| The economy continues to dominate news headlines | | | | IRP1 = expected industry risk premium reflecting the |
| on a daily basis. The stock markets are extremely | | | | relative risk of companies in that industry (if |
| volatile, and even the most seasoned economists and | | | | appropriate), SP = size premium, SCR = specific |
| financial experts remain at a loss for predicting when | | | | company risk) |
| things will start to change for the better. As a result, | | | | As a business valuator applies this formula, he/she |
| many businesses have had to adjust their | | | | typically refers to databases, government publications |
| projections, lenders continue to place more scrutiny | | | | and other resources to capture relevant data. |
| on borrowers, and the consumer is more cautious. | | | | Needless to say, that data may warrant extra |
| The business valuation community has had to | | | | scrutiny in the current environment. |
| respond to this turbulent environment as well, and | | | | First, due to the extreme volatility in the stock |
| analysts have had to pay special attention to the | | | | market, money has flowed into treasury bonds |
| fluctuating market conditions when valuing an ongoing | | | | causing the yields to drop down to zero and even |
| business enterprise. For example, if an analyst has | | | | below at times. If these low yields are used as a |
| decided to prepare a valuation of a company based | | | | proxy for the risk free rate in the build up method, |
| on the income approach (one of the three generally | | | | the result will be an unusually low cost of capital. |
| accepted valuation approaches), the economic impact | | | | Likewise, as a result of the poor stock market |
| must be addressed. After the analyst has completed | | | | performance, the equity risk premium (which is based |
| much of the necessary functions of the typical | | | | on the long-term average of the S&P500) has |
| engagement, including analyzing the financials of the | | | | declined recently. However, the risk associated with |
| company, normalizing the earnings, assessing the | | | | holding stocks has clearly not declined. |
| economic and industry conditions, forecasting and | | | | Third, additional risk premiums, including those for |
| evaluating the internal and external risk factors, and | | | | size, might be somewhat unreliable due to recent |
| estimating the future benefit stream, the analyst | | | | events. For instance, the theory that a large |
| must then determine the cost of capital for the | | | | company is less risky as a result of its size and |
| company being valued. | | | | market share must be questioned now that we have |
| Cost of capital is a key factor when determining the | | | | seen so many "too big to fail" companies collapse. |
| value of an ongoing business enterprise. Cost of | | | | Overall, the simple application of the traditional cost |
| Capital can be defined as the expected rate of | | | | of capital calculations will likely result in misleading |
| return that the market requires to attract funds to a | | | | conclusions due to recent events. |
| particular investment. When the valuation analyst | | | | Now more than ever, a thorough business valuation |
| determines the cost of equity capital, he or she | | | | analyst needs to employ his/her judgment when |
| typically employs what is referred to as a "build-up" | | | | valuing an enterprise. For example, the valuation |
| method. Basically, the analyst takes the "risk-free | | | | analyst's experience educational background, insight |
| rate", or the yield on long term U.S. government | | | | and peer resources are going to be critical resources. |
| bonds plus a risk premium, or rate of return | | | | Simply relying on published data points and previously |
| expected for taking on additional risk. In addition, the | | | | decided case law alone may not be enough. If the |
| analyst will consider an industry risk premium, a size | | | | valuation analyst chooses to rely only on these |
| premium and company-risk premium for the particular | | | | traditional methods of analyzes, he/she will likely be |
| enterprise. The formula is as follows: | | | | subject to skeptical inquiry. |
| Ke = Rf + ERP + IRP1 + SP + SCR | | | | We are in the midst of a very difficult economic |
| (Where Ke = cost of equity, Rf = risk free rate of | | | | environment. Therefore, it is critical that the valuation |
| return, ERP = expected equity risk premium, or the | | | | analyst be alert and well informed about this |
| amount by which investors expect the future return | | | | constantly changing market. In so doing, the valuation |
| on equity securities to exceed the risk free rate, | | | | analyst's clients will be appropriately served. |