The valuation of any company by the discounted cash flow method is divided into two different tasks: forecasting cash flows and discounting these same cash flows using the appropriate discount rate. The latter requires a good understanding of the risks faced by the subject company's cash flows to be able to determine the appropriate risk premia to compensate a typical willing buyer and satisfy a typical willing seller. There is a high level of ambiguity and dispersion of opinions about how to quantify these risks especially when valuing closely held companies. To avoid dealing with the task of identifying and measuring components of the appropriate risk premia for the subject company, some practitioners have turned to a measure that, supposedly, lumps all risks together (which they term Total Beta) and purportedly then allows one to estimate a total cost of equity. The proponents of total beta believe that by using a “total risk” beta there is no need to consider size premia, lack of marketability premia or company specific risk premia.
Critics of total beta argue that there is no theoretical basis for total beta as a measure of total risk. This paper argues for the camp of the critics of total beta because we believe it represents a major departure from finance theory and does not adjust the cost of capital correctly for Company Specific Risk. Then, we examine academic research to show that the two major arguments used by total beta proponents to discredit the existing model do not hold. We do not argue that the existing models are absolute truth. We recognize the limitation of the CAPM and/or Modified CAPM models and we admit their inability of answer all questions regarding the cost of equity. However, we believe that total beta is not a step in the right direction.