Said simply, the value of any business is the present value of its expected cash flows. In order to convert these estimated cash flows to present value, they must be discounted using a required rate of return. The discount rate used should be commensurate with the risk of achieving these expected cash flows. It represents an “opportunity cost of capital,” or the expected market-driven yield foregone by investing in your business rather than other investments that are comparable in terms of risk. While there is a multitude of available data that can be leveraged in determining certain inputs in the build-up of an appropriate discount rate, estimating a company-specific risk premium is one of the most subjective aspects of this process and there are a number of factors (both quantitative and qualitative) that should be taken into consideration.
The discount rate used to value a business should incorporate a “risk-free rate,” or the rate of return available in the market on an investment free of default risk and a premium for risk, which includes both systematic and unsystematic risk. Systematic risk is common to all risky businesses and cannot be eliminated through diversification. Unsystematic risk is the risk specific to an individual business that can be avoided through diversification. While there are several sources of data that can be used to estimate systematic risk factors, such as the equity risk premium and size premium used in the build-up model, estimating company-specific risk reflecting unsystematic risk is largely a matter of judgement.
While the use of judgement is key in estimating company-specific risk, both quantitative and qualitative analyses are often used. Quantitative analyses may involve comparing your company to its industry and/or a set of guideline public companies from both a financial and operating performance perspective. This often includes ratio analyses, such as profitability (e.g. return on assets, etc.), asset utilization (e.g. accounts receivable turnover, etc.) and short-term liquidity risk (e.g. current ratio, etc.). Qualitative analyses can be based on a number of factors that affect the risk of your company, including, but not limited to, the following:
- Management depth and expertise
- Leverage and access to capital
- Quality and volatility of financial information
- Customer concentration, pricing leverage, loyalty and stability
- Level of current and potential new competition
- Supplier concentration and pricing advantages
- Product/service diversification and life cycle
- Geographical distribution, location and demographics
- Availability of labor and employee stability
- Internal and external culture
- Economic and political factors
- Industry and government regulations
- Fixed assets’ age and condition
- Strength of intangible assets
- Distribution systems
- IT systems and technology life cycle
- Legal issues
- Internal controls
- Currency risk
For example, if your business’ competitive position in the marketplace is lacking, or if there is extreme volatility in your company’s historical and/or projected financial information, the inclusion of a company-specific risk premium in the discount rate used to value your business may be warranted.
The magnitude of the company-specific risk premium utilized in estimating your company’s discount rate must be supported by the data gathered and analyses performed. However, there are no widely accepted models or formulas used to translate the results of these analyses into an exact, quantifiable premium. Rather, it is based on judgement regarding your company’s results compared to those of guideline public companies and/or the broader industry.
Estimating a company-specific risk premium is one of the most difficult aspects of any business valuation in normal circumstances, let alone in the middle of a pandemic. Practitioners who rely on their own judgement in quantifying a company-specific risk premium should be prepared for challenges and must have solid documentation and support for their conclusions.