Discount rate and risk
Risk & Return – how risk determines the return
This article explains the relation between the discount rate and risk and factors that drive risk.
Value is function of future cash flows and the risks attached to those cash flows. The discount rate reflects risk and is the rate of return required by investors and financiers to compensate them for that risk.
The higher the risk attached to the earnings (the higher the uncertainty), the higher the return required to compensate investors for that risk.
Companies raise finance from a variety of sources which are either equity based, debt based or a hybrid of the two. A company’s cost of capital is the rate expected to be paid on average to all security holders.
Risk and returns
The required rate of return is relative. The investor requires the same return as an investment with a similar risk profile. The investor wants a better return than a less risky investment and a lower return than a riskier investment.
Low risk investments
The least risky investment is treasury bonds. There is very little risk. The government guarantees you will get your money back. The key risk would be if the government got in to difficulty and defaulted on the debt. Treasury bonds in stable strong countries, are very low risk. Consequently, the annual rate of return on a treasury bond is low. The current German ten year bond yield (the annual return) is actually negative. it’s -2.39%. As an investor, you actually have to pay to keep your money invested with the government, it is so safe!
The more unstable the country and the government, the higher the return required. The current South African ten year bond yield is 0%. Investing in South Africa is perceived as more risky than investing in Germany.
Investing in stocks
A riskier investment is in investing in traded stocks. There is no guarantee that the business and so the stocks will be successful. The average return on the ASX 200 is currently approximately 19%.
The risks attached to earnings in listed stocks varies dramatically. A large, international blue chip stock with established earnings driven by a large and reliable customer base has a relative low level of risk attached to its earnings. Consequently, the return investors require is relatively low. For example, the current forward rate of return for Ford is approximately 15%.
Conversely, a new entrant to the market, with a new product and early growth, has far more risk attached to the earnings. Consequently, investors require a higher rate of return. Investors in Tesla for example would demand a much higher return than if ther were to invest in Ford.
Investing in a private business
An advantage of investing in listed companies is that shares can be easily bought and sold. There are also strict information disclosure requirements. Oh the other hand, if you investing in private companies you don’t have these advantages. Consequently, returns required on private companies are typically higher than returns required by investors in public companies.
In addition, the smaller the size of the company in terms of earnings, the more closely it is held by the current owner operators, then the higher the risk and so the higher return required.
Factors that drive the risk and return
Some key factors that drive risk in a business include:
- Contracts with customers and suppliers. Long term contracts with customers provide security of earnings. Exclusivity agreements with suppliers, provide a competitive advantage.
- The threat of new competition or reductions in competitors
- Changes in technology and threats to (or opportunities for) the business
- Changes in legislation – restricting or improving the market, eg. changes to environmental legislation
- Changes in customer’s habits and culture
- Any limiting factors, such as limited natural resources, skilled labour or production capacity
The discount rate is a function of risk. The higher the risk of the investment, the higher return the investors demand, which implies a higher discount rate.
Simon is a CA Accredited Business Valuation expert, Chartered Accountant and a Certified Fraud Examiner. Simon specialises in providing forensic accounting and valuation services. Prior to founding Lotus Amity, he was a Forensic Accounting partner with BDO Australia and led their National Forensics practice. He has worked as a forensic director for a major offshore forensic accounting practice which included assisting in multi-billion-dollar litigation in relation to giant Bernie Madoff Ponzi scheme. Simon provides valuation services in disputes, for raising finance, for restructuring, transactions and for tax purposes.
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