Risk and return go hand in hand when it comes to valuing a business. Every company must be able to attract and retain the needed capital in order to continue. The cost of capital is thus an important input in your business valuation.
Beta and systematic business risk
Beta, a key element of the capital asset pricing model, measures the so-called systematic risk of a given company. In plain English, a company’s beta indicates how well the company’s stock price correlates with the market ebbs and flows.
The market beta equals 1. Any business with a beta of 1 has the same level of risk as the overall equities market. In other words, the stock price moves up and down exactly with the changes in the broad stock market.
A company seen as a riskier investment will have a higher beta, as its stock price will fluctuate more than the market at large. A safer company has a lower beta. The investors tend to hold on to its stock longer and don’t drop it at the first sign of market volatility.
Risk-free return, equity risk premium and CAPM model
As you can see from the CAPM model, the company’s risk is the sum of the risk free rate of return plus the risk premium. The latter equals the product of the company’s beta and the equity risk premium. The equity risk premium represents the extra return the investors demand over and above a risk-free return on investments. Investors like to use the long term US Treasury coupon bonds for this.
Beta for private companies?
For public companies, whose stock trades on the open market, estimating beta is straightforward. If the company is privately held, historic stock prices are not readily available, so using betas of similar small public companies as a proxy is common.
When a beta is calculated for a public company, the correlation is established relative to a well known measure of the stock market. Typical choices are major indices such as Standard and Poor 500, or Morningstar US Market. Such broad indicators are all very good at predicting the overall market behavior, so the choice is up to you.
The key takeaway is no business operates in a vacuum. So a big part of your risk assessment is to see just how sensitive the company’s value is to the overall market.