Fans of boxing history (or those with enough gray hair) will remember the “Thrilla in
Imagine the surprise when a “Thrilla in
The latter claim was based on a reworking of the modified CAPM traditionally used by BV experts. In the modified CAPM,
Cost of Equity = Rf + β (Rm - Rf) + SP + CSRP
where
Rf = the risk-free rate
β = beta
(Rm - Rf) = the market risk premium
SP = the size premium, and
CSRP = the company specific risk premium.
Using Tβ, the BPM’s Cost of Equity = Rf +Tβ (Rm - Rf).
By equating the BPM with the modified CAPM, one can solve for the company specific risk premium, CSRP = (Tβ – β) (Rm - Rf) – SP.
The champion of the business valuation orthodoxy was Larry Kasper, who fought back in Round Two[2] using several strategies. First, Kasper gave
Kasper then let loose a fusillade of jabs to the Butler Pinkerton model, saying among other things that it lacked peer-reviewed academic support, had inconsistent definitions of risk, broke down if an investment had zero correlation with the market, and produced different results for the CSRP depending upon whether the size premium was from Ibbotson or Duff & Phelps.
In Round Three[3],
Butler and Pinkerton then used a bit of Muhammad Ali’s “rope a dope” strategy, backing away from calculating the CSRP, and saying instead that Tβ made the calculation of size premiums and CSRPs unnecessary, as the Butler Pinkerton model’s basic equation where the Cost of Equity = Rf +Tβ (Rm - Rf) was all that was needed.
Kasper for his part displayed more statistical muscle in Round Four[4]. He pounded away at the underlying logic of Tβ and the BPM, first by stating that the definition of β in the CAPM is not the “risk” of the security, it is the proportion of the market return received by investors in a particular stock. Thus the underlying correlation between an individual stock and the market return would be unchanged whether it was measured by β or Tβ. Kasper then threw an uppercut to the jaw, asking how a measure like Tβ, which is being multiplied by a measure of systematic risk (the market return) in the BPM, can measure specific risk, which is supposed to be independent of the market? Kasper said the BPM was trying incorrectly to convert the regression “alpha” and unexplained error term, which are uncorrelated with the market return, into a Tβ measure that is a function of the market return.
So how do we score this sparring match? First, one needs to examine the logic of the BPM and the arguments of its critics. Is the BPM correct or not? Read the articles listed in the endnotes and decide.
Second, understand the concept of nondiversifiable risk. This is the risk that cannot be removed by balancing out a portfolio with other assets, and finance theory says that only nondiversifiable risk is compensated with a higher return. In the basic CAPM, this is accounted for by adjusting the market return using β. In the modified CAPM, it can also be accounted for in the CSRP. Business valuation experts consider this intuitively when they consider factors making up the CSRP. For example, if a small company has so much dependence on the owner that it might not survive if the owner were hit by a bus, then the CSRP would be high, as no other assets could balance out this risk. Is the BPM including diversifiable risk, or just the nondiversifiable risk?
In the end, the winner of BV’s Thrilla in
[1] Peter Butler and Keith Pinkerton, “Company-Specific Risk—A Different Paradigm: A New Benchmark,” Business Valuation Review, Spring 2006.
[2] Larry Kasper, “The
[3] Peter Butler and Keith Pinkerton, “Total Beta: The Missing Piece of the Cost of Capital Puzzle,” Valuation Strategies, May-June 2009.
[4] Larry Kasper, “Total Beta: The Missing Piece of the Cost of Capital Puzzle – A Reply,” Valuation Strategies, November-December 2009.
**Please note when reading the comments to this blog that they are listed in order of most recent first. So start at the bottom if you want to read them in chronological order.**
- 2024 reads
Total beta is not controversial
I have some observations related to Mr. Kasper’s recent posts:
We re-named the Butler Pinkerton Model to the Butler Pinkerton Calculator because of the fact that numerous PhDs in finance beat us to the punch (unbeknownst to us) regarding the extra return required for undiversified investors relative to diversified investors. Please see articles written by Professors Meulbroek, Covrig and McConaughy, for example. It had nothing to do with Mr. Kasper’s attacks on the technique, but out of respect for others who recognized the merits of total beta before us for private company valuation.I agree that Professor Tofallis was neutral in the debate at the ASA Advanced BV Conference. He was invited by Roger Grabowski, who thought he was going to speak negatively about the technique – specifically about the separation between systematic and unsystematic risk. Contrary to Mr. Kasper’s assertions, the panel was two for total beta (Damodaran and Butler) and two against total beta (Kasper and Grabowski, our “independent” moderator) and one neutral (Tofallis). Mr. Kasper should not have felt ganged-up upon.As pointed out by Mr. Kasper, I highly encourage all readers to carefully read those side-by-side Value Examiner articles. I was grateful that the Value Examiner gave me the opportunity to go side-by-side; much like a debate, only in written form. While each reader must come to his own conclusion, I believe I successfully refuted Mr. Kasper’s major criticisms.Contrary to Mr. Kasper’s analysis of the debate at the ASA Advanced BV Conference, while I have my own opinions, I encourage all readers of this blog to ask attendees what they thought. In the end, Mr. Kasper or my opinion does not matter.I sat right next to Professor Damodaran during the debate. I would not use the term “shell-shocked” to determine his demeanor during the debate. I thought he handled the debate in quite a calm and professional manner. If he was surprised about anything, it probably was at the level of personal attacks Mr. Kasper threw at him.I will comment upon the following specific observation of Mr. Kasper: “In fact their company specific risk premium is not specific risk at all, but a lineal factor of market, or systemic, risk. Although one can derive total beta from the unexplained variation, to assert that the return can be predicted by using total beta is little more than conjecture. The Butler Pinkerton Model does nothing to lessen the subjective nature of estimating company specific risk premiums when one works through the procedure they recommend”. We need a market to price a total risk premium or company-specific risk premium (CSRP). Otherwise, it is just a risk metric or standard deviation. The reference point for any rate of return is the market portfolio. Is a single stock riskier than the market portfolio (a perfectly diversified portfolio)? Yes, it is. The market portfolio’s total beta = 1.0; a single stock’s total beta is greater than 1.0. (Traditional betas less than 1.0 miss this for individual assets). The total beta framework is a model (not conjecture) since we know total risk is not priced for public stocks; it is, however, often times, priced for private companies. Total beta (and the resultant total risk premium or TCOE) of public companies should, therefore, be used as proxies for private company valuation. Mr. Kasper cannot separate the two markets. It is a lineal factor, which should not concern anyone. If one considers a single stock as an (inefficient) portfolio, one would require a higher rate of return over and beyond the market portfolio’s rate of return to account for the additional risk to be ambivalent as to whether they owned the market portfolio or the individual stock. This is the Sharpe ratio at work. Now, of course, a public investor will earn the same rate of return in an individual stock whether he/she is diversified or undiversified. But, private investors price private companies as if they are (partially or completely) undiversified. So, this model works well for private company valuation. By comparing public disclosures of risk in the guidelines, one can less subjectively assign a cost of capital to a private company – contrary to Mr. Kasper’s opinion. While I am ready to debate again anytime, Mr. Kasper has to be invited to the table. Based on how personal he has been in his writings and verbal assaults, the major organizations may not ask him back – but I f they do and they want me there too, I would be happy to have a rematch.
Thrilla in Manila
There is no point in trying to refute every issue raised here by Mr. Butler. However it is worth pointing out that there is a distinction between the specific risk of Sharpe, and the company specific risk inherent (priced) in any company’s cost of capital. The specific risk of Sharpe is the unexplained returns or “scatter” found for actual returns as deviations from the predicted returns of the capital asset pricing model. The effects of these unexpected or unexplained returns can be ameliorated by diversification. For public companies, the company specific risk premium is the α factor of regression found when beta is estimated by regression. The specific risk premium of private companies is subjectively estimated in the build up method (BUM). Messrs. Butler and Pinkerton have not presented a convincing case why the market correlation or unexplained variation of public companies translates into specific risk of private companies or their specific risk premium. In fact their company specific risk premium is not specific risk at all, but a lineal factor of market, or systemic, risk. Although one can derive total beta from the unexplained variation, to assert that the return can be predicted by using total beta is little more than conjecture. The Butler Pinkerton Model does nothing to lessen the subjective nature of estimating company specific risk premiums when one works through the procedure they recommend.
-- Larry J. Kasper, CPA, CVA, CBA
Thrilla in Manila
Although there are few things that Peter Butler and I agree upon concerning total beta (see below), he is correct on a few points. First, the presentation was not the great fight by Ali and Joe as portrayed. Yes, I am old enough to remember. Our presentations, for those not present, were part of a four person panel on the topic of “Total Beta”; albeit, a slanted panel in favor of total beta.
Ever since Peter Butler’s first publication on total beta appeared in Business Valuation Review in the Spring 2006 issue, there has been interest in the “Butler Pinkerton Model for Company Specific Risk.” Using “total beta” in what is now Messrs. Butler and Pinkerton’s “Calculator” (the model has now been reduced to a calculator as a result of my presentation and subsequent articles) to estimate the required cost of capital of a private firm was first suggested by New York University Finance Professor Aswath Damodaran in 2006 in his book, Damodaran on Valuation, 2nd ed. Sort of on-the-sidelines, was Dr. Christopher Tofallis, a Professor of mathematics in England, who happened to notice a statistical oddity called ‘total beta” and published an article on its properties in the European Journal of Operations Research in June 2008. Until I published my article in Business Valuation Review in Winter 2008, there were no published discussions critical of the model or its CSRP. Consequently, the four of us were asked to participate in a unique panel for what had to be a record three-hour presentation, with each participant given only half a hour and a small response/summary in rotational format. I considered this to be somewhat unfair since the total beta panel appeared to be 3-against-1, and because both Messrs Butler and Damodaran had given several presentations previously to the ASA and other business valuation groups promoting total beta. As it turned out, Dr. Tofallis had no interest in whether total beta had any predictive power for returns; to him it was merely an interesting math problem, despite being quoted as authority by Messrs. Butler and Pinkerton, and simply did not have a dog in the fight. He told me he really did not know financial theory, did not participate in business valuations, and frankly, did not understand why he was asked to be there. It was now down to 2-against-1.
Originally, I was asked by the ASA to debate Mr. Butler one-on-one, and agreed, but somehow between April and June, the program became a panel instead of a debate. I was faced with the daunting task of debunking Total beta, the diversification discount, and the Butler Pinkerton Model in just 30 minutes. I feel that the participants and the profession would have been better served had that debate occurred. A more decisive result would have been better. As it is now, there are still a few who “called it for Butler.” However, judging from the applause received by each, it was a split decision, decidedly in Kasper’s favor. I’m sure that Mr. Butler would not characterize it that way, but perhaps he would like a rematch? When Dr. Damodaran followed my presentation he appeared almost shell-shocked that someone would question his whole basis for total beta and his popular diversification argument. Previously, he had been accepted without question by many in the ASA almost as a prophet. One thing I think we can agree upon here is this was one of the liveliest presentations ever seen by a normally gentile, if not boring gathering.
Another thing that Peter Butler and I agree upon is that I am not a champion of BV orthodoxy as portrayed. Although Mr. Butler characterized his presentation as one between traditional beta and total beta, I never defended beta per se, other than pointing out that financial theory supported beta and not total beta as a predictor of returns, except in the case of Sharpe’s Capital Market Theory for efficient portfolios. And without either financial theory or evidence, valuators had only the word of Mr. Butler that it worked since he had no evidence to support his hypothesis. Personally, I have never accepted or used the build up method in the traditional way. My book, Business Valuations: Advanced Topics, suggests a different buildup approach using financial theory adjusted for a liquidity premium to obtain the rate. I have since used other methods to estimate the discount rate, none of which relied upon the orthodox buildup methods.
For those interested, my entire ASA presentation is available free at https://www.asabv.org/userfiles/files/Website%20Content/BV%202009%20Conference%20Free%20Docs/Kasper_ASA%20BVConference%20slides%20FINAL.pdf or by “Googleing” “Larry J. Kasper”, with my name as exact wording, then “ASA” and “Business valuation conference” as key words. The entire 79 page paper presented at the conference can be obtained by emailing me at ljkasper@kaspercpa.com. You can learn more of my background at www.kaspercpa.com. The most concise explanation of why their model and calculator are not correct can be found in the January/February 2010 issue of Valuation Examiner. In that issue Messrs. Butler and Pinkerton published a response, repeating much of what is here and on the website that sells their calculator, without ever addressing any of the real issues and problems raised with the model. My reply to their response will be published shortly, in Valuation Examiner, which provides very specific issues to question any expert who uses this method for determining the total cost of capital or company specific risk of their model.
- Larry J. Kasper, CPA, CVA, CBA
Thrilla in Manilla
Ray: Your title was intriguing. I had a sneaking suspicion what the topic was about. I appreciate you taking the opportunity to learn much about the debate and provide your analyses to the community. I wanted to touch on some observations: 1) You mention that Butler-Pinkerton (BP) threw a "one-two combination directed at the gut of the BV profession". This was not our intention. I don't think many people think of it that way. Our goal was merely to bring attention to a relatively new metric, TB, which could be used for the benefit of all. 2) You also state that BP "got into the corner of the BV expert" by developing proprietary computer software. There is nothing proprietary about the program. All inputs are disclosed. All outputs can be verified - contrary to Mr. Kapser's assertions. Every appraiser can perform these calculations themselves. What the Calculator provides is more free-time. It is painstaking to get the data and calculate these metrics by hand - particulary for all 5 days of the trading week. 3) I do not agree that Mr. Kasper is the champion of BV orthodoxy. If I understand his stance, I do not believe he advocates a CSRP for privately-held companies - which is against BV orthodoxy. 4) I agree with Mr. Kasper: A buyer of a public stock is not compensated if he chooses not to diversify away specific risk. Potential private business owners, however, are compensated because they cannot completely shed this risk. Why have we as an industry placed a CSRP on the cost of capital in the first place? Mr. Kasper has failed to realize that this technique only uses TB and the resultant TCOE as proxies for private companies where, often times, total risk is priced. TCOE is not priced for publicly-traded companies - we never said it was - contrary to Mr. Kasper's false assertions. 5) Mr. Kasper claims that it lacks peer-reviewed support. While this may be true as far as having an article in the Journal of Finance, I counter that Mr. Kasper's views have not been peer-reviewed by any academic. At least this technique has multiple Ph.Ds in finance claiming that the theory is sound - for private companies. 6) Having run the Calculator hundreds of times for multiple stocks each time, I have yet to get a zero correlation with the market. While Mr. Kapser's assertion about the technique breaking down with a zero correlation is theoretically correct, practically speaking it is of no concern. 7) Yes, the CSRP will be different if Duff & Phelps or Ibbotson's SP is used. Obviously, if you used one or the other, the private company's SP will be different too. The math is correct to get a CSRP, however. While we originally came out recommending use of these other sources, we do not any longer recommend you use either D&P or Ibbotson with this technique. They introduce non-guideline specific SPs into the equation. So, you can calculate your own guideline SPs - albeit this is subjective or you can concentrate on the TCOE or the combined SP:CSRP. I do not think anyone can separate size from CSRP in reality anyway. Is a company risky because it is small, or is it small because it is risky? Yes and yes. So, I take exception that it is a "rope a dope" strategy. We came forward with all of these recommendations before Mr. Kasper expressed his views. 8) Last but not least, this technique is a model - just like CAPM and BUM are models. It is based on assumptions. We know that beta and SP miss CSRP. The major assumption is that total risk, which captures CSRP, is priced. It is as simple as that. Total beta is a measure that captures total risk - since it is based on standard deviation. For it to be priced, the risk measure, TB, must be multiplied by the market premium. Second, the results are only used as proxies for private company valuation - not to value public stock since total risk is not priced in the public markets. 9) I appreciate the opportunity to address some of these observations.