|
|
|
1 Typical Asset Based Approaches
2 Typical Comparison Based Methods
3 Typical Capitalization/Discount Based Methods
Capitalization of Earnings/Income/Dividends/Dividend-Paying Capacity (defined income ÷ appropriate cap rate = value) Same as Multiple of Earnings (earnings or dividend paying capacity × multiplier = value where multiplier is reciprocal of cap rate)
Excess Earnings (value of tangible assets + value of intangible assets)
Discounted Cash Flow (PV of forecasted earnings + PV of future value)
4 Discount & Capitalization RatesCapitalization rates that are derived directly from market transactions most likely include market assumptions concerning growth in both income and overall value as well as holding period assumptions; i.e. it likely measures total return just as the discount rate does and probably should be used as a discount rate instead of as a cap rate.
Discount rate may equal capitalization rate when:
5 Typical Capitalization Rate Sources
Market (1÷ P/E ratio) = cap rate
This cap rate incorporates TOTAL market expectations regarding future growth, future value, holding period, etc.... In theory, it is the best available method of estimating market value since it relates value to earnings (before or after tax earnings pared with before or after tax P/E ratio) using market derived data. PROBLEM is that P/E ratios often vary widely over time and between comparable firms and great care must be taken when developing a list of comparable firms to use in developing the ratios. Major problems may exist when appraiser seeks to use cap rate developed using publicly traded companies to value a privately held company. It is possible to use statistical analysis with a large data base of transactions to develop statistical measures of mean cap rate and standard deviation. Still comparability problems may exist unless data base is very comparable to subject company (i.e. closely held rather than public companies).
Discount Rate - estimated growth rate = cap rate
Discount rate can be developed using a number of methods:
(debt-to-value ratio × before tax cost of debt) + (equity-to-value ratio × before tax required equity return)
(debt-to-value ratio × (before tax cost of debt × (1 - marginal tax rate))) + (equity-to-value ratio × after tax required equity return)
long term risk free rate: US Gov bond rate - long term CPI used for risk free return without growth element (20 year bonds frequently used)
risk premiums: Specific to subject company & those arising from economic conditions
Schilt: 6-10% for established businesses with strong trade position whose future is highly predictable up to 26-30% for a small one-man business of a personal services nature.
size premium: Ibbotson & Associates IBBA ( 10th decile stock returns less 1st decile returns less CPI is a measure of return for "small" firms - about 7% as of 1998 issue)
Price-Waterhouse (Grabowski & King): for NYSE companies under $30,000,000 in value the estimated premium was about 15%.
illiquidity (marketability): care must be taken not to build this adj into discount rate and then also take another discount of resulting value as a marketability discount.
John Emory has studied the marketability problem extensively since the 1960's by careful analysis of registered investment companies that invested in restricted stocks prior to an initial public offering (IPO) and the "...price relationship between stock transactions and subsequent initial public offering (IPO's) of the same issues.". Writing on page 3 of the March, 1993 issue of Business Valuation Review (ASA publication), he reported that in his latest study, using 1992-1993 data, that "...54 private sales and transactions took place at a 45% mean discount and a 44% median discount from the price at which the stock subsequently came to market. The range was from a discount of 90% to a premium of 4%. The average of the means and the average of the medians of the six studies were 47% and 46% respectively."
These court cases imply acceptance by tax courts of marketability discounts ranging from 7½% up to 25% with an average marketability discount of 17.5% and a median of 20%. IRS tax court cases are based upon situations that are strongly contested by the IRS and probably represent the very low range of appropriate discounts.
Administrative Costs: estimate based upon bank trust dept fees for managing estate with similar assets.
Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Model (APT)
CAPM: Cap rate = Risk-free Rate + Beta (Market Risk Premium - Risk-free Rate) where the risk free rate is the traditional 20 year bond rate less inflation, the market risk premium is the average excess return over the risk free rate for the subject market segment or market as a whole and the beta is the excess volatility of the subject company over the whole market or the market segment volatility. A Key Point here is that use of the CAPM approach implicitly assumes that risk is the only major factor that affects the cap rate. Other major concerns with the use of the CAPM to develop cap rates for use with closely held companies is that it assumes that the market is efficient (NO WAY for these companies) and that it uses public company data to develop rates for use with private companies (comparability problems). The CAPM also uses beta as a measure of individual company risk which gives rise to a couple of problems. First, it is VERY difficult to develop beta estimates for small, closely held companies. Second, beta may actually be a measure of price elasticity rather than of risk.
The APT model attempts to improve upon the CAPM approach by adding more factors to the analysis (remember that risk was the only factor used in the CAPM other than the risk-free rate). Think of it as a model with multiple betas and multiple risk factors. While this is intellectually pleasing, it is difficult to impossible to parameterize the APT model for small, closely held companies and it suffers from the same efficient market/beta = risk assumptions.
6 DISCOUNT RATE Rate Sources
| Risk Free Rate | 6% |
| Long-term equity risk premium | 8% |
| Long-term horizon premium | 1% |
| Default premium | 1% |
| Micro-cap size premium | 3% = 19% + individual company risk premium |
 |  |  |
|
|
|