Everything in life begins as an embryo. We use professionally provided financial data services without a thought as to how they began and/or evolved. A little nostalgia is useful and enlightening to add perspective to this story of the evolution of Kroll’s Cost of Capital Navigator.
Capital Asset Pricing Model (CAPM)
CAPM was independently presented by Jack Treynor (1961, 1962), William F. Sharpe (1964), John Lintner (1965), and Jan Mossin (1966). They each expanded on the previous work by Harry Markowitz on diversification and modern portfolio theory.
Sharpe is an American economist who won the 1990 Nobel Prize in Economic Sciences along with Markowitz and Merton Miller for developing models to assist with investment decision making. “Investment Decision Making” is the backbone that valuation professionals must utilize to assure that a particular Standard of Value reflects a reasonable conclusion of value; one that is not horribly ”wrong”.
According to Gary R. Trugman, “The (CAPM) model was originally developed in the context of portfolio theory as a way to measure the risk an individual stock contributes to a well-diversified portfolio.” The model presumes a fully efficient market which doesn’t really exist, whereas a well-diversified portfolio doesn’t apply for most of the clients we prepare business valuations.
Stated differently by Wikipedia, “In finance, the CAPM is a model used to determine a theoretically appropriate required rate of return (the Discount Rate) of an asset, to make decisions about adding assets to a well-diversified portfolio.”
Morningstar® states that the “cost of capital measures the returns needed to make a company’s investment financially worthwhile.” 
It continues by saying that “cost of capital helps companies decide which projects to fund. Because most businesses are profit-driven, they will rarely invest in projects that cost more than the expected return. Companies may also weigh the project’s opportunity cost, the potential benefit of putting money elsewhere.”
Professor Roger G. Ibbotson, former chairman and founder of Ibbotson Associates, which first published the Stock, Bonds, Bills, and Inflation® book series, stated in his praise to Cost of Capital – Applications and Examples, 5th Ed.:
“Estimating the cost of capital is critical in determining the valuation of assets, in evaluating the capital structure of corporations, and in estimating the long-run expected return of investments. Shannon Pratt and Roger Grabowski have the most thorough text on the subject, not only providing various estimation methods, but also numerous ways to use the cost of capital.”
As we know, Ibbotson Associates, followed by Morningstar, used data provided by the Center for Research in Security Prices (CRSP®), University of Chicago Booth School of Business to calculate the decile size premiums.
Cost of Capital Today
Early on, when the Institute of Business Appraisers began in 1978 by Raymond C. Miles (an engineer), there wasn’t much to choose from for cost of capital guidance. Today, Kroll is providing its unique and evolving blend of research and data insights to the valuation community (see the last two sections of this article for more on this).
The CPA Practice Beginnings and Links to the Valuation Profession
In 1849, Samuel Lowell Price started an accounting practice in London.
In 1854, William Cooper started his accounting practice in London. Seven years later the practice became known as Cooper Brothers.
In 1865, Price, Holyland and Waterhouse form their partnership. By 1874, they change their name to Price, Waterhouse & Co.
In 1898, Robert H. Montgomery, William M. Lybrand, Adam A. Ross, Jr., and his brother T. Edward Ross form the accounting firm Lybrand, Ross Brothers, and Montgomery.
In 1910, the “Big Eight” was known as Arthur Anderson, Coopers and Lybrand, Ernst & Whinney, Deloitte Haskins & Sells, Peat Marwick Mitchell, Price Waterhouse, Touche Ross, and Arthur Young.
In 1957, Cooper Brothers & Co. (UK), McDonald, Currie and Co. (Canada), and Lybrand, Ross Bros & Montgomery (U.S.) merger to form Coopers & Lybrand.
In 1977, Roger Ibbotson (then a professor at the University of Chicago; Ibbotson later joined Yale School of Management in 1984) founded Ibbotson Associates. He and his co-author Rex Sinquefield started collecting capital market returns for the United States starting with data in 1926. In this manner they could provide historic returns data on stocks, bonds (U.S. government and corporate), U.S. Treasury bills (cash-like, short-term U.S. Treasury obligations), and inflation (a hypothetical asset returning the rate of increase of the Consumer Price Index).
Ibbotson Associates started including the size premium in a CFAI Research Foundation publication in 1982 which included a small capitalization series over the period 1926‒1981. In 1983, Ibbotson Associates began publishing annual Stocks, Bonds, Bills, and Inflation® (SBBI®) Yearbooks, each of which included the small cap series. Starting in the 1995 edition of the SBBI® Yearbook, Ibbotson Associates began discussing adjusting the beta of the size premium.
In 1982, Price Waterhouse World is formed.
In 1987, Peat Marwick International (PMI) and Klynveld Main Goerdeler (KMG) merged to form KPMG.
In 1990, Coopers & Lybrand merges with Deloitte Haskins & Sells in various countries around the world.
In 1990, Roger Grabowski began closely studying the relationship between company size and stock returns. Grabowski’s early research focused on size as measured by market capitalization, but quickly advanced to two additional areas of inquiry: whether stock returns were predicted by (i) measures of size other than market capitalization, and also whether stock returns were predicted by (ii) fundamental risk measures based on accounting data. After writing a series of articles on the findings of this research in 1995, 1996, and 1997, Roger Grabowski and his colleague David King published the first annual PricewaterhouseCoopers’ Risk Premium Report from 1998 to 2001. From 2002 to 2004 this report was published as the Standard & Poor’s Corporate Value Consulting Risk Premium Report, and then from 2005 to 2017 as the Duff & Phelps Risk Premium Report. Starting in 2018, the information and data from the Risk Premium Report Study is available exclusively in the online Kroll Cost of Capital Navigator, for all years from 1999–present.
In 1998, Price Waterhouse and Coopers & Lybrand merged to create PricewaterhouseCoopers (known as PwC starting in 2010). Today, the “Big Four” have emerged from consolidations to be PricewaterhouseCoopers (PwC), Deloitte, Ernst & Young, and KPMG.
In 1999, Ibbotson Associates began publishing the Stocks, Bonds, Bills and Inflation® (SBBI®) Valuation Yearbook. This book included size premia based on market capitalization calculated using data from the Center for Research in Security Prices (CRSP®). This annual book was published from 1999–2005 by Ibbotson Associates, and from 2006–2013 by Morningstar (Morningstar acquired Ibbotson Associates in 2006). Starting in 2014, the information and data from this book has been updated and published by Kroll (previously Duff & Phelps) (see the section below entitled “Kroll (Previously Duff & Phelps): The Rest of the Story” for more information about the 2014–present history).
Financial cause and effect occurred on December 2, 2001 when Enron Corp. filed for bankruptcy. This was a company that had been lauded when its share price reached a peak of $90.75, but it was worth only $0.26 per share at the end, causing worldwide panic when investors lost their investments and pension assets. It was later determined that the company had misled regulators and the public with fake holdings and complex accounting practices promoting non-existent assets.
Because of Enron, the Sarbanes-Oxley Act of 2002 was enacted to impose sweeping auditing and financial regulations upon public companies. This act had far-reaching results, causing valuators to acknowledge (at least to themselves) they had to better scrutinize company financials and ask management more detailed questions when conducting interviews.
In 2005, Standard & Poor’s (S&P) sold its valuation practice because it wasn’t related to its core financial business, credit ratings and analytics. The former S&P Corporate Value Consulting practice merged with Duff & Phelps, a boutique valuation and investment banking firm, making the combined valuation practice the largest independent valuation practice in the world.
In 2006, Morningstar, Inc. purchased Ibbotson Associates.
Kroll (Previously Duff & Phelps): The Rest of the Story
According to an interview that David Fein, President/CEO of ValuSource, had with Carla S. Nunes, CFA, Kroll Managing Director and Kevin Madden Kroll Director, Morningstar had previously published two “Ibbotson® SBBI®” yearbooks: (i) The Stocks, Bonds, Bills, and Inflation® (SBBI®) “Classic” Yearbook, which focuses on U.S. asset class performance and does not provide valuation data (this book has been published by Kroll since 2016 as the SBBI® Yearbook), and (ii) the Stocks, Bonds, Bills, and Inflation® (SBBI®) “Valuation” Yearbook, which was discontinued by Morningstar in 2013 because valuation data was not related to its core businesses.
The former SBBI® “Valuation” Yearbook had been the resource of choice for valuation data (e.g., size premium and equity risk premium) since 1999, so there was a great need to continue to provide this data to valuation analysts. James Harrington (who had worked at both Ibbotson Associates and Morningstar, and had joined Kroll – then Duff & Phelps – in 2010) and Roger Grabowski (Managing Director at Kroll) simultaneously secured a license from Morningstar to all previous valuation data from the SBBI® Valuation Yearbook since its inception in 1999 (referred collectively to as the “CRSP Deciles Size Study” here), and licensed the data needed to continue to update the calculations of this data from the Center for Research in Security Prices (CRSP®), and various other data vendors.
Harrington and Grabowski then combined the CRSP Deciles Size Study data (the previous SBBI® Valuation Yearbook data) with Grabowski’s Risk Premium Report data into a new valuation data resource – the 2014 Valuation Handbook – U.S. Guide to Cost of Capital, and they invited Carla Nunes to join as a co-author. The launch of this book was immediately well-received by finance and valuation professionals and other users of valuation data.
Here Begins an Explosion of Meaningful Changes in Presentation and Offerings
With incredible speed Kroll (previously Duff & Phelps) then produced the Valuation Handbook – U.S. Industry Cost of Capital in 2014 and went “international” with two more books: the Valuation Handbook – International Guide to Cost of Capital (added in 2014) and then the Valuation Handbook – International Industry Cost of Capital (added in 2016). Along with Cost of Capital: Applications and Examples 5th edition (John Wiley & Sons, Inc., 2014), which Grabowski had co-authored with Shannon Pratt in 2014, Kroll had a total of five “valuation” books in their portfolio by 2016. (They did add another book in 2016, the 2016 Stocks, Bonds, Bills, and Inflation® (SBBI)® Yearbook, but that book focuses on U.S. asset class performance, not valuation data).
Kroll quickly realized that there were enormous advantages to moving the vast information and data in the four “Valuation Handbooks” online. These advantages included (i) making updates to the data more efficient and timely, and (ii) providing subscribers “anytime anywhere” access to the data. As a result, in 2018 the Cost of Capital Navigator was launched. The first of the four Valuation Handbooks to be added to Cost of Capital Navigator in 2018 was the Valuation Handbook – U.S. Guide to Cost of Capital. The information and valuation data from this book is known as the “U.S. Cost of Capital Module” in the Cost of Capital Navigator. Not only did this first module include the historical size premium and other valuation data from both the CRSP Deciles Size Study (formerly Ibbotson/Morningstar) and the Risk Premium Report from 1999 to present, but it also provided an interactive step-by-step approach to walk valuation and financial professionals through the steps of estimating the cost of capital. Another driving factor in developing the online platform was the desire by Kroll to assist and ensure that valuation practitioners were following best practices in developing their cost of capital estimates. Some of the data in the Cost of Capital Navigator’s U.S. Cost of Capital Module is updated quarterly (e.g. betas, industry risk premiums, etc.), whereas other data sets are updated only annually (e.g., historical equity risk premia, size premia, etc.). In the following years Kroll delivered on its promise to transition the voluminous information and data from the remaining three Valuation Handbooks over to the Cost of Capital Navigator:
- In 2019 the information and data from the Valuation Handbook – U.S. Industry Cost of Capital was added. The information and valuation data from this book is known as the “U.S. Industry Benchmarking Module” in the Cost of Capital Navigator. The data in the Cost of Capital Navigator’s U.S. Industry Benchmarking Module is updated quarterly.
- In 2020 the information and data from the Valuation Handbook – International Guide to Cost of Capital was added. The information and valuation data from this book is known as the “International Cost of Capital Module” in the Cost of Capital Navigator. Some of the data in the Cost of Capital Navigator’s International Cost of Capital Module is updated quarterly (e.g., country risk measures), whereas other data is updated annually (e.g., equity risk premia).
- In 2021 the information and data from the Valuation Handbook – International Industry Cost of Capital was added. The information and valuation data from this book is known as the “International Industry Benchmarking Module” in the Cost of Capital Navigator. The data in the Cost of Capital Navigator’s International Industry Benchmarking Module is updated quarterly.
What’s the Future Looks Like for Kroll and “World Valuation”
Subscribers have access to the vast U.S. and international data that includes size premia, equity risk premia, country risk premia, and industry data in the Cost of Capital Navigator’s existing four modules, but the Kroll team also provides a lot of valuable information for free. For example, the Cost of Capital Navigator team regularly updates Cost of Capital Infographics, wherein it tracks the financial market and economic indicators used to support Kroll’s recommended U.S. Equity Risk Premium and accompanying Normalized Risk-Free Rate, including how COVID-19 has impacted these factors.
Ms. Nunes stated, “In 2022 we will add a fifth module to the Cost of Capital Navigator. The new Beta module will include individual company betas, but also enable the user to form custom peer group betas. This is a long-awaited functionality that enables the selection of comparable companies for the market approach. The user will be able to select and unselect peer companies and the system will adjust the data accordingly.”
Nunes continued, “The ‘Pro’ version of the new Beta module will enable the user to look at data over time to see the impact of economic factors on betas. For example, tracking the stock prices over time to see the impact of COVID-19 on a given industry, such as restaurants. By looking at these trends vs. the overall stock market will help measure the correlation between stock prices and economic factors, to judge whether significant changes in betas will persist (e.g., have betas of restaurants changed permanently after COVID-19) or if it’s better to take a long-term view (e.g., will betas revert back to where they were prior to the pandemic).”
Ms. Nunes is excited about the ongoing development and success of the Cost of Capital Navigator, and says that “the future is indeed bright”. With the benefit of our subscribers’ expert feedback and the hard work, analytical firepower, and creativity of our team, you will continue to see regular innovations added to the Cost of Capital Navigator for years to come.
Final Thoughts from David Fein, CEO of ValuSource
There have been many people and firms involved in the evolution and delivery of cost of capital data for the valuation profession. David Fein, CEO of ValuSource, is one of them and has been involved with cost of capital data for over 30 years. David and his team at ValuSource provided feedback to Kroll for the initial development and launch of the Cost of Capital Navigator as well as now being a major Kroll reseller. ValuSource also works closely with the Kroll Cost of Capital Navigator team to assure the product continually evolves to meet the needs of the valuation profession both in the U.S. and around the world. David says “Cost of Capital data is simply foundational to the valuation profession and Kroll (previously Duff & Phelps) has played a vital role in developing this crucial resource for the entire profession, I’m excited to have played a small part in all of this.”
There are many people at Kroll that play a part in the Cost of Capital Navigator product, below are the team’s key members:
Source: Seeney, Makena, “What is cost of capital?”, September 10, 2021. Available here: https://www.morningstar.com/investing-definitions/cost-of-capital.