We recently received an e-mail form an attorney who noticed the opposing plaintiff’s expert failed to include a specific company risk rate in his build up method used for valuing a privately held company. This greatly increased the amount of the Plaintiff’s claimed damages. The opposing expert supported his position by a reference to a published article:
“…. one last comment about company-specific risk. Judges hate it. In a litigation setting, although it really does exist, judges do not like to see a valuation analyst add this risk premium into the derivation of a discount rate. The reason for this is because it is subjective, and many valuation analysts do a poor job in supporting it.”
As testifying experts, we must determine or rebut the specific company risk component in virtually all of our engagements. For example, when rebutting a damages report, we can easily question the damages as too great or a value as too high by arguing the specific company risk associated with the company’s discount rate build up.
More about the specific company rate:
Roger Ibbotson defines the cost of capital as “the price charged by investors for bearing the risk that the company’s future cash flows may differ from what they anticipated when they made the investment.”
The build-up method is one of the most widely used methods to estimate the cost capital. It is an additive model in which the return on any asset is estimated as the sum of two or more components. Each component, except for the specific company risk component, is based on researched and published financial information such as treasury bill yields and actual returns of S&P 500 common stocks.
Specific company risk is meant to account for the differences between the data derived from publicly traded companies mentioned above and the subject company. These differences usually take the form of size, access to capital markets, breadth of customer base, key executive dependence, limited product lines, industry volatility, and a plethora of other criteria.
In conclusion, specific company risk does exist, and it is subjective. It can be a double-edged sword at deposition or trial and it is the expert’s role to adequately defend his or her conclusion. It can and should be explained when a build-up method is used to calculate a discount or capitalization rate and care should be taken to adequately support the stated value.
If you have any questions or comments about this article or of other related topics, please give us a call or an email and we’ll be happy to discuss them with you.