ValuAdder Business Valuation Blog

Business valuation tips, updates and advice. Pick up a few suggestions on how to value a business. Feel free to browse the contents or share your thoughts by leaving a comment.

Tired of blowing wads of money on overpriced database subscriptions? In business valuation, like in many things, the devil is in the detail. Without a detailed work up of the cost of capital your discount and capitalization rates are not worth much.

Slick data brokers would have you believe that they somehow create the market data you need. No surprises there, if you are persuaded that the expensive database subscriptions are the only way to get at the data, you feel stuck with the bill.

Good News: business valuation data is public and free

Here is the secret the data brokers don’t want you to know: all the market data you need for your business valuation comes from the public capital markets. Best of all, this data is absolutely free.

Let’s take a look at the renowned Build-Up cost of capital model the professional appraisers use to calculate their discount and capitalization rates, as well as the valuation multiples.

What you see is a number of components that are added up, starting with the risk-free rate of return.

Where do the gurus get the risk-free rate? That’s right, from the US Treasury yields, published for free by the, you guessed it, US Treasury.

The reason that these yields are taken as the measure of risk free rate of return is that the market participants believe Uncle Sam to pay off its debt obligations.

Because the USA controls the reserve currency (US dollar), the Treasury can always cover its debt by printing more paper money. If you invest by buying US Treasurys, you are guaranteed to be paid off at maturity and receive your interest payments in full and on time.

What about the equity risk premium or ERP in the Build-Up model? Available from the public capital markets for free again! The ERP is easily calculated from the S&P 500 index total returns using standard models such as the discounted cash flow. You don’t need to waste a penny on this one!

The same goes for the industry risk premium. You look at a sample of public companies in your industry sector using either SIC or NAICS codes published by the US government. Stock prices of these companies are public knowledge so figuring out the returns in your industry sector is a breeze. Compare this to the return observed in the market as a whole and you can factor out the industry risk premium.

If you followed the discussion above, you have probably guessed that the company size premium is similar to the industry risk premium. Except in this case you check out a bunch of companies within a market capitalization range that matches your subject business. Again, compare this to the returns of the equities market as a whole to figure out the size premium.

If you are valuing businesses in a specific country or region, there is a degree of risk your subject business may be exposed to just because of the economic conditions over there. Governments sell their debt obligations on the public capital markets. So you would do well to compare the yield spreads of these government bonds to the US Treasurys. The difference indicates the additional risk of running a business in that country or region.

Valuation multiples that don’t burn a hole in your pocket

But what about the ubiquitous valuation multiples? Same story, in almost all industry sectors there are plenty of public companies whose stock prices and enterprise values are well known. If you put together some comparables from the public companies, be sure to adjust them for lack of marketability using the so-called DLOM before applying them to private company valuation.

 

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