If you are valuing a private company risk assessment is one of the key steps. Business value depends on the company’s earning capacity at a certain level of risk. The greater the risk, the greater the returns should be to justify the investment. This risk assessment is typically represented by the discount and capitalization rates you use in your business valuation calculations.
If you look at how the discount rate is determined, you will see a number of elements that make it up. One of these is the so-called company specific risk premium. This element of the discount risk is unique in private company valuations.
In fact, public company investors generally do not seek additional returns by investing in a specific company. What they do instead is diversify their investment by putting their money in a number of firms. Hence, for the purposes of valuing a public company, the company specific risk premium is 0.
The situation is quite different if you need to value a privately owned firm. Business owners, who often represent the major investors, are unlikely to be well-diversified. Instead, they tend to focus on the company often to the exclusion of other attractive investments.
With this level of focus comes additional risk. Unlike the other risk elements such as those associated with the company’s industry sector, this risk is defined by the company itself.
So to assess just how much additional risk the private company investors incur, you need to look at a number of factors:
- How the company’s revenue growth compares to its industry peers.
- What level of financial risk, such as raising debt capital, the company takes.
- How risky the operations are in general. Is the firm easy to run? Are major investments required for expansion?
- How profitable is the firm?
- Is most revenue derived from just a few customers?
- Does the company have a large number of products and services?
- Is the firm’s market large enough to support future growth?
- How strong is the competition?
- Does the company have a talented and effective management team?
- Are the employees skilled and motivated to do their jobs?
Depending on the answers to these questions, your company may experience additional risks that change the discount rate. Generally, the higher the risk across any of the factors the greater the company specific risk premium.
Are the above risk factors considered by public company investors? The answer is yes. However, most investors in public companies usually own just a small part of the business. Such minority owners cannot affect the decisions that a company must make in order to change these risk factors. Instead, the investors choose to reduce their overall investment risk by spreading their money across many public firms.
Put differently, the public capital market does not reward the investors for limiting their portfolio to just some companies.
In contrast, owner-managers of private firms have a lot of say in how their company is run. So they can make strategic decisions that affect such company specific risk factors. In other words, these investors usually have control over how much company specific risk exists.
ValuAdder includes a risk assessment tool that helps you estimate this type of business risk. You rank the firm across each of the factors above by assigning a risk weight to each. The result is a calculated company specific risk premium that is added on top of the other discount rate elements.