All variants of income methods utilize risk adjusted hurdle rates. This means that the discount factor used to convert future cash flows into a single lump sum value consists of three components: an inflation rate, a risk-free rate and a rate based on the assessed risk of the firm. To generate a capitalization rate a fourth component is needed: an assumed constant growth rate.
From a practical standpoint it is not hard to find reliable data on forecasted inflation rates nor is it hard to find the risk-free Treasury bond rate. But what about the added risk factor rate? Where do we find those rates? There have been three approaches developed but only one of these is in dominant use:
1. Rates of Return from publicly traded companies
2.Company specific risk factor analysis using ordinal scales
3. Surveys of private company lenders and investors
The most widely used source of establishing risk adjusted hurdle rates has been the rates of return on publicly traded equities. If the record of returns on publicly traded securities can be parsed over long enough periods, certain patterns emerge. Among these patterns are that smaller capitalized and more volatile securities have achieved greater rates of return than larger capitalized securities with less volatility (in this context capitalization refers to the number and value of common shares outstanding).
Unfortunately, these patterns do not always appear to prevail. Much depends on the time periods studied and even the methods used to measure volatility. Measures of volatility (called beta measures to add gravitas to the discussion) have proven to be particularly troublesome because these measures are not so stable over time.
Some appraisal theorists realized that it did not make economic sense to compare the risks and rewards facing publicly traded investors with the risks and rewards facing investors in the control equity positions of smaller closely held firms. These theorists developed methods that do not rely on the record of publicly traded securities.
The Black Green and Schilt Methods of Discount Rate Development
The Black Green method starts by taking a risk-free rate
of return and adds a weighted average risk premium for each of the following
general risk factor categories:
2. Financial strength
3. Management ability and depth
4. Profitability and stability of earnings
5. National economic effects
6. Local economic effects
The ranges of the suggested percentage risk factors are as follows:
The method requires appraisers to make more refined specific judgments for each general risk category. For example, under the category of competition, the analyst is expected to evaluate the following underlying risk factors:
In the ordinal scale approach, each of these factors is
evaluated and assigned a risk premium percentage, then weighted according to
the relative degree of influence it has on the general category.
If the local and national economy is considered to be weak, an additional risk premium of two percentage points would be added to derive a five percent adjustment for risk. If the risk free premium rate is three percent, then the total discount rate for expected future cash flows would be eight percent.
A more simplified but similar approach was developed by Jim Schilt. Schilt posits a hierarchy of five types of closely held businesses ranging from those that are very well established with stable earnings to the very smallest businesses with more variable earnings streams. The most established businesses require the lowest risk premiums (6-10%) and the smallest least established firms are assigned risk premiums of between 26-30%. There are three intermediate types of business each with their own range of premiums intermediate to these two extreme types.
Neither of these approaches has found much traction in the appraisal community, despite the fact that they focus on precisely the sorts of risks a control investor should consider in evaluating an acquisition of a firm. One reason for the lack of acceptance has to do with the somewhat arbitrary and static ranges of premium levels specified. An even more important reason for rejecting these methods is their reliance on appraiser judgment about the risk associated with a firm. Most appraisers prefer to develop risk adjusted risk premiums based on hard data rather than qualitative judgment; even if the hard data is totally irrelevant as is the case with data from publicly traded firms, appraisers still prefer it.
Robert Slee, working with Pepperdine University, has developed an alternative solution to the dilemma faced by appraisers committed to the idea of utilizing risk adjusted discount and capitalization rates. Slee recognized the irrelevance of public traded rates of return when analyzing private equity exchanges. He also recognized that relying on qualitative judgments of appraisers to develop risk adjusted discount and capitalization rates was looked upon with disfavor in the appraisal community. Slee’s solution was to develop discount and capitalization rates based upon survey data collected from lenders and investors in private companies. Here is the description of their survey goals:
“The survey specifically examined the behavior of senior lenders, asset-based lenders (ABLs), mezzanine funds, private equity groups, and venture capital firms. The Pepperdine PCOC (Private Cost of Capital) survey investigated, for each private capital market segment, the important benchmarks that must be met in order to qualify for capital, how much capital is typically accessible, what the required returns are for extending capital in today’s economic environment, and outlooks on demand for various capital types, interest rates, and the economy in general.”
One problem with this survey data is that it applies to larger private equity only (which is not a problem if you are only interested in appraising larger private companies). The smaller owner managed firms we are concerned with here are usually acquired without the use of the funding sources surveyed. And of course, the larger problem remains. The use of hurdle rates when expertise is a key component of cash flow generation is not rational. Expertise is a sunk cost and hurdle rates should not be a criterion for its utilization no matter how those hurdle rates are generated.
The need to develop a risk adjusted discount or capitalization rate is based on the securities valuation method known as the Capital Asset Pricing Model (CAPM). While I believe this model is totally inapplicable to the valuation of closely held equities, there is also some doubt as to its usefulness in valuing publicly traded securities. For a good outline and overview of CAPM see this link.
Copyright 2018 Michael Sack Elmaleh