The questions of risk and return are at the foundation of business value. Think about it: if you are putting your hard earned money into an investment, you would like to see a handsome return. But there is no guarantee. In fact, depending on the investment, you could get the return you expect, get more or less, or even lose your entire investment. Happens every day.
What is at play here? In short, the investment risk, meaning that you may not see your return expectations realized in full measure or on time. So in addition to estimating the financial returns, your business investment considerations should include risk assessment.
If you take a closer look at public capital markets, where most investors play, you will notice that larger companies, involved in stable industry sectors, tend to produce lower returns. Lots of investors buy the shares of stock in these bellwether firms because they are seen as relatively more safe and predictable investments. On the other hand, smaller growing companies must generate higher returns for the investors to bother putting their money into these as yet unproven businesses.
Flight to quality in troubled times – risk free returns
If the clouds gather in the markets, investors tend to dump risky companies and run for cover. In dire times, this is usually government backed obligations, most notably US Treasury coupon bonds. Why? Because Uncle Sam never defaults on its obligations, and always pays interest as promised. You money is guaranteed to be safe.
So any business investment is about both the risk and return. The higher the risk of a company, the higher the return investors expect.
Discount and cap rates – measure of company’s risk
In business valuation, company risk is quantified in the form of two factors: discount rate and capitalization rate or cap rate for short. In the simplest form, business value is calculated as the ratio of its returns divided by the cap rate. If you want to be more precise, you can use the discounting formula to calculate the so-called present value of the business. It shows you how much all that money you expect to get from your investment over time is worth today. Thus you can figure out the value of a business, based on a stream of income to be received in the future.
Take a look at the Build-Up model of calculating the discount rate. It clearly captures the various parts of investment risk in one neat formula. You start with a risk free investment, such as the US Treasury bonds. Then add up additional risk components as you narrow down your investment options.
The takeaway is: every piece of investment action has a price and reward. If you do your homework investigating companies, you should be able to figure out how much risk you are willing to take to get the returns you want. This process is called business valuation.