There are two categories of equity risk: market-risk and firm-specific risk. The exposure to those risks will depend on the nature of the firm’s cash flows and also the ability of an investor diversify those risks.
Equity risk is defined as the variance between the expected return and the actual return provided by an investment. The greater the variance in returns the greater the risk.
Types of equity 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 one or a few businesses. 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 fails, or underperforms
- Competitive risk is the risk 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 equity risk
An investor may choose to invest all their wealth into one business. In which case, the investor exposes themselves to both the market risk and the firm-specific risk of that business.
Alternatively, 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
Diversified marginal investor
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 – the risk that cannot be diversified.
Consequently, a diversified investor will be prepared to pay a higher price for an investment in a company than a non-diversified investor (assuming both investors have the same expectations about future cash flows to the firm).
A significant proportion of investments in global stock markets is by institutional investors, who hold diversified portfolios. Further, share brokerage costs are minimal, and stocks can be traded very easily bought and sold, so an individual investor can create a diversified portfolio easily and at a lost cost.
The upshot is that market prices of stocks markets are deemed to reflect the value to diversified investors. Stock market prices reflect only market-risk.
Investors in private businesses
Private investors who buy private companies, typically invest a significant percentage of their wealth in the company. The investors are unlikely to be able to hold a diversified portfolio. Consequently, investors in private business are often unable to diversify away firm-specific risk.
The costs of buying and selling an investment in a private business are significant. A buyer and seller in a private company transaction have to pay for lawyers and accountants, and the seller often incurs a substantial business brokerage fees.
An investor in a listed company can sell their stock immediately. An investor in a private business has to spend the time to find buyers for their shares.
Take two identical businesses, A and B; A is listed on an exchange and B is private. Business A will have a higher price as an investor can diversify away firm-specific risk, and the investment is relatively liquid.
Simon is a CA Business Valuation specialist, Chartered Accountant and a Certified Fraud Examiner. Simon specialises in providing valuation services. Prior to founding Lotus Amity, he was a Corporate Finance and Forensic Accounting partner with BDO Australia. Simon provides valuation services in disputes, for raising finance, for restructuring, transactions and for tax purposes.