The OPM Backsolve Valuation Method: What's the Right Volatility?
David Howell
Expert in valuation for private equity. I simplify financial reporting and GAAP | IFRS compliance for CFOs and accountants. Passionate about making complex fair value requirements easy to understand.
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The OPM backsolve valuation method is used in private equity to estimate fair value for financial reporting.? This can include financial interests such as rollover, warrants, profits interests, phantom shares, convertibles, or even earnouts.
Because this method relies heavily on math, key inputs have a significant impact on the result. A volatility estimate is one of these key inputs.
>>> 3 Things CFOs and Accountants Need to Know
One: What is Volatility?
Volatility is a measure of financial risk, expressed as an annual percentage (such as 50 percent). It is an indicator of the potential for changes in value of a financial interest over time.
The OPM Backsolve valuation method often uses an equity volatility relating to the total equity of the company. There can also be circumstances where an asset (business enterprise) or class (subject financial interest) volatility may be used.
Volatility is related to, and different from, an expected rate of return. An expected rate of return (such as 10 percent per year) defines the anticipated returns to an investor in a financial interest over a period of time. Volatility defines how a rate of return might vary, creating the possibility of a higher or lower result.
Together, volatility and rate of return are indicators of risk for a financial interest. Higher levels in these measures generally suggest an expectation of greater risk.
Two: What Does the Volatility Estimate Do?
The volatility estimate has a direct impact on the value of financial interests in the OPM Backsolve valuation method.
There is a simple effect:
Higher Volatility >>> Higher Value
Lower Volatility >>> Lower Value
These outcomes are expected where there are no other changes or unusual facts and circumstances.
Three: How To Estimate Volatility
The OPM Backsolve valuation method requires a forward-looking estimate of future volatility. For financial reporting, such estimates are typically based on historical information.
The challenge is adequate data on historical volatility of financial interests for privately owned companies rarely exists.
To address this issue, best practices were created to estimate volatility for a privately owned company for purposes of financial reporting:
There is no requirement on how many companies make a good peer group.? Generally, a minimum of 2 to 3 and up to 10 to 15 will work for most situations.? If not already identified, industry research is used to build out the group. The group should be based on individual companies and not an industry index.
Peers don’t have to be perfect matches. There will always be differences.? The peers only serve as a proxy for how value might vary in the future.
The company is then compared to the peer group on factors that can impact future value including:
Higher levels for these factors relative to the peer group generally indicate higher volatility for the company. ?Lower levels on these measures suggest lower volatility. Comparable levels imply similar volatility.
A business that is smaller, less diversified, or with fewer resources will generally have higher volatility. Greater levels in these areas would indicate less volatility. Comparable levels imply similar volatility.
It is helpful to create a ranking of the company to the peer group for the various factors evaluated.
All of this information can then be used to select a volatility.
As an example, assume a peer group has volatilities that range from 35 to 70 percent, with an average of 50 percent.? The most similar peer has a volatility of 45 percent. Comparative review and ranking generally show no particular differences. However, the company is smaller than all of the peers.
In this scenario, there could be a variety of equally reasonable choices for a volatility estimate:
There could be other selections and rationale.
Bottom Line: What’s The Right Volatility?
What’s a good volatility estimate? There’s no standard rule for this. Equity volatility estimates in private equity can range from under 25 percent to over 75 percent. The selection relies on peer data, business knowledge, and judgement.
So it depends.
Just looking at the volatility estimate alone won’t reveal if it is appropriate.
The support for any selection comes from review of peer group selections, comparative analysis, business factors, and rationale.
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Additional Information and Resources
How to Calculate Volatility
The volatility estimate is a key input. CFOs and accountants should understand, review, and confirm how it was determined.
Volatility is calculated for each peer group company as of the valuation (measurement) date, for a historical (lookback) period that corresponds to the future time frame (term), and basis (equity, asset, subject interest) consistent with the OPM Backsolve valuation method applied.
The process starts by taking the historical stock prices of the peer group to compute an equity volatility.
This can be accomplished several ways.
Go Online
A search for a term such as “volatility calculator” can turn up websites, templates, or apps that compute historical equity volatility for a publicly traded company.? Using one of these online resources can be fast, easy, and might be free.
The challenge with online resources is the data and calculations usually can’t be checked. There can be differences in how these automated online resources compute volatility.
This means additional testing is necessary when using an online resource. This could be done by comparing answers for different online resources.? Another way is to verify results against the Microsoft ?Excel approach described below. Checking a couple of peer results should reveal any concerns.
TIPS: Make sure the online resource can run the calculations as of the valuation date and historical lookback period required. Don’t use ones that calculate “beta” – that is a different risk measure and not appropriate in the OPM Backsolve valuation method.
Use Microsoft Excel
A Microsoft Excel worksheet can be set up to calculate equity volatility using stock price data for a public company obtained from Google Finance, Yahoo Finance, the public company website, or other sources.
This approach provides control and confidence over how the volatility estimate is calculated.? The process is generally described below.
For each peer company:
TIPS: Don’t worry, it’s not necessary to be an expert in math or statistics to do this. Please contact me if you would like a copy of a free template to calculate volatility in Microsoft Excel.
For Both Online and Microsoft Excel Approaches
Information for comparative factors can be assembled from Yahoo Finance, Google Finance, or peer websites.
The peer group data produces an equity volatility because it uses stock (equity) price data. An equity volatility is most often needed for the OPM Backsolve valuation method.
In certain situations, an asset (enterprise) or class (subject interest) volatility estimate will be applied.
For example, an asset volatility may be used when a value for debt and equity interests is needed. An asset volatility may be used to modify the equity volatility or develop a class volatility based on the capital structure. A class volatility may be used to adjust the value of certain financial interests for factors such as differences in rights or marketability.
In all cases an equity volatility is the starting point. It is then adjusted to an asset or class volatility.
?? Hit "Book and Appointment" on my profile if you need help in anyway on finding the right volatility.