Volume 9, Issue 1 -

The aim of this paper is to contribute to a deeper knowledge of the discount rate in the framework of privately held company (PHC) valuation. Their main purpose is to test if the expected rate of return on equity differs between PHCs and quoted companies and if their accounting rate of return is greater than the cost of equity capital. This paper contributes in two different ways: first, distinguishing between the so-called purely financial investor and the economic risk investor to construct a model that permits to calculate the PHC’s cost of equity capital; second, assuming rational economic behavior. It is argued that in the valuation of non-quoted companies, investors need to be able to choose a model that goes beyond the beta of the capital asset pricing model (CAPM), proposing the three-component model based on Rojo-Ramírez, Cruz-Rambaud and Alonso Cañadas (2011). The empirical analysis leads us to conclude that the use of this model improves the overestimated value of a company by applying the discount rate of the CAPM (between 28% and 49%), which is consistent with professional practice.

This study investigates whether firms with negative value indicators (e.g. negative EBIT) should be excluded from peer groups in relative valuation. While this approach is chosen in many empirical studies and recommended by practitioners, valuation textbooks suggest including firms with negative value indicators in the peer groups. Evidence regarding which alternative leads to more accurate firm value estimates is missing. We conduct an empirical study using a sample from the S&P Composite 1,500 Index for the period 1994–2010 to answer this question. We find that, contrary to textbook recommendations, eliminating firms with negative value indicators generally leads to more accurate firm value estimates.

Courts are often required to determine a stock’s “fair value,” which by definition excludes any reduction to value because of a lack of liquidity. The method of computing fair value most frequently used by practitioners is the discounted cash flow analysis, which requires calculating the cost of equity. Over the last decade, many practitioners have included a size premium in the computation of the cost of equity based on the finding that historic returns for firms with lower market capitalization are greater than the returns implied by the standard capital asset pricing model. Our findings show that a substantial fraction of the measurement of size premiums reflects a lack of liquidity, which disproportionately affects smaller sized companies. Because a reduction to value from illiquidity should not be reflected in the measurement of fair value, this finding has implications for assessments of fair value that employ the commonly used size premiums. Specifically, our findings suggest that valuations of small capitalization stocks that reflect these size premiums will cause the fair value to be underestimated because of the effect of lower liquidity. The smaller the size, the greater is the underestimation in value.

As a result of the Securities and Exchange Commission’s relaxation of its prohibition against the marketing of private placements, investors will soon be exposed to a broad array of syndicated commercial real estate investments. Private placement commercial real estate investments are illiquid and so cannot be easily valued by reference to frequent transactions in the same asset in active markets. We have reviewed over 200 syndicated commercial real estate private placement memorandums and find that virtually all include projected cash flows. This study explains how investors and their advisors can use these projections to develop estimates of investment value. We determine a lower bound for discount rates applicable to the cash flows derived from commercial real estate and apply the methodology to an actual commercial real estate private placement investment. Our findings suggest significant overvaluation by commercial real estate private placement investment sponsors even when using conservative estimates of discount rates.

Taking into account the recent worldwide strive for raw materials, the emergence of start-ups in the mining sector for rare metals, and tendencies of financial and strategic investors to invest in such companies, the paper critically evaluates the suitability of common methods widely used to value mining companies. Building on the deficiencies of single methods to capture the specificities of rare earth junior mining companies, which are generally single-project companies, the paper suggests using a combined approach including discounted cash flow, real options, and multipliers methods. Compared to the value obtained using singular methods, the resulting specific value is argued to better reflect the value of a specific early stage mining company within the rare earth junior mining industry.

From the viewpoint of a well-diversified investor, an equity investment in an operationally distressed company resembles an equity investment in a financially levered company. However, the risk characteristics of the “virtual debt” in a distressed company are not necessarily identical to those of typical financial debt, which makes investments into distressed companies unique. In this paper, we show that risk-adjusted discount rates of distressed companies can differ quite significantly from those of healthy companies. We further illustrate how to determine such discount rates and how to account for these findings in practical discounted cash flow valuation cases.