To put it simply, risk and the required rate of return are directly related by the simple fact that as risk increases, the required rate of return increases. When risk decreases, the required rate of return decreases. However, it is a bit more complex than that, so let’s examine how the relationship between risk and the required rate of affects the value of a company.
Actual Rate of Return / Required Rate of Return
While we have explained how the two terms are related, it is also important that we understanding their differences:
- Actual Rate of Return: The actual rate of return reflects historical financial performance and calculates the company’s actual return on investment
- Required Rate of Return: The required rate of return reflects the amount of risk associated with an investment in a particular company.
Business valuation theory indicates that the required rate of return corresponds with the perceived risk of the investment. In other words, it is the rate of return required to attract an investor over another investment opportunity in the current market. Effectively, as risk increases, the required rate of return increases, which produces a lower value of the subject company (and vice versa).
In the business valuation community, the required rate of return is frequently referred to as the discount rate. As a primary approach used in valuing operating companies, the income approach is based on the concept that that the value of a company is equal to the present value of the future cash flows it is expected to generate. Using this theory, we first determine the company’s expected future cash flows and then discount those cash flows to the valuation date using the required rate of return, or discount rate.
A variety of risk components are used to determine the value of a company:
- Interest rate risk: Based on the yield to maturity of U.S. treasury securities.
- Market risk: Determined based on returns generated in the public equity markets.
- Size risk: determined based on the differences in returns generated by companies in public equity markets based on their size (market capitalization)
- Industry risk: Determined by consideration of risk premiums (reductions) associated with certain industries in the public equity markets. Rather than a separate adjustment, this is also sometimes considered in the company-specific risk adjustment described below.
- Company-specific risk: Related to risk factors that are specific to the subject company, including:
- Economic environment and outlook
- Financial and operational risks
- Management talent and depth
- Historical financial performance
- Projected financial performance
- Other company-specific factors
The discount rate and company-specific risk adjustment applied in a valuation are dependent upon the facts and circumstances surrounding the company being valued. Due to the nature of the factors discussed above, company-specific risk is considered the most subjective of the discount rate components. However, valuation analysts should be able to describe the factors considered in determining the company-specific risk adjustment and how those factors impact the company’s required rate of return.