Abstract

The standard, market-based valuation approach uses pricing multiples from guideline public companies with industry, size, and growth characteristics similar to those of the subject private company. These multiples must be adjusted for the fact that diversified investors' Cost of Equity Capital (COEC) for a given firm is lower than the COEC of an undiversified investor in the same firm who has all his financial and human capital invested in one firm. This article presents a practical method to determine the Discount for Lack of Diversification to apply to guideline public companies' multiples. The adjustment is based on the premise that the owners of private companies are undiversified investors facing the total risk of the business unlike the owners of public companies that diversify their risks by holding a large number of securities. We further provide an illustrative case study that shows the reader how one might apply the model for firm-specific risk.