Size effect is ‘fiction,’ Damodaran reiterates

“There has been no size premium for the past 40 years,” said Professor Aswath Damodaran (New York University Stern School of Business), who has been called the “Dean of Valuation.” This was in response to an audience question during his keynote address at the recent CBV Institute Congress 2021.

Two camps: This is not a new remark by Damodaran—he has been saying this for years (see his 2015 post here). He is referring to ongoing academic research that concludes that the size effect has diminished or disappeared since it was first documented in 1981 (recent paper here). But the vast majority of valuation practitioners believe that the size premium exists. During a BVR webinar, a poll of the audience (of about 200 attendees) found that 94% of them use a size premium.

If the academic community says that the size effect disappeared long ago, why do valuation practitioners continue to embrace it? As Damodaran points out, one reason is the time horizon of historical returns. If you look at the last 40 years, the size effect is very different than if you go all the way back to the 1920s. You can clearly see this difference in the Cost of Capital Professional platform, which gives you control over the time horizon of historical return data that are appropriate for your subject entity. That is, professional judgment is required in choosing the part of history you believe best represents investor expectations of the future.

Damodaran points to another reason for clinging to the size effect, which is simply this: It’s easier to defend something everyone else is doing.

He also notes that the market does not seem to buy into the size effect. “After all, if the proponents of small cap premiums are right, bundling together small companies into a larger company should instantly generate a bonus, since you are replacing the much higher required returns of smaller companies with the lower expected return of a larger one. In fact, small companies should disappear from the market.”

In buyout dispute, ‘downward bias’ sinks expert’s fair value determination

In a bitter buyout dispute involving a successful private family business and featuring two veteran appraisers, the Nebraska Supreme Court recently affirmed the district court’s decision to unreservedly credit the valuation testimony of the expert for the late majority shareholder. In contrast, the district court found the company’s expert’s valuations under various methods showed a “downward bias” that made the expert’s value conclusion unreliable.

Oppression claim: Streck Inc. was a worldwide industry leader in developing and manufacturing cell stabilization technology for use in hematology, immunology, and molecular diagnostics. Sales were strong and increasing every year since its creation, and it had no product recalls in the past 25 years. The company had long-lasting relationships with large customers and a valuable portfolio of intellectual property. Its financial performance surged in recent years, and it expected more growth in future years.

Streck was founded by Dr. Wayne Ryan, who, at the relevant time, owned over 52% of the company’s stock by way of a trust (RRT). However, one of his daughters came to own two-thirds of the company’s voting shares, enabling her to appoint a majority of the members of the board of directors. In September 2013, she replaced her father as CEO. She encouraged her father to retire. Dr. Ryan did not object to her becoming CEO as long as the company was sold. In 2014, the CEO took steps to sell the company.

According to a trial industry expert for RRT, the sales process was “flawed and failed.” Despite the company’s ongoing solid performance and a growing healthcare life sciences market, bids solicited by an investment banker on behalf of Streck were relatively low, which the expert found was due to growth projections that were too conservative and not properly explained to prospective buyers. The industry expert said the investment banker lacked experience in the appropriate market. Further, the company decided to exclude the highest bidder in the first round.

Dr. Ryan complained he was not listened to and could not approve the sale. The board and his daughter, as CEO, abandoned the process. RRT, representing Dr. Ryan (who died before trial), sued the daughter and Streck, alleging oppression and breach of fiduciary duty and asking for judicial dissolution of the company. Ultimately, Streck elected to buy RRT’s shares under the applicable statute, which triggered a fair value determination by the district court.

‘Dysfunctional’ sales process: Both sides’ experts were highly experienced appraisers and used the discounted cash flow (DCF) approach in combination with the guideline publicly traded company (GPTC) and guideline merger and acquisition (GMA) methods to determine the fair value of Dr. Ryan’s shares. In adopting RRT’s 74-page proposed findings verbatim, the district court wholly adopted the testimony of RRT’s industry and valuation experts. Regarding the DCF, the court said the appraiser’s revenue and income projections aligned with the company’s projections and prospects for growth; his growth rate was reasonable as were the selected company-size risk premium and company-specific risk premiums. Further, the expert, who applied a 14% S corp premium, “credibly and convincingly testified” that no rational company would convert from an S corp to a C corp prior to a sale. In contrast, the company’s expert gave “misleading and not credible” explanations for his projections and “double-counted” the same risks to justify his projections and company-specific risk premium, the court said. It noted this expert arrived at the same 14% S corp premium but decided to half it to account for the risk of the company becoming a C corp in the future. The district court found this adjustment was “arbitrary” and said it reflected the expert’s “downward bias.”

The company appealed, and, based on the parties’ request for bypass, the case went in front of the state Supreme Court, which affirmed. The high court said its de novo review of the record led to the conclusion that the district court’s valuation was reasonable and based in fact and principle.

A digest of Ryan Trust v. Ryan, 308 Neb. 851 (April 9, 2021), as well as the court’s opinion will be available soon at BVLaw.

Michael Jackson case featured on BVR ‘power panel’ July 27

Experts involved in the high-profile case involving the Michael Jackson estate versus the IRS will discuss the contentious valuation issues in the case during a BVR webinar, Power Panel: Estate of Michael J. Jackson v. Commissioner. The panel, moderated by Jay E. Fishman (Financial Research Associates), includes celebrity licensing expert Mark Roesler (CMG Worldwide) and music industry financial advisor David Dunn (Shot Tower Capital).

As a sneak preview, hear the prevailing valuation expert, Jay Fishman, discuss some of the questions arising in the Jackson case. Click here.

A few recent papers of note

“Forecasting: Theory and Practice” is a recently updated encyclopedic presentation of forecasting methods in theory and practice. Even though it’s quite long (268 pages), the authors do not claim it’s an exhaustive list of forecasting methods and applications. The paper is freely available for download.

Another paper finds that there are problems with the Black-Scholes options pricing formulas during times of market stress. The authors examined two periods—the subprime crisis (October 2008) and the onset of the COVID-19 pandemic (March 2020)—and found that the “accuracy of these formulas is very poor.” A link to the paper is here, and it’s available for a charge.

Thanks to Dr. Michael A. Crain (Florida Atlantic University) for alerting us to these papers.

Reminder: Please take a survey about company-specific risk

BVWire is pleased to present a survey by The Appraisal Foundation’s Business Valuation Resources Panel’s Work Group on Company-Specific Risk Premia to understand how valuation practitioners address such premia within their valuations. While the Working Group’s focus is financial reporting, input from other practice areas is welcome and encouraged. Your input will help to prepare more formal guidance relating to the subjective area of cost of capital. All responses will be confidential. To take the survey, click here. Thank you in advance for participating!

Global BV News

Global valuers challenged by lack of data

A lack of empirical data on small private companies outside the U.S. makes valuations challenging. It’s a “real problem,” noted Andrew Neuman, a valuer in Canada. Speaking at the NACVA 2021 Business Valuation and Financial Litigation Hybrid and Virtual Super Conference, he pointed out that, because of the dearth of data, more professional judgment is necessary.

One idea:A valuer who practices mostly in Australia, Morris Kaplan, ICVS, agreed with Neuman. So what do you do? In one case in Australia, Kaplan used U.S. data in developing his buildup method—and he was not challenged on it when he testified in court.

Kaplan also gave kudos to the global research Pablo Fernandez (University of Navarra—IESE Business School) did on the equity risk premium and risk-free rate used in various countries (see the latest research here).