I’m pleased to present a guest post on an important valuation topic by business appraiser Jeffrey M. Risius (firstname.lastname@example.org). Jeff is a Managing Director at Stout Risius Ross, Inc., a financial advisory firm specializing in valuation and financial opinions, investment banking, and dispute advisory and forensic services. Jeff specializes in valuation in a litigation setting including shareholder proceedings, bankruptcy matters and transaction disputes. Jeff’s below post elegantly explains one of the fundamental aspects of business appraisal, namely, ascertaining the equity risk premium component of the capitalization rate used in the discounted cash flow ("DCF") method. As you’ll read, this issue took front and center in a recent decision by the Delaware Chancery Court. I think you’ll find it very informative. – P.A.M.
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One commonly applied methodology in the valuation of businesses is the Discounted Cash Flow (“DCF”) Method. The premise of this method is that a company’s value is equal to the present value of all future cash flows expected to be generated by that company using a rate of return that incorporates the time value of money and the business risk associated with the cash flows. The appropriate rate of return to utilize in the DCF Method is closely related to the perceived level of risk associated with the projected cash flows.
There are numerous models utilized by valuation experts to calculate an appropriate cost of equity capital; one of these is called the build-up method. The build-up method begins with the rate of return required by investors for risk-free assets (e.g., U.S. Government Bond) and adds one or more premiums for different risk factors to account for the fact that the investment is not risk-free. The build-up method formula is as follows:
ke = rf + ERP + IRP + SRP + CSRP
ke = Required rate of return on equity
rf = Risk-free rate of return
ERP = Equity risk premium
IRP = Industry risk premium
SRP = Size risk premium
CSRP = Company specific risk premium
The ERP that is utilized by the valuation expert is one of the most important decisions he or she must make, as it has a direct impact on the development of a cost of equity capital.
The Delaware Chancery Court, in Global GT LP v. Golden Telecom, Inc., C.A. No. 3698-VCS (Del. Ch. Apr. 23, 2010), recently rendered a very detailed decision with respect to various valuation issues, including the issue of the proper market data to utilize in the estimation of an ERP when calculating a cost of equity capital. One expert in the case estimated the ERP to equal 7.1% based on an average of premiums realized over time by investors in equity securities (e.g., the S&P500). Specifically, he utilized the ERP from the 2008 Ibbotson SBBI Valuation Year Book, which is based on long-term historical data from 1926 to year-end 2007 (“Historical ERP”). (Ibbotson is the most commonly cited source by valuation experts for various required inputs in a rate of return calculation. It includes research of historical rates of return earned by investors in various types of publicly traded securities that is compiled in such a way as to be useful for experts in their valuation of closely-held companies.)
The other expert in the Global GT matter selected an ERP of 6% which was based on his teaching experience, the relevant academic and empirical literature, and the supply-side ERP reported in the 2007 Ibbotson Yearbook (“Supply-Side ERP”). While a difference of 100 basis points may seem de minimis, the impact on the valuation conclusion utilizing the DCF Method was not, which is why the ruling on this issue was so important.
Thirty years ago, the vast, vast majority of valuation practitioners utilized the Historical ERP figure reported by Ibbotson. The general theory was that an average of historical actual returns is a valid proxy for current investors’ expectations. One problem with this theory is that future investor expectations are not necessarily equivalent to an average of the past. In addition, Ibbotson’s selection of 1926 as the starting point has a significant impact on the resulting average. As a result and as more research was conducted over the last thirty years, it has become more widely accepted that a Supply-Side ERP is a more reliable, market accepted method. Under this approach, long-term expected equity returns are estimated based on the use of various supply side models as measured by factors such as the expected growth in corporate earnings and dividends. The theory under a Supply-Side ERP is that investors cannot expect a return in the long-run that is different than that produced by businesses in the real economy.
Ultimately, the Court viewed the evidence presented by the experts on the ERP issue and sided with the expert that utilized the Supply-Side ERP stating that “to cling to Ibbotson Historic ERP blindly gives undue weight to Ibbotson’s use of a single data set. 1926 might have been a special year because for example, that was the year when Marilyn Monroe was born, but it has no magic as a starting point for estimating long-term equity returns. If one is going to use an approach that simply involves taking into account historical equity returns, then one has to consider that very well-respected scholars have made estimates in peer-reviewed studies of long-term equity returns for periods much longer than Ibbotson and have come to an estimate of the ERP which is much closer to the supply side rate Ibbotson himself now publishes as a reliable ERP for use in a DCF valuation.”
The lesson learned in this case is that it is important that valuation practitioners keep abreast of the ever changing and more sophisticated valuation research available and the prevailing standards in utilizing this data as appropriate.