George DuRant, CPA, ABV, ASA
Durant, Schraibman & Lindsay, LLC
Valuation expertise, a notch above…
Among the many jewels of wisdom shared by Warren Buffett this year in his annual letter to Berkshire Hathaway shareholders was this one (referring to the way he looks for investment managers):
It’s easy to identify many investment managers with great records. But past results, though important, do not suffice when prospective performance is being judged. How the record has been achieved is crucial, as is the manager’s understanding of – and sensitivity to – risk (which in no way should be measured by beta, the choice of too many academics). In respect to the risk criterion, we were looking for someone with a hard-to-evaluate skill: the ability to anticipate the effects of economic scenarios not previously observed.
Let’s talk about risk and how we estimate a company’s discount rate. It is generally accepted in the financial community that some version of the capital asset pricing model (CAPM) be used to develop a company’s discount rate. Warren pooh-poohs the use of a beta as a reliable means of adjusting the equity premium for risk. And, unadjusted equity premiums from a book such as Ibbotson or Duff and Phelps just don’t rise to the level of reasonable certainty. Furthermore, equity risk premiums from those sources adjusted based solely on the valuator’s “judgment” and experience (gut) are totally indefensible.
So, how does a CPA defend his or her estimate of a company’s discount rate? One way is to estimate the forward-looking premium implicit in prices for guideline public company shares. In other words, solve for the cost of equity capital (k) using the following formula: