The cost of equity capital is the discount rate used to calculate the present value of expected equity cash flow and thus to value equity.
For a publicly traded company, securities analysts project equity cash flow and, based on the current market price, calculate the implied discount rate that equates the current market price and the present value of expected equity cash flow. Alternatively, they estimate the cost of equity capital from public (e.g. Ibbotson or Duff & Phelps) data, compute the present value of equity cash flow (“intrinsic value”) and make trading decisions based on the intrinsic value versus the current market price.
For a private company, appraisers project equity cash flow, but then we are stuck. We don’t know either the “current market price” or the discount rate. We then make a big assumption – that public market discount rates estimated from historical data can be used to estimate future private market discount rates – and compute the present value of equity cash flow.
None of this is news; it just restates what we know. I review it because Ibbotson is introducing new data on the size premium that breaks the old tenth decile into four (10w, x, y and z) rather than two (10a and b) parts. Moreover, the new 10z size premium, the smallest one, covers companies with market values of from $1.6 to $74.9 million as of December 31, 2008. That is news, because (at least for me) that size range more closely brackets the values of the companies I work (most are at the low end of that range).
Ibbotson states that the new four-part 10th decile analysis eliminates distressed companies, a known source of error in the old two-part analysis: I accept that on faith.
I am sure there is going to be a barrage of great articles, posts, and discussions about the new data, and I look forward to studying and learning from all of them. Right off the bat, I wonder how this will affect the Butler-Pinkerton model results. I also wonder whether the 10z (and other larger value) brackets now include illiquidity effects or are adjusted for them. That will have implications for my use of benchmarking, the QMDM, and option methodologies (volatility) to estimate the LOMD.
But, in considering all of this, review the italicized statement. Our goal is to estimate the FUTURE cost of PRIVATE equity capital, and we are starting with the HISTORICAL cost of PUBLIC equity capital, however elegantly analyzed, parsed, sliced, and diced, to do so. We are still responsible for converting the historical cost of public equity capital into an estimate of the future cost of private equity capital. Not only are we responsible for that, but we have the right and obligation to do so, based on common sense, informed judgment, and reasonableness.