When comparing two companies, it may seem very logical that a business that makes more money is worth more than another business with smaller earnings. However, business’ are often exceedingly complex and need to be examined in greater detail.
Would you pay more for Company A that generated $500,000 last year or Company B that generated $600,000 last year? What if Company B derived 75% of its revenue from a single customer? Or, what if Company B was in an industry on the verge of collapse?
Posing these questions makes it clear that we need to look at more than just a company’s bottom line when determining value. Risk may seem like a difficult thing to quantify, as people generally group things into two buckets, “risky” or “not risky.” Quitting a steady job to start a company or riding a bike without a helmet may be labeled “risky” by some people. It is often not necessary and virtually impossible to quantify how “risky” these activities are.
When determining the value of a business, however, the valuator often must quantify the business’ risk with a number known as the risk rate.
The two primary components in nearly any business valuation approach are:
- Benefit Stream (i.e. how much money does the business make?)
- Risk Rate (i.e. how risky is the business?)
The interaction between the benefit stream (often net income or cash flow) provided by a business and the business’ risk drives its valuation. The benefit stream and risk rate are measured and utilized in determining the value of business interest using many approaches to business valuation.
The risk rate, which is often referred to as the cost of capital or discount rate, is a measure of the risk associated with investing in a business. The risk rate is unique and specific to each business and is essentially a measure of the required rate of return that an investor would need to be enticed to buy an ownership interest in the business. The higher the risk rate, the riskier the business, and the lower the value. The risk rate that is used in the computation of business value in many cases is the weighted average cost of capital.
Weighted Average Cost of Capital (WACC)
A business’ weighted average cost of capital is a formula that takes into account its cost of raising money through both debt and equity.
Cost of Debt
A business’ cost of debt is generally its cost to borrow money from lenders, which equates to the interest rate that it pays on debt borrowings. In a simple example, Company A borrows $1 million from Federal National Bank and pays interest at 6% on this loan. Company A’s cost of debt would be 6%. As stated previously, companies are complex and often have multiple loans at varying interest rates. The interest rates on all debt are considered when determining a company’s cost of debt. Companies could also have no debt and an assumed borrowing rate may need to be used to determine the cost of debt in the WACC formula.
Cost of Equity
The second component of WACC is generally not as easily grasped. In most cases, there is not a stated cost of raising equity capital. The cost of equity is not included in an agreement such as a loan agreement that explicitly states the interest rate that is being charge. The cost of equity is often determined using a buildup method, where additional risk is added for specific attributes of the company. The following is the general formula used to calculate the cost of equity:
Cost of Equity = risk-free rate + equity risk premium + size premium + specific company premium
The risk-free rate is essentially the starting point for all investments. From there, specific premiums are added to reflect the risks of the business.
After the risk-free rate, a premium is included for investing in equity. The equity risk premium is often derived from public market data and reflects the additional return that investors obtain by investing in equities.
The size premium is then tacked on, as investing in smaller companies requires additional return for investors to compensate for risk. The size premium is essential in valuing small, privately held business interests as the equity risk premium is calculated based on the returns of large publicly traded companies. There are additional risks associated with investing in a privately held business that can be significantly smaller than even the smallest publicly traded company. Investors need to be compensated for this risk as reflected in the size premium.
The last premium that is included in the formula is often the most subjective and can be highly scrutinized. The specific company risk premium captures the risks that are not reflected in any of the other premiums in the formula. The company specific risk premium often includes factors such as depth of management, importance of key personnel, stability of industry, and diversification of customer base. In the questions relating Company B in the opening paragraph, a 75% customer concentration or a faltering industry would increase the specific company risk premium and drive down valuation. Although there is no clear answer to the questions posed, it is evident that we must take into account the specific risk factors of the business when determining value.
Risk is as important as cash flow when determining business value and careful consideration must be taken to quantify that risk. When examining a business to estimate its value, or while assessing your own business as an owner, it is imperative to consider the effects of risk on value. If you interested in determining your business’ valuation contact the DKB team today!