CAPM received a Nobel Prize, is used in nearly every business valuation textbook from McKinsey to Pratt and Grabowski’s Valuing a Business, appears in all business valuation certifications and the CFA exam, and is used in corporate finance. There isn’t a better alternative. Nonetheless, Pablo Fernandez (IESE Business School, Universidad de Navarra) told ICAEW 2021 Business Valuation Conference attendees on 20 May that “CAPM can be an absurd model, lacking any relationship to human understanding.”
- It’s easy to attack the use of CAPM, betas, WACC, and market premia as follows:
- Discount rates are not observable, for one thing.
- Every source, from Bloomberg on down, derives different betas for the same company, Fernandez said, looking, for instance, at the published beta for Coca-Cola on a specific date in 2014.
- Some sources use betas with false precision (Fernandez cited a UK utilities study that derived an average beta to nine decimals to the right of the decimal point).
- CAPM “also assumes all investors have homogeneous expectations, and only care about the expected return and the volatility of their investments.” Without disagreement on expected or required returns, Fernandez points out that “trading volume would be very small.”
- Ian Cooper did a separate session on the adjustments many analysts apply (for small size, distressed assets, country risk, or other factors). These adjustments can compound business valuation “anomalies.” In 2021, we’re now in an economy with a negative risk-free rate, for instance, a lower equity risk premium of perhaps 5% and a resulting real cost of capital as low as 2%. At such historically low rates, premiums have a disproportionate impact and, in fact, can “drive your entire valuation. Your adjustments matter a lot, at the moment,” Cooper concluded—a 12% micro-cap size premium reduces value by about 76% for small firms, he showed. “Certainly, the evidence for this kind of adjustment is less clear now than it was in the past,” making the application of size premia more complicated.
“This is the schizophrenic approach: to be a democrat for the expected cash flows but a dictator for the discount rate,” Fernandez said, since investors have different expected cash flows but equal expectations of the required return.
“There is a great dispersion and some odd betas (for instance, negative, or higher than one). We kept all the betas and averaged.
And they used the last two years of STOXX averages. Why two years? “The historical period (five years, three years) and the returns period (monthly, yearly) change considerably from one day to the next.”
Then, they unlever the betas, calculate the average of the unlevered betas, and relever it using the average debt-to-equity ratio of the comparable companies. The result was a levered beta with nine figures after the decimal point.
Business valuers, of course, have to assume a representative or common buyer—as defined by standards having to do with “willing buyer, willing seller” and “market participants.” Furthermore, Fernandez agrees that the use of industry betas reduces the strange variances between individual company beta calculations and actual market risk. This puts business valuation on a stronger methodological basis than much of the investment analysis community.
Another advantage that business valuers have over the investment market is that there’s more agreement about whether CAPM is driven by historical, expected, required, or implied equity premia. Fernandez argues confusion arises because many analysts don’t distinguish, so some are “creating a discount rate based on something that happened to my father when he was very young.”
As George Bower said in discussion at the end of the session, the question is still “how should valuators ensure that their judgment is robust and free from bias/noise? How can we make our valuations defensible?” And, of course, as David Greene commented, “Most people still get lost in the maths of the DCF basis.”