What is it worth?

By Lola Sim + Klemens Wilhelm
Illustration: Gary Clement

The mechanics of valuing a small, private firm are not difficult; the challenge is in arriving at a reasonable discount

The increasing optimism of economic recovery presents opportunities and challenges for businesses. Some industries contract during volatile economies, others evolve. Within each industry, stronger players acquire weaker ones while others merge to grow or survive. Business valuations become increasingly relevant. In addition to mergers, acquisitions and divestitures, examples of other situations that may require a valuation include business reorganizations, structuring shareholder agreements, minority shareholder actions and other shareholder disputes, employee share ownership plans and stock options, estate planning and in-come tax transactions.

Many Canadian businesses are private and small. Industry Canada defines a small business as one with fewer than 100 employees whereas Statistics Canada defines it as one with fewer than 500 employees and less than $50 million in annual revenue. Based on Statistics Canada’s December 2008 Business Register, 75.2% of Canadian businesses had fewer than 10 employees, 97.9% had fewer than 100 employees and 99.7% had fewer than 500 employees. So, practically speaking, all are small.

Empirical studies show that smaller firms generally attract a higher cost of capital and are viewed by investors as riskier than larger firms. And just what are the cost of capital, the cost of equity and their application in valuing small companies?

Cost of capital
To value a small, privately held Canadian business, one cannot simply look up its share price on a stock exchange. Calculating the trading multiples of large public companies in the same industry and applying these multiples to a small company does not provide a reasonable solution either. There are several acceptable methods of valuing a business that is a going concern. Most methods are based on the company’s earnings or cash flows. Earnings or cash flow valuations utilize capitalization rates or multiples applied to earnings before interest, income taxes, depreciation and amortization (EBITDA), net earnings or after-tax cash flows. Discount rates are applied to forecasted cash flows to calculate a capital value of business operations. All capitalization and discount rates are a function of the cost of capital.

The cost of capital represents the economic cost to a business to finance its operations with debt capital an equity. It is a rate of return that reflects the risks and opportunities associated with ongoing or projected earnings or cash flows of the business.

Where debt-free cash flow is forecasted, the weighted average cost of capital (WACC) is the basis of the discount rate for a discounted cash flow valuation and the capitalization rate for a capitalized cash flow valuation.

The WACC of a business enterprise is comprised of the cost of equity, the after-tax cost of debt and the optimal capital structure of the company. Of the three components, the most controversial is the cost of equity due to an inherent degree of subjectivity in its derivation.

Cost of equity
Two common methodologies for estimating the cost of equity of a company are the build-up approach and the capital asset pricing model (CAPM).

The build-up model for estimating the cost of common equity capital is the sum of the risk-free rate, equity risk premium and an industry premium. The build-up model is more often used in the valuation of small and privately held companies.

The conventional CAPM is based on a risk-free rate and an equity risk premium that compensates investors for taking on risk equal to the risk of the equity market. The equity premium is modified by a factor called beta, which measures the extent to which a company is exposed to the equity risk. An industry premium adjustment is not made in the CAPM, as the industry risk is captured in the beta factor. In the valuation of large and publicly traded companies, the CAPM approach is more commonly used. It assumes that the market is perfectly efficient and that all investors can diversify risks from any particular investment by holding a portfolio of investments. In practice, investors do not behave in the manner prescribed by the theories behind the CAPM. To account for the difference, a size premium and a specific company premium are generally added to the cost of equity estimation methods.

Size effect — regardless of being public or private
Many empirical studies show that equity returns (and as a result the cost of capital) of public companies are higher for small companies than for large firms as smaller firms have greater risk. Most empirical studies use the conventional CAPM to adjust expected equity returns for risk and find that smaller firms consistently generate returns that are above their expected returns predicted by the conventional CAPM. This phenomenon is known as the small firm effect or size effect.

Empirical studies suggest that CAPM’s risk measure, beta, underestimates the true risk of small companies. Small firms have risks that are not reflected by beta but are related to size, such as lack of liquidity, higher default risk, lack of information and resulting estimation risk, lack of pricing power, lack of resources to adjust to competitive forces and less control over product and demand. The introduction of the size premium is an appropriate adjustment of the conventional cost of equity estimation models for small companies.

Size premiums studies
Two separate US studies by Morningstar and Duff & Phelps measure size premiums and are widely accepted and applied by valuation professionals when estimating cost of equity.

Morningstar estimates size premiums based on long-term empirical tests (starting in 1926) of companies that are publicly listed in the US. Companies are grouped into 10 size portfolios (the smallest size portfolio is further broken down in two additional portfolios) and risk premiums for each size category are estimated whereby size is measured by market value of equity. To use the Morningstar size premium, the subject company is placed within the appropriate size portfolio.

Duff & Phelps estimates size premiums based on a similar data basis as Morningstar (although the study starts in 1963) and breaks the market into 25 size portfolios. Other measures of size are introduced as market value of equity is an imperfect measure of size of a company’s underlying operations. Also, market value of equity as a measure of size may include certain circularities as some companies are not risky because they are small, but are small because they are risky (the riskier the company, the higher the discount rate and the lower market value of equity). The seven alternative measures of size are enterprise value, book value of equity, average EBITDA, average net income, total assets, sales and number of employees.

Limitations of applying size premiums
The Duff & Phelps data is particularly relevant when determining cost of equity for private companies as several fundamental accounting size measures can be used to estimate an appropriate risk measure — rather than market data that is not available for private companies.

All eight Duff & Phelps size measures and Morningstar data should be considered to determine size premium for a subject company being valued. Significant discrepancies in results would indicate that the use of empirical studies may not be a reasonable way to measure small-firm risk. As a result, more emphasis should be placed on identifying and quantifying company specific risk.

The smallest size portfolios of the empirical studies are companies with fewer than 200 employees. The majority of Canadian companies rank at the bottom of the smallest size portfolios. The size premiums of the smallest size portfolio approximates 10% based on the two empirical studies. Size premiums generally increase significantly (approximately 4%) from the second smallest to the smallest size portfolio. This is due likely to a higher number of distressed companies in the smallest size portfolio compared with other size portfolios. The high degree of size premium variability of the smallest size portfolio introduces high-size premium estimation risk and suggests alternative measures of risk.

The specific underlying risks of the subject company should be reviewed and quantified. Smaller companies are generally riskier than larger companies because of the quality of governance and management, lower ability to diversify operations, supply chain dependencies, less research and development along with fewer resources to defend owned technology and numerous operational risks. On the other hand, small companies may be more nimble when adapting to changes and economic uncertainties. Certainly, Canadian businesses by and large weathered the recent recession quite well, as evidenced by the lack of significant increase in reported bankruptcies from year-to-year.

Specific company risks
In addition to the equity and size premiums, valuators often include specific company risks to the cost of equity. Typical specific company risks include those earlier noted plus key-person dependence, key-supplier dependence, key-customers dependence, labour disputes, pending lawsuits and abnormal present or pending events.

To arrive at an appropriate premium for specific company risks, it is important to have a thorough understanding of the subject company as well as its industry. Often, some business risks are common within an industry and not necessarily specific to the company being valued. These risks would be captured by beta or industry risk premium already.

Sometimes, unintended or duplicative business risks may have been reflected in the size premium. To avoid double-counting a risk factor, it may be more suitable to incorporate foreseeable events through probability-weighting the cash flows rather than by increasing the discount rate.

Conclusion
The mechanics of valuing a small private Canadian company are not difficult. The challenge lies in arriving at a reasonable discount or capitalization rate.

With fewer market transactions in the past year that can be used to test the reasonability of the discount rate adopted, a more reasoned approach to determine the equity rate of return needs to be taken.

To remove some of the subjectivity that often forms part of the cost of equity, understanding the economic and social circumstances, the industry and the company itself are essential.

Lola Sim, CA, CBV, and Klemens Wilhelm, CPA, are managers in financial advisory with the Vancouver office of Deloitte Canada

Technical editor: Stephen Cole, FCA, FCBV, partner at Cole & Partners in Toronto