2016 Valuation Handbook: Guide to Cost of Capital - … · 2016 Valuation Handbook – Guide to Cost of Capital iii About the Data The information and data presented in the 2016 Valuation

2016 Valuation HandbookGuide to Cost of Capital

Market Results Through 2015Duff & Phelps

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Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Copyright © 2016 by John Wiley & Sons, Inc. All rights reserved. Published simultaneously in Canada.

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2016 Valuation Handbook – Guide to Cost of Capital iii

About the Data

The information and data presented in the 2016 Valuation Handbook – Guide to Cost of Capital and the online Risk Premium Toolkit and the online Cost of Capital Analyzer has been obtained with the greatest of care from sources believed to be reliable, but is not guaranteed to be complete, accurate or timely. Duff & Phelps, LLC (www.duffandphelps.com) and/or its data providers expressly disclaim any liability, including incidental or consequential damages, arising from the use of the 2016 Valuation Handbook – Guide to Cost of Capital and/or the online Risk Premium Toolkit and/or the Cost of Capital Analyzer or any errors or omissions that may be contained in the 2016 Valuation Handbook – Guide to Cost of Capital and/or the online Risk Premium Toolkit and/or the online Cost of Capital Analyzer, or any other product (existing or to be developed) based upon the methodology and/or data published herein. One of the sources of raw data used to produce the derived data and information herein is Morningstar, Inc. Use of raw data from Morningstar to produce the derived data and information herein does not necessarily constitute agreement by Morningstar, Inc. of any investment philosophy or strategy presented in this publication.

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About Duff & Phelps

Duff & Phelps is the premier global valuation and corporate finance advisor with expertise in com-plex valuation, dispute and legal management consulting, M&A, restructuring, and compliance and regulatory consulting. The firm’s more than 2,000 employees serve a diverse range of clients from offices around the world. For more information, visit www.duffandphelps.com.

M&A advisory and capital raising services in the United States are provided by Duff & Phelps Securi-ties, LLC. Member FINRA/SIPC. Pagemill Partners is a Division of Duff & Phelps Securities, LLC. M&A advisory and capital raising services in the United Kingdom and Germany are provided by Duff & Phelps Securities Ltd., which is authorized and regulated by the Financial Conduct Authority.

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Additional Resources

To learn more about the latest theory and practice in cost of capital estimation, see Cost of Capital: Applications and Examples 5th edition, by Shannon P. Pratt and Roger J. Grabowski (John Wiley & Sons, Inc., 2014).

The Cost of Capital: Applications and Examples 5th edition is a one-stop shop for background and current thinking on the development and uses of rates of return on capital. This book contains expanded materials on estimating the basic building blocks of the cost of equity capital, the risk-free rate, and equity risk premium, plus in-depth discussion of the volatility created by the 2008 Financial Crisis, the subsequent recession and uncertain recovery, and how those events have fundamentally changed how we need to interpret the inputs to the models we use to develop these estimates.

The Cost of Capital: Applications and Examples 5th edition includes case studies providing comprehensive discussion of cost of capital estimates for valuing a business and damages calculations for small and medium-sized businesses, cross-referenced to the chapters covering the theory and data. This book puts an emphasis on practical application. To that end, this updated edition provides readers with exclusive access to a companion website filled with supplementary materials, allowing you to continue to learn in a hands-on fashion long after closing the book.

The Cost of Capital: Applications and Examples has been published since 1998, and is updated every three to four years. The 6th edition of this book is scheduled to be available in spring 2017.

“Shannon Pratt and Roger Grabowski have produced a remarkably comprehensive review of the subject…it is a work that valuation practitioners, CFOs, and others will find an invaluable reference.”

– Professor Richard Brealey, London Business School (from the Foreword)

“Estimating the cost of capital is critical in determining the valuation of assets, in evaluating the capital structure of corporations, and in estimating the long run expected return of investments. Shannon Pratt and Roger Grabowski have the most thorough text on the subject, not only providing various estimation methods, but also numerous ways to use the cost of capital.”

– Professor Roger G. Ibbotson, Professor Emeritus of Finance at the Yale School of Management , former chairman and founder of Ibbotson Associates, chairman, founder, and CIO of Zebra Capital

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Other Duff & Phelps Valuation Data Resources Published by John Wiley & Sons

In addition to the 2016 Valuation Handbook – Guide to Cost of Capital (this book) and the Cost of Capital: Applications and Examples 5th edition, other Duff & Phelps valuation data resources published by John Wiley & Sons are as follows:

Valuation Handbook – Industry Cost of Capital: The Valuation Handbook – Industry Cost of Capital provides cost of capital estimates (i.e., equity capital, debt capital, and WACC) for approximately 180 U.S. industries and size groupings (i.e., Large-, Mid-, Low- , and Micro-capitalization companies), plus a host of detailed statistics that can be used for benchmarking purposes (over 300 critical industry-level data points calculated for each industry, depending on data availability).

The Valuation Handbook – Industry Cost of Capital has been published since 2014 (2014 and 2015 editions are available with data through March 31, 2014 and March 31, 2015, respectively; the 2016 edition, with data through March 31, 2016, will be available in June 2016). This book includes three optional quarterly updates (June, September, and December).

International Valuation Handbook – Guide to Cost of Capital: This annual book provides country-level equity risk premia (ERPs), relative volatility (RV) factors, and country risk premia (CRPs) which can be used to estimate country-level cost of equity capital globally, for up to 188 countries, from the perspective of investors based in any one of up to 56 countries (depending on data availability).

The International Valuation Handbook – Guide to of Capital has been published since 2014 (2014 and 2015 editions are available with data through (i) December 31, 2013 and March 31, 2014, and (ii) December 31, 2014 and March 31, 2015, respectively; the 2016 edition, with data through December 31, 2015 and March 31, 2016, will be available in June 2016). This book includes an optional Semi-annual update, with data through June and September.

International Valuation Handbook – Industry Cost of Capital: This annual book provides the same type of rigorous industry-level analysis published in the U.S.-centric Valuation Handbook – Industry Cost of Capital, on a global scale.

The inaugural 2015 International Valuation Handbook – Industry Cost of Capital includes industry-level analyses for four global economic areas: (i) the “World”, (ii) the European Union, (iii) the Eurozone, and (iv) the United Kingdom.i.1 Industries in the book are identified by their Global Industry Classification Standard (GICS) code. Each of the four global economic area’s industry analyses are presented in three currencies: (i) the euro (€ or EUR), (ii) the British pound (£ or GBP), and (iii) the U.S. dollar ($ or USD).

i.1 In the 2015 International Valuation Handbook – Industry Cost of Capital, “World” companies are defined as companies that (i) are components of the MSCI ACWI IMI, and (ii) satisfy the rigorous screening requirements that are employed to define the company sets used therein.

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The 2015 International Valuation Handbook – Industry Cost of Capital provides industry-level cost of capital estimates (cost of equity, cost of debt, and weighted average cost of capital, or WACC), plus detailed industry-level statistics for sales, market capitalization, capital structure, various levered and unlevered beta estimates (e.g. ordinary-least squares (OLS) beta, sum beta, peer group beta, downside beta, etc.), valuation (trading) multiples, financial and profitability ratios, equity returns, aggregate forward-looking earnings-per-share (EPS) growth rates, and more.

The 2015 International Valuation Handbook – Industry Cost of Capital is published with data through March 31, 2015, and includes one optional intra-year Semi-annual Update (data through September 30, 2015).

The inaugural 2015 version of the International Valuation Handbook – Industry Cost of Capital will be available in March 2016. The inaugural 2015 version of this book is on a delayed publication schedule because of the extensive work involved in gathering the data, establishing the needed data permissions, developing new procedures and methodologies to appropriately deal with international financial data in multiple currencies, and producing the inaugural 2015 book from scratch. The 2016 version of the hardcover book will be published with data through March 31, 2016, and will be back on a “regular” schedule of shipping in late May/early June 2016, followed by the Semi-annual Update (with data through September 30, 2016) in PDF format, delivered in late October/early November 2016.

To learn more about cost of capital issues, and to ensure that you are using the most recent Duff & Phelps Recommended ERP, visit www.duffandphelps.com/CostofCapital.

To order additional copies of the 2016 Valuation Handbook – Guide to Cost of Capital (this book), or other Duff & Phelps valuation data resources published by John Wiley & Sons, please go to: www.wiley.com/go/ValuationHandbooks.

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Table of Contents

Acknowledgements xi

Introduction xii Chapter 1 Cost of Capital Defined 1-1

Introduction 1-1 Income Approach Overview 1-2 Discounting versus Capitalizing Concepts 1-2 Valuation Date 1-5 Basic Cost of Capital Concepts 1-5 Sources of Capital 1-9 Cost of Capital Input Assumptions 1-10 Capital Structure Considerations 1-16 Calculating WACC 1-17 Estimates of Cost of Capital are Imprecise 1-19 Key Things to Remember about Cost of Capital 1-20

Chapter 2 Methods for Estimating the Cost of Equity Capital 2-1

Basic Framework 2-1 Types of Risk 2-6

Cost of Equity Capital Estimation Methods 2-8 Build-up 2-10 CAPM 2-11 Other Cost of Equity Capital Estimation Methods 2-15 Key Things to Remember about the Methods for Estimating the Cost of Equity Capital 2-16

Chapter 3 Basic Building Blocks of the Cost of Equity Capital – Risk-free Rate and Equity Risk Premium 3-1

The Risk-free Rate and Equity Risk Premium: Interrelated Concepts 3-1 Spot Risk-free Rates versus Normalized Risk-free Rates 3-2 Methods of Risk-free Rate Normalization 3-15 Spot Yield or Normalized Yield? 3-18 Equity Risk Premium 3-20 Estimating the Equity Risk Premium 3-21 Duff & Phelps Recommended ERP 3-33

Concluding on an ERP 3-39

Chapter 4 Basic Building Blocks of the Cost of Equity Capital – Size Premium 4-1 Size as a Predictor of Equity Returns 4-1 Possible Explanations for the Greater Returns of Smaller Companies 4-2 The Size Effect: Empirical Evidence 4-2 The Size Effect Over Longer Periods 4-3 The Size Effect Tends to Stabilize Over Time 4-6 The Size Effect Changes Over Time 4-7 Criticisms of the Size Effect 4-8 Data Issues 4-12 Has the Size Effect Disappeared in More Recent Periods? 4-17 Relationship of Size and Liquidity 4-21 Key Things to Remember about the Size Premium 4-26

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Chapter 5 Basic Building Blocks of the Cost of Equity Capital – Betas and Industry Risk Premia 5-1 Beta 5-1 Differences in Estimation of Equity Betas 5-7 Full-Information Beta 5-11 Industry Risk Premia 5-12 Full-Information Beta Methodology 5-16 Debt Betas 5-17 Unlevering and Levering Equity Betas 5-18 Key Things to Remember about Betas and the Industry Risk Premia 5-19

Chapter 6 Basic Building Blocks of the Cost of Equity Capital – Company-specific Risk Premia 6-1 Introduction 6-1 Adjustments for Differences in Risk 6-2 Adjustments for Risk in Net Cash Flows and Biased Projections 6-5 Adjustments for Other Risk Factors 6-7 Matching Fundamental Risk and Return 6-8 Key Things to Remember about Company-specific Risk Premia 6-10

Chapter 7 The CRSP Deciles Size Premia Studies and the Risk Premium Report Studies – A Comparison 7-1

History of the CRSP Deciles Size Premia Studies 7-1 History of the Risk Premium Report Studies 7-2 Data Sources 7-2 Definitions of “Size” 7-6 Time Period Examined 7-6 Number of Portfolios 7-7 Portfolio Overlap 7-7 Guideline Portfolio Method and Regression Equation Method 7-8 Risk Premia Over CAPM (Size Premia) 7-8 “Smoothed” Premia versus “Average” Premia 7-12 OLS Beta versus Sum Beta 7-12 Risk Premia Over the Risk Free Rate 7-12 Unlevered Premia 7-13 Risk Study 7-13 Characteristics of Companies in Portfolios 7-13 Online Applications 7-14

Chapter 8 CRSP Deciles Size Premia Examples 8-1 Build-up Example 8-1 CAPM Example 8-4 Key Things to Remember about the CRSP Deciles Size Premia 8-7

Chapter 9 Risk Premium Report Exhibits – General Information 9-1 Appropriate Use of the Risk Premium Report Exhibits 9-1 How the Risk Premium Report Exhibits are Organized 9-1 Cost of Equity Capital Estimation Methods Available 9-3 Proper Application of the Equity Risk Premium (ERP) Adjustment 9-4 “Smoothed” Premia versus “Average” Premia 9-7 The “Guideline Portfolio Method” versus the “Regression Equation Method” 9-8 Example: Calculating an Interpolated Premium Using the Regression Equation Method 9-9 Tips Regarding the Regression Equation Method 9-10 Can the Regression Equation Method be Used if the Subject Company is Small? 9-10 Size Study or Risk Study? 9-11 Key Things to Remember About the Risk Premium Report Exhibits 9-12

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Chapter 10 Risk Premium Report Exhibits – Examples 10-1 Size Study 10-1 Reasons for Using Additional Measures of Size 10-1 The Difference Between the Size Study’s A Exhibits and the B Exhibits 10-2 The Difference Between “Risk Premia Over the Risk-free Rate” and “Risk Premia Over CAPM” 10-2 Calculating Custom Interpolated Premia for Smaller Companies 10-6 Overview of Methods Used to Estimate Cost of Equity Capital Using the Size Study 10-9 Size Study Examples: Assumptions Used 10-10 Size Study Examples 10-12 Unlevered Cost of Equity Capital 10-17 Overview of the Methodology and Assumptions Used to Unlever Risk Premia 10-18 Estimating Cost of Equity Capital Using the “Build-up 1-Unlevered” Method 10-22 Estimating Cost of Equity Capital Using the Capital Asset Pricing Model (CAPM) 10-26 Estimating Cost of Equity Capital Using the “Build-up 2” Method 10-30 Risk Study 10-35 Overview of Methods Used to Estimate Cost of Equity Capital Using the Risk Study 10-42 Risk Study Examples 10-45 Build-up 3-Unlevered 10-49 High-Financial-Risk Study 10-51 Overview of Methods Used to Estimate Cost of Equity Capital Using the High-Financial-Risk Study 10-57 Estimating Cost of Equity Capital Using the “Build-up 1-High-Financial-Risk” Method 10-58 Estimating Cost of Equity Capital Using the “CAPM-High-Financial-Risk” Method 10-61 Comparative Risk Study 10-63 Using the Comparative Risk Study to Refine Build-up Method Estimates 10-67 Using the Comparative Risk Study to Refine CAPM Estimates 10-69 Chapter 11 Real Estate 11-1 Individual Real Estate Assets 11-1 Real Estate Investment Trusts (REITs) 11-2 Structure of Real Estate Entities 11-2 Correlation of U.S. REITs Compared to Other U.S. Asset Classes 11-3 Summary Statistics of U.S. REITs Compared to Other U.S. Asset Classes 11-5 Real Estate Property Valuation Inputs 11-8 Key Things to Remember about Real Property Valuation 11-16 Chapter 12 Answers to Commonly Asked Questions 12-1 Glossary Index Appendix 1 – Definitions of Standard & Poor’s Compustat Data Items Used to Calculated the Risk Premium Report Exhibits Appendix 2 – Changes to the Risk Premium Report Over Time Appendix 3 – CRSP Deciles Size Premia Study: Key Variables Appendix 3a – Industry Risk Premium (RPi) Appendix 3b – Debt Betas Appendix 4 – Risk Premium Report Study Exhibits

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Acknowledgements

Authors

Roger J. Grabowski, FASA Managing Director, Duff & Phelps James P. Harrington Director, Duff & Phelps Carla Nunes, CFA Senior Director, Duff & Phelps Thank you

The authors give special thanks to Analyst Kevin Madden, and Interns Aaron Russo and Andrew Vey of Duff & Phelps for their assistance in assembling the exhibits presented herein, analysis, editing, and quality control. We thank Executive Assistant Michelle Phillips for production assistance, Director Kelly Hunter for securing data permissions, Director Trevor Boake and Vice President Daniel Eliades for technology support, and Vice President Tim Harms for design, production and layout design. We also thank Niel Patel, former Senior Analyst at Duff & Phelps, whose contributions to the creation of the Duff & Phelps Valuation Handbook series were invaluable. Dedicated to Paul Wittman In April 2015 we lost a dear friend and important contributor to the Risk Premium Report Study, Paul Wittman, fondly remembered as the “gentle giant”. Paul authored the software that supports those calculations.

We dedicate the 2016 edition of this book to his memory.

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Introduction The Valuation Handbook – Guide to Cost of Capital (“Valuation Handbook”) is not designed to duplicate the contents of comprehensive, learned treatises on estimating the cost of equity capital such as, Shannon P. Pratt and Roger J. Grabowski, Cost of Capital: Applications and Examples 5th edition (John Wiley & Sons, Inc., 2014). That book, for example, covers the latest theory and practice in cost of capital estimation, including cost of capital for uses in business valuation, project assessment and capital budgeting, divisional cost of capital, reporting unit valuation and goodwill impairment testing, valuing intangible assets for financial reporting, and transfer pricing.

Rather, the Valuation Handbook is designed to complement such works, providing a brief refresher for valuation analyst on the approaches to valuation and estimating the cost of equity capital, but primarily focusing on the data sources commonly available for estimating the cost of equity capital.

Who Should Use the Valuation Handbook – Guide to Cost of Capital

The Valuation Handbook is designed to assist financial professionals in estimating the cost of equity capital (ke) for a subject company. Cost of equity capital is the return necessary to attract funds to an equity investment. The valuation data and methodology in the Valuation Handbook can be used to develop cost of equity capital estimates using both the build-up method and the capital asset pricing model (CAPM). In addition to the traditional professional valuation analyst, the Valuation Handbook, and the online Risk Premium Toolkit, and online Cost of Capital Analyzer, are designed to serve the needs of:i.1

Corporate finance officers for pricing or evaluating mergers and acquisitions, raising private or public equity, property taxation, and stakeholder disputes.

Corporate officers for the evaluation of investments for capital budgeting decisions.

Investment bankers for pricing public offerings, mergers and acquisitions, and private equity financing.

CPAs who deal with either valuation for financial reporting or client valuations issues.

Judges and attorneys who deal with valuation issues in mergers and acquisitions (M&A), shareholder and partner disputes, damage cases, solvency cases, bankruptcy reorganizations, property taxes, rate setting, transfer pricing, and financial reporting.

i.1 The Risk Premium Toolkit (previously called the “Risk Premium Calculator”) and Cost of Capital Analyzer are web-based companion applications that are based on the same data and methodology that is published in the Valuation Handbook ‒ Guide to Cost of Capi-tal. Both the Risk Premium Toolkit and the Cost of Capital Analyzer can be used by the valuation analyst to estimate cost of equity capital for a subject company dependent on its size and risk characteristics using multiple models (including the build-up method and CAPM). The Risk Premium Toolkit is available from Business Valuation Resources, LLC (BVR) (website: www.bvresources.com/costofcapital; phone: 1 (503) 291-7963 ext. 2). The Cost of Capital Analyzer is available from ValuSource, (website: www.valusource.com/vhb; phone: 1 (800) 825-8763).

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About the Valuation Handbook – Guide to Cost of Capital

The 2016 Valuation Handbook – Guide to Cost of Capital includes two sets of valuation data:

Data previously available in the Duff & Phelps Risk Premium Report (no longer published as a stand-alone publication), and

Data previously available in the Morningstar/Ibbotson Stocks, Bonds, Bills, and Inflation® SBBI® Valuation Yearbook.1.2

The Risk Premium Report has been published annually since 1996 and, like the former SBBI Valuation Yearbook, provides data and methodology to assist financial professionals in estimating the cost of equity capital for a subject company using various build-up models and the CAPM.

The size premia data previously published in the SBBI Valuation Yearbook is referred to as the “CRSP Deciles Size Premia” exhibits in the Valuation Handbook, while the size and risk premia data published in the Duff & Phelps Risk Premium Report continues to be titled “Risk Premium Report” exhibits.

The 2016 Valuation Handbook’s “data through” date:

The 2016 Valuation Handbook includes data through December 31, 2015, and is intended to be used for 2016 valuation dates.

i.2 Morningstar, Inc. announced in September 2013 that it would no longer publish the Morningstar/Ibbotson SBBI Valuation Yearbook and other valuation publications and products.