The Butler Pinkerton Calculator: An Update - BVMarketData

The Butler Pinkerton Calculator:
An Update
American Society of Appraisers
Advanced BV Conference
October 20, 2009
Peter J. Butler, CFA, ASA
1

Learning Objectives:
• Problems with traditional factor models: Use at own
peril!
• The Choice: Empirical Data v. No data
– The choice is yours:
• Make it wisely
• Impeach inferior cost of capital estimates
• Secondary Choices: Empowerment/Transparency
• Other Applications for the Calculator
Determination of the proper capitalization rate
presents one of the most difficult problems in
valuation – RR 59-60
2

Let’s Get Some Things Out of the Way First
• You can do all of these calculations yourself.
– You do not need the BPC!
• Total Beta and the BPC violate the CAPM!
– So does every single privately-held company!
– The size premium violates the CAPM.
– The CSRP violates the CAPM.
– Total Beta and the BPC do not, however, violate financial theory
for individual assets.
• Total Beta assumes a completely undiversified investor (or pool of
completely undiversified investors)
– Good assumption? It depends on the assignment
– Regardless, it is still a data point that is better than guessing
• Not asking you to abandon other cost of capital models, BUT:
3

The BUM is Problematic
• Double counting size risk and industry risk?
– Both based on actual returns compared to expected returns
based on beta
• Size risk and CSR risk are next to impossible to separate
– Is a company risky because it is small or is it small because it is
risky?
– Yes and Yes!
• Is there a liquidity premium in the size premium?
– Highly likely
• Is there a liquidity premium in the industry risk premium?
– Likely
• Industry risk premium may include questionable guidelines
• How much different would the data look if another day of the month
had been selected?
• After you get through the gauntlet above; You still have to
completely guess at the CSRP!
4

Traditional Factor Models: Use at Own Peril!
Negative risk factors +/- Numeric Listing
Operating history, volatility of rev & earn. +++ 3.5 X
Lack of management depth ++ 1.0 X
Lack of access to capital resources + 0.5 X
Over reliance on key persons ++ 1.0 X
Lack of size and geographic diversification + 0.5 X
Lack of customer diversification 0.0
Lack of marketing resources + 0.5 X
Lack of purchasing power 0.0
Lack of product/market. dev. resources + 0.5 X
Over reliance on vendors/suppliers 0.0
Limitations on distribution system 0.0
Limitations on fin. reporting/controls + 0.5 X
Positive risk factors
Where is
the
empirical
data?
Long term contracts, unique product 0.0
Patents, copyrights, franchise rights - (1.0) X
Net increase to Cost of Equity 7.0 7.0 7.0
5

The Problem: What Do the Courts Want?
• Gesoff v. IIC Industries
– “This court has also explained that we have been
understandably . . . suspicious of expert
valuations offered at trial that incorporate
subjective measures of company-specific risk
premia, as subjective measures may easily be
employed as a means to smuggle improper
risk assumptions into the discount rate so as
to affect dramatically the expert’s ultimate
opinion on value.”
6

The Courts Want Empirical Data!
• Delaware Open MRI Radiology Associates
v. Howard B. Kessler, et al
– “To judges, the company specific risk
premium often seems like the device
experts employ to bring their final
results into line with their clients’
objectives, when other valuation
inputs fail to do the trick.”
7

Summary of Factor Models
• Excellent models to understand Size:CSR
• But, do not provide what the courts want:
– Empirical data on Total Risk and/or CSR
• If you want to make enemies, try to change
something.
Woodrow Wilson, 28 th President of the United States
8

The Solution: Total Beta and the BPC
Solving for the only unknown in the two equations, CSRP:
• TCOE = R f + Tβ*ERP = R f + β*ERP + SP + CSRP
Professors of
Finance and
Economics
Damodaran
Well–known appraisers
CAPM
Modified CAPM
Risk Allocation:
• Combined Size:CSRP = (Tβ–β)*ERP
• CSRP = (Tβ–β)*ERP – SP
BPC
“Market approach twist to developing a discount rate.”
9

The Calculator is:
1) Empirical,
2) Transparent,
3) Real-time (or as close as possible),
4) The only source (that appraisers typically
rely upon) that captures total risk, and
5) Empowering
12

More Transparency
13

Practical Advice
• This is clearly a great addition to what we
have done in the past. We used to use
Cost of Capital Quarterly to get an idea of
the cost of equity by SIC code. We would
adjust from there. Now, instead of using
the entire industry, we can choose
better guideline data as a starting point.
– Gary Trugman, CPA/ABV, MCBA,
ASA
14

Impeach Inferior Estimates of Cost of Capital
Build-Up Method:SIC Code 8742
(Management Consulting Services, but really interested in litigation
consulting)
• ACCESS WORLDWIDE CMMNCTNS
• ADVISORY BOARD CO
• AON CORP
• BEARINGPOINT INC
• BUTLER NATIONAL CORP
• CIRTRAN CORP
• COMFORCE CORP
• CORPORATE EXECUTIVE BRD CO
• CROSS COUNTRY HEALTHCARE INC
• DIAMOND MANAGEMENT & TECHNL
• ELOYALTY CORP
• EMCOR GROUP INC
• EXPONENT INC
• FTI CONSULTING INC
• GARTNER INC
• HALLWOOD GROUP INC
• HEWITT ASSOCIATES INC
• HURON CONSULTING GROUP INC
• INVENTIV HEALTH INC
• LECG CORP
• MANAGEMENT NETWORK GROUP INC
• MAXIMUS INC
• NAVIGANT CONSULTING INC
• OCEANIC EXPLORATION CO
• PAREXEL INTERNATIONAL CORP
• PDI INC
• PHC INC/MA -CL A
• QUANTUM GROUP INC
• RAHAXI INC
• REHABCARE GROUP INC
• SOUTHWEST CASINO CORP
• SPHERIX INC
• SUNRISE SENIOR LIVING INC
• TALEO CORP
• TETRA TECH INC
• THOMAS GROUP INC
• TRI-ISTHMUS GROUP INC
• TURNAROUND PARTNERS INC
• TYSON FOODS INC -CL A
• UNITEDHEALTH GROUP INC
• VERSAR INC
• WATSON WYATT WORLDWIDE INC
15

The “Battle of the Experts” is Over Before it Even Began
Total Cost of Equity (TCOE)
Litigation Consulting Firms
More defensible
18.50%
18.00%
17.50%
Empirical data
BPC
BPC
17.00%
16.50%
16.00%
15.50%
BPC
BPC
BUM
Out of
thin air
15.00%
Guess
14.50%
14.00%
FCN ($2.7B) HURN ($1.0B) NCI ($600M) CRAI ($265M) Subject ($?)
Subject: risk-free=4.16% (5/18/09); ERP = 6.5%; BUM = build-up method: IRP = -1.46%; SP = 5.81%; CSRP = 0.5% (Guess);
BPC = Butler Pinkerton Calculator: 5-year-lookback; Market proxy = S&P 500
16

Interesting Observation: “I Don’t Have
any Good Guidelines!”
• BUM with an IRP: You already have assumed
“good” guidelines – at least for systematic risk.
– Use BPC to impeach inferior estimates of the
cost of capital
• Broaden your search: Guidelines = guidance
– Joyce C. Hall v. Commissioner:
• Hallmark Cards v. MCD, BUD, IBM, KO,
AVP
• Many small publicly-traded companies.
• Company-specific risk is just that – company
specific.
17

Practical Advice Related to Guidelines
• Frankly, it was this analysis (reviewing Forms 10-K, etc.)
that gave me the best insight into the characteristics
that affect risk in this industry. I don’t believe that you
can reasonably assess company specific risk factors
without an understanding and analysis of the
benchmarks derived from the BPC.
• I much prefer BPC because it forces me to examine
public company data about industry risk factors and value
drivers which is available through public filings, press
releases, analyst reports, etc. The data is much more
comprehensive in nature than the limited data
available for private companies.
– James M. Skorheim, JD, CPA/ABV/CFF, CFE, CVA,
CrFA
18

Other BPC Applications:
• First, we do a significant amount of Fair Value compliance
work, and the BPC is a great tool for developing capital
costs for hypothetical market participants. We've had
general acceptance of this method in audit review, and it's
a great time saver.
• Second, in documenting a decision regarding discounts for
lack of marketability, we regularly use QMDM as one of the
methods considered. The BPC enables us to develop
actual market equity returns for smaller publicly traded
companies, providing a lower limit for the expected return
input in QMDM.
– James B. Lurie, CPA/ABV, ASA, CBA, CVA, BVAL, CIRA
19

Other BPC Applications (continued):
• In using the market approach, the market multiples can be adjusted not
only for size and growth, but also for the CSRP. Again, the judgment gap
is narrowed. Finally, I have found that the variance between the values
determined by the income and GPTC methods has been significantly
reduced.
– Donald P. Wisehart, ASA, CPA/ABV/CFF, CVA, MST
• There is a reason why your method (BPC) and our method (used to adjust
public company multiples for CSR) are similar, that’s because both are
actually the same method, developed a long time ago.
– Vicentiu M. Covrig, Ph.D., CFA in an e-mail to Butler
There is nothing more difficult to take in hand, more perilous to conduct,
or more uncertain in its success, than to take the lead in the introduction
of a new order of things.
– Niccolo Machiavelli, Italian philosopher
20

Other BPC Applications (continued): 123R
21

Other BPC Applications (continued): In Search of the “True” Beta
Beta Source Market Proxy Period Frequency Adjustment
1 Bloomberg Over 20 domestic series Adjustable Adjustable (0.67*OLS Beta)+(0.33*1.0)
2 Compustat S&P 500 5 years Monthly None
3 Ibbotson S&P 500 5 years Monthly Adjusted toward peer group beta
weighted by stat. significance
4 Value Line NYSE Composite 5 years Weekly 0.35+0.67*OLS Beta
5 Yahoo!Finance S&P 500 3 years Monthly None
6 BPC 6 domestic series Adjustable Weekly - default None
Adjustable - manual
BPC rank 2nd Tied first 2nd Debatable
Sources: Table 6-11, SBBI Valuation Yearbook and definitions from Yahoo!Finance.
22

Total Beta:BPC and Peer Review
1) Referenced in AICPA textbook
written by G. Trugman,
Understanding Business
Valuation;
2) Referenced in PPC’s 19 th
Annual Guide to Business
Valuations;
3) Referenced in CCH’s Business
Valuation Guide;
4) E-book in collaboration with
Morningstar;
5) Current Update in
Valuations/part of training
material for NACVA;
6) Part of HBS Case Study;
7) Numerous independent
endorsements and
testimonials;
8) Can be proven with the Sharpe
ratio. It is just CAPM theory
for the undiversified investor;
9) Academic support;
10) More than 10 articles;
11) Numerous presentations;
12) Cost of Capital, 3 rd edition
23

Independent Select Testimonial
• Total beta is a widely accepted measure of
risk in situations where investors are not
well diversified. The Butler-Pinkerton
Calculator is a convenient and flexible
tool for quickly arriving at an objective
estimate of total beta and the company
specific risk premium for a privately held
company.
– Keith Harvey, Ph.D., CFA (A finance professor
made aware of Mr. Kasper’s allegations)
24

Another Select Testimonial
• We believe that the Butler-Pinkerton Calculator
is a useful tool for appraisers who want a
quantitative way to assess the maximum
CSRP. What the Total Beta and calculator
computes is the maximum or upper bound for
the CSRP. A good appraisal should also use
subjective techniques and judgment to
determine the appropriate CSRP for the
subject company.
– Vicentiu M. Covrig, Ph.D., CFA and Daniel
McConaughy, ASA, Ph.D. (Finance professors made
aware of Mr. Kasper’s allegations)
25

Total Beta and The BPC: Why Not Now?
• Subjective Factor Models Provide NO empirical data for
Total Risk or CSRP!
– Any other source is subject to harsh criticism
– BPC is not a solution in search of a problem
• BPC provides (moderately subjective) EMPIRICAL data:
– Defend/support all assumptions/inputs
• No different than any other cost of capital input
– Except the BPC provides real-time, transparency for
specific guidelines
– Except the BPC empowers you to observe the
sensitivities in the calculations
26

Questions to Consider:
• If Total Beta and the BPC (which empirically
capture total risk) were developed first, would
you abandon them to rely upon other databases
(which only capture partial risk)?
• If Total Beta and the BPC were developed first,
would you abandon them to rely upon the purely
subjective factor models (which require a
complete guess for a CSRP)?
– One thing we do recognize is that the valuation profession can use
more tools grounded in market observations to help develop discount
rates – Roger Grabowski; BV Update - November 2006
• Note: The BPC was commercialized in November 2007
27

Questions
An important scientific innovation rarely makes its way rapidly winning over
and converting its opponents; it rarely happens that Saul becomes Paul.
What does happen is that its opponents gradually die out and the growing
generation is familiarized with the idea from the beginning.
– Max Planck, German physicist, founder of quantum theory
28

The Butler Pinkerton Calculator:
An Update and A Response
American Society of Appraisers
Advanced ASA BV Conference
October 20, 2009
Peter J. Butler, CFA, ASA
Never let the search for the perfect get in the way of the perfectly good
- John Elson, Time editor
29

Whose Misunderstanding of Financial Theory
is the Question
• “We have argued that in equilibrium there will be a simple
linear relationship between the expected return and standard
deviation of return for efficient combinations of risky assets.
Thus far nothing has been said about such a relationship for
individual assets. Typically the ER, σR values associated with
single assets will lie above the capital market line, reflecting the
inefficiency of undiversified holdings. Moreover, such points may be
scattered throughout the feasible region, with no consistent
relationship between their expected return and total risk (σR).
However, there will be a consistent relationship between their
expected returns and what might best be called systematic risk, as
we will now show.”
Portfolio risk
William F. Sharpe (1964), “Capital asset prices: A theory of market
equilibrium under conditions of risk,” Journal of Finance, 19 (3), p.436.
A
Portfolio
30

Are You on the Left-side or the “Right”-side?
• Correlated relative volatility v. Relative volatility
• Covariance v. Standard deviation
• Well-diversified portfolio v. Stand-alone asset
• Portfolio managers v. Appraisers
• Partial risk v. Total risk
• NO empirical data v. Empirical data
• A few appraisers v. Ph.Ds and a growing
number of appraisers
• It’s your choice – I have made mine.
31

Conclusion from Mr. Kasper’s Paper
• “Until the authors provide empirical evidence
that total beta produces better estimates of
actual public company returns…”
– Why would we?
– Mentioned in very first article that the
technique does not do this – Mr. Kasper
missed it!
– CSR is at least partially diversified away for
publicly-held stocks.
• CSR, however, is priced for PRIVATE
companies
• Use Total Beta as a proxy for PRIVATE
companies
32

Other Observations: Instability of Beta
Dnacq Healthcare (DYII)
Dryships (DRYS)
Beta Total Beta Beta Total Beta
Jan-08
Nov-08
Monday 0.34 10.72 Monday 2.88 4.33
Tuesday 1.18 11.60 Tuesday 2.52 4.70
Wednesday 0.60 12.05 Wednesday 2.41 4.39
Thursday 0.60 12.93 Thursday 2.31 4.25
Friday -0.47 11.92 Friday 2.18 3.93
Mean 0.45 11.84 Mean 2.46 4.32
Median 0.60 11.92 Median 2.41 4.33
SD 0.60 0.80 SD 0.27 0.28
CV 1.33 0.07 CV 0.11 0.06
33

Other Findings (continued):
• Statistical errors with beta (instability of beta) (continued)…
– Total beta (TCOE-side of Calculator) is relatively immune
– BPC uses OLS beta to keep the following intact:
• Other commercial sources use OLS regression
– Recommendations: Calculations are very quick and easy
• Look at all 5 days of the trading week
• Look at different look-back periods
• T-stat greater than 80% (or whatever you so choose)
• Select an appropriate R-square as a hurdle
• Question: Maybe a low R-square captures exactly what it should
be capturing – a stock with low systematic risk?
34

Response to Roger Grabowski’s Slides
• Which is it?
– “The cost of capital should reflect the risk of
the investment, not the cost of funds to the
investor”.
– “Risk of an investment and its FMV must be
developed based on the risks (and pricing)
perceived by investors that comprise the pool
of likely buyers for the subject asset…”
• “No one (researchers) uses TCOE = R f +
TB*RP m ”
– Why would an academic use TCOE?
– TCOE is not priced in the public markets
35

Response to Roger Grabowski’s Slides
• “CSRP estimates derived from beta estimates are subject to
estimation error (i.e., CSRP estimates are unreliable)”
– True; Use all five days of the trading week
– Duff & Phelps’ data, dependent upon sum beta, is also subject to
estimation error
• How would Duff & Phelps or Morningstar’s data look if
another day of the month was used?
– No one knows. The databases are not transparent.
– What is not subject to estimation error? This is valuation!
• “The Sharpe Ratio does not cover cases in which one investment
return is involved”
– Other than in private company valuation there are no individual
investments.
– Stocks are part of portfolios
36

Summary:
• All models are wrong, but some are useful.
George Box, statistician
– Total beta and the BPC are very useful.
– You can use them (or perform the calculations yourself)
and be subject to Mr. Kasper’s alleged criticisms or be
subject to harsh criticisms from the Court.
• Your Choice!
• It takes a model to beat a model.
Milton Friedman, Nobel Prize winning economist
– Total beta and/or the BPC have beaten other
models/databases that require a complete guess for
CSRP:
1) And do not empirically capture total risk and
2) Are not transparent and empowering
37