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Finance academics and practitioners do not dispute the existence of company-specific risk. However,
some finance academics and practitioners dispute the existence of a company-specific risk premium
based on their view that company-specific risk is not priced into the cost of capital. In other words, it is
their view that current research supports the position that holders of risky securities who do not hold a
diversified portfolio of investments are not compensated for bearing company-specific risk. fn 1 Among
other things, these professionals state that a company-specific risk premium should not be used as a tool
to adjust for forecasts that are overly optimistic. Instead, such forecasts should be properly evaluated and
"scrubbed" of unrealistic assumptions.

Market Approach

The market approach may be based on any one of the three methods (guideline public company method,
guideline company transaction method, or transaction in the subject company’s stock method) or any
combination thereof. For example, it is common to assign weights to both the guideline public company
method and the guideline company transaction method (see discussion of each method in chapter 9 of
this practice aid), if there is timely, relevant market information for both methods.

With any of the market approach methods, however, the following must be considered when evaluating
how heavily to weight the market approach indications of value in reaching a conclusion of value:

a. The magnitude of price differentials caused by acquisition premiums (typically caused by premi-
ums paid for anticipated synergies);

b. The quality of transactions or guideline companies;

c. The degree of consistency in pricing multiples derived from transactions or guideline companies;

d. The quality of information regarding prices, financial data, and company descriptions; and

e. The degree of similarity in the underlying economics between the subject company and the
guideline companies or the companies involved in the transactions.

The market approach relies on two assumptions that may not necessarily apply to valuations done for
companies in financial distress. Practitioners will need to make this determination on a case-by-case ba-
sis. First, the market approach assumes that the value of the subject company is driven by similar factors
as the guideline companies selected and hence would trade at similar multiples to those companies. The
value of companies in financial distress can be highly influenced by company-specific factors that are
not typically reflected in the multiples of the guideline public companies. fn 2 The market approach also
assumes that the financial measures used to calculate the multiples are reasonable measures of the ex-
pected future performance of the guideline companies and the subject company. Companies in financial
distress, however, are generally not in a "steady state." Current and historical financial performance are
typically not good predictors of future performance, so applying a multiple to current or historical finan-
cial measures will often not be a good predictor of value.

fn 1 See Brian C. Calvert and David C. Smith, "Company-Specific Risk Premiums: Update on the Scholarly Evidence" (working pa-
per, March 2011), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1791213.

fn 2 As stated in the previous section, some academics and practitioners refute the existence of company-specific risk premiums.

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