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sean39 Group Title

When valuing a very small private company with no public comps in its industry, what is the best way to estimate the cost of capital? Using the build-up method with a small stock premium (non-beta adjusted) seems tantamount to assuming a beta of one. Then we must add a large and subjective Company Specific Risk Premium which should taken into account this industry-specific risk. To make matters worse, Ibbotson breaks down the small stock premium (as oppposed to the size premium) only into mid, low and microcap categories, not into deciles, or 10a and 10b sub-deciles.

  • 3 years ago
  • 3 years ago

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  1. business1 Group Title
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    damodaran has compiled a useful detailed manual which includes information on cost of capital for private companies. attached.

    • 3 years ago
  2. sean39 Group Title
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    I've read that paper before. The company I am valuing is neither a startup nor a growth company. This paper does not answer the question of what to use as a substitute for beta or an industry risk premium when there are no public comps in the subject company's industry. My approach is likely going to be to calculate the small stock premium for Ibbotson's decile 10. (This assumes the subject company's beta is the same as the beta computed using all public companies with market caps between $1mm and $214mm). Since my company likely has a value of close to $1mm, my Company Specific Risk Premium will have to include a very subjective additional size premium. Anyone have thoughts on this approach?

    • 3 years ago
  3. sean39 Group Title
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    I think I made a mistake in my original question (which I corrected in my previous post). If I use the small company premium which is non-beta adjusted, that assumes that the beta of my company is equal to the beta of all small companies from which that premium is derived -- it does not assume a beta of one. The problem is that even if I use the small company premium for the 10th decile of companies, that is still calculated from companies with market caps between $1mm and $214mm -- so it is still a very bad proxy for a company that is likely worth about $1mm. Ibbotson has data on sub-deciles (10a and 10b or even 10w, 10x, 10y and 10z), but the valuation profession has definitely shied away from using the lower end of these deciles due to the high number of fallen angels, distressed companies, etc. in these categories. My subject company is not distressed and is not a fallen angel, and would still be orders of magnitude smaller than most of the companies in these categories. Thoughts?

    • 3 years ago
  4. business1 Group Title
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    look through pages 33, 34, 35

    • 3 years ago
  5. sean39 Group Title
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    I re-read those pages, and it still does not address the issue. On page 32-33 it says "there are generally other companies in the same business that have made it through the early stage in the life cycle and are publicly traded. We would use the betas of these firms to arrive at the market risk associated with being in this business." No mention of the proper approach when there are no public companies in the sector. Pages 34 and 35 discuss other adjustments once you have the basic estimate of beta.

    • 3 years ago
  6. Hermits@4 Group Title
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    I believe in this case you need to use a subjective wacc. Refer to Perrino and kidwell corporate finance textbook. the key though is to classify the firm as a very risky firm r risk, or normal or safe etc...

    • 3 years ago
  7. sean39 Group Title
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    Hermits -- I appreciate the response, but I don't understand how using WACC gets around the issue. It seems to just raise other assumptions about the capital structure. In this case the business has no debt, and I would not likely assume any changes to the all-equity capital structure given that I am valuing a minority interest. I also have no data on the market value of debt to equity for comparable companies since there are no public comparables. So WACC seems to be a step in the wrong direction.

    • 3 years ago
  8. kalika_jain Group Title
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    Hi sean, I am also facing the same problem. I am valuing a private firm in its growth phase. Moreover in my case the industry (Event Management) is also comparatively new and unorganized and there is no publicly listed firm. However I found these two articles, see if they can help you. Also please share anything relevant you find to calculate the cost of capital.

    • 3 years ago
  9. sean39 Group Title
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    Thank you. This is what I have been looking for. I have been a strong believer that directly measuring the private cost of capital is a better approach than indirect comparisons to the public markets. I have referenced the Pepperdine Cost of Capital study in many formal valuations I have done, but generally as supporting evidence for the cost of capital derived from more traditional models, rather than as a primary method for directly determining the cost of capital. I doubt that using a cost of capital derived from the survey results and professional judgment alone would withstand a Daubert challenge. But my background is in the angel, venture, and private equity industries. I know that the real investors in these markets make their decisions by comparing their expected return to typical expected returns specific to that market -- these funds are not readily substituted between private and public markets based on fluctuations in the market.

    • 3 years ago
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