March 23, 2011
The next time you review a valuation report, the numbers may be different from what you expected. Size premiums, which valuators typically use to develop a discount rate for their appraisal subject, recently were updated. Whether you seek an appraisal as part of a marital dissolution case, shareholder dispute, buy-sell agreement or potential merger, these updates could significantly affect the value of your client’s business.
Power of 10
Valuators use size premiums, in part, to develop discount rates (the cost of equity). Generally speaking, the higher the discount rate is, the lower the value of the company, and vice versa. To determine size premiums, experts rely on guidelines developed by the investment research firm Ibbotson.
Ibbotson defines a size premium as the return on small company stocks in excess of that predicted by the Capital Asset Pricing Model (CAPM), or the return that can’t be explained by a small company’s beta (a traditional risk metric). In essence, size premiums measure the additional risk, or premium, a company carries relative to its size.
Ibbotson breaks down size premiums into deciles based on market capitalization so that the first decile represents the largest companies and the 10th decile, the smallest. These size premiums generally illustrate the relationship between a company’s size and its return.
In Ibbotson’s SBBI® 2010 Valuation Yearbook (published by Morningstar), the company updates the 10th decile. This is the first change to the 10th decile since 2001, when Ibbotson split it into two parts, 10a and 10b, to enable a closer look at the smallest companies. The 2010 Yearbook further splits the 10th decile by dividing 10a into subportfolios 10w and 10x, and 10b into subportfolios 10y and 10z.
By introducing these subportfolios, Ibbotson increases the range of size premium choices, which could affect a company’s valuation — particularly if the business falls in the 10th decile. For example, if a valuator uses subportfolio 10z (which has the highest discount rate), it will result in a lower value for the company than if the valuator had used another size premium in the 10th decile.
The above table illustrates how size premiums affect the value of a company by comparing the 10th decile with a size premium of 6.28% to subportfolio 10z with a size premium of 12.06%. Assume a discount rate of 10% (without applying a size premium), a long-term growth rate of 3% and a single-period cash flow of $1,000,000.
As shown, the difference between the two scenarios is approximately $2.284 million, with the Scenario A value approximately 40% greater than the Scenario B value.
Larger range = different values
The purpose of the subportfolios is to enable valuators to more accurately appraise small companies. But attorneys and their clients should prepare themselves for a value that may be significantly less than they expected.
|Scenario A – 10th decile 6.28%
||Scenario B – 10th decile subportfolio 10z 12.06%
||10.00% + 6.28% = 16.28%
(Discount rate without size premium plus 10th decile size premium)
||10.00% + 12.06% = 22.06%
(Discount rate without size premium plus 10z size premium)
||16.28% – 3.00% = 13.28%
(Discount rate minus growth)
||22.06% – 3.00% = 19.06%
(Discount rate minus growth)
||$1,000,000 divided by 13.28% = $7,530,120
||$1,000,000 divided by 19.06% = $5,246,590
Issue 3 - Spring 2011