Butler comments on Damodaran’s ‘dynamite’ remarks regarding COE

BVWireIssue #237-4
June 29, 2022

valuation methods & approaches
beta, cost of capital, Aswath Damodaran, cost of equity

Last weeks’ issue covered some very choice words (some of which we can’t print here) Aswath Damodaran (New York University Stern School of Business) made about various inputs some analysts use to determine the cost of equity (COE). His remarks triggered some comments from Peter J. Butler (Valtrend), who is the co-developer of the Butler Pinkerton Calculator, which offers empirical data for total cost of equity (TCOE) and company-specific risk premiums (CSRP).

“I listened to Professor Damodaran’s excellent presentation the other week titled, ‘In Search of a Steady State: Inflation, Interest Rates, and Value; The (Inflation) Genie Escapes the Bottle!’ And yes, as BVR indicates, the professor threw some dynamite on how some (but not all) appraisers develop a cost of equity for their privately held company, such as the use of:

  • “A ‘normalized’ risk-free rate—whatever that is;
  • “A stagnant and backward-looking historical risk premium; and
  • “The alleged and dubious size premium, which he calls fiction.”

Butler continues: “He also offered some choice words over the use of the company-specific risk premium (CSRP). For what it’s worth, I have never used a CSRP either (although I have previously been lazy and called what I am actually capturing—an unsystematic risk premium—a CSRP to match, generally speaking, the BV community’s faulty nomenclature).”

“For what it’s worth, I have never added a completely qualitative CSRP to my cost of equity—to make my valuations ‘make sense,’” he says. “I have never had a subject company that is just so unique—so company-specific—that no other company in the world has the same (or at least very similar) risk profile. Rather, I have added an unsystematic risk premium in many (but not all) of my valuations for the last 15-plus years to adjust for the less-than-perfect diversification of hypothetical willing buyers and willing sellers in the private marketplace. How do I do this? ‘Simply’ with the use of total beta, which explicitly captures total risk and, therefore, implicitly captures unsystematic (and systematic) risk. Thus, there is no need to build up the rate and potentially and easily double count risk.”

Butler concludes: “If appraisers use beta in their development of the cost of equity, which I believe we all do in one form or another, it is time to start getting the full benefit of publicly traded stock returns. The only way to do that is to also use total beta.”

Extra: A full recap of Damodaran’s remarks on how to assess inflation’s impact on company valuation will be in the August issue of Business Valuation Update.

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