If the CAPM fits…
Calculating discount rates in valuing a
business or shares can be a minefield. Recent cases have shown how
far the opinions of expert witnesses can diverge even when agreed
formulae and conventions are followed in determining value.
It is generally, although not universally, accepted that in arriving at the value of an income stream in today’s money, the Capital Asset Pricing Model (CAPM) is a useful tool in determining the rate at which to discount the future income streams. While it's the job of the expert to get down to the nitty gritty of the calculations, lawyers play an important part in framing the terms of reference within which the expert is working – and they require an understanding of how discount rates are determined, and why they can vary so widely.
The purpose of CAPM is to calculate the return that an investor would require from an investment with the same level of risk as the income stream being valued. The formula itself is fixed – but there is a great deal of subjectivity as to which figures go into the formula. In DSG Retail v Revenue & Customs [2009], the principal disagreement between the accounting experts related to the figures to be used in applying CAPM.
The first CAPM component looks at what would be a risk-free rate of return, usually taking UK government bonds as a baseline. This sounds straightforward, but (putting aside recent concerns over the government's credit worthiness) there is still room for subjectivity. For example, in Cadogan v Sportelli [2006], where the three experts differed on almost every component of the formula, opinions were also divided as to whether the rate should reflect 10-year gilts, or should reflect the term of the life of the asset being valued. While there may only be an apparently insignificant variation in the rate of return – say 0.25% – when this is translated into a company valuation that could run to several billion pounds, the difference in real terms is considerable.
The second component – the equity market risk premium – allows for much greater subjective variation, taking as its basis the likely future performance of the equity market. The risk associated with equity is greater that than of risk-free debt, so a premium is required to reflect the additional risk. Anywhere between four and seven percent are typical. This is a wide range given and a three percent difference is potentially very significant.
And that's before even including the third element, the so-called 'Alpha factor'. This adds a premium which reflects the specific features of the company under consideration, such as size and geographic diversification. This is the area that depends most of all on the professional opinion of the expert witness, so it is crucial that their judgement is credible and well substantiated.
It is necessary to understand each of the steps taken in arriving at the discount rate before the reasonableness of the rate can be assessed. In Levicom v Linklaters [2009], it was noted that some valuers will take a more aggressive assumption on future cash flows, and then use a higher cost of capital to discount those cash flows. A lower discount rate might reasonably be applied to a more prudent set of forecasts. The same observation was made in Dennard & Ors v PWC [2010]. In that case, it was also recognised that discount rates could change over even short periods of time as the market changed.
Although generally accepted in valuations and discounted cash flow workings, the CAPM model is not appropriate for all cases. In Masri v Consolidated Contractors [2007], the “real battle” between the experts was whether a WACC approach, incorporating the CAPM element, was the correct approach, or whether a borrowing rate was more appropriate. The judge in that case preferred the borrowing rate.
Any valuation model has flaws, and even the widely used CAPM is no exception: different information in the standard calculations can make a huge difference to the results obtained. Instructing lawyers and counsel need to wary of their experts adopting positions that appear extreme or could be considered biased towards their own client’s interests so that such views can be challenged, or at least prepared for.
