Key Drivers of Value - Part 3

The Cost of Capital

In previous articles, we discussed the "value trifecta" and profitability, risk and growth, and explored in depth the first of these components, profitability.  This article will discuss the second component of the value trifecta, risk.

Risk is the uncertainty of a return and the potential for financial loss and is measured by the cost of capital for a business.  Determining the cost of capital for a private business is one of the most difficult and challenging tasks for an appraiser in determining value because there is no direct evidence of what this rate should be for a specific business.  In theory, the cost of equity capital for a private business is the rate of return that an investor would require in order to invest in a business given the perceived risk of realizing the economic benefits that the business generates.  This is true for any investment and not just an ownership interest in a private business.  By measuring the actual realized returns on different types of investments, you can develop what is referred to as a "capital access line."  The capital access line provides valuable information that an investor can use to help quantify the required rate of return on an investment and supports the basic concept that the higher the risk in an investment, the higher the required rate of return.

So it all comes back to measuring perceived risk.  But what is perceived risk?  How does it affect the rate of return required by an investor?  And how is it measured?

In its simplest form, risk is measured by the variability of the expected return for an investment.  The expected return for an investment consists of two parts:  income return and appreciation return.  Using the total returns from the public marketplace as an example, the income return measures the return received from dividends paid by a publicly traded company and the appreciation return measures the change in the price of the common stock in the publicly traded company.

Exhibit 1 presents the total return,Cost of Capital income return, appreciation return, and standard deviation for each of these returns for three different portfolios:  long-term government bonds, large company stocks, and micro-cap stocks.

The long-term government bond portfolio has the lowest perceived risk because its income and appreciation returns have the most certainty.  If the bonds are held to maturity, the income and appreciation return are certain. 

The large company stock portfolio has higher perceived risk than the long-term government bond portfolio but not as high as the micro-cap stock portfolio.  Why?  Because its income return is higher (meaning the investor is receiving a portion of his/her return quarterly) than the micro-cap stock portfolio but its appreciation return is more predictable as evidenced by the lower standard deviation. 

The micro-cap stock portfolio has a lower income return and its appreciation return is higher in order to compensate the investor for higher perceived risks as evidenced by the higher standard deviation.

With this understanding, one can begin to understand how the cost of capital for a privately held business is estimated.  An investment in the common stock of any company faces two types of basic risk:  operating risk and financial risk.

Operating risk is the risk associated with the people, systems, and processes through which a company operates.  The operating risk of a company can be measured by the observed variability of its operating earnings over time regressed against a level of expected earnings.  If the operating earnings are highly predictable, then the perceived level of operating risk will be low.  There is a long list of factors that affect the variability of a company's earnings, including, but certainly not limited to, the following:

  • Stage of life cycle of the industry - will potentially affect volume demand and pricing
  • Type of revenue - recurring vs. non-recurring
  • Pricing - elasticity market-based or contracted
  • Product/service differentiation - patents, restricted market areas in distributor agreements, etc.
  • Company's competitive strategic positioning - operational excellence, product leadership, or customer intimacy
  • Customer concentration, tenure, and dependency
  • Level and type of competition - changes in competitive conditions
  • Variability of cost of production inputs - market-based or contracted
  • Labor force/management - training, competency, tenure, turnover, etc.
  • Labor market conditions - geographic and industry
  • Vendor concentration and dependency - availability of alternative sources
  • Adequacy of company's systems and processes - do they produce expected results
  • Protection against unexpected losses - both legally and through insurance
  • Profitability of the business

Financial risk measures the stability and predictability of a business's earnings before taxes in relation to the business's operating earnings.  The asset composition, degree of reliance on debt financing, the cost of debt financing, and the size of the business's operations all affect the level of financial risk.

Through a careful and deliberate assessment of the preceding factors, an investor is able to quantify the perceived level of risk of an investment in the common stock of a private business and quantify this risk into a required rate of return.  While this process involves a quantitative and qualitative analysis of the factors that affect risk, in the end the determination of the required rate of return is subjective to each investor.  The better informed the investor is in making this determination, the more likely it is that the business's risk will be adequately measured and the required rate of return will be realized. 

The determination of the cost of capital cannot be made in isolation because its derivation is dependent on understanding the relationship of the cost of capital to the economic benefits and growth rate that are used in the valuation.

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