Size effect, ERP analyzed in landmark book on cost of capital

What has 1,300 pages of text, 26 pages of bibliography, 14 pages of data resources, and 40 pages of index? It’s the newly arrived Cost of Capital: Applications and Examples by Roger Grabowski (Duff & Phelps) and Shannon Pratt (Shannon Pratt Valuations Inc.), now in its fifth edition. Two interesting issues among the many covered are the size effect and equity risk premium.

Size effect is alive and well: Acknowledging research that has questioned the existence of the size premium, Pratt and Grabowski delve deep into the issue. They expand the analysis and look at permutations from every period of time. The essence of the size premium is how often small companies earn a higher rate of return than large ones. The authors came up with statistics indicating that, even with 10-year holding periods during 2000-2012, every month showed small companies with returns higher than big companies. This extensive analysis of data—not just a summary of other people's studies—helps explain what goes on with the size premium.

Of course, the size premium will waver and may even be negative when measured over certain periods of time. But, as the new Pratt and Grabowski analysis shows, small stocks on average over time outperform large stocks because of their greater risks, which means that an adjustment for size is indeed appropriate.

ERP conclusions: “Roger and I present summaries of a great deal of research on the equity risk premium (ERP),” says Pratt, writing in the ASA BV Success E-Letter. They conclude that the long-term (unconditional) ERP is between 3.5% and 6.0% on an arithmetic average basis relative to long-term (20-year) U.S. government bonds. Also, they concluded that the “conditional” (reflecting current economic and market conditions) ERP was 5.0% as the book went to press, and it remains the same today, according to Pratt.

BVWire applauds Pratt and Grabowski for their monumental work. For more details on this book, click here.

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Court balks when expert veers from classic analysis

When it comes to methodology, stick to the tried and true. This is the takeaway from a recent intellectual property case involving a patent related to a dual-flush valve mechanism in toilets. An experienced appraiser tinkered with the royalty base and royalty rate formulas—and saw his damages calculation go down the drain.

Per-unit royalty: The plaintiff had no claim for lost profits, but its expert calculated a reasonable royalty in the amount of $7.8 million. He acknowledged that a reasonable royalty had two parts: a royalty base multiplied by a royalty rate. But instead of using the revenue resulting from the infringement as the base, he used the number of infringing products the defendant sold. He claimed the total revenue did not capture the full value of the patented products, which, he contended, included the value of sales of products that featured the valve and other components and nonpatented collateral goods. He also changed the royalty rate, which typically represents the percentage of revenue owed to the patent holder. Instead, he applied a dollar figure to the number of infringing products.

To calculate the dollar amount, he said, he applied the Georgia-Pacific factors “quantitatively and qualitatively.” “Quantitatively” meant he used individual factors to justify the inclusion of two separate items: lost sales from collateral goods and additional profits the plaintiff would have made from increasing its prices if the defendant had not entered the market. “Qualitatively” meant deciding whether a factor supported a higher or lower royalty. He concluded that a hypothetical negotiation between the parties would have yielded a rate of $106 per accused product.

Lost profits in disguise: In ruling on the defendants’ Daubert challenge, the court struck down many of the elements underpinning the analysis. For example, it found the royalty base was overinclusive. The expert failed to justify why the plaintiff was entitled to the full value of products with parts other than the valve when it only showed that the valve mechanism drove customer demand. At a minimum, he had to apportion the value of the patented component. Also, under Federal Circuit law, the Georgia-Pacific methodology does not allow for including sales of nonpatented items in the royalty base but allows for using a factor to demonstrate that the sales were relevant to determining the royalty. Here, he improperly used factors to add specific figures to the royalty base.

But ultimately the bigger issue for the court was the methodology itself. The expert’s per-unit royalty was not the “classic way” to determine a reasonable royalty. By identifying the base as the number of infringing units and the rate as a dollar figure, he improperly tried to include lost profits in his reasonable royalty calculation. He created an expansive base without applying a royalty rate to it, said the court. This method bore “no resemblance to a reasonable royalty analysis.”

An extended discussion of Sloan Valve Company v. Zurn Industries, Inc., 2014 U.S. Dist. LEXIS 39678 (March 26, 2014), will appear in the June edition of Business Valuation Update; the court’s opinion will be available soon at BVLaw.

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IPCPL across the Pond

The implied private company pricing line (IPCPL), a new model for estimating the cost of capital for small private companies, will be discussed during a session at the Valuation Group Conference 2014 to be held in London on July 3. Andrew Strickland (Scrutton Bland) will conduct a session, Valuing Small Companies, that will include, among other things, coverage of IPCPL.

The IPCPL model was featured in the September 2013 issue of Business Valuation Update, and the article is now available as a free download. In addition, you can learn more about IPCPL at BVR’s Cost of Capital Resource Center and receive monthly updates on the back page of the Business Valuation Update in the Cost of Capital Center section.

The all-day London conference, put on by the Institute of Chartered Accountants in England and Wales (ICAEW), will be held at Moorgate Place at the ICAEW headquarters. Representatives from the Big Four, Duff & Phelps, American Appraisal, Houlihan Lokey, other valuation boutiques, national firms, and regional firms will be there.

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BV movers . . .

People: Tom De Filippe was appointed managing director at Valuation Services of Arlington, Va. … James Hogan has taken on the role of managing director in the national tax office of WTAS in Washington, D.C. … Jeffrey Miller, a managing director at the New York City office of Valuation Research Corp., was named a “40 Under 40” award winner by The M&A Advisor … Ben McCallum was appointed leader of the valuation and advisory services business of Colliers International in Victoria, Australia … Walter O’Haire, vice president at Valuation Research Corp. (San Francisco office), was elected to the Global Board of Directors for the Association for Corporate Growth (ACG), a global organization focused on driving middle-market growth.

Firms: Abacus Worldwide added Shelley Stock Hutter LLP, London, to its worldwide members’ network … BDO USA LLP (Chicago) was named one of the 25 Best Places to Work for Recent Grads by ConnectEDU … Fiske and Co. was a finalist at the South Florida Business Journal’s “2014 Business of the Year Awards”… Friedman LLP was ranked the third "Best Place to Work in New Jersey" by New Jersey-based weekly business journal, NJBIZ … Fuller Landau, a Toronto-based audit, tax, and advisory firm, was named one of the "Best Workplaces in Canada" by the Great Place to Work Institute and The Globe and Mail … Plante Moran has received a “Volunteer Kalamazoo STAR Award” for its support of their child welfare programs and services, and Plante Moran Financial Advisors was recognized by Forbes in its annual list “The Top 50 Wealth Managers” … UHY LLP added Abdul Jabbar Certified Accountants and Consultants Office in Jeddah, Saudi Arabia, to its global accountancy network.

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NYSSCPA BV conference in NYC May 19

Two former IRS managers will speak at the 16th Annual Business Valuation Conference in New York City on May 19. In addition to IRS issues, the conference topics include a DLOM update, detecting errors in transactional databases, and valuation issues in divorce. Hosted by the New York State Society of CPAs, this is the premier event for valuation and forensic professionals in the NYC area. For details and to register, click here.

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Spring is in full bloom with CPE events

There’s something for everyone in the newest list of CPE events.

Valuing Ancillary Medical Services for Carve Out Purposes (May 20), featuring Jason Ruchaber (Root Valuation). In Part 5 of the Online Symposium on Healthcare Valuation, learn how to identify and avoid the pitfalls created when a healthcare entity sells its ancillary services while keeping the rest of the business intact.

Valuing Voting v. Non-Voting Stock (May 22), featuring Ronald Rudich (Gorfine, Schiller & Gardyn). The valuation of voting and nonvoting shares would, like many valuation assignments, appear to be a simple consideration between two variations of the same structure. The truth is much more complex.

The Duff & Phelps Risk Premium Calculator: Utilizing New Data & Features for 2014 (May 29), featuring James Harrington (Duff & Phelps). In this free one-hour presentation, Calculator co-creator Harrington gives a guided tour of the new features and resources packed into the latest update of this powerful valuation tool.

Advanced Workshop on Monte Carlo Simulations: Applications & Examples (June 12), featuring David Dufendach, Randy Heng, and Oksana Westerbeke (all Grant Thornton). This intensive, four-hour, interactive workshop, previously scheduled for May 15, shows how to put Monte Carlo simulations to use through a thorough examination, including two exhaustive case studies of its implementation.

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We welcome your feedback and comments. Contact the editor, Andy Dzamba at: info@bvresources.com or (503) 291-7963