Here is the short answer: risk and the required rate of return are directly related. As risk increases, the required rate of return increases. As risk decreases, the required rate of return decreases. Let’s take a closer look at what that means and how it affects the value of a company.
Be careful not to confuse actual rate of return with required rate of return. The former reflects historical financial performance and calculates the company’s actual return on investment while the latter reflects the amount of risk associated with the investment in a particular company. A general theory of business valuation is that the required rate of return is commensurate with the perceived risk of the investment. In other words, this is the rate of return that would be required to attract a hypothetical investor over other investment opportunities in the current market. As risk increases, therefore increasing the required rate of return, the value of a company decreases. Essentially, by paying a lower price for the investment, the hypothetical investor is being compensated for investing in a company that is subject to greater risk.
It is helpful to think of the required rate of return as the discount rate, a term often used in the business valuation community. The income approach to valuation, often the primary approach used in valuing operating companies, is based on the theory that the value of a company is based on the amount of future cash flows it will generate. This approach calculates the company’s expected future cash flows and then discounts those amounts to a present value using the required rate of return, or discount rate. A higher discount rate results in a lower current value, and a lower discount rate results in a higher current value.
When valuing a company, the required rate of return is determined by the aggregate of three discrete risk components, interest rate risk, market risk and company specific risk. Interest rate risk is based on the yield to maturity of U.S. treasury securities while market risk is determined by returns generated in the public equity markets. Company specific risk is related to, as you might guess, factors that are specific to the subject company, which are not reflected in the general market return. These factors include the company’s size, management, historical financial performance, geographic location, environment and many others. These numerous factors make company specific risk the most subjective piece of the required rate of return.
In valuation projects that I have recently worked on, company specific risk has ranged from 0% for large established companies with a long history of strong financial performance to 10% or more for small companies with a history of volatile financial performance. For some perspective, if an investor expected to receive $1M at the end of each of the next five years, the present value of those cash flows discounted at 15% is $3.4 million, but the present value of the same cash flows discounted at 25% is only $2.7 million. That’s a 25% difference in value and a significant amount of money! While company specific risk is subjective, valuation analysts conduct significant quantitative and qualitative analysis to support the level of risk incorporated in the required rate of return.
The required rate of return is a key input when using the income approach to valuation. It is determined based on different components of risk and is a key driver in reaching a conclusion of value. When determining the required rate of return, it is important to conduct thorough research on each of the components of risk and ensure the subjective components are well-supported.
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