How Risk Applies to Business Valuation
Almost everything we do has risk. And as we have defined in an earlier post:
“Risk measures an event which causes an outcome different from my expectation. With every event, there is a consequence and a likelihood of it occurring.” ~Bruce Everitt
This means that every event has a consequence. Taking that risk should have some form of reward. If you read the earlier post and remember the example, the risk is getting caught taking a cookie. The consequence is loosing a night of TV. The reward is enjoying a freshly baked chocolate chip cookie. This same risk reward decision can be applied to the purchase of a business.
For the purpose of valuation, there are two ways we will be looking at the risk reward and how it impacts business valuation. First, the most common approach is to consider what return you will get for investing in an investment. The second approach to consider is what you are prepared to pay to get a certain stream of cash flow in the future
What Return Will I Get For The Risk I Take
If I had $100, and I wanted to make an investment, I have some decisions to make. I could invest that $100 into a relatively risk free asset, something that has some guarantee of my future return. Let’s consider an US Government Bond. This type of investment pretty much guarantees that not only will I get my $100 back after my investment horizon, but pretty much guarantees that I will get some sort of reward for making the investment in the first place. As of writing, the US Treasury Bills are paying next to nothing for a 1 year investment. For our example we will use a fictitious 5% 1-year return. This means this type of investment would return to me $105 in 1 year’s time. I have next to no risk of “not getting $105”, and the risk of “getting less than my original investment” of $100 is non-existent. In this case, my return potential is 5%.
I also have the choice of investing my $100 into a more risky venture such as a private company. There is a greater risk associated with this investment because there is no guarantee I will make a return, let alone a guarantee I will get my $100 back in 1 year. For our example, let’s say that there is a possibility I will get $120 back in 1 year, but also a chance of getting only $80. In order to get a chance to get $120 I need to take the risk of getting less than my original investment back. In this case, my return potential is 20%. There is a higher reward and higher risk.
What Will I Pay For The Risk I Take
The second approach to consider is what I am prepared to pay to get a certain stream of cash flow in the future. If we look at the risk free investment above, I am getting $5 each year for a $100 investment, and next to no risk involved. But how much will I be willing to pay for $5 of cash flow from a risky investment? An investment which can’t guarantee I will get $5 per year.
If we look at the risky investment above, I need a 20% return potential to make that investment. Or in other words, in order for me to take the risk of potentially loosing some of my investment I need to have the potential of a 20% return.
With a cash flow potential of $5 per year, I am prepared to invest $100 if it is risk free, but if it is risky, I am prepared to invest only $25. How do we get this figure? I need a 20% return for investing in a risky investment. If I invest $25 into a risky investment with a 20% return, I would get $5 ($25 x 20%) per year of potential return. Another way to find this is taking the cash flow potential ($5) and divide it by your return expectation (20%). The result is $25.
This second concept is the most important for business valuation. If your company offers up $5 per year of potential cash flow and a competitor is also offering up $5 per year of potential cash flow, who is going to get the most money for their company? The company with the lowest risk profile. If your company is considered less risky, the investor is prepared to accept a lower potential return because there is more certainty around the cash flow. By accepting a lower potential return, they will be willing to pay more for the same $5 of potential cash flow then they would for a company that has less certain returns and is considered more risky.
If looking at the same reward, why would any one want to take on the riskier of two options?
Copyright 2012. Bruce Everitt. All rights reserved.
Bruce Everitt, a CFA® charterholder, is the Principal of Willo Consulting Group, and specializes in increasing business value for small and medium businesses around the world. www.willoconsulting.com
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