There are no better indicators of what a business is worth than its earning prospects and risk profile. Savvy investors analyze business opportunities by doing careful forecast of their income. But forecasts and money in the bank do differ in one key respect – there is a risk that the business may not live up to your expectations.
Hence, business value depends upon its risk assessment. Well-known income-based business valuation methods, such as the Discounted Cash Flow, let you account for the business risk directly – via the appropriate discount rate.
Alternatively, you can use the capitalization rate to factor in the company risk when valuing a business. The direct capitalization business valuation methods, for example the powerful the Multiple of Discretionary Earnings, let you do just that.
Since the discount and cap rates are related via the business growth rate, you can use both business valuation techniques.
Given the importance of company risk assessment via the discount and cap rates, how do you determine these important factors?
Do they depend on the economic conditions? Also, do the discount and cap rates change over time?
Each company has its own risk profile. Not surprisingly, the discount and capitalization rates for each business will differ. Here is how the discount rate is determined using the famous Build-Up formula:
- Start with a risk-free return.
- Add a risk premium for equity investment.
- Add another risk premium for small company size.
- Add a risk premum for the industry the company operates in.
- Finally, add the company-specific risk premium.
Risk-free investments do pay!
Risk-free return means no risk of default. Investors like to use the current yields on long-term government debt obligations, such as the US Treasury bonds, as a measure of the current risk-free rate of return.
Even the most diversified stock investment portfolio is risky
You can examine the prevailing rates of return across the stock market to determine the additional returns the investors get for putting their money into publicly traded companies. This additional return is the premium required to keep investors interested in these companies, given their risk.
Small companies are riskier still
Small firms are seen as more risky than large ones. Again, you can study the market to see that the so-called “small cap” companies tend to generate higher returns. The additional return is the company size risk premium that can be used in the Build-Up formula.
Business risk varies by industry
Each industry has a set of unique risks that companies must overcome to be successful. You can study the returns in the specific industry in comparison to the stock performance across the entire market. The difference in the returns is the industry risk premium. Note that this number can be negative – if the industry is seen as less risky than the market as a whole.
Each company has its own risks
No company risk assessment is complete without analyzing its own set of strengths and weaknesses. Decisions made by the company management such as financial leverage, entering and exiting certain markets, hiring skilled staff, and making critical investments affect the company’s income prospects and its risk. Your goal here is to assess how these factors translate into the company-specific risk premium number.
Your business risk changes over time – so does business value
If you glance at the Build-Up formula elements, it is clear that the overall discount rate will vary over time.
Risk-free returns vary based on the prevailing interest rate climate. Public company fortunes change, so do their returns. Small companies may become a haven for investment money in some markets.
Industries go through cycles of expansion and contraction. And, of course, strategic decisions in the company itself affect its own risk.
It is a good idea to revise your risk assessment at least annually. This helps smooth over any transient effects in the markets and lets you spot important trends.
Tools to calculate the discount and cap rates
ValuAdder 4.0 business valuation software contains several tools you can use to assess the risk of any company.
Using the latest market data, ValuAdder financial recasting worksheets let you build up your discount rate, calculate your capitalization rate and account for the various business financing scenarios – with different costs of debt and equity capital.