Cost of Capital Data Choices: Duff & Phelps Cost of Capital Navigator

vs. BVResources Cost of Capital Professional

Jim Hitchner, CPA/ABV/CFA, ASAFinancial Valuation Advisors, Inc.

All slides copyright 2019 Valuation Products and Services, LLC

James R. Hitchner, CPA/ABV/CFF, ASA• Managing Director, Financial Valuation Advisors Inc.

• CEO, Valuation Products and Services LLC

• President, Financial Consulting Group LLC

• Editor in Chief, Financial Valuation and Litigation Expert

• 38 years in valuation services

• Former member of the AICPA task force on BV standards

• Inductee in the AICPA BV Hall of Fame

• Two-time recipient – AICPA Volunteer of the Year award

• Coauthored over 20 courses; taught over 60 courses

• Published over 150 articles; made over 350 presentations1

James R. Hitchner, CPA/ABV/CFF, ASA• Editor and/or coauthor of the books:

• Discount for Lack of Marketability Guide and Toolkit, 2017

• Financial Valuation Applications and Models, 4th edition, 2017

• Financial Valuation Workbook, 4th edition, 2017

• PPC’s Guide to Business Valuations, 29th edition, 2019

• Hitchner • Pratt • Fishman, A Consensus View, Q&A Guide to Financial Valuation, 2016

• Valuation for Financial Reporting: Fair Value, Business Combinations, Intangible Assets, Goodwill, and Impairment Analysis, 3rd edition, 2011

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Learning Objectives

• Cost of capital alternatives

• Duff & Phelps vs. BVResources COC data• Summary of each database• What are the pros and cons of each database?• Do the databases produce supportable results?• Complexity vs. simplicity – which is better?

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Cost of Capital Alternatives

• Duff & Phelps Cost of Capital Navigator

• BVResources Cost of Capital Professional

• Dr. Aswath Damodaran

• Dr. Pablo Fernandez

• BVResources Implied Private Company Price Line Tool (IPCPL)

• Pepperdine Private Capital Markets Reports

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Application of Cost of Capital Data

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• Duff & Phelps CRSP Historical 1926 (2019) (1) 6.9%

• Duff & Phelps CRSP Supply-Side 1926 (2019) 6.1%

• Duff & Phelps Risk Study 1963 (2019) 5.1%

• Duff & Phelps Recommended ERP (2019) 5.5%

• BVR Cost of Capital Professional 1928 (2019) (2) 5.8%

• BVR Cost of Capital Professional 1963 (2019) (2) 3.8%

• BVR COC Pro Damodaran (2)• Implied ERP (2018)* 7.7%• Implied ERP (2018)

w/Sustainable Payout* 7.3%• Historical ERP (1928-2018)* 6.3%

• Fernandez Survey (3) 5.6%

• Pepperdine Appraisers (4) 5.9%

* 10-year T-Bond, Arithmetic

ERP

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Size Premiums – 2019

• Duff & Phelps CRSP 1926 (tenth) 5.2%

• Duff & Phelps Risk Study 1963 (25th) 5.1%

• BVR COC Pro 1928 (S&P 500) 7.7%

• BVR COC Pro 1928 (Beta Adjusted) 5.4%

• BVR COC Pro 1963 (S&P 500) 3.6%

• BVR COC Pro 1963 (Beta Adjusted) 3.1%

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Industry Risk Premiums

• “If there are no comparable public betas, the analyst will not use an IRP in the buildup method because the IRP is developed using the betas from the same companies that the CAPM uses for its beta. If the analyst has rejected companies and their betas as not comparable for use in the CAPM, he or she should not use those same betas for an IRP in the buildup method.” (p. 9) [Emphasis added.]

• “Be consistent. If you rejected public companies in your IRP and/or CAPM analysis, you must also reject them for your market approach.” (p. 11) [Emphasis added.]

“Inclusion of Betas in CCPro Platform Puts the Spotlight on the IRP,” Business Valuation Update, July 2019, Vol. 25, No. 7, BVResources.

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Dr. Aswath Damodaran

• Build up models are “recipes for disaster.”1

• “The problem with any historical premium approach, even with substantial modifications, is that it is backward looking. Given that our objective is to estimate an updated, forward-looking premium, it seems foolhardy to put your faith in mean reversion and past data.”2 [Emphasis added.]

• 1 Don Wisehart, “Boston’s Battle of the Beta,” Financial Valuation and Litigation Expert, Issue 22, December 2009/January 2010, Valuation Products and Services, LLC, p. 15.

• 2 “Equity Risk Premiums (ERP): Determinants, Estimation and Implications – The 2019 Edition” (May 22, 2019), http://pages.stern.nyu.edu/~adamodar/, p. 74.

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Damodaran

• “We have looked at three different approaches to estimating risk premiums, the survey approach, where the answer seems to depend on who you ask and what you ask them, the historical premium approach, with wildly different results depending on how you slice and dice historical data and the implied premium approach, where the final number is a function of the model you use and the assumptions you make about the future. Ultimately, though, we have to choose a number to use in analysis and that number has consequences.”3 [Emphasis added.]

3 Ibid., p. 115.

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IPCPL (BV Update, August 2019, p. 36)

4 After-tax cost of capital (calibrated for 35% tax rate and mid-period convention) for average/typical risk company. For use on unlevered, after-tax expected free cash flows. (5)

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Implied Private Company Price Line Tool (IPCPL)

• Question: Is IPCPL ready for the courthouse?

• Answer: No.

• This model was developed very recently and has not yet been widely distributed and exposed, so even though it’s more reliable than traditional methods, it needs some time to be vetted and used in nonlitigation.

• We recommend IPCPL as a means to calibrate the traditional “recipe for disaster” cost of capital methods to avoid the disaster and to accurately test opposing expert’s cost of capital figures.

• Also, for nonlitigation and or “calculation” engagements, we prefer IPCPL. [Emphasis added.]

https://sub.bvresources.com/pdfs/IPCPLfaq.pdf

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Pepperdine Surveys• “One of the biggest business valuation mistakes is confusing historical equity returns with

expected or required equity returns.”1

• The bottom line is that the traditional backward-looking models do not provide anything close to a reasonable estimate for the required rate of return on equity capital for most investments, with the possible exception of a highly diversified portfolio of public companies that will be held for at least a generation.

• CAPM and BUM as typically applied are not a product of reliable procedures, they cannot be applied in a way that creates a reliable result, and, indeed, if done blindly and without the application of judgment, the results obtained from use of these methods will almost always be wrong, because, in isolation, they are incapable of reflecting the thought processes of actual buyers and sellers in the market.2 [Emphasis added.]

1 Eric W. Nath, ASA, “The Biggest Business Valuation Myth,” Business Valuation Review, Fall 2011, p. 91.2 Ibid., pp. 98-99.

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Pepperdine Surveys

• Although the Pepperdine University study is still young, and the procedures, questions, and reporting will no doubt continue to be refined and improved, it is nevertheless a much more plausible and believable means for obtaining a forward-looking required rate of return than the historical-based models and data published by traditional sources.3

[Emphasis added.]

3 Ibid., p. 97.

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Pepperdine Surveys

• Besides bond yields, the only forward-looking data in the Cost of Capital Professional are the implied ERP

• However, this has its own idiosyncrasies, which make it all but useless for estimating cost of capital in most cases

• Other shortcomings with the implied ERP … include the fact that empirically demonstrated optimism biases of analysts skew the implied ERP

• Declines in the number of public companies and lack of coverage by analysts for all but the biggest firms also make implied ERP hard to extrapolate to private entities and certainly is irrelevant for a minority interest in a private entity

Eric W. Nath, ASA, “Letter to the Editor: Comments on the Cost of Capital Professional,” Business Valuation Update, Vol. 25, No. 2, February 2019, BVResources, pp. 1, 4-5.

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Pepperdine Surveys

• What’s needed is a truly forward-looking required rate of return system that gives appraisers an understanding of how to estimate cost of capital for private companies and interests in private companies

• The Pepperdine Survey, published annually, partially addresses certain aspects of this in the private equity and venture capital segments of the capital market line

• If we focused more on improving this type of research and less on refining irrelevancies, we would be a lot further ahead in understanding how to estimate required rates of return

Ibid., p. 5.

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Pepperdine

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Pepperdine

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Pepperdine

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Data Sources

1) Duff & Phelps Cost of Capital Navigator 2019

2) BVResources Cost of Capital Professional, BVResources, 2019, https://www.bvresources.com/products/cost-of-capital-professional

3) Pablo Fernandez, Mar Martinez, and Isabel Fernandez Acin, “Market Risk Premium and Risk-Free Rate Used for 69 Countries in 2019: A Survey” (March 23, 2019). Available at SSRN: https://ssrn.com/abstract=3358901or http://dx.doi.org/10.2139/ssrn.3358901

4) Pepperdine Private Capital Markets Reports (2019),https://digitalcommons.pepperdine.edu/gsbm_pcm_pcmr/11/

5) BVResources, Business Valuation Update, August 2019

6) “Equity Risk Premiums (ERP): Determinants, Estimation and Implications –The 2019 Edition” (May 22, 2019), http://pages.stern.nyu.edu/~adamodar/

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Cost of Capital Benchmark

Data –December 31,

2018

• U.S. 30-day Treasury bill1 2.44%

• U.S. five-year Treasury note2 2.51%

• U.S. 20-year Treasury bond3 2.87%

• Aaa corporate bond5 3.99%

• 30-year conventional mortgage6 4.55%

• Baa corporate bond7 5.14%

• Prime rate4 5.50%

• Large-cap stock ($29 billion - $1.1 trillion)8 11.04%

• Micro-cap stock ($2.5 million - $728 million)8 17.67%

• Small-cap stock ($2.5 million - $322 million)8 19.80%

• Subdecile category 10b ($2.5 million - $185 million)8 22.67%

• D&P size category 25 ($157 million average)9 20.53%

• Subdecile category 10z ($2.5 million - $109 million)8 24.97%

• VC Bridge/IPO10 20%-35%

• VC second stage/expansion10 30%-50%

• VC first stage/early development10 40%-60% 21

1 https://fred.stlouisfed.org/series/TB4WK

2 https://fred.stlouisfed.org/series/DGS5

3 https://fred.stlouisfed.org/series/DGS20

4 https://fred.stlouisfed.org/series/DPRIME

5 https://fred.stlouisfed.org/series/DAAA

6 https://fred.stlouisfed.org/series/MORTGAGE30US

7 https://fred.stlouisfed.org/series/DBAA

8 Duff & Phelps 2019 Cost of Capital Navigator, CRSP Deciles Size Study –Supplementary Data Exhibits, all data from 1926 to 2018, large cap is decile 1, micro-cap is deciles 9 and 10, small cap is decile 10.

9 Duff and Phelps 2019 Cost of Capital Navigator, CRSP Deciles Size Study and Risk Premium Report Study –Supplementary Data Exhibits, all data from 1963 to 2018.

10 Valuation of Privately-Held-Company Equity Securities Issued as Compensation, Accounting & Valuation Guide, 2013, American Institute of Certified Public Accountants, p. 148.

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Duff and Phelps Cost of Capital Navigator

• There are two mainstays in cost of capital data, both included in the Duff and Phelps Cost of Capital Navigator:

- CRSP Deciles Size Premia studies (1926)

• Been around for about 37 years

- Risk Premium Report studies (1963)

• Been around for about 24 years

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CRSP Deciles Size Premia Studies

Includes:• Financial service companies• High-financial risk companies• Decile portfolios that are rebalanced quarterly vs. annually• Portfolio returns that are market-cap-weighted vs. equal-weighted

Excludes:• Closed-end mutual funds• Preferred stocks• Real estate investment trusts• Foreign stocks• American depository receipts unit investment trusts• Americus trusts

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Risk Premium Report Studies

Combines the data from the CRSP and the Standard & Poor’s Compustat databases (converges in 1963)

Excludes• American depositary receipts• Non-operating holding companies• Financial service companies (SIC code 6)• Unseasoned companies

• Lacking 5 years of publicly traded price history• Sales below $1 million in any of the previous five fiscal years• Negative 5-year-average EBITDA for the previous five fiscal years• Not listed on one of the major U.S. stock exchanges (NYSE, NYSE MKT

(formerly AMEX), or NASDAQ) 25

Risk Premium Report Studies

Excludes

• High-financial-risk companies• In bankruptcy or in liquidation• 5-year-average net income less than zero for the previous five years• 5-year-average operating income less than zero for the previous five

years• Negative book value at any one of the previous fiscal year-ends• Debt-to-total capital ratio exceeding 80%

The portfolios are rebalanced annually, and the market cap is equal-weighted.

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BVResources Cost of Capital Professional

• New online platform provides equity risk premia, size premia, risk-free rates, and industry risk premiums

• Based on two types of data sources: – CRSP historical data going back to 1928 – Dr. Damodaran’s forward looking implied equity risk premium

(ERP) data

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Case Study Examples

• Build Up Method• Modified CAPM• D&P COC Navigator• BVResources COC Pro• Manufactures auto parts• Valuation date July 1, 2019• 10th decile company (CRSP)• 25th category company (Risk Premium Report)• Leave company-specific risk out for comparison purposes

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D&P COC Navigator

Build Up (CRSP back to 1926)

• ke = Rf + RPm + RPs + RPi

• ke = 2.3 + 6.9 + 5.2 + 1.2 = 15.6% Historical ERP

• ke = 2.3 + 6.1 + 5.2 + 1.0 = 14.6% Supply-side ERP

• ke = 3.5 + 5.5 + 5.2 + 0.9 = 15.1% D&P Recommended ERP

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D&P COC Navigator

Build Up (Risk Premium Report Study back to 1963)

• ke = Rf + RPm+s + ERPadj.

• ke = 2.3 + 12.0 + 1.9 = 16.2% Historical ERP

• ke = 2.3 + 12.0 + 1.1 = 15.4% Supply-side ERP

• ke = 3.5 + 12.0 + 0.4 = 15.9% D&P Recommended ERP

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D&P COC Navigator

Build Up (Risk Premium Report Study back to 1963)

• ke = Rf + RPm + RPs + RPi

• ke = 2.3 + 6.9 + 5.2 + 1.2 = 15.6% Historical ERP

• ke = 2.3 + 6.1 + 5.2 + 1.0 = 14.6% Supply-side ERP

• ke = 3.5 + 5.5 + 5.2 + 0.9 = 15.1% D&P Recommended ERP

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D&P COC Navigator

MCAPM (Risk Premium Report Study back to 1963)

• ke = Rf + β(RPm) + RPs

• ke = 2.3 + 1.17(6.9) + 5.2 = 15.6% Historical ERP

• ke = 2.3 + 1.17(6.1) + 5.2 = 14.6% Supply-side ERP

• ke = 3.5 + 1.17(5.5) + 5.2 = 15.1% D&P Recommended ERP

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BVR COC Pro

Build Up (CRSP back to 1928; RPs over the S&P 500)

• ke = Rf + RPm + RPs + RPi

• ke = 2.3 + 5.8 + 7.7 + 1.0 = 16.8%

• ke = 2.3 + 5.8 + 7.7 + 2.0 = 17.8%

• ke = 2.3 + 5.8 + 7.7 + (0.1) = 15.7%

Note: No Damodaran data used since he doesn’t believe in the build up model, saying they are “recipes for disaster.”Don Wisehart, “Boston’s Battle of the Beta,” Financial Valuation and Litigation Expert, Issue 22, December 2009/January 2010, Valuation Products and Services, LLC, p. 15.

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Historical CRSP Data - BVR COC Pro

Start 20-Year S&P 500 DamodaranYear Rf RPm RPs 10th Beta RPi COEC

1928 2.3 5.8 7.7 1.0 16.81930 2.3 5.6 8.4 1.0 17.31940 2.3 6.2 4.8 1.1 14.41950 2.3 6.0 2.6 1.0 11.91960 2.3 3.6 3.2 0.6 9.71963 2.3 3.8 3.6 0.7 10.41970 2.3 2.8 2.0 0.5 7.61980 2.3 3.2 0.6 0.5 6.61981 2.3 2.4 0.6 0.4 5.71990 2.3 2.5 2.8 0.4 8.02000 2.3 -1.4 6.3 -0.2 7.02010 2.3 6.0 -2.1 1.0 7.2

Historical CRSP Data - BVR COC

Pro

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BVR COC Pro

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Start 20-Year S&P 500 Salvidio Salvidio Salvidio Salvidio DamodaranYear Rf RPm RPs - 10th Beta(2) IRP Beta(5) IRP COEC (2) COEC (5) COEC

1928 2.3 5.8 7.7 -0.1 2.0 15.7 17.8 16.8

1930 2.3 5.6 8.4 -0.1 1.9 16.2 18.2 17.3

1940 2.3 6.2 4.8 -0.1 2.1 13.2 15.4 14.4

1950 2.3 6.0 2.6 -0.1 2.0 10.8 12.9 11.9

1960 2.3 3.6 3.2 0.0 1.2 9.1 10.3 9.7

1963 2.3 3.8 3.6 0.0 1.3 9.7 11.0 10.4

1970 2.3 2.8 2.0 0.0 1.0 7.1 8.1 7.6

1980 2.3 3.2 0.6 0.0 1.1 6.1 7.2 6.6

1981 2.3 2.4 0.6 0.0 0.8 5.3 6.1 5.7

1990 2.3 2.5 2.8 0.0 0.9 7.6 8.5 8.0

2000 2.3 -1.4 6.3 0.0 -0.5 7.2 6.7 7.0

2010 2.3 6.0 -2.1 -0.1 2.1 6.1 8.3 7.235

BVR COC Pro

MCAPM (CRSP back to 1928; RPs in excess of CAPM)

• ke = Rf + β(RPm) + RPs

• ke = 2.3 + 1.17(5.8) + 5.4 = 14.5% Historical ERP

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D&P COC Navigator

vs. BVR COC ProBuild Up

Build Up (CRSP back to 1926) Navigator

• ke = Rf + RPm + RPs + RPi

• ke = 2.3 + 6.9 + 5.2 + 1.2 = 15.6% Historical ERP

• ke = 2.3 + 6.1 + 5.2 + 1.0 = 14.6% Supply-side ERP

• ke = 3.5 + 5.5 + 5.2 + 0.9 = 15.1% D&P Recommended ERP

Build Up (Risk Premium Report Study back to 1963) Navigator

• ke = Rf + RPm+s + ERPadj.

• ke = 2.3 + 12.0 + 1.9 = 16.2% Historical ERP

• ke = 2.3 + 12.0 + 1.1 = 15.4% Supply-side ERP

• ke = 3.5 + 12.0 + 0.4 = 15.9% D&P Recommended ERP

Build Up (Risk Premium Report Study back to 1963) Navigator

• ke = Rf + RPm + RPs + RPi

• ke = 2.3 + 6.9 + 5.2 + 1.2 = 15.6% Historical ERP

• ke = 2.3 + 6.1 + 5.2 + 1.0 = 14.6% Supply-side ERP

• ke = 3.5 + 5.5 + 5.2 + 0.9 = 15.1% D&P Recommended ERP

Build Up (CRSP back to 1928; RPs over the S&P 500) Pro

• ke = Rf + RPm + RPs + RPi

• ke = 2.3 + 5.8 + 7.7 + 1.0 = 16.8% Historical ERP 37

D&P COC Navigator vs. BVR COC Pro

MCAPM (Risk Premium Report Study back to 1963) Navigator

• ke = Rf + β(RPm) + RPs

• ke = 2.3 + 1.17(6.9) + 5.2 = 15.6% Historical ERP

• ke = 2.3 + 1.17(6.1) + 5.2 = 14.6% Supply-side ERP

• ke = 3.5 + 1.17(5.5) + 5.2 = 15.1% D&P Recommended ERP

MCAPM (CRSP back to 1928; RPs in excess of CAPM) Pro

• ke = Rf + β(RPm) + RPs

• ke = 2.3 + 1.17(5.8) + 5.4 = 14.5% Historical ERP

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D&P COC Navigator vs. BVR COC Pro

What are the pros and cons of each database?

Do the databases produce supportable results?

Complexity vs. simplicity – which is better?

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• 1300 pages

• Completely updated

• Coauthored by many of the top names in BV

Jim Alerding

Rosanne Aumiller

Jeff Balcombe

Neil Beaton

Melissa Bizyak

Marcie Bour

Jim Budyak

Carol Carden

Stacy Collins

Larry Cook

Don Drysdale

Ed Dupke

Jay Fishman

Chris Hamilton

Tom Hilton

Jim Hitchner

Vince Kickirillo

Mark Kucik

Eva Lang

Harold Martin

Ed Moran

Ray Moran

Kate Morris

Shannon Pratt

Ron Seigneur

Stacey Udell

Sam Wessinger Richard

Wise

Don Wisehart

Kevin Yeanoplos40

Discount for Lack of Marketability Guide and ToolkitJames R. HitchnerR. James AlerdingJoshua B. AngellKatherine E. Morris

A Consensus ViewQ&A Guide to Financial ValuationJames R. HitchnerShannon P. PrattJay E. Fishman

Lost Profits Damages:Principles, Methods, and ApplicationsEdited byEverette P. Harry IIIJeffrey H. Kinrich

www.valuationproducts.com/books 41

Bimonthly Journal

April/May 2019Front-page article

Federal Court Accepts Tax Affecting an S Corp “The court finds GBP’s subchapter S status is a neutral

consideration with respect to the valuation of its stock.”

• Also in this issue:• Stock-based Compensation & Guidelines to Estimate a

Supportable Value

• Transparency in Cost of Capital Data• Practical Guidance Related to Forensic Analysis Due Diligence

Interviews• A Look at the Ever-evolving U.S. Health Care Industry

• Being different is more profitable than being better42