At the CalCPA conference in San Francisco last week, Ted Israel (Eckhoff Forensic & Valuation Services) joined James Harrington (Duff and Phelps) to discuss the issues surrounding company-specific risk (CSR). Many valuation analysts may be double-counting CSR, Israel said, because they are not aware of the risk already embedded in the companies in Ibbotson’s lower tenth deciles and Duff & Phelps Portfolio 25. The subject company’s earnings may already manifest many of the ills normally associated with small private companies. “We’re spending too much time obsessing over the denominator [the discount rate] and ignoring the effects on the numerator [earnings],” he said. Some analysts might also be blurring the line between risk of the investment (the proper focus of the CSR analysis) and the investor’s risk. Through a Fama-French analysis, Harrington demonstrated that although greater CSR may indeed be associated with the non-diversified holdings, the market did not necessarily compensate them with greater returns. As for the “total beta” model, he believes that a “one size fits all, ‘silver bullet’” for estimating CSR does not exist. The more important question: How does the subject company compare to those in the selected peer group from, e.g., the SBBI 10z or Duff & Phelps Portfolio 25 companies?
For more on this complex, always controversial topic, Israel’s paper, “Risky Business” is in the current BVUpdate (June 2011) and is now available as a free download here.
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