Photo Gallery
Private Cost of Capital Model
Published: 06/20/2010 by Rob Slee, CBA and John K. Paglia, PHD
This article is excerpted from "Private Cost of Capital Model" by Rob Slee, CBA and John K. Paglia, PhD, CPA/ABV, CFA, ASA originally published in the March/April 2010 issue of the Value Examiner. The full article can be read by clicking here.
“Business valuation is an attempt to estimate the balance between risk and return in an entity. Risk is the capital market’s assessment of the likelihood that a subject will actually achieve its expected returns. Business appraisal quantifies this risk assessment as a company’s cost of capital. Cost of capital is the expected rate of return that the relevant market requires in order to attract funds to a particular investment.”
“…Currently business appraisers…employ public securities data as a surrogate for private return expectations. This is inappropriate, as the public and private markets are not substitutes; they are driven by different, unrelated factors.” In addition to demonstrating that the public and private capital markets are not substitutes, Slee and Paglia look to point out the fundamental flaws of capital models that “…rely on public market data, such as the build-up method and capital asset pricing model (CAPM)…”
The article discusses the structure of the private capital markets and the results from two recent surveys of private capital markets. They go on to discuss “…a new discount rate model, called the Private Cost of Capital model” along with its impact on business appraisal.
The authors note that: “Business appraisers spend a considerable amount of time and energy using public securities information to derive private business values. This is understandable, since Revenue Ruling 59-60 gives justification to considering the ‘market prices of…stocks actively traded…either on an exchange or over the counter’ as one of eight factors when valuing privately held businesses. Comparing public and private securities has created the need for elaborate economic bridges that enable appraisers to value private business interests vis-à-vis public data with ever more frequency.” The authors reference Slee’s Spring 2005 article in Business Appraisal Practice titled “Public and Private Markets are Not Substitutes” in which he identified a number of factors that differentiate these markets. In the current article, Slee and Paglia build a solid argument against financial models utilizing build-up or CAPM and make the simple points that “Players within a market do not approach the problem of calculating real-world investment decisions this way…A scale derived from direct observation of the market is more accurate, useful and responsible than a theoretical construct attempting to mimic that market.”
The authors go on to discuss the Pepperdine private cost of capital survey project, an ongoing project which they describe as “…the first comprehensive and simultaneous investigation of the behavior of the major private capital market segments.” The first of these was published in August 2009 (Pepperdine Private Capital Markets Project Survey Report, August, 2009, John K. Paglia) and the second in February 2010 (Pepperdine Private Capital Markets Project Survey Report, February 2010, John K. Paglia). The Paglia/Slee article in the March/April 2010 issue of The Value Examiner graphically illustrates many of the studies findings.
In concluding the current article, Paglia and Slee state: "Private company business appraisal is performed using an assumption that public market cost of capital is relevant to the private capital markets. We argue that the private and public markets are not substitutes for each other, as each has its unique risk and return expectations, as well as structural differences. We propose a cost of capital model that use private capital market return data, which is relevant to privately held businesses. The model relies on current survey data to guide return expectations, risk assessment, and investment qualification assessment. The private cost of capital model replaces appraisers’ reliance on public market data for the valuation of privately held companies.”