By Brock Benson
We've got a bit of a surprise for you. Something that you probably won't expect. Here it is. The overwhelming majority of the valuation industry doesn't actually develop or calculate the inputs and assumptions used in a valuation. We know this sounds crazy but it is a fact with key items such as equity or asset betas, equity risk premiums, stock price volatility, and trading multiples pulled directly from providers and sources such as Standard and Poor’s Capital IQ. To make things worse, this is mostly done without a second thought and often without a full understanding of the underlying calculations used by the provider. In fact, you'd be hard pressed to find a practitioner who could calculate the stock price volatility of an equity without looking it up. This has always seemed odd to us and when we saw it first hand at one of the largest consulting firms in the world it honestly shocked us. Given the sharp economic and market changes over the last year(s), this shock has now turned to a genuine concern for the industry and the clients we are supposed to be serving.
Shock turned to concern
Now you may be saying to yourself, "What's wrong with pulling data directly from a firm like Standard and Poor’s? They know what they're doing so this is a good thing. Also, don't we want an industry standard?" On the surface, this appears to be a good thing. Consistency across providers, valuations, etc is nice. But, what happens when adjustments to key valuation inputs and assumptions are warranted and/or required? What do we do then?
The previous 20+ years have been relatively unchanged, setting aside a few large bumps along the way. Interest rates have remained historically low and, generally, the market has been on a steady upward path. Set aside for now the signs of a pending personal debt crisis, among other things, looming in the shadows. From a valuation perspective, it was reasonable to assume that the past would be indicative of the future over this relatively consistent period. Not much to argue with there.
Uh-oh! What about now? The economy, market, and overall conditions impacting valuation have fundamentally changed. The past is, at least for the time being, not likely to be indicative of the future. So, what do you do if you can't reasonably rely on the future looking like the past? You make required adjustments to historical inputs and assumptions based on a solid understanding of how these items are calculated and what factors are driving these calculations. Well, how do you go about making these adjustments if you don't calculate these items on your own or know how these calculation are performed? The answer is you can't and this is the problem. The idea that some of the largest valuation firms in the world are dependent upon third party calculations is insanity to us and we believe this does not best serve clients.
To be fair, it's our belief that most firms would choose to calculate all required assumptions and inputs internally if they could. The fact is that this approach is substantially more complex from both a resource and capability standpoint than simply using pre-calculated sources. We get it and most firms would likely argue that using provided calculations frees them up to focus more on the analysis. Again, this is reasonable, but we don't believe that having full control and understanding over inputs and assumptions and focusing on the analysis are mutually exclusive. Ultimately, our goal as providers and as an industry must be to provide the best outcomes possible for our clients. Period. And we believe that performing internal calculations from raw financial and market data plays a key role in this process.
Aren't we estimating a comparable market value?
One of the most common things we see in the industry is input and assumption stability. The biggest culprit for this is the equity risk premium. But why? Again, we believe that this is largely a function of not being able to perform these calculation internally and in real-time. This is the reality of a largely consulting based industry that has seen very little innovation and technology uptake.
The purpose of most if not all valuations is to estimate the value of the asset or liability from the perspective of an independent, arms-length market participant. The economy and markets are choppy so what's wrong with assumptions and inputs being the same. New information is constantly coming to light and markets adjust. Why would we assume that a private market participant would act any different? Well, it's our belief that we wouldn't and shouldn't be assumed to do so. But it's the norm of the valuation industry to use outdated (i.e. not real-time) data? Why? Our take on why the industry uses outdated data is because there is simply an inability on the part of most, if not all, of the industry to actually perform all of the calculations underlying each assumption and do this in real-time. Simply, Wall Street doesn't put money at risk based on outdated data so it shouldn't be ok for the valuation industry.
Our approach
We license raw market and financial data. From this data, we calculate every multiple, fundamental, and assumption, including equity risk premiums in real-time. Again, this requires substantial technical expertise and resources so why do we do it instead of just licensing this data like everyone else? Well, first, our goal is to provide the best possible outcomes for our clients. To do so, it is important that we have the knowledge and capabilities to make real-time adjustments to every assumption and input used in a valuation when warranted. Period. Lastly, we want to be able to look at the data differently and move the industry forward so we chose the harder path. This expertise allows us to perform analysis that is simply unavailable anywhere else, including the industry standard Excel.
For example, here are rolling monthly Enterprise Value to EBIT multiples over a 10 year period developed within our proprietary Trading Multiples component. You can't do this with pre-calculated sources or within Excel. This chart allows us to see longer term trends, in this case EV / EBIT multiples, leading to more defensible outcomes for our clients.
What we hope for
Again, although calculating every input and assumption internally requires substantially more resources, we do it because it provides a significantly deeper understanding of each item, its impact on the valuation, and ultimately allows us to provide more defensible and better outcomes for our clients. Our hope is that as technology continues to become more accessible that this will become the industry standard. Until then, we'll keep doing things the hard way and "crunch" the data.
If you want to learn more, contact us to schedule a demo. Or get a quote and get started on a valuation in less than 5 minutes.