The cliché: ‘the higher the risk, the higher the return,’ is technically not true, because the higher your risk, the higher your chances of investment failure. What the saying should be instead, is; ‘the higher the risk, the higher the demanded returns should be.’ The rationale for this is that the higher returns for successful riskier investments, must offset the investment failures of other, similar risky investments. In this article, we look at how such higher returns can be achieved and how risk and return work hand in glove when conducting a business valuation to determine what the underlying investment is worth.
How is higher return achieved?
You must actually demand a higher return for pursuing higher risk, as this is not necessarily automatically achieved. So, how are these higher returns then yielded? By picking investments with a lower value compared to their earnings. To explain what we mean, let’s look at a simple, practical example. Say you can invest in two investments, both of which will yield a return of R1,000 per year, but the one investment costs R5,000 and the other costs R10,000. Obviously, you’ll opt for the R5,000 investment as it costs less, but will yield the same return in Rands than the more expensive option. In terms of a business valuation, where two companies are forecast to achieve the same earnings over the forecast period, the company with the most risk of not achieving this forecast, should be priced lower to lock in a higher rate of return. There is thus clearly an inverse relationship between risk and value, because the higher the risk, the lower the value should be.
How is risk then applied in a business valuation?
When conducting a company valuation itself, how do you then actually apply risk in a rational and quantified manner to calculate the risk-adjusted value? We discuss this for both the “market approach” or the “income valuation approach.”
The market approach
The market approach is based on the earnings multiple method. This method calculates the enterprise value (EV) by applying a multiple to the earnings before interest, taxes, depreciation and amortisation (EV/EBITDA, or when ignoring depreciation and amortisation then EV/EBIT). There are two main disadvantages to this approach. Firstly, it incorporates complex information into a single multiple factor, without sufficient quantification. Secondly, the risk and growth prospects of your peers, as reflected in their respective multiples, are used as a point of departure, and from there it is adjusted for your own specific risk and growth prospects. The different risk and growth profiles are seldom analysed and the adjustment to the average multiple is mostly highly subjective.
The income valuation approach
The income valuation approach is a more nuanced and detailed approach which sets out how the value is constructed in a much more logical and systematic manner. This approach includes the use of the discounted cash flow (DCF) method, as well as the discounted dividends method (DDM). The approach is premised on the theory that one can determine what your business is worth, by predicting future expected returns and then discounting them back to a net present value. In such an instance, the discount rate is priced for risk, which basically means the higher the risk, the higher the discount rate will be. And the higher the discount rate, the lower the value. Thus, once again, there is that inverse relationship between risk and value, as higher risk equates to lower value. By extension, investing at a lower value then also means your returns will be higher, as the forecast returns remain the same.
How this risk is priced, is a topic for another article, so do keep your eye on our website for any new content and upcoming webinars. In the meantime, why not test Worth.Business’ online business valuation application first-hand, to see how it works. Click here to register for your obligation-free, complimentary trial subscription today.