risk /rɪsk/ — a situation involving exposure to danger, from Italian risco “danger”
Business value is a function of the future expected cash flows from the business and the risk attached to those cash flows. The value of a business is the present value of future cash flows discounted back, using a discount rate, to a value today.
The discount rate reflects the return investors, and financiers require to compensate them for that risk. The riskier the cash flow, the higher the return demanded and the lower the business value.
Companies raise finance from a variety of sources which are either equity-based, debt based or a hybrid of the two. A company’s overall discount rate (cost of capital) is the combined rate of the return required by equity holders and debt holders.
The business valuer calculates a cost of capital by weighting the equity and debt returns according to the respective amounts of equity and debt.
Typically, the least risky investments are treasury bonds. The government guarantees you will get your money back.
The key risk would be if the government got into difficulty and defaulted on the debt. Treasury bonds in stable countries are low risk. The current Australian ten-year bond rate is 2.63%; this is an indicator of a “risk-free” rate.
All other investments require a return above the risk-free rate to reflect the additional risk to the investors.
Cost of debt
The cost of debt to a company reflects the default risk. Default risk is the perceived risk that the company may be unable to repay interest and or debt repayments.
The more debt the business has relative to equity and the less cash it generates to cover interest payments, the higher the default risk and the higher the return demanded by lenders.
Cost of equity
Equity investment represents both a threat and opportunity. There is the opportunity for equity investors to receive a return above the expected return, but a threat that it will be less.
The cost of equity reflects the risks investors perceive in expected earnings and their ability to diversify some of that risk. Equity risk incorporates market risk and firm-specific risk.
When the economy weakens all, or most businesses are affected. Some industries, such as mining, feel the economic downturn more and some industries, like food retailing, feel the effects less. This risk is the market risk.
Certain risks will only affect particular businesses and industries. This risk is known as firm-specific risk. Firm-specific risk includes project risk, competitive risk and sector risk:
- Project risk is the risk that investments in a new product, service or market fail, or underperforms
- Competitive risk is the threat that new entrants or new technology lead to a loss of customers and demand
- Sector risk includes risks that affect all firms in the sector, for example, changes in specific industry regulation
Diversifying firm-specific risk
An investor may choose to invest their wealth into a large number of very different investments. That is they create a diversified portfolio. Through diversification, firm-specific risk exposure can be reduced, for two key reasons:
- Limited exposure — the diversified investor only has minimal exposure to any one business; consequently, should an investment falter, there is limited impact on the overall portfolio
- Offsetting — investments can go up or down in any period due to company-specific risk, and in a broad portfolio these movements will cancel themselves out; so for example, if firm A’s value reduces due to the entrance of a new firm B, providing you have equal investments in both, the effect should be neutral
On the assumption that most investors will rationally seek to diversify away firm-specific risk, then the only equity risk those investors are concerned about is market-risk. Consequently, stock market prices are theoretically assumed to reflect only market-risk.
Private business valuation
Unlike investors in stocks, investors in private businesses typically invest a large portion of their wealth in the business, and as a result, they can not diversify away firm-specific risk.
A critical role of the business valuer is to identify the key risks attached to the future cash flows of the business and the ability of investors to diversify away risk.
When making comparisons with other company valuations, the business valuation expert needs to compare relative risk profiles and adjusts the value accordingly.
Simon is a Chartered Accountant Business Valuation specialist. Simon specialises in providing valuation services. Simon provides valuation services in disputes, for raising finance, for restructuring, transactions and for tax purposes.