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Importance of Company Specific Risk Premium print this article

This handout addresses the “company specific risk premium” or CSRP as used in the Ibbotson Buildup Discount Rate estimation process (and the Adjusted CAPM model).  In addition, commentary is presented which relates to matching “pretax versus after-tax” measures of income with appropriate cap rates, multiples and discount rates for different sizes of companies (the three main segments) as well as conversion mechanisms between net cash flow and net income-based valuation applications.

Depending upon the approach taken to estimate a discount rate, a variety of important assumptions must be made in order to derive a final percentage for application against the future earnings stream.  Whether the “direct” methods for estimating discount rates are used, e.g. Ibbotson or the Adjusted CAPM, or the “indirect” methods such as Jones, Snowden, Schilt’s, Black & Green or ValueNetex or even market data, the derivation of the discount rate (or cap rate or multiple) represents one of the most challenging areas of business valuation.  Irrespective of which method is used, the valuator’s judgment, experience, insight, due diligence and general perspective will combine to generate this important value-determinant.

Before discussing some of the more important aspects of discount rate estimation, let’s gain a general perspective by reviewing comments made by various authoritative sources about the size of discount/capitalization rates that are utilized to value closely-held businesses (compare these with NACVA contents in Chapter Five, page 28):

Dr. Shannon Pratt
The consensus among participants in the marketplace (buyers, sellers,    brokers, appraisers, and others) seems to be that the required total rate of   return on an equity investment in a small closely-held business is in the range of 20% to 40%; this depends on the degree or risk, and is higher for unusually risky situations.

A very large portion of the empirical pricing multiples fall in the range of .75 to 2.75 times. Nonetheless, the empirical pricing multiples sometimes range all the way from .4 to 5.8 times.  Analysis of 500 transactions prepared by Certified Business Brokers of Houston, Texas shows an average overall pricing multiple of 1.67 times…..Jack Saunders, Publisher of Bizcomps and an experienced business broker says, ‘the ultimate sales price of a business sold should be …..1.5 to 3.5 times Seller’s Discretionary Cash Flow.”

Jay Fishman
In general, the resulting net cash flow discount rate after application of these additional risk factors will usually be between 18% and 30%, given risk-free rates that existed during April, 1994.”

Scott Gabehart
It is interesting to note that the average price to ACF multiple associated with the full spectrum of thousands of annual transactions completed by the national firm VR Business Brokers is consistently between 2.2 and 2.4 times, year in and year out…..”

Gary Trugman
A few years ago, we appraised a business and determined that the discount rate should be 80%.  Everyone involved in the litigation thought exactly what    you are now thinking – we must be crazy…..Over lunch, ….the conversation     led to the client telling me that his major supplier was financing his payables for 90 days at 19% interest….Since 19% for 90 days adds up to approximately 76% for the year, I went back to the courtroom feeling pretty good about my 80% rate.

Many professional valuators choose a “build-up” approach for determining the proper discount (and therefore capitalization rate) rate due to its highly empirical nature, i.e. the discount rate is “built” up based upon readily available investment “risk-return” data, e.g. Ibbotson and Associates publications.

The most controversial component of the typical build-up method for determining the proper discount rate concerns the element of risk associated with unique features of the subject firm (normally called the “company-specific” risk premium).  The controversy lies in the fact that most valuators rely almost entirely on their subjective opinion (hopefully based upon experience and good judgment) in adding this final risk premium to reach the discount rate. 

In essence, addition of a specific company risk premium to the discount rate (and by implication the capitalization rate) implies that the subject company is riskier than the hypothetical typical “micro-cap” or small company.  Note that a “micro-cap” firm, e.g. the smallest 5% of companies listed on the NYSE in terms of market capitalization, is normally much larger than the “typical” privately-held business subject to business valuation (including the subject company, even when combined with related entities).  For example, the median (as measured in financial size) micro-cap in a recent Ibbotson Associates survey had a total market capitalization of about $41 million.  Importantly, this is only median in terms of financial size (not investment risk).  Note that other stock indices are used to estimate such premia as well, e.g. S&P 500.

Many factors form the parameters of a subject company’s degree of risk. Some commonly encountered factors include:

· Size. Investments in smaller entities are typically more speculative in nature. The Ibbotson data is a treatise on how investments in small companies typically carry a greater expected rate of return. Small size tends to be accompanied by many of the risks listed below.

· Access to Capital Markets. Publicly traded entities and larger companies generally have greater access to avenues of raising money than small, closely held firms.

· Breadth of Customer Base. Dependence upon a few customers who could easily buy from a competitor is a significant risk. This is the "all-eggs-in-one-basket" issue.

· Geographic Area. Many businesses have suffered in recent years not by their own fault, but because they were located in a particular region of the country that fell into recession.

· Key Executive Dependency. Companies that cannot operate without the relationships or expertise of certain executives are vulnerable - particularly if the key executive is older. This is more the case with smaller companies, but not exclusively so.

· Limited Product Line. This is not always a problem, but if a particular product is in transition from being proprietary to becoming a commodity, or if the market for it is particularly transient, or if its patent is about to expire, then the producer must take steps to either diversify its offerings or protect market share.

· Litigation / Regulatory Risk. Is the very existence of the company threatened by adverse judgments or governmental interference? Many profitable, otherwise healthy, companies have been significantly effected overnight by lawsuits and legislation.

· Volatility of the Industry. Certain industries only prosper under certain conditions. Home building is much stronger during times of general economic prosperity. Suppliers of home building materials are thus more cyclical than the general economy.

There are no set rules as to how much a particular perceived risk is worth in terms of additional return. According to the 2002 Stocks, Bonds, Bills and Inflation Yearbook (Ibbotson Associates), micro-cap stocks (by one measure) have historically received a premium return of 1.8% per annum over that of large-cap stocks. As recently as 1996, this premium was more than 5%, illustrating the impact that the recent “runup and rundown” of the stock market has had on such premiums.  Pricing or adjusting for the additional risk associated with companies which appear more speculative than the median return for micro-caps would appear to be quite important, but very difficult.

Placing a subject company at the appropriate place on the spectrum requires knowledge, informed judgment, experience and skill on the part of the appraiser.  For a perspective that focuses on the impact of the company-specific risk premium, consider the following relationships based upon the following HYPOTHETICAL  (actual build-up process will follow shortly) “build-up” scenario:

Risk-free rate (US Treasury Yield) 6.5%
+ Equity premium (average excess return
over risk-free Treasuries)
7.0%
+ Small stock premium (average excess
return over large stock returns)
5.2%
  18.7%
- Expected growth rate in earnings 5.0%
Capitalization rate (prior to company
specific risk premium is applied)
13.7%
+ Company specific risk premium ???%
Final Risk-Adjusted Cap Rate* ???%

*Recall that the company specific risk premium may also be added after the small stock premium above to reach the final “discount rate” rather than as presented above (the above derivation is focused on the estimation of the “cap rate” rather than the discount rate).

Specific Company
Risk Premium
Increase in Cap Rate (Decrease in Value)
1%
(From 13.7% to 14.7%/Relative increase of 7.2%)
2%
Relative increase of 14.5%
3%
Relative increase of 21.8%
4%, 5%………
10%
Relative increase of 72.9%

Note: The larger the cap rate (or discount rate) prior to company-specific risk adjustments, the smaller the relative impact of each additional percent of company specific risk (and vice-versa, e.g. a 1% increase due to company specific risk from a base rate of 20% would be a smaller impact than a 1% increase from 10%, etc..

One important message is that maximizing shareholder value can often be achieved by minimizing shareholder risk. Other than that, there are no absolutes or rules-of-thumb for how much particular risks in particular companies are worth.  It is purely a matter of informed judgment.  It is not impossible to envision a scenario in which a financially sound company with a strong history of growth in earnings and a lock on a stable market might have a negative specific company risk.

Generally, many experts agree that a financially sound, closely held company with a market capitalization below $100 million or so that possesses some of the risk characteristics inherent in being small might warrant a risk premium of 0% to 5%.   Given certain conditions, this would effectively discount the capitalization (value) of the company by as much as 25% or more relative to the base build-up capitalization rate. 

Companies with less than $50 million in market capitalization which possess greater degrees of executive dependency, customer dependency, or those in particularly volatile industries might have a risk premium in the neighborhood of 3% to 6%, and thus would have their market capitalizations discounted for risk as much as 35%.

Risk premiums above 6% generally imply fairly high risk or small size, and those above more than about 10% result in market capitalizations being discounted close to 50% just for risk, an assessment implying that an investment is either quite speculative or very small.  Within this perspective, note that “very small” would be a proper descriptive term for many privately-held companies (including the subject stores, especially on a single-store basis).  In conclusion, the decision as to what the company-specific risk premium is or should be will have a direct and material impact on company value.

Other Perspectives on Company Specific Risk Premium (CSRP)
Leonard Sliwoski (Sliwoski & Associates) offers the following advice concerning the CSRP in conjunction with the Ibbotson Build-Up Rate:

  • 0% to 5% could be considered a “low” range figure
  • 6% to 10% could be considered a “mid-range” figure
  • Greater than 10% could be considered a “high-range” figure

Shannon Pratt and PPC Guide to Business Valuations
Suggest that the most common range is between minus 3% to plus 15%, with CSRP’s higher than 15% pertaining to highly risky enterprises, e.g. one man business, history of losses, etc.

Industry Risk Premia

As introduced earlier, the industry premium is based on the unique attributes of the specific industry within which the subject firm operates.  The 6.68% figure is estimated by Ibbotson Associates and included in their annual yearbooks.  The relevant SIC code here is the 3670 series involving electrical components.  It is interesting to note that this particular premium appears to be one of the higher industry premiums (based on the perusal of the industry list and corresponding premiums).  In fact, certain industries enjoyed a “negative” risk premium, i.e. their industries were considered to be “risk reducing” relative to the other build-up components.

The final premium of 8% reflects the unique risks associated with the subject company and its operating environment.  The general concept here is that the subject firm is yet riskier than even the smallest of publicly-traded stocks (the so-called “micro-cap” stocks or the smallest of NYSE-listed firms based on market capitalization, typically the smallest 10% of such firms), i.e. the privately-held firm under scrutiny in this report is substantially different in makeup than the smallest of publicly-traded firms.  For example, ABC’s non-ESOP shareholder is the company’s President and lone executive officer actively working for the business, its financial statements are compiled only (not audited or reviewed), access to capital is limited, etc.

This figure was estimated based upon a thorough review of the firm and industry and in comparison with other premia developed for other companies in the past (both similar and different firms and industries for comparison purposes) and a review of professional valuation literature regarding firm-specific risk assessments.  Because a separate “industry risk premium” has already been incorporated into the “build-up” discount rate, caution was exercised to focus on those outstanding risk elements pertaining exclusively to the subject enterprise, i.e. the strengths and weaknesses of the valuation target. 

Recalling the fact that a one percent increase in the discount rate will impart a leveraged impact on the overall discounting process, i.e. it is not uncommon for a 1% increase in the discount rate to effectively discount the company value by more than 6%, it is clear that the estimation of this risk component requires diligence and proper perspective.

Overall, there is substantial evidence supporting a relatively low company-specific risk premium (as compared to the typical, small privately-held business).  For example, the Ibbotson industry data for PCB manufacturing firms presents an average “cost of equity” equal to approximately 24.22% (SIC composite figure based on use of partially adjusted capital asset pricing model, i.e. inclusive of a small stock premium that also captures the company-specific risk elements).  Because these firms are all publicly-traded, however, we still are lacking an accurate “company specific” risk assessment.

A full understanding of discount rates and their impact on business value leads to the potentially troubling conclusion that maximizing shareholder value can often be achieved by minimizing shareholder risk, i.e. lower risk implies a lower discount rate and higher business value.  As noted previously, there are no absolutes or rules-of-thumb for how much particular “risks” in particular companies are worth.  It is purely a matter of informed judgment.   It is often argued, in fact, that a “small” yet financially sound company with a strong history of growth in earnings and a lock on a stable market might have a negative specific company risk.

Earlier analysis suggested that firms with a market capitalization below $100 million or so that possesses some of the risk characteristics inherent in being small might warrant a company-specific risk premium of 0% to 5%.   Given certain conditions, this would effectively discount the capitalization of the company by as much as 25% or more relative to the base build-up capitalization rate.  Companies with less than $50 million in market capitalization which possess greater degrees of executive dependency, customer dependency, or those in particularly volatile industries might have a risk premium in the neighborhood of 3% to 6%, and thus would have their market capitalizations discounted for risk as much as 35%.

Risk premiums above 6% generally imply fairly high risk or small size, and those above more than about 10% result in market capitalizations being discounted close to 50% just for risk, an assessment implying that an investment is either quite speculative or very small.  Within this perspective, note that “very small” would be a proper descriptive term for many privately-held companies (including the subject stores, especially on a single-store basis).  In the “big picture”, it is the valuator’s opinion that the subject firm lies in between these latter two categorizations (between the 6% and 10% company-specific risk premium).  Because the subject firm’s capitalization is nowhere near the $50 million level associated with the 3% to 6% company-specific risk premium, it is necessary to drop further down the “ladder” to reach the appropriate discount rate addition in this case.

Another interesting insight in regards to risk assessment comes in the form of the earlier-mentioned  industry-specific risk premium estimated by Ibbotson Associates in their 2001 SBBI Yearbook of 6.68%.  The addition of this premium to the risk-free rate, equity premium and small stock premium generates a discount rate equal to approximately 23.5%.  Interestingly, this is very close to the cost of equity estimate presented on the Ibbotson SIC code 3672 Industry Analysis report in the amount of 24.22%.   To the extent that both of these “costs of equity capital” refer to publicly-traded firms, this near equality should not be surprising.

The most common application of the industry risk premium is, in fact, in situations where the subject firm is a large private firm of a size similar to those included in the Ibbotson cost of capital report for SIC code 3672, i.e. the large private firm is considered more or less equal to the largest of the publicly-traded firms and therefore does not require an assessment of the “company-specific” risk premium on top of the industry risk premium.  In other words, the generally accepted application of the industry risk premium is for the largest of private firms, whereby the industry risk premium effectively replaces the company-specific risk premium in building up the pertinent discount rate.

Although both of the above estimates (24.22% and 23.5% are grounded in industry-specific considerations, they still lack an assessment of the “firm-specific” elements involving ABC, Inc.  The pertinent question, therefore, involves the relative placement of the subject firm vis-à-vis the “norm” or “average” firm in the industry (whether the industry is comprised of the 17 firms related to the 24.22% figure or a broader collection of firms related to the 23.5% figure).  Despite the smaller size of the subject entity ($8 million in sales) the unique history, financial performance and selected market niche must be considered as being very positive in nature.

PPC Guide to Business Valuation

One of the premier resources for business appraisers today is the PPC Guide to Business Valuations.  Authored by a group of the leading valuation professionals in the history of the industry, the PPC provides a unique “how to” approach which can be invaluable to the apprentice and seasoned veteran alike.

With respect to the company specific risk premium, the PPC authors speak in terms of “other risk factors” when describing the build-up method for determining the cost of equity discount rate.  Procedurally, they include the “company specific risk premium” with other risk factors which correspond to the difference between the “average market return” of publicly-traded stocks and the higher required rate of return for small, private firm investors.  In short, the size premium and the company-specific risk premium must be added to the average market return to determine the appropriate “required rate of return”, “cost of equity capital” or discount rate.

They note that “once the average market return has been determined, the next step in building up a discount rate is to add or subtract increments for risk factors that differ between the company being valued and the market.  The PPC “average market return” represents the rate of return that an average investor would consider adequate for an investment in an S&P 500 company (as opposed to the NYSE).  Because the typical small business is associated with more “risk” than the typical S&P 500 company, investors will demand a higher rate of return.  Rather than being satisfied with the 15.5% return comprised of the risk-free rate and the equity risk premium (average market return), investors will insist on a “premium” for the smaller size and corresponding risk factors.

Once the size premium has been calculated, the “other risk factors” must be assessed.  As any experienced valuator knows, this determination is “very subjective and requires a great deal of judgment – perhaps moreso than any other rate component”.  While conceptually quite straightforward, the actual calculation is troublesome to say the least.  The goal is to compare the risk related to investing in the subject firm visavis the average S&P 500 company.  The PPC Guide categorizes the company specific risk into four categories, as below:

  1. The Company’s Industry
    • Some industries have above-average or below-average investment risk
    • Ibbotson’s Yearbook contains “industry risk premia” (some are positive, e.g. construction and some are negative, e.g. niche manufacturing)
  2. The Company’s Financial Risk
    • Defined as risks related to all types of financing (not only debt)
    • Involves assessment of the following:
      1. Interest-bearing leverage and coverage ratios
      2. Total leverage ratios, such as total liabilities to equity
      3. Liquidity ratios, such as the current or quick ratio ratios, such as inventory and receivables turnover
    • A company that runs too lean or is too highly leveraged with debt will generally be riskier than a company not so burdened
  3. The Diversification of the Company’s Operations
      • In general, greater diversification reduces operations risk
      • Areas to evaluate include:
        1. Products
        2. Customer Base
        3. Geographic Locations
        4. Employees (added by authors)
        5. Suppliers (added by authors)
  4. Other Operational Characteristics
    • Valuer should assess all other factors that could lead to additional adjustments
    • Often includes key man issues and management depth and competence
    • Every business, industry and business cycle is unique and must be evaluated accordingly (added by authors)

As is the case with each authoritative source, the description of factors which might increase or decrease the relative risk associated with investing in a smaller, privately-held firm is both wide-ranging and helpful.  Recognizing the key risk determinants related to the subject business is an important and necessary condition for successful business valuation, but it is not a sufficient condition.  The real challenge lies in transforming the myriad risk factor assessments into a particular number or percentage to be added to the average market return to reach the overall discount rate for a specific company. 

The problem is that even if two appraisers agreed in full as to what the relevant risk factors were and could even rank the importance of such factors, they would still likely derive diverging “risk premia” for the company specific element of the build-up rate.  In other words, does a given risk factor raise the overall rate by 1% or 5% or 10% and why?  How is this “leap” made other than through faith?

For better or worse, there are no answers to this question.  What the valuator can do is develop an appreciation for what “typical” discount rates are for particular types and sizes of companies at specific points in time by reviewing other appraisals which are deemed authoritative and somehow accurate, by reviewing market multiples and converting them into after-tax discount rates, by reading authoritative articles from authoritative journals dealing with discount rate estimation and by using what other empirical data might exist for purposes of building a true and accurate perspective regarding the “cost of capital” in different situations.

The PPC discussion regarding this transformation, like most sources, is somewhat lacking and generalized (perhaps as it must be).  As they note once again:

            “The determination of the risk factors discussed (above) represents one of the    most difficult and judgmental steps in building up the discount rate.  It will also     be one of the most time consuming……. that generally must be performed by        the most experienced member of the valuation team.”

Taking a step in the quantitative direction, the PPC authors state that:

            “In general, the resulting net cash flow discount rate…will usually be between             18% and 30%, given the risk-free rates that existed during January of 2003.        However, the adjustments may be significantly greater….for some high risk             companies, or even negative for companies with lower risk….”


Pretax Versus After-Tax Adjustments

For the sake of discussion, let’s try to compare this “after-tax discount rate” with the commonly used “pretax multiples” associated with the smallest (riskiest) of firms within the “business brokerage” segment of business sales.  As per the PPC Guide, “a company’s cap rate is often derived from its discount rate.”  Strictly speaking, there are two different “cap rates” that can be developed from the Ibbotson discount rate:

  • Cap rate applied to NEXT YEAR’S net cash flows

            CNY  =  D – G

  • Cap rate applied to HISTORICAL net cash flows

            CCY   =   D - G
                         1 – G

Where: C = capitalization rate, D = discount rate, G = growth rate,
NY = next year and CY = current year

Consider the following steps to convert the discount rate to a cap rate and then from after-tax to pretax and then to a pretax multiple.  For the sake of this analysis, the midpoint of the PPC range shall be used (24%) and the resulting percentages shall be rounded to the nearest whole percent:

            After-Tax Discount Rate                               24%
         Less Growth Rate*                                          5%
         After-Tax Capitalization RateNY                   19%

         Convert to Pretax Cap RateNY (C/1-t)**     27%

         Convert to Pretax MultipleNY (M=1/C)        3.7 times

*This is a fairly common long term growth rate for earnings or cash flow measures.

**The tax rate is assumed to be 30% for this general application.

Thus it is that the multiple derived above should be applied to the next year’s net cash flows on a pretax basis.  Alternatively, consider the following path of adjustments:

            After-Tax Discount Rate                               24%
         Less Growth Rate*                                          5%
         After-Tax Capitalization RateNY                   19%

         Convert to Cap RateCY  (19%/1-G)               20%

         Convert to Pretax Cap RateCY (CCY/1-t)**  29%

         Convert to Pretax MultipleCY (M=1/CCY)     3.4 times

*This is a fairly common long term growth rate for earnings or cash flow measures.

**The tax rate is assumed to be 30% for this general application.

As the above analysis demonstrates, the pretax multiple applied to next year’s net cash flows is greater (by approximately 8%) than the pretax multiple applied to this year’s (historical) net cash flow.  Alternatively, next year’s discount/cap rate is lower (about 7%) than this year’s discount/cap rate.

Remaining true to the important link between the chosen income stream and value convertor (discount rate, cap rate, multiple), this multiple would theoretically apply to some version of a pretax net cash flow to equity.  By eliminating the income tax costs from the income stream, the resulting higher amount requires a higher discount rate for valuation purposes.

A rational question at this juncture would be to ask how the above discount/cap/multiple schemes apply to the smallest of firms within the business brokerage segment.  Given that the average price to adjusted cash flow (generic term) results found in both the national Bizcomps database and the national VR Business Brokers database consistently range between 2 and 2.5 times, it appears at first glance that the above multiples are more closely linked to middle-market firms (return on investment perspective) than the business brokerage segment (return on labor), i.e. the “average” multiple of 3.4 to 3.7 is considerably higher than that associated with the Bizcomps/VRBB databases.

In order to make a fair comparison, however, it must be understood that the income streams are different.  Whereas the 3.4 to 3.7 multiples apply to “net cash flow to equity”, the 2 to 2.5 multiples apply to “adjusted cash flow” or discretionary earnings.  What are the differences between these two benefit streams?  The answer is a function of both tradition and the valuator’s normalization efforts.

Traditionally speaking, ACF always includes the following components which are typically lacking in the net cash flow to equity stream:

  1. Owner Compensation (all salary, benefits, perks, etc. to a single owner-operator).
  2. Interest Expense (more of an “invested capital” or “debt-free” basis)

To the extent that net cash flow to equity will often include the owner’s excessive compensation, the difference is somewhat lessened.  On the other hand, net cash flow to equity contains the following elements which ACF does not:

  1. Investment in new working capital accounts
  2. Investment in new fixed assets
  3. Changes in long term debt
  4. Income taxes

Although net cash flows are by definition less than net income, the same blanket conclusion cannot be drawn between net cash flow and adjusted cash flow.  Depending on circumstances, one might be larger than or smaller than the other.  If owner compensation, interest expense and income taxes are greater than investments in working capital and fixed assets (and debt remains constant), then ACF will be larger and vice-versa.  Overall, the two streams are clearly “apples and oranges”.

Comparing pretax net cash flows to ACF is somewhat more straightforward, but the other differences still remain.  Assuming constant long term debt, the difference is narrowed to owner compensation, interest and taxes versus investments in productive assets.  The problem in comparing these two schemes goes beyond the benefit stream.  The derivation of a pretax multiple from the Ibbotson discount rate is still based on public stock return data and net cash flows to equity, i.e. it is simply not possible to apply the Ibbotson pretax multiple to adjusted cash flow.

The end result of the above comparison is that these two different situations require different techniques for estimating pertinent multiples.  The multiples applied to ACF are typically drawn from either market data or one of five different factor-based models which explicitly derive pretax multiples (Jones Method or Snowden Technique) or capitalization rates (Schilt’s Risk Premia, Black & Green, ValueNetex).

In practice, the Jones, Snowden and Schilt’s multiples and cap rates are typically applied to the smaller, business brokerage segment business size and type.  The Black & Green method (and accordingly the ValueNetex method, which is an extension of the Black & Green method) , however, has been used to capitalize (or discount) net cash flows to equity by certain valuators (rightly or wrongly).  As noted in Hitchner’s book, “many analysts have determined that the method is not empirically grounded and can be misleading, especially with regard to the suggested range of rate adjustments for each category.  However, the detailed list of questions for the various factors can be very useful as an analytical tool and for work paper support.”.  There is a relative consensus, it appears, that the Black & Green and ValueNetex methods are problematic yet best suited to the smaller, owner-dependent firms and the adjusted cash flow benefit stream.

Accordingly, we return to the typical dichotomy between the smaller, business brokerage sector, owner-dependent “return on labor” perspective and the larger, middle-market segment and its “return on investment” perspective.  As concluded by Mr. Leonard J. Sliwoski (Sliwoski & Associates) in a presentation at the IBA’s 2002 Annual Conference in Washington, D.C. , this distinction generally involves three different segments, as below:

Small, Owner-Operated Business/Less than $1M in Annual Revenues
Use of a “factor rating system” to derive a multiple (cap rate) for application     against “seller’s discretionary cash flow” (ACF) is the primary income        approach method.

Mid-Sized Businesses/Revenues between $1M and $20M
Use of the capitalized future returns and the discounted future returns     valuation methods via the Ibbotson Build-Up discount rate is commonplace    and appropriate.

Large, Closely-Held Businesses/Greater than $20M in Revenues
Use of the capitalized future returns and the discounted future returns     valuation methods via the Ibbotson Build-Up and Adjusted CAPM discount    rate is commonplace and appropriate.

In other words, it does not appear to be proper to utilize Ibbotson build-up discount rates for manipulation into pretax multiples for application to smaller business brokerage firms.  Alternatively, it may not make sense to utilize pretax multiples or cap rates drawn from the Jones through ValueNetex tools for transformation into after-tax discount rates for purposes of middle-market firm valuation.  Apples and oranges!

Having ruled out this particular type of transformation, we can discuss another similar adjustment scheme which is widely accepted and practiced (and theoretically applied to the ACF to net cash flow scheme just discussed).  Specifically, it is possible and commonly undertaken to transform a “cash flow” based discount or cap rate into an “earnings” based discount or cap rate and then multiple.

Many authoritative sources present this type of transformation, including PPC, Trugman, Hitchner, Mercer, etc.  A complete discussion of this adjustment process is found in Z. Christopher Mercer’s “Adjusting Capitalization Rates for the Differences between Net Income and Net Free Cash Flow” (Business Valuation Review, December 1992, pages 201-207).

In short, traditionally derived discount rates and capitalization rates are applicable to “net cash flows” and not “net earnings”, e.g. Ibbotson Build-Up Rate and the Adjusted CAPM Rate.  As a result, an upward adjustment is needed to “convert” the cash flow discount rate to an earnings discount rate (or cap rate).  The process behind this conversion appears to be relatively consistent from one source to the next and involves the following:

Risk-Free Rate
+ Equity Risk Premium
Average Market Return for Large Cap Stock Portfolio as of Valuation Date
+ Size Risk Premium
+ Company-Specific Risk Premium
After-Tax Net Cash Flow Discount Rate
+ Additional Increment by Which the Net Earnings Discount Rate Exceeds
the Net Cash Flow Discount Rate

Net Earnings Discount Rate

As described earlier, discount rates can be converted into cap rates via an adjustment for expected growth in the relevant earnings or cash flow stream.  Recall also that there are two distinct cap rates involved with the income approach methods, namely one for “next year’s” income and one for the “current year’s” income (as below):

Net Earnings Discount Rate (from above)
- Average Growth Rate
Net Earnings Cap Rate/Next Year
And
Net Earnings Cap Rate/Next Year  = Net Earnings Cap Rate/Current Year
1 – Growth Rate

All of the steps above have been discussed already with the exception of the new element in the form of “additional increment by which the net earnings discount rate exceeds the net cash flow discount rate”.  This is, after all, what this entire transformation is all about.  Just how is this “increment” calculated?  Consider the following example:

Assume the following…….

Net Income =      $300,000
Net Cash Flow = $240,000

Ratio of Net Income to Net Cash Flow = 1.25 times

Net Cash Flow Discount Rate = 20%
            Then…….
Net Earnings Discount Rate = 20%(1.25) = 25%

It is simply a matter of comparing the relative magnitude of the two different earnings streams and adjusting the net cash flow rate derived via Ibbotson (or ACAPM) to reach the net earnings discount rate.



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