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TOTAL BETA
TOTAL BETA: WHO'S RIGHT, WHO'S WRONG
Sometime between the third and fourth editions of the Cost of Capital,
Pratt and Grabowski appear to have had a change of heart regarding total
beta.
Author: PETER J. BUTLER
PETER J. BUTLER, CFA, ASA, MBA, is the principal of Valtrend, LLC.
The fourth edition of Pratt and Grabowski's Cost of Capital 1 undoubtedly is an
outstanding contribution to our body of knowledge. Yet some portions of Chapter 15,
titled “Company-Specific Risk,” are misguided. Unquestionably, there is confusion
regarding total beta in the appraisal profession. Surprisingly, however, a comparison of
the criticisms of total beta in the newest edition of the Cost of Capital to the coverage this
issue received in the previous edition indicates that even Pratt and Grabowski appear to
be confused about the topic.
Total Beta
Total beta is the relative standard deviation between a stock and the market. It is used to
capture total risk. Privately-held companies are often valued (and priced) as stand-alone
assets with total risk in mind. Total risk is generally priced in private markets because of
prospective business owners' inability to shed company-specific risk (CSR) due to a lack
of diversification. According to traditional financial theory, only systematic risk is priced in
the public markets because investors have the ability to shed CSR.
ln the present author's opinion, a total beta perspective is better at assigning a private
company's cost of capital than the standard build-up method because it allows appraisers
to compare and contrast specific public guidelines with private companies as opposed to
building up the rate (from averages) and then making a guess as to the appropriate
company specific risk premium (CSRP). ln short, total beta gives appraisers empirical
evidence that did not exist before.
Discrepancies Between the third and fourth Editions
A highlight from the third edition of Cost of Capital states:
In this chapter we discuss approaches to better quantify the total risk and
related market returns of guideline companies. When you use the total
risk and the related return, you are including company-specific risk. 2

The third edition then described the use of total beta as one of the better approaches to
quantifying total risk.
In the fourth edition, however, it is stated:
No researcher studying whether the market prices unsystematic risk or the
magnitude of that pricing has used E(R i ) = R f +(TB × RP m ). 3
The equation above is the total cost of equity (TCOE) equation developed by New York
University Professor Aswath Damodaran. This equation replaces the CAPM beta with total
beta for private company valuation. In the fourth edition, Pratt and Grabowski imply that
they believe that the theory is flawed. But the statement from the fourth edition was
certainly true when the third edition was written, so why the change of heart
This article will analyze criticisms against total beta and the Butler Pinkerton Calculator
(BPC) 4 with the goal of allowing the readers to determine if those criticisms are wrong,
unfair, 5 or potentially biased.
Background
The 2011 study material for the Chartered Financial Analyst program states:
[W]e can assume that in an efficient market, no incremental reward can
be earned for taking on diversifiable risk. [Emphasis added.]
This is an obvious point. All appraisers know, however, that markets may not be perfectly
efficient. In the fourth edition of Cost of Capital, Pratt and Grabowski point to research
indicating that CSR may be priced—at least on some level—in the public markets. If true,
do the public markets completely price CSR (which is what total beta does) The present
author does not believe so, finding it hard to accept that someone can create a well
diversified portfolio with only (or mostly) systematic risk, yet would be compensated
completely for all CSR that they no longer have, or have only in immaterial amounts.
That would be a nice deal if one could get it, but no one can. In short, even if CSR is
priced in the public markets, it is not priced completely.
Total beta, on the other hand, prices CSR completely. In fact, it completely prices total
risk. That is the reason that no academic researcher has used total beta and the total
cost of equity (TCOE) calculation set out earlier. If a researcher used total beta, he or she
would obviously think that diversification was of no benefit whatsoever. (Try to get that
hypothesis published somewhere.) Researchers do not use total beta to describe public
stock returns because they know that CSR is not completely priced in that market. We
proponents merely use it as a proxy for private company returns where CSR is priced due
to lack of diversification.
Unfair, Incorrect, or Inconsistent Criticisms
Pratt and Grabowski make unfair, incorrect, or inconsistent criticisms about total beta
results. These criticisms are examined below.
Two costs of capital.

Prat and Grabowski claim that total beta results in the “unreasonable position” that there
are at least two costs of capital for a business:
(1) The cost of capital for investors (i.e., the pool of potential buyers), who are
likely to be diversified.
(2) The cost of capital to the current owner, who is completely undiversified. 6
This claim is disputable. First, cost of capital has always been about the pool of potential
buyers. Second, why is it assumed that the pool of buyers is likely to be diversified for
every engagement How many potential business owners are well diversified after
purchasing a privately held company Not many.
Guessing at diversification.
Prat and Grabowski ask “how can a company estimate its cost of capital if it needs to
guess if the pool of likely buyers is diversified” 7 Simply stated, a company need not
guess, at least not in most instances. Traditionally, privately held companies are valued
as stand-alone assets and priced on total risk, whereas public companies are priced only
(or primarily) on systematic risk. This is why appraisers add company-specific risk
premiums (CSRP) in the build-up approach, and not, as Pratt and Grabowski surmise,
because investors view a private company's risk differently than the average risk
characteristics of a pure play guideline public company to which it would be compared.
Pratt and Grabowski's view is an affront to modern portfolio theory, which is based on the
ability to diversify away all (or most) CSRs. Most private business owners simply do not
have this ability. In addition, Pratt and Grabowski do not tell readers what they mean by
a “pure play guideline company.”
Total beta, however, is not appropriate in all circumstances. For example, if a company is
being acquired by a public company, is going public, or is large enough to be publicly
owned, an appraiser should use the capital asset pricing model (CAPM) beta. Total beta
also may not be appropriate if an appraiser determines that a pool of buyers is somewhat
diversified. This situation may require a “private company beta.” 8 A private company
beta exists somewhere between a CAPM beta, in which only systematic risk is priced, and
total beta, in which total risk is priced. Of course, certain assumptions will have to be
made, but it is far more empirical than merely guessing at an appropriate (adjusted
downward) CSRP in the build-up method to account for some level of diversification. 9
Total Beta violates FMV and FV.
Pratt and Grabowski suggest that total beta violates the definitions of fair market value
(FMV) and fair value (FV). 10 The present author strongly disagrees. In fact, total beta no
more violates FMV or FV than the build-up method, in which an appraiser has subjectively
added a CSRP due to lack of diversification. Appraisers do not have a specific investor in
mind, other than assuming that the investor is (generally) undiversified. If an appraiser
does not add a CSRP, then he or she has made the determination that the likely buyer is
diversified. Does this violate the FMV or FV standard Of course not.
Cost of capital is a function of the investment, not the
investor.
Pratt and Grabowski claim that the cost of capital is a function of the investment, and not
the investor. On the same page, however, they also claim that “as the more diversified

uyer is likely to pay a higher price, the value of the business and business interests in
most cases must be greater than their value determined using total beta.” 11 Which is it
Admittedly, the investor matters, and cost of capital is not just about the investment.
This is modern portfolio theory in action, which gave rise to total beta. In short, if a buyer
is diversified, an appraiser should use beta (private company beta), not total beta. If,
however, the buyer lacks diversification, total beta should be used. Pratt and Grabowksi
appear to be saying one thing, when they really mean something else (which happens to
be consistent with total beta).
In sum, marginal investors set the price, and the cost of capital is a function of both the
investment and the investor. An appraiser must assume that he or she is dealing with
well diversified investors in the public markets and nondiversified investors for (most)
private markets. And yes, the investor obviously matters. Thus, one needs to improve
CAPM beta for private company valuation, and total beta or private company beta are
just such improvements.
Small private companies do not have public guidelines.
Grabowski is apparently comfortable with using guideline publicly traded stocks in his
Duff & Phelps Risk Premium Report to assist in the determination of the appropriate cost
of capital for a small privately held company, yet Pratt and Grabowski object to using
publicly traded data in a total beta framework. Either the use of publicly traded stock
data is unacceptable or it is not. Total beta simply provides another metric that a valuator
may use—a metric that captures total risk, and therefore systematic risk, size risk, and
CSR, in one fell swoop. In short, total beta offers many advantages.
Total beta includes an embedded discount for lack of
marketability.
Pratt and Grabowski suggest that total beta captures lack of marketability since it
purports to capture total risk, citing, in support, a paper written by Professors
McConaughy and Covrig. 12 Total beta proxies, however, come from publicly traded
stocks. If the stock is efficiently traded (i.e., not thinly traded), there is no concern about
a lack of marketability. If, on the other hand, the guideline is thinly traded, the guideline
should be removed from consideration as a proxy. If Grabowski is concerned about this
issue for total beta, he should be equally concerned for his Duff & Phelps Risk Premium
Report Portfolio 25.
In addition, Professors McConaughy and Covrig are on record as being strong supporters
of total beta and the BPC. 13 Specifically, they state:
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.
Too many factors, too few guidelines for using total beta
or the BPC.

Pratt and Grabowski claim that there may be too many risk factors to consider, or too few
guidelines, to use total beta or the BPC. If an appraiser uses the CAPM, he or she has to
select guidelines. If the market approach is used, the appraiser has to select guidelines.
If an appraiser calculates a discount for lack of marketability (DLOM), the courts prefer
that the appraiser use guidelines and not averages. Guidelines, of course, are never
perfect, but appraisers do the best they can do with what they have.
The build-up method, however, simply uses averages for the industry risk premium and
size premium. Moreover, the build-up method has neither averages nor guidelines for
CSR. So even if there was only one guideline to help select a total beta for a particular
privately held company, it would be far better than no guidelines. There is no data on
CSR if the appraiser only makes an educated guess under the build-up method.
If an appraiser is comfortable using only the build-up method, he or she must also
consider that courts find in the company-specific risk premium the means by which
appraisers can provide final results that neatly support their clients' objectives when
other valuation inputs fail to do the trick. 14
CSRP is an aggregate calculation; subjectivity remains.
Carefully comparing guidelines to a subject company is a subjective exercise. This is
positive. With total beta, at least an appraiser has relative empirical benchmarks. Thus, it
is much less subjective than a pure guess with no data at all. An appraiser can ignore the
benchmarks and guess at his or her own peril, but many highly qualified appraisers no
longer feel comfortable guessing. As one commentator put it:
Years ago, when I first attended a BPC session at a NACVA conference, I
immediately recognized the BPC as a great step forward for the business
valuation profession. Total Beta and the BPC made so much sense and
represented such an improvement over the totally subjective methods that
I wondered why I had not thought of it myself. Failure to utilize the BPC in
the litigation environment could well be fatal to a Valuation Analyst's
expert career. 15
CSR is a function of the beta estimate, which is subject
to error.
Everything in valuation is subject to “error,” some metrics more than others. Duf &
Phelps Risk Premium Report's use of sum beta is also subject to “error,” but Grabowski
uses sum beta to counter a problem with CAPM beta, noting that “[b]ecause of nonsynchronous
price reactions, the traditional betas estimated by ordinary least squares are
biased down for al but the largest companies.” 16 Total beta, however, already captures
non-synchronous price (i.e., CSR) reactions. If an appraiser does not want to isolate the
CSRP because of worries related to beta or in determining a specific size premium for
each guideline, then he or she should just use total beta. Beta is (generally) more volatile
than total beta due to the volatility of the correlation coefficient.
Many appraisers rely on total beta, which is just the relative standard deviation between
a stock and the market, because it makes for a much easier deposition or crossexamination.
An appraiser who uses total beta has to defend one number (total beta)
rather than other numbers, such as the beta (sum beta) or industry risk premium, the
size premium, and the CSRP.

Total beta quantifies two risks simultaneously.
Pratt and Grabowski claim that total beta simultaneously captures CSR and the lack of
diversification risk of the venture. The present author agrees that these two risks are
inseparable, adding that if, and only if, the venturer lacks proper diversification will CSR
be priced (either completely or partially).
The BPC is not the answer.
Nothing in Chapter 15 of Cost of Capital should make an appraiser second-guess his or
her use of total beta or the BPC.
Pratt and Grabowski quote M. Mark Lee for the statement that total beta or the BPC are
not the answers. 17 The present author agrees—total beta or the BPC are not the answers,
but they can assist in finding the “answer” more empiricaly than a pure guess. And in
spite of all of the problems with the build-up method, the present author does not
recommend abandoning it. After all, the more information an appraiser can gather, the
better able he or she will be in determining an appropriate cost of capital for a privately
held company. The present author merely recommends that total beta be part of an
appraiser's toolbox.
Perhaps a better way to think about total beta's eventual adoption is this: If total beta
had been invented before the build-up method, would anyone consider abandoning it to
use the build-up method, which has been described as a “recipe for disaster” 18 by
Professor Damodaran Unlikely. Although not examined here, in addition to a pure guess
on CSR, the build-up method may result in double- and triple-count risks. In short, no
one builds up multiples in the market approach. Rather, an appraiser observes market
multiples and adjusts accordingly for differences between the subject and the guidelines.
It is no different for total beta.
Conclusion
Total beta and the BPC receive negative attention in the fourth edition of Cost of Capital.
Sadly, Pratt and Grabowski reference only naysayers in Chapter 15. 19 The present author
and others, however, have refuted the naysayers' views, and other proponents are
stepping up in defense of total beta. 20
Specifically, a growing number of well regarded, independent appraisers and academics
are debating, publishing and providing positive testimonials about, 21 and defending the
total beta theory. The proponents recognize that total beta is theoretically sound for
private company valuation, is empirically-based, and is a major step forward for the
valuation industry. Clearly they are willing to put their reputations on the line in support
of the technique, so they must believe in it. As Gary Schurman, CFA, stated recently,
“total beta is just the CAPM beta without the benefit of diversification.” 22 It is as simple
as that. It is not controversial for those who are willing to perform their own due
diligence on the topic.
Maybe total beta is a better approach, as the third edition of the Cost of Capital stated.
The alternative, after all, is to guess at CSR, a theory that Pratt and Grabowski are
implicitly promoting. But Pratt and Grabowski have no answer for the harsh indictment of
our industry.

Long and short, if an appraiser uses total beta, he or she will not be alone. In fact, the
appraiser who uses total beta will be in highly regarded company. Ultimately, however,
analysts must dig into the theory, examine its practical applications, and reach their own
conclusions. Appraisers who engage in their own due diligence on total beta will not be
disappointed with the results.
1
2
Grabowski and Pratt, Cost of Capital, 4th ed. (John Wiley & Sons, 2010).
Grabowski and Pratt, Cost of Capital, 3rd ed. (John Wiley & Sons, 2008), at page 226.
[Emphasis added.]
3
4
See note 1, supra, at page 310.
The BPC is a commercial application hosted by Business Valuation Resources on their
website, www.bvmarketdata.com. The BPC calculates guideline betas, total betas, and
TCOEs, among other statistics, for use as benchmarks in private company valuations.
5
For example, can some of these same criticisms also be made about the build-up
method
6
7
8
Cost of Capital, 4th ed., at pages 306 and 307.
Cost of Capital, 4th ed., at page 307.
Butler and Schurman, "A Tale of Two Betas," The Value Examiner (January/February
2011).
9
For more information on private company beta, see the frequently asked questions
under the BPC at www.bvmarketdata.com.
10
Cost of Capital, 4th ed., at page 307.
11
Id.
12
Cost of Capital, 4th ed., at page 308.
13
McConaughy and Covrig, “Comments on Butler-Pinkerton series of papers and Larry
Kasper's “The Butler Pinkerton Model for Company-Specific Risk—A Critique,” Business
Valuation Review (Winter 2008).
14
See e.g., Delaware Open MRI Radiology Associates, P.A. v. Howard B. Kessler et al.,
898 A.2d 290 (Del. Ch. 2006).
15
See the testimonial of Paul C. French, III CPA/ABV, CVA, BVAL, under the testimonial
tab, Butler Pinkerton Calculator link, at www.bvmarketdata.com.
16
Ibbotson® Beta Book (Chicago Morningstar, 2006).
17
Cost of Capital, 4th ed., at page 310.
18

Damodaran, "Ruminations on Risk," 2010 AICPA National Business Valuation
Conference, Slide 15.
19
Namely, Kasper, von Helfenstein, and Lee.
20
See the articles tab under Butler Pinkerton Calculator at www.bvmarketdata.com.
21
See the testimonials under the testimonial tab, Butler Pinkerton Calculator link, at
www.bvmarketdata.com.
22
“Gaining Clarity: The Great Debate over Total Beta,” 2010 NACVA CPE Webinar,
available at http://www.nacva.com/ecommerce/product.asppc=10WBV1116.
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