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The Specific Company Risk Premium
A New Approach
The business appraisal process
involves a great deal of science in arriving at
an indication of value, but also requires some
art on the part of the appraiser. The science
of business appraisals involves the approaches
and methodologies used in arriving at a value
conclusion. The market approach using the
direct market data method requires statistics
from actual transactions in the market in order
to apply an appropriate multiple to the subject
company’s selected earnings, revenues, or other
income stream. The single period capitalization
method and the multi-period discounted earnings
method under the income approach require
calculated inputs for the appropriate earnings.
In addition, data directly observed in the
market place such as the risk free rate and the
equity risk premium (obtained from Ibbotson
Associates) are required to build up the
company’s appropriate cost of equity and
discount rate.
Though many of the required inputs
for company valuation are available from third
parties, there are certain elements in the
valuation process for which the appraiser must
rely on experience and subjective judgment.
Though various studies have quantified
marketability discounts and discounts for lack
of control, the appraiser must utilize
experience in conjunction with the empirical
data to determine the appropriate marketability
discount for a specific company. The most
obvious example of the art involved in business
appraisal centers on the specific company risk
premium. Given that errors in the specific
company risk premium may have a significant
impact upon the value indication, it is crucial
that business appraisers be keenly aware of the
ramifications their selection of this risk
premium may have upon the valuation process.
The lack of empirical data regarding the
specific company risk premium necessitates the
development of a model or factor analysis to
estimate the appropriate premium and to better
justify the appraiser’s selection of this
premium.
Recall that the total risk associated
with an investment is comprised of unsystematic
risk and systematic risk. Systematic risk, such
as that associated with the market,
macroeconomic factors, or equity investments, is
the risk that is unavoidable and impacts all
investments to varying degrees. This risk
cannot be reduced through diversification of a
portfolio. In the business appraisal process,
this risk is represented by the equity risk
premium and the small company size premium that
are added to the risk-free rate in building the
appropriate discount rate. Unsystematic risk,
on the other hand, is the risk associated with a
particular investment which can usually be
reduced or virtually eliminated by holding a
diversified portfolio. However, given that the
owner of a privately-held business likely does
not achieve the same degree of diversification
as an owner of a portfolio of publicly-traded
stocks, the unsystematic risk associated with
the privately-held company is usually not
eliminated. For valuation purposes, the
firm-specific risk or unsystematic risk
associated with a privately-owned company is
represented in large part by the specific
company risk premium. Once estimated by the
appraiser, the specific company risk premium is
added to the risk-free rate and the estimate of
systematic risk to yield the company’s required
return or cost of equity. The following table
illustrates the build-up of the cost of equity
for a privately-held business for valuation
purposes.
The risk-free rate along with the
equity risk premium and the small company size
premium are readily obtained from Ibbotson
Associates which publishes its annual valuation
edition of Stocks, Bonds, Bills & Inflation
statistics. Based on the 2003 edition, the
estimates of these figures are as presented in
the following table.
However, there is no empirical data or
observable data regarding the specific company
risk premium to assist the appraiser in
analyzing the appropriate increment to the
discount rate to account for firm-specific
risk. In Valuing a Business: The
Analysis and Appraisal of Closely Held Companies,
Fourth Edition, Shannon Pratt, Robert Reilly,
and Robert Schweihs state the following with
respect to the investment specific risk:
…the unsystematic risk specific to the subject
business or business interest still remains
largely a matter of the analyst’s judgment,
without a commonly accepted set of empirical
support evidence. The analyst will base this
judgment on factors…such as financial statement
and comparative ratio analysis and the
qualitative matters to be considered during the
site visit and management interviews. However,
after carefully analyzing these elements of
investment-specific risk, there is no specific
model for quantifying the exact effect of these
factors of the discount rate. The analyst must
depend on experience and judgment in this final
element of the discount rate development, but
should explicitly describe the factors that
impact this final element.
It should be apparent that the lack of
any guidelines to estimate the specific company
risk premium presents significant challenges to
the appraiser in conducting the valuation.
Though an appraiser may have performed hundreds
of valuations, the specific company risk premium
for one company (in the textile industry for
example) is not necessarily representative of
the appropriate specific company risk premium
applicable to another firm (in the shipping
industry for example). Therefore, experience is
not necessarily enough for an appraiser to rely
upon in estimating the specific company risk
premium, unless the appraiser has performed a
number of valuations on other privately-held
companies in the exact same line of business.
As a result, the estimation of the specific
company risk premium is nothing more than the
appraiser’s educated, best guess of an
appropriate premium.
While the estimation of the specific
company risk premium may seem a relatively minor
issue, errors in estimating the appropriate risk
premium may have a significant impact upon the
valuation estimate. As a result, this may
result in an inflated value estimate for a
business which may lead the client to overpay
taxes, or vice versa. For example, assume that
the company being valued is expected to generate
free cash flow to equity of $100,000 per year in
perpetuity with zero growth. Based on the risk
premium data from Ibbotson Associates previously
discussed, the cost of equity or the discount
rate with no specific company risk premium is
21%, which results in a capitalization multiple
of 4.8. Based on this, the company is valued at
roughly $476,000. The following table provides
various value estimates based on an incremental
specific company risk premium.
Though the change in value resulting
from a 1% increase or decrease in the specific
company risk premium may not be significant, the
difference resulting from a 5% change in the
risk premium is more noticeable. The following
chart illustrates the change in the value of the
firm resulting from incremental 5% changes in
the specific company risk premium, recalling
that there is an inverse relationship between
the discount rate and the value estimate of the
firm.
As illustrated, the valuation with a
5% specific company risk premium as compared to
no risk premium is roughly 19% lower. As the
specific company risk premium increases from 5%
to 10% and from 10% to 15%, the value estimates
decrease by 16% and 14%, respectively. These
dramatic changes in value resulting from
inaccuracies in the estimation of the specific
company risk premium further strengthen the case
for a model to support the appraiser’s selection
of an appropriate firm-specific risk premium.
The case is further supported by the overriding
need for the factors used by an appraiser to be
credible – for example, in an expert witness or
fairness opinion situation, With little or no
support for the appraiser’s estimation of the
specific company risk premium, a skilled
attorney could relatively easily discredit the
appraiser and the valuation. It would,
therefore, be prudent for business appraisers to
have empirical data, a model, or a factor
analysis in order to reinforce the estimate of
the company specific risk premium.
A factor analysis would seem the
likely choice in supporting the appraiser’s
selection of a specific company risk premium for
two reasons. First, there is no database from
which to draw statistics regarding the specific
company risk premium used in various
valuations. Second, attempting to create a
model would likely require a great deal of
historic data for each company in order to
perform a regression analysis. Since there is
likely not enough historic data for a
privately-held company to perform a regression,
creating a model may not be possible or
appropriate. Therefore, a factor analysis would
be the logical choice in assisting the appraiser
in developing an appropriate specific company
risk premium.
The first step in developing the
factor analysis is to determine the appropriate
factors that impact the specific company risk
premium. Some of the factors that are likely to
influence the specific company risk are:
Business Risk, Operational Risk, Financial Risk,
Market Risk, Economic Risk, Industry Risk,
Profitability, Revenue Growth,
Management/Corporate Governance, Competition,
Customer Concentration, Diversification, and
Employee Relations. For simplicity, we believe
that only the most influential factors that may
be quantified should be included in the factor
analysis. Furthermore, we believe that the
factors should be equally weighted as there is
no method to quantify which factors would have a
greater impact or to justify any other weighting
scheme. Each factor will then be rated from
zero to ten with zero having no impact on the
risk premium and ten having the highest impact
upon the risk premium. With this approach,
though it is unlikely, a firm could
theoretically have no specific company risk
premium based on the factor analysis indicating
a highly stable, low risk profile firm. On the
other hand, a firm could have a specific company
risk premium of ten, which added to the
risk-free rate, the equity risk premium, and the
small company size premium may result in a cost
of equity or discount rate in excess of 35%.
This would likely be indicative of a young, high
risk firm that requires a rate of return
comparable to a venture capital investment.
Having established the rationale
for the factor analysis, the following sections
discuss the reasoning behind the seven factors
and ratings that we have selected. The factor
analysis table is included at the end of this
article for reference purposes regarding the
ratings used for each factor.
Revenue Growth
Although in some cases, particularly
in early-stage companies, revenue growth and
risk are positively correlated, there is
typically an inverse relationship between
revenue growth and the appropriate specific
company risk premium. As revenue growth of the
firm increases, firm risk typically falls as a
result of greater prospects for increased
earnings, dividends, etc. Therefore, a rating
of ten implies declining revenues with a rating
of zero indicating annual revenue growth of 8%
and above. We recommend using either the
compound annual growth rate over the last three
to five years or the forecasted revenue growth
rate in determining the appropriate rating.
Financial Risk
There is a direct relationship between
the financial risk of a firm and the specific
company risk premium. In measuring financial
risk, we have selected the total debt ratio of
the firm. Increased leverage in a firm’s
capital structure indicates that the threat of a
possible bankruptcy increases as well. In our
factor analysis, a firm with no leverage in the
capital structure for the most recent fiscal
year receives a rating of zero with a firm
having a total debt ratio above 90% receiving a
rating of ten. We suggest using the most recent
fiscal year-end balance sheet for this analysis,
unless there is a significant interim or
projected change in the firm’s capital
structure.
Operational Risk
Operating leverage, defined as the
ratio of fixed costs to sales, is an indication
of a firm’s risk of not meeting its fixed costs
in the event of a decline in sales. There is a
direct relationship between the operating
leverage of a firm and the specific company risk
premium. As the ratio increases, indicating a
higher level of fixed costs to sales, the risk
of the firm not being able to meet its fixed
cost obligations rises, thus increasing the
possibility of bankruptcy. In our analysis, a
firm with no fixed costs would receive a
weighting of zero with a firm having fixed costs
in excess of 90% receiving a rating of ten. In
the absence of a major cost cutting initiative
to be implemented in the foreseeable future, we
recommend using most recent fiscal year data for
this calculation.
Profitability
A firm’s profitability is a clear
indication of the level of risk associated with
that firm. More profitable firms clearly have a
lower level of risk than unprofitable firms,
ceteris paribus. Therefore, firms with a higher
net profit margin will receive a lower rating
risk in the factor analysis, thus reducing the
specific company risk premium. Firms with net
losses will receive a rating of ten. For stable
firms, we suggest using the most recent fiscal
year net profit margin on an adjusted basis for
analysis. For firms with erratic earnings or
profitability, we suggest using a three or five
year average of the net profit margin on an
adjusted basis or the projected net profit
margin if the erratic behavior of the earnings
is anticipated to subside. If the earnings are
not adjusted for the previous three to five
years, the most recent fiscal year performance
is the appropriate figure to use.
Industry Risk
A firm’s performance relative to the
industry performance is an indication of the
industry risk associated with a firm. Industry
risk is the risk specific to the industry which
would be expected to impact all firms in the
industry. However, if one firm outperforms the
industry, the impact of this industry risk is
likely to be less on the firm than on those
firms that do not outperform the industry.
Based on this, we believe that a ratio of the
firm’s performance to the industry performance
is an appropriate measure of risk. The Return
on Asset ratio measures the ability of the firm
to generate revenues with its asset base,
ignoring the financing structure of those
assets. Dividing the firm ROA by the industry
ROA produces a ratio indicative of the firm risk
relative to the average industry risk. As this
ratio increases, the specific company risk
premium will then decrease. A rating of ten is
assigned to those firms with a negative ROA
while a rating of zero is assigned to those
firms with a ratio greater than 1.8.
Economic Risk
Our measure of economic risk is based
on the same premise as the measure of industry
risk. Instead of the industry average ROA, for
this metric we use the most recent annual GDP
figure. This suggests that economic risk for
the firm is a function of its ability to
generate a return on its asset base relative to
the ability of the overall economy to generate a
return on its total asset base. The upper limit
for the GDP figure is likely to be 6%-8%
(nominal) based on estimates of the long-run
sustainable growth rate of the U.S. economy.
Therefore, if a firm has a low ROA relative to
economic growth, the specific company risk
premium increases and vice versa.
Customer Concentration
If a firm derives a large percentage
of annual sales from a few customers, the risk
to the firm increases, as losing a major
customer and source of revenues may have a
significant adverse impact upon the performance
of the company. As the customer concentration
(measure by sales of top five customers divided
by total sales) increases, the specific company
risk premium should increase as well. If the
company’s top five customers account for more
than 90% of total annual sales, a rating of ten
is appropriate. A rating of zero is appropriate
if the sales of the top five customers account
for less than 1% of total annual sales. We
suggest using the most recent fiscal year sales
figures unless there is an anticipated change
for the future (i.e. the loss of one of the top
five customers in the next year).
While this factor analysis is not
perfect, it represents an attempt to provide the
business appraiser with a method of reinforcing
the estimation of the specific company risk
premium. As previously discussed, the
estimation of the specific company risk premium
is solely a matter of the appraiser’s subjective
judgment, and an incorrect estimation of this
risk premium may have a significant impact upon
the value estimate of the privately-held
business. Therefore, there is a need for a
quantifiable analysis for the specific company
risk premium to further strengthen business
valuations and to limit the appraiser’s exposure
to attacks on credibility and results. The
factor analysis present herein, though not
perfect, provides a foundation for business
appraisers in developing the specific company
risk premium.
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