The Art of Determining Specific Company Risk
By Ashley DeCress, Senior Manager, Advisory Services
Valuation professionals often say the process involves “a mixture of art and science.” Although many valuation inputs involve empirical data and supporting research, certain elements require a component of professional judgment.
One of these elements is specific company risk. This risk addresses a range of financial, operational, economic, or other factors specific to the subject company being valued.
Specific company risk is a component of the company’s discount rate, which is critical to valuing a business under the income approach. The discount rate (or capitalization rate) is the rate of return a reasonable investor would expect given the nature, size, and risks inherent in an investment in the subject company. Generally, the riskier the company, the higher the specific company risk, and in turn, the higher the discount rate (or capitalization rate) of the projected future income or benefit stream. This, in turn, translates to a lower overall value for the subject company.
There are a number of risk factors that make up the specific company risk adjustment for a particular company:
Does the subject company have volatility in revenue and earnings? Is the subject company more highly leveraged or less liquid than similar companies? If yes, these factors may indicate an increase in specific company risk.
What are the subject company’s historical profitability levels and how do they relate to other companies? If the subject company is less profitable than its competitors, this may translate to an increase in specific company risk. Does the subject company have significant customer concentrations or supplier limitations? Companies relying on a small number of customers for a majority of revenues, or on a limited number of suppliers for production, are riskier than companies with diverse revenue streams and suppliers.
The current economic climate (both long-term and short-term) can impact risk factors as well. For example, the COVID-19 pandemic might have increased specific company risk if the subject company’s operations were impaired.
Are there certain employees that are integral to the subject company’s operations and/or leadership? Are they subject to restrictive covenants? Would the departure of these key employees strain the subject company’s ability to operate at similar levels? If so, this may result in an increase to specific company risk.
Does the subject company have aggressive growth projections they have not reached in the past? This may lead to an increase in specific company risk.
Is the subject company’s industry competitive? Are there certain regulations within the industry? What are the barriers to entry? Does the subject company’s industry have any upcoming opportunities or threats?
Is the subject company relatively small compared to other companies (i.e., number of employees, revenue/operations, etc.)? If the subject company is smaller or on the low end compared to other peer companies based on size premium data, this may translate to an increase in specific company risk.
Does the subject company have any pending litigation matters that may impact its operations or reputation? If so, this may result in an increase to specific company risk.
Is the subject company’s revenue stream dependent on patents or intellectual property that will expire in the near future? If so, then expiration of this intellectual property could impair the company’s estimated revenue stream, thereby increasing specific company risk.
These factors, among others, help analysts assess and determine specific company risk. Risk factors differ from company to company, so a thorough understanding of the subject company and its potential risk factors is key when performing a valuation.