Tests of Reasonableness Business appraisers use tests that ask whether decisions made are legitimate and designed to remedy a certain issue under the circumstances. These tests are commonly referred to in the valuation literature as tests of reasonableness. Several methods have been suggested and employed (e.g., purchase justification test), but limited literature speaks to the use of a test of reasonableness for company specific risk premia (CSRP). This article explores data sources and analyses available to appraisers to provide a “test of reasonableness” to increase the confidence level and analysis of their CSRP analysis. Business appraisers use tests that ask…
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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,…
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Using Weights and Factors to Quantify Risk This is a condensation of the author’s article, originally published in The Value Examiner, July/August 2022. The author proposes an alternative way of calculating the company specific risk premium. This is a condensation of my article originally published in The Value Examiner, July/August 2022. Most of us who value businesses are not valuing businesses in the middle market or the size of businesses that the major writers and instructors on business valuation are valuing. We generally value businesses with revenues under $3,000,000, if not $1,000,000. Not only is there a substantial difference between…
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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…
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When Guideline Companies are Not Very Good? When given a choice, do you prefer to minimize errors of commission or omission? The answer will likely influence your view as to whether the market approach should be used when valuing a company with guideline companies that are not very good. Someone who seeks to minimize errors of commission will likely exclude the market approach due to the difficulties in executing the analysis. Conversely, someone who seeks to minimize errors of omission will likely include the market approach due to the insight it can provide as a ‘sanity check’ to the other…
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(Part IV of IV) This is the final article of the four-part series that sets forth best practices for estimating the company-specific risk premium. This discussion of the series summarizes best practices about the analyst’s conduct of the functional analysis as one component in developing the CSRP estimate. [su_pullquote align=”right”]Resources: Best Practices for Estimating the Company-Specific Risk Premium (Part I of IV) Best Practices for Estimating the Company-Specific Risk Premium (Part II of IV) Best Practices for Estimating the Company-Specific Risk Premium (Part III of IV) [/su_pullquote] Introduction Valuation analysts (analysts) often apply income approach business valuation methods to value…
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(Part III of IV) This is the third of a four-part article that sets forth best practices for estimating the company-specific risk premium. This part of the discussion describes the various empirical data sources that analysts may consider as proxies—or benchmarks—or approximations—in developing the CSRP estimate. [su_pullquote align=”right”]Resources: Best Practices for Estimating the Company-Specific Risk Premium (Part I of IV) Best Practices for Estimating the Company-Specific Risk Premium (Part II of IV) [/su_pullquote] Introduction Estimating the cost of capital is one component of private company business valuation performed for financing, transaction, taxation, business planning, financial accounting, litigation, and other purposes.…
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(Part II of IV) This is the second of a four-part article that sets forth best practices for estimating the company-specific risk premium. The first part of this series summarized where and how the CSRP applies in the various generally accepted cost of capital measurement models. This second part summarizes (1) the concepts of systematic risk and unsystematic risk and (2) the considerations of unsystematic risk in the analyst’s CSRP estimate. [su_pullquote align=”right”]Resources: Best Practices for Estimating the Company-Specific Risk Premium (Part I of IV) [/su_pullquote] Introduction This discussion is the second of a four-part series that summarizes best practices…
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(Part I of IV) This is a four-part article that sets forth best practices for estimating the company-specific risk premium. The identification and quantification of alpha—or the subject-specific risk component—is sometimes a controversial issue in the private company valuation. This discussion summarizes best practices on what is included in—or should be considered in—the analysis of this Ke alpha component (or unsystematic risk component). These best practices discussion is presented in four parts. The first part of the discussion focuses on the factors that analysts may consider in developing the alpha estimate when selecting a Ke for a private company valuation.…
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Business Valuation in a COVID-19 World—Cost of Capital, Growth Rates, and Uncertainties Jim Hitchner, Managing Member of Valuation Products and Services (VPS), unveiled the first of a series of two-hour webinars that targets business valuation and litigation support professionals seeking an intermediate level program. This is a review of the first webinar titled “Business Valuation in a COVID-19 World—Cost of Capital, Growth Rates, and Uncertainties”. This article summarizes the issues discussed during this first webinar. [su_pullquote align=”right”]Resources: Best Practices in Business Valuation—A Practical Approach to Advanced Issues and Applications [/su_pullquote] On October 29, 2020, Jim Hitchner, Managing Member of Valuation…
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The Cost of Equity Capital (Part II of II) This is the second of a two-part series article focused on issues that arise estimating the cost of equity capital. In most forensic-related valuation analyses, one procedure that affects most valuations is the measurement of the present value discount rate. This discount rate analysis may affect the forensic-related valuation of private companies, business ownership interests, securities, and intangible assets. This discussion summarizes three models that analysts typically apply to estimate the cost of equity capital component of the present value discount rate: (1) the capital asset pricing model, (2) the modified…
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The Cost of Equity Capital (Part I of II) This is the first of a two-part series article focused on issues that arise estimating the cost of equity capital. In most forensic-related valuation analyses, one procedure that affects most valuations is the measurement of the present value discount rate. This discount rate analysis may affect the forensic-related valuation of private companies, business ownership interests, securities, and intangible assets. This discussion summarizes three models that analysts typically apply to estimate the cost of equity capital component of the present value discount rate: (1) the capital asset pricing model, (2) the modified…
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A Discussion of Rover Pipeline, LLC v. 10.55 Acres of Land, More or Less, in Ashland County, Ohio, et al. “In God we trust. All others must bring data.” This famous saying has been attributed to various people, but it implies that when data is presented, the conclusion can be trusted. However, the Ohio District Court’s decision in Rover Pipeline, LLC v. 10.55 Acres of Land, More or Less, in Ashland County, Ohio, et al., demonstrates that data is only trustworthy if it is understood and applied correctly. The case, in which the expert’s valuation report was discarded due in…
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Tax Controversy Insights In matters argued before the U.S. Tax Court, valuation professionals are frequently asked to provide opinions related to the value of closely held businesses and of fractional ownership interests in closely held businesses. This discussion relates to a recent appeal of a U.S. Tax Court decision involving such valuation issues. The case in question is Natale B. Giustina v. Commissioner. In this case, the Tax Court’s selection of the method for valuing a fractional ownership interest in a closely held business was appealed to the United States Court of Appeals for the Ninth Circuit. The Appeals Court…