If you're doing an extremely structured deal... think a 4-way cluster-f*ck between subs and parents... if Im valuing non-voting, non-dividend, non-control, open capital call preferred... my comps are giving me an extremely high valuation(in terms of cost of equity) since none of them incorporate the above mentioned "handicaps" to value.
I know I need to increase my equity risk premium, but I'm not sure how I can substantively determine what the equity risk premium increment is... say my comps give me an eqty risk prem of 10.5%, and I know my Subject Co should be somewhere between 12.5% to 14%, how can I quantify the incremental risk premium prescribed to this class of equity?
I know which direction I need to go in, but I don't know how to quantitatively determine this value in a way which I can explain without making it seem like a BS adjustment because I didn't get the valuation I wanted. Essentially, it needs to be intuitive and a quantitative adjustment for qualitative attributes.
If anyone can share their experiences in similar situations or point me towards some empirical studies, I would very much appreciate it.
I need a way to determine the additional discount increment more so than any alternate methods of valuing the entity/securities.
How have you guys, in the past, justified handicapping a valuation by means of equity risk premium? It goes without saying, the reasoning has to be able to hold water, even under the scrutiny of a court of law.
Tough to say without getting more color on the industry, comps used, etc. You'll probably need to base the equity risk premium off some sort of volatility based correlation. Just keep in mind I've never had to do an analysis like this that needed to hold water under the scrutiny of a court.
This might give some direction:
http://research.stlouisfed.org/wp/2006/2006-007.pdf
At the end of the day, it's all BS.
Ha, I cited this paper on a final exam this year...
Deal valuation is more of an art than a science, and by your comments I'm assuming you're bearing the risk of issuing a fairness opinion for your shareholders or a special committee set up by your board.
With that being said you have a couple of weapons you can consider:
The size premium can be added to your cost of equity capital and there are tables you can look up in the Ibbotson's SBBI year book. The size premium tracks the company's relative size (parent/subco is really irrelevant, unless they are just shells set up to consummate a specific transaction) based on revenues, market cap, etc. and correlates that with company risk that you can plug into your cost of equity.
Company specific risk is another one you can use. I had this one client whose REVS and COGS lines were highly volatile and tied to very volatile long term contractual markets and commodity prices respectively, so we were able to justify this plug along with Management's guidance.
On the comp side, the control premium is very subjective. In the deal valuation world, control premium that you add to your non-controlling equity is usually no more than 20%, implying that if you changed management, and were able to realize your synergies on the cost and revenue side, your equity value will go up by 20% relative to status quo.
I'll leave it to you to be realistic with your synergies, paying more attention to the cost saving synergies, so if you believe that your synergies effected by a controlling position would increase value by around 20%, by all means go for it, but like in anything valuation, I'd err on the side of caution.
You can also model various series of preferred stock using option pricing, but I don't think it can stand the scrutiny of a court, so I'll just stick to multiples (albeit screwed up right now) and a 5 - 7 year DCF with a meaningful terminal value based on some average of exit multiples in that sector.
Sounds like you're on the right track though.
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