I have been a Cleveland sports fan my entire life. I was born and raised in Cleveland, and I love cheering for the Indians, Browns and Cavaliers. I remember like it was yesterday when Kenny Lofton hit that home run against the Yankees during the 2007 playoffs. As Lofton trotted around the bases I thought for sure our beloved Indians were going to finally win a World Series. Do you remember when the Browns had that outstanding 2007 season and went 10-6? The Browns must be one of only a few teams to win 10 games and miss the playoffs. How about the Cavaliers? They signed LeBron James in the summer of 2014, but ended up losing in the Finals because of injuries to two other all-stars on the team.
As evidenced by the Cavs’ trading their #1 draft pick for Kevin Love after signing LeBron James, there is a common theme that runs deep in signings and trades by professional sports teams—if they take large risks, they expect a large return.
While trading an unproven NBA player, #1 draft pick Andrew Wiggins, for Love may not be considered “risky” by some, there was still some risk involved. In the Cavs’ case, the risk went well beyond the trade itself as subsequent injuries to both Love and Kyrie Irving in the playoffs proved out. Not only was Irving unavailable when he was injured, but Cleveland was left to rely on free agent Matthew Dellavedova to fill Irving’s large shoes. Further complicating the matter, Dan Gilbert took on an additional slice of financial risk in the form of a high luxury tax bill since the team’s payroll was over the threshold. By taking on these risks, the Cavaliers raised the expectations that the team would win a championship. Similar to the Cavaliers, other sports teams may take on some “risk” to win a championship. So, by taking on the higher level of risk, the team anticipates a commensurate return, which is to win it all.
The relationship between risk and return is a very important concept in a business valuation. To account for risk associated with an investment in a company, a valuation analyst develops an appropriate discount rate based on his or her assessment of the likelihood that a company’s performance will continue as it has in the past or, better yet, improve. Again, there is risk involved and being assessed. In a business valuation, risk and return work in conjunction with each other. The higher the level of risk, the higher the required rate of return an investor will demand. This, in turn, equates to a lower company value due to the riskier likelihood that an investor will receive the expected benefits from a transaction. Alternatively, the lower the level of risk, or the more likely that a company’s performance will match or surpass historical results, the lower the required rate of return. This equates to a higher company value.
The two schedules below incorporate the same set of financial facts and circumstances but utilize different rates of return based on an assessment of risks. In this example, Company A is perceived to be less risky than Company B because it has a much broader customer base, less reliance on key employees and a more stable earnings history. As a result, Company A has a lower required rate of return demanded by its prospective investor.
As indicated by these two calculations, despite each company having the same cash flow, Company A is more valuable than Company B because of the absence of the risk factors noted above. Just like the sports team that takes on additional risk to win a championship, an investor will expect to receive a higher return for investing in a company that is considered more risky than another. This additional return compensates for the additional risk that is being shouldered. Therefore, it is very important that a valuation analyst determines an appropriate rate of return for a company that takes into consideration the level of risk associated with an investment in the company.