Alexander v. Alexander, 2013 Mich. App. LEXIS 1490 (Sept. 10, 2013) (slip op.)

It is no mystery that financial experts rely on the Ibbotson SBBI Valuation Yearbook for their valuations, but what makes a recent divorce case intriguing is how two experts used the same authority to argue for a vastly different equity risk premium (ERP).

Cap rate gaps: The parties contested the value of a small, agriculture-based business that the husband owned and operated during the marriage. Three experts appeared in front of the court: the spouses’ appraisers and a third-party valuator whom the court appointed because it found the parties’ valuations “not convincing.” The experts used a capitalization of net income approach, with vastly different capitalization rates. The wife’s expert applied an 18% capitalization rate, including a 5.7% ERP and a 5% company-specific risk premium. It reflected a low-risk business, he said, because the agriculture industry was relatively stable and healthy. The husband’s expert used a 26.6% capitalization rate, noting the industry was “relatively unstable”; also, the company relied on only a few customers, and the loss of any one client put its profitability at grave risk, he said. The third-party appraiser determined a 13.1% capitalization rate, including a 5.2% equity risk premium from the 2010 Ibbotson Valuation Yearbook. He also believed a 10% size premium and a 4% company-specific risk premium were reasonable. The trial court adopted his valuation in its entirety, finding that the business risk was less than the risk the husband’s expert claimed.

The husband appealed the decision, arguing the appointed expert used an improperly low capitalization rate. As to the ERP component, he said, the expert falsely claimed to use the 5.2% ERP appearing in the 2010 Ibbotson Valuation Yearbook, when in reality Ibbotson showed a 6.6% value.

The appellate court dismissed that argument quickly. “Presumably [Ibbotson] is a manual used to value businesses, but it is not included in the lower court’s record,” it said. Without evidence, the court could not determine whether the trial court had erred in accepting the valuation. But, the appellate court added, the 5.2% rate was comparable to the 5.7% rate the wife’s expert had applied. At the same time, no expert had argued for an ERP as high as 6.6%.

Mystery of two ERPs: Business valuator Dan Gilbert (Gilbert Valuations LLC) confirms that the 2010 Ibbotson Yearbook lists a 5.2% supply-side ERP and a 6.7% historical ERP. In short, the historical ERP derives the premium using historical market returns. The yearbook calculates the historical ERP using the simple average of returns since 1926. The supply-side ERP relies on basic information, including earnings, dividends, or general economic productivity figures in determining the expected ERP. “Most appraisers I know use the supply-side ERP, which attempts to eliminate investor bias in price-to-earnings multiples,” Gilbert says. He also points out that, in 2010, the differential between the supply-side and historical ERPs was the highest in the past five years (2008-2013).

It seems that in this case the husband’s reference to a 6.6% ERP was to the historical rate, which his expert may have used (although the opinion does not expressly say so). This choice would result in the highest cost of equity and the lowest overall valuation—which his expert achieved and the court discredited.