Litigation + Valuation Perspectives

Demystifying Valuation, Economic Damages + Forensic Accounting

How the stock market affects the valuation of privately held companies – part 1

Everyone is aware of the large swings in the overall stock market over the past several years with daily gains and losses of over 3% and weekly gains and losses of over 25%. In fact, certain individual stocks have posted gains and losses greatly exceeding these figures.

During this period of extraordinary volatility in the public market, does it logically follow that the value of privately held companies would experience similar dramatic shifts in value over a few days or weeks? To begin to answer this question, it is important to understand the data from public markets used by business appraisers when performing valuations of privately held companies.

The three approaches to business valuation consist of the asset, income and market approaches. The income approach and the guideline public company method under the market approach both utilize public market data to determine the value of a privately held company.

The income approach

The income approach determines the fair market value of a privately held company by multiplying the economic benefit stream (typically cash flow or net income) generated by the subject company times a factor (i.e., a multiple), determined based on a discount or capitalization rate;  the result is a conversion of the stream of future benefits into present value. These rates are based upon benchmark data derived from historical public stock market returns. There are four common methods of developing a required rate of return, or equity discount rate, on an investment in a privately held business, all of which are based upon estimated cost of equity models. These models are as follows:

  • The Capital Asset Pricing Model (CAPM)
  • The build-up method;
  • The Duff & Phelps (D&P) Risk Study; and
  • The D&P Size Study.

The CAPM and build up methods utilize historical data between 1926 and the date of valuation provided in Morningstar’s Stocks, Bonds, Bills and Inflation Yearbook (SBBI), Valuation Edition which tracks the total annual return {1} of the S&P 500. The D&P Risk Study and D&P Size Study also rely on historical S&P data collected since 1963. The D&P Risk Study enables the appraiser to analyze average historical measures of risk over the past five fiscal years.  These risk factors include Operating Margin, Volatility of Operating Margin, and Volatility of Return of Book Equity.  The D&P Size Study corroborates the relationship between the size of S&P companies and historical rates of return.

As you can see, the cost of equity models discussed above utilize long-term historical stock market data to determine an appropriate equity discount rate to apply to the subject company’s economic benefit stream. Due to the utilization of long-term historical averages, the equity discount rates produced under these models do not fluctuate significantly with short-term changes in the stock market.

Henry+Horne

[1]  Total annual return is the sum of the annual appreciation rate of a price of a stock plus its annual dividend distribution rate.