An Overview of the Ibbotson Associates SBBI 2001 Valuation Edition
Reviewed by Ronald L. Seigneur, MBA, CPA/ABV, CVA*
2001 SBBI Valuation Edition Yearbook, Ibbotson Associates. 225 North Michigan Avenue, Suite 700, Chicago, Illinois 60601-7676, (800) 758-3557, Fax (312) 616-0404, www.ibbotson.com. $110, $12.50 shipping and handling.
Continuing the trend established with the first two editions of this well recognized cost of capital resource, IA has again expanded the information which business valuators draw upon for this segment of practice. This article will provide an overview of what is new in the 2001 VE edition, together with some limited insights on how to apply the SBBI empirical data for rate determinations in business valuation assignments.
The SBBI yearbooks
The VE edition is an outgrowth of what is referred to as the classic SBBI edition, which has been published each year since 1977. The classic IA SBBI yearbook originated as a result of a 1976 study by Roger Ibbotson, which analyzed the long-term returns of the principal asset classes in the U.S. Economy. Professor Ibbotson’s study documented the relationship between risk and return and quantified the ability to reduce risk through diversification. The underlying study of long-term returns on asset classes also led to the development of such relevant cost of capital concepts as the equity risk premium and the size premium.
While both editions of the book draw upon the same fundamental research of the domestic public equity market, IA has determined that practitioners involved in rate development for business valuation assignments will benefit from expanded coverage of certain aspects of rate determinations in this area of practice versus the more traditional application of the SBBI data within the financial and public equity markets for use in asset allocation analysis under portfolio theory.
Highlights of the 2001 VE Edition
The new VE edition will include many of the summary charts and graphs in full color format this year, which is a nice upgrade. Many of these summary graphics are a great tool for practitioners to better comprehend the underlying detail presented within the book. For example, Graph 1-1 shows the total returns over time in relation to inflation on treasury bills, long-term government bonds, large company stocks and small company stocks. This graph does an excellent job of conveying the higher volatility evident in the historical stock returns, which the underlying studies detailed within the book translate into higher risk. Table 1-1 offers a great snapshot of key data points, showing a summary of annual returns for the period 1926 to 2000, sorted by both geometric and arithmetic means, together with the respective standard deviations and serial correlations, for the various stock market classes (e.g. large, mid-cap, micro-cap and Ibbotson small company stocks), corporate and governmental bonds, treasury bills and inflation.
The focus of the VE text continues to be on the development and application of discount rates under the discounted cash flow (“DCF”) approach to valuation. There is a very good fundamental discussion of the relationship between discount rates developed using IA data and tax rate assumptions, and the use of cash flows versus other benefits streams. The Fama-French Three Factor model and Beta estimation methodologies are again covered in detail in the VE edition. The bulk of the statistical data has been placed in appendices, which makes the text itself much easier to digest.
Valuation tools
Recognizing the specialized needs of business valuation practitioners, IA has continued to focus on expanded discussion of critical concepts, including expanded coverage of Beta and the Capital Asset Pricing Model(“CAPM”). A key feature, which many valuation professionals found very helpful in the 2000 VE, was the expanded coverage of size premiums. Using the IA empirical data based on size of entity considerations, the valuation practitioners are able to better quantify risk. The VE book also includes some excellent expanded discussion of the underlying theory regarding the capital markets over time and the related influence on risk and rates of returns.
The VE book includes expanded coverage on the use of Ibbotson data in the build-up method of rate determination, more information on industry risk premia to be used in the build-up method and a continued expansion of the size premia study by industry, which was in the 2000 book. A chapter on International cost of capital considerations provides some interesting guidance on the capital markets in several established and developing countries, much of which draws on capital market studies by Morgan Stanley, as well as Ibbotson research. More detailed international data can be obtained in the Ibbotson International Cost of Capital Report which can be found at the IA website discussed later.
Industry Risk Premia
Expanding on the coverage provided in the 2000 VE edition, IA has added more detailed coverage of industry risk premia for almost 300 industry segments. This information draws upon empirically supported studies of the risk associated with specific industries using a concept called full information beta. Full information betas essentially calculate a weighted-average beta for an industry segment by segregating the proportion of each publicly traded enterprise working within a specific industry based on gross revenues by industry segment. Overly simplified, the beta for each company with sales in any of the specific industries identified in the VE study is combined with the proportionate beta for all other qualifying companies contributing sales to the same industry, with the overall weighting based on combined industry revenues. The result is an indication of the beta coefficient for an industry as a whole in relation to an overall market beta of 1.0.
For example, Table 2-3 in the 2000 VE edition listed estimates of industry premia for over sixty general SIC codes as of September 30, 1999. These estimates are shown as percentage adjustments ranging from – 12.59% to +7.41% in the 2000 book. The 2001 edition expands this industry risk information to almost 300 two and three digit SIC codes with an indication of the number of companies underlying each of the industry data points ranging from –7.75% to +8.57%. Conceptually, the emergence of this new empirically supported data, means that the traditional model utilized to develop rates can be adjusted in certain situations as follows:
Traditional Application of the Ibbotson Build- up Approach
•
Risk-free rate•
+ Equity risk premium•
+ Size premium•
+ ?? Unsystematic Risks ??•
= Cost of capital discount rateApplication of the Ibbotson Build - up Approach Using Industry Risk Premia
•
Risk-free rate•
+ Equity risk premium•
+ Size premium•
+/- Industry risk premium•
+ ?? Specific company risks ??•
= Cost of capital discount rateThe key to this new framework is to close the gap between the use of risk elements that can be empirically measured and the subjective judgments that must be applied within the unsystematic risk elements. Given that the industry risk premia provided is still quite limited at this point, the selection of appropriate adjustments for industry risk will continue to be judgmental. Because the evolving data points available in these new studies will rarely be an exact match to a valuation target the valuator will still need to evaluate industry - related factors not captured by this new premia information. Nonetheless this new data should greatly assist practitioners in certain assignments where a strong relationship between available industry data and the valuation target can be made.
Expanded Coverage of CAPM
The VE edition includes expanded coverage of the CAPM, which originated from the Nobel Prize winning studies of Harry Markowitz, James Tobin and William Sharpe. CAPM theory is widely accepted within the public securities markets as a fundamental model of future rate determination for securities and securities portfolios. In relation to a traditional build-up model for rate determination, CAPM relies upon the concept of beta to adjust for systematic risk, as segregated from unsystematic risk attributes. The additional discussion of this key conceptual area is important for business valuators to grasp, as the underlying size premia data, which most practitioners utilize regularly for smaller valuation targets, is derived from the CAPM studies.
Expansion of the Base Portfolio
The 2001 VE edition will incorporate the full U.S. publicly traded securities markets in its calculations of size premia. The addition of the NASDAQ stocks brings in over 5,200 publicly traded companies to the combined portfolio. This is a significant change from prior years’ data calculations where only the NYSE exchange portfolio was utilized for calculations of size premia. One obvious benefit to business valuators from this change is that many more companies, which may be more closely aligned with the smaller closely held businesses being valued, will now be included within the database from which the SBBI data points are drawn.
Breakout of tenth decile
For business valuation practitioners utilizing a traditional build-up method for rate determination, reference to the IA size premia is widely accepted as the source for deriving an adjustment for size. The SBBI has historically provided support for the additional return required by the market as a function of size of the security held, based on the S & P 500 stock portfolio. Table 6-5 in the 2001 VE edition now shows the same data points using the full public market portfolio, stratified based on market capitalization, with the 10th decile now capturing approximately 1,900 companies with total market capitalization up to $84
million.
In the 2001 VE edition of SBBI, the 10th decile, not only captures the 10th decile of the full public market,
including AMEX and NASDAQ publicly traded stocks, but it has now been stratified further between what IA refers to as 10-A and 10-B to essentially split this decile in half, with the 10-B strata including companies with total market capitalization up to approximately $48 million. This is a significant enhancement for valuation practitioners attempting to derive rates for small closely held businesses.
The 10-B group of publicly traded stocks exhibits a calculated size premium that is more than double the size premium of the 10-A strata. Given the relatively large volatility found in this smallest group of publicly traded stocks caution is advised when using this new group.
The business valuation community is already somewhat fragmented as to what element of the size premia data (e.g. 10th decile, combined 9th and 10th decile referred to as the micro cap), as presented in prior
editions, is appropriate to use when applying this method of rate determination. The author of this article is currently researching certain arguments others have put forth over the past several years regarding the overall applicability of an adjustment for size within the build-up model and anticipates a follow up piece to address this further.
*Ron Seigneur serves on an Ibbotson Associates advisory panel for their cost of capital workshops, is a member of the AICPA Business Valuation subcommittee, and teaches Capitalization/Discount Rates at NACVA CDI. Contact Ron at ron@cpavalue.com or (303) 980-1111.
