There are shortcomings to using historical data in developing an equity risk premium (ERP) when estimating the cost of capital, points out Eric Nath (Eric Nath & Associates LLC) in the February issue of Business Valuation Update. His comments were triggered by the release of BVR’s Cost of Capital Professional, but they refer to any process to estimate the cost of capital that uses historical data or Damodaran’s implied ERP. The issue is illuminated by the feature in the Cost of Capital Professional that allows users to use different start and end dates for historical data, a “positive aspect” of the platform, he notes.

“What’s needed is a truly forward-looking required rate of return system that gives appraisers an understanding of how to estimate cost of capital for private companies and interests in private companies,” Nath says. In response, Ron Seigneur (Seigneur Gustafson LLP), a co-chair of the Cost of Capital Professional advisory board, points out that one of the ideas behind the platform is to “give valuators insights into the data they’re using so they can be empowered with information and flexibility.” Historical data are useful but should not be used in isolation, he says, and professional judgment must be used in how to apply the data.

Better way: To estimate returns, Nath says the better alternative is to find out what returns investors required on the investments they recently made. The Pepperdine Survey of the private capital market does this to a certain degree. Nath maintains that, if we focused more on improving this type of research, “we would be a lot further ahead in understanding how to estimate required rates of return.”

Extra: Pepperdine’s annual cost of capital survey is now open and seeks input from investors, lenders, business owners, and anyone else involved in the funding of private businesses.