Business valuation tends to be a complicated animal with numerous factors that need to be evaluated and quantified in order to muster up an effective result. Key among those factors are company-specific risk premiums and the methodology used to calculate them, beta risk. The following excerpt comes from the May 2021 issue of the Business Valuation Update and discusses the use of an alternative method—total beta.
Simply stated, academia focuses on publicly traded stocks and assumes that every investor is perfectly diversified (to use the CAPM). If everyone is perfectly diversified, or can easily become so, then all investors are homogeneous and, therefore, irrelevant from an individual perspective. Thus, beta (in the CAPM) is all that matters.
This is not the world in which private markets typically operate, however. Therefore, the private-company investor—in the fact that he or she does not own the “market portfolio” and is not perfectly diversified—matters and matters greatly. So academia and the public markets assume everyone is the same, perfectly diversified investor and, therefore, only pricing systematic risk. On the other hand, in many instances, business appraisers and private markets should assume marginal buyers are not perfectly diversified and, therefore, price systematic as well as unsystematic risk.
The Way Forward
One can use total beta (TB), defined as the standard deviation of a stock/standard deviation of the market, to calculate the general equity stock market participants’ total cost of equity (TCOE), or their unsystematic risk premium—if necessary. (As a reminder, since unsystematic risk can be easily diversified away, do not use TB and TCOE when analyzing publicly traded stock for investment purposes). Then, and only then, can the analyst carefully compare the subject company to the guidelines to select a TCOE or unsystematic risk premium for the subject company since, as pointed out, this risk is not about any unique or “company-specific” risk per se.
TCOE = risk-free rate + TB*(equity risk premium)
Notice that beta has been replaced with total beta in the CAPM.[i] It’s a simple adjustment based on modern portfolio theory (MPT). Thus, while we all understand that CAPM has its issues, if you accept this ubiquitous cost of capital model, which is taught in all universities (with a finance program) and is the most popular choice on Wall Street, no one should have any issues with using TB and the TCOE for privately held company valuation. (Please see discussion of a simplified, two-asset portfolio below and the resultant private company beta (PCB) as a supplement to TB’s use.)
If you use TB, there is no need to select the subject company’s beta (or industry risk premium in the buildup method), the alleged and dubious size premium, and then completely guess at the CSRP. So you either have to select and defend three selections (beta/industry risk premium, the size premium, and the CSRP) in the buildup method or just TB—and TB has market-based evidence, unlike the completely qualitative estimate of a CSRP. By qualitatively estimating the CSRP, analysts may be essentially guessing at the TCOE—the ultimate conclusion. Thus, I believe the choice is simple. Use publicly traded stock data to their maximum potential—which should include both beta and TB—at a minimum as a check on the ubiquitous buildup method.
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[i] Professor Aswath Damodaran of New York University first introduced the TCOE equation to the business valuation community in the late 1990s—more than 20 years ago. Total beta was introduced in 1981 in “The Beta Quotient: A New Measure of Portfolio Risk,” written by Robert C. Camp and Arthur A. Eubank Jr., published in the Journal of Portfolio Management. (Note: Total beta was referred to as the “beta quotient” in the article.)