Should your business valuation consider company specific risk premium?
If you look at either the build-up or CAPM cost of capital models for discount rate calculation, the elements can be broken down into two major groups: systematic and unsystematic risk.
Systematic risk is unavoidable, you cannot diversify away from it as it affects the entire market. Unsystematic risk, on the other hand, is something the investors should handle by diversification. In other words, you should not expect additional returns just because you put all your eggs in one basket.
Yet this is precisely what many small business owners do. Their company is the major source of their investment and commands their undivided attention to run successfully. Even if the public capital markets are silent about the company specific risk, it is quite real.
In the eyes of a financial expert, company specific risk premium or CSRP for short, cannot be observed. That’s because public company investors do in fact diversify from risks inherent in any particular company or asset. But if your company is more or less risky than the market as a whole, you are incurring the additional risks every day.
So a realistic approach when valuing a private firm that is expected to continue in private ownership is to account for this additional risk element. The typical factors that contribute to make a company more or less risky are these:
- Earnings growth expectations: is the firm likely to be more or less profitable than its industry peers?
- Financial leverage: can the company service its debt without financial failure?
- Operational risk: can the operations be successfully scaled to meet the market demand and sustain growth?
- Profitability: will the firm be able to generate profits in line with investor expectations?
- Customer concentration: does the company depend on just a few customers for most of its sales?
- Competitive position: does the firm operate in a well defended market niche or can it be easily replaced by competitors?
- Management and key staff: what is the quality of the management team when compared to the industry peers?
Successful private companies with smooth, predictable earnings operating in a market niche they can defend skillfully tend to be less risky. On the other hand, a firm that is likely to experience competitive headwinds from well funded, large companies without a strategy of defending its turf is likely to be far more risky. The way to assess this level of risk is to analyze the company specific risk factors and adjust your discount and capitalization rates accordingly.