A previous article explored the relationship between risk and required returns, specifically in the context of a business valuation, highlighting the inverse correlation between risk and business value. But how is this risk quantified and applied in a business valuation? This is subject to the valuation method. Allow us to explain.
The enterprise value (EV) calculated through the “market approach valuation”, is based on a very simple formula: EV = EBITDA (or EBIT) x multiple. EBITDA of course being earnings before interest, taxes, depreciation, and amortisation. The multiple is usually derived from the average of comparable listed companies, adjusted for known differences in medium-term and long-term earnings expectations, as well as additional risk assumed. The higher the risk of not achieving the expected medium- and long-term earnings, the lower the multiple should be. Care should be taken to adjust the multiple for risk, and not just rely on an average industry multiple.
When applying the discounted cash flow (DCF) method, forecast free cash flows are discounted back to a net present value, by using an appropriate discount rate. This discount rate is a weighted combination of the return expected by shareholders and debt funders to compensate them for the risk inherent to their investments. The higher the perceived risk in the business, the higher the cost of equity should be to compensate shareholders for the additional risk assumed. Debt financiers also price risk into their interest rates. The cost of equity and cost of debt are weighted with reference to a market participant’s view on the appropriate capital structure, being debt ÷ (debt + equity). This is also known as the weighted average cost of capital (WACC).
The value of a minority stake is often valued by applying the discounted dividend method (DDM). The appropriate risk-adjusted discount rate in this case, is the cost of equity.
Other than for the above, risk should also be considered when valuing a minority equity stake, especially where there are restrictions in participating in management decisions. This risk is normally expressed as a minority discount. Finally, a discount for lack of marketability (DLOM) should be applied where shareholders are not able to readily sell their shares if they want to (such as unlisted shares of highly illiquid listed shares).
It is important to quantify the different elements of risk with a reference to market statistics, whilst also taking the unique circumstances of the business being valued into account. Finally, these risk components must be applied in the correct manner when doing a business valuation.
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