BV's Thrilla in Manila
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
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 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,
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. 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
 Peter Butler and Keith Pinkerton, “Company-Specific Risk—A Different Paradigm: A New Benchmark,” Business Valuation Review, Spring 2006.
 Larry Kasper, “The
 Peter Butler and Keith Pinkerton, “Total Beta: The Missing Piece of the Cost of Capital Puzzle,” Valuation Strategies, May-June 2009.
 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.**
Raymond J. ("RJ") Dragon MBA, MS, ASA, CFFA is a Principal in Citrin Cooperman's Valuation & Forensic Services practice in the New Jersey / New York City area. His work encompasses valuations for litigation support, marital dissolution, shareholder disputes, estate and gift tax, intangible asset valuation, purchase price allocation and financial reporting.