Just keep on doing what you’re doing with cost of capital, advises Jim Hitchner (Valuation Products and Services), despite what academics say. During a recent webinar, he responded to some severe criticisms Aswath Damodaran (New York University Stern School of Business) made during a recent BVR webinar about certain inputs to the cost of capital. Damodaran rejects some concepts that most valuation practitioners use, such as the historical ERP, the company-specific risk premium, and the size premium. Other academics have also questioned cost of capital models and inputs practitioners typically use.
The two-hour webinar was very comprehensive and went into great detail on how analysts can support their cost of capital estimates. Hitchner offered his list of best practices, and he conducted some polls of the large audience about the use of certain models and inputs. Yes, there are different opinions about many elements, but it’s a healthy dialogue. And it’s important to understand the framework you are using, whether it’s the Kroll Cost of Capital Navigator, BVR’s Cost of Capital Pro, or Damodaran’s data.
Be reasonable: Getting deep into the weeds of cost of capital can be mind-boggling, so, at the end of the day, you need to see whether your overall rate is reasonable. Hitchner advised that a good check on this is to show where your subject company falls in the spectrum of rates out in the market, starting with the U.S. 30-day T-bill (0.06% in 2021) all the way up to venture capital for first stage/early development (40% to 60%). Hitchner showed this as a listing of rates, but you can also depict it in some other form. We’ve seen it done as a gauge, like the gas gauge in your car, with a needle going from low risk to high risk.
During the BVR webinar, Damodaran had made some remarks about total beta that, when taken out of context, lead you to believe that he rejects that concept also. During the Hitchner webinar, he provided the full remarks made about total beta, a concept Damodaran does not criticize in the same vein as he does some of the other concepts. Damodaran publishes total betas and includes the concept in his teachings and writings.
A recording of the July 21 webinar will be made available on the VPS website. The title is: Cost of Capital Dispute: Damodaran vs. Kroll Cost of Capital Navigator vs. BVResources Cost of Capital Professional. What Is Right and What Is Wrong?