Your discount rate includes company-specific risk!
You will hear this advice time and again – if you need to get a solid business valuation, roll up your sleeves and use the Discounted Cash Flow method.
Used by professionals to value businesses small and large, this income-based business valuation method has become the de facto standard for precise business valuation.
When you use this powerful method in ValuAdder, you need to select your discount rate. This key input reflects the risk of the business being valued.
A straightforward way to determine the discount rate is to use the Build-Up procedure. Basically, you start with a risk-free rate of return and then add to it the so-called premia which reflect various types of risk taken when owning and running a small business. The idea is that business owners take a risk and, like all investors, should receive an appropriate return.
There is one difference between a typical investor and a small business owner – diversification. Investment theory tells us that we should use diversification to minimize risk. Put differently, the market place does not reward investors who put all their eggs in one basket by investing in one or just a few companies. This is known as unsystematic risk.
Yet, most small business owners do just that – by investing heavily in the businesses they own. Hence, there is an additional risk element you need to account for when valuing what a small business is worth. It is the company-specific risk.
Assessing this type of risk is trickier than it seems. You can estimate the risk of investing in publicly traded companies, companies of certain size or firms doing business in a specific industry. So far, so good. But the public capital markets are silent on the company-specific risk since they offer no reward for investment in any specific company. Hence, you must look elsewhere to assess this additional risk.
Theories on this subject abound. But one thing is clear – as a small business owner you incur the opportunity cost in owning a business. By putting your time and effort into your business, you forgo other, potentially rewarding investments.
This opportunity cost should lead to additional returns to make economic sense. Hence, you can assess the company-specific risk as the additional return you require for actively managing the business, something a typical public company investor would not do.
The additional return required depends upon the company risk profile and its owners’ perception of the risks involved. You can compare your firm against rivals of similar size who compete in the same industry. If your company is more risky than the competitors, then additional return is required. On the other hand, if the company operates in a protected market where it commands superior earnings and expects to enjoy such competitive advantages into the future, its specific risk may be negative.
Typically, company-specific risk premium values range within a few percentage points. Depending on the company’s size and industry, this can make a significant difference to its value.