big-picture analysis finds that the company is of lower (30%) to medium (35%) risk, I am comfortable. My two different procedures for estimating the cost of equity capital are consistent.

If not, it is back to the drawing board to see what I am missing. Note that I am not saying that the cost of equity capital should be 25, 30, or 35%. I am simply citing these breakpoints to see how close my detailed estimate of the cost of equity capital comes to them. Note also that this implies some flexibility on my part in estimating the cost of equity capital: if a cross-examiner were to ask whether my (say) 33% estimate could be 34%, I would say it is probable. I am willing to concede in a range of plus or minus 2%. Anything more, however, would put me at a different risk level, which contradicts my big picture assessment.

My point is, however you do it, be sure to ask yourself Dirty Harry’s question and answer it in your report. It is not enough just to build up a 33% cost of equity capital. You have to show why that is reasonable using other means. If you do not, you might “make their day.”

Rand M. Curtiss, MCBA, FIBA, ASA, ASA is President of Loveman-Curtiss, Inc. in Cleveland, OH. He can be reached at 216-831-1795 or by e-mail at rand@curtiss.com.