Accounting for Risk in a Valuation

Charles Hattingh valuation buzzValuation Buzz series is written and published by Charles Hattingh CA (SA)...

Accounting for Risk in a Valuation

The three major determinants of value are:

  1. The ability of the entity to generate free cash flow
  2. The expected growth in the projected free cash flow
  3. The risks attaching to the future cash flows

Being an optimist (you need to be if you want to create wealth) I seldom dwell on the third element. However, if you are performing a professional valuation you must focus on this element as, if you arrive at a valuation and an event subsequently takes place that destroys the projected cash flows that you never foresaw, you could be in serious trouble. Your valuation report should therefore carefully spell out the potential risks and the fact that you took them into account in your valuation. My latest valuation report spells it out as follows:

Introduction

The modified capital asset pricing model was applied in arriving at the fair rate of return used to discount the projected cash flows. The fair rate of return comprises three elements:

  1. The rate the investor could earn after tax on government bonds, which was used as a surrogate for a risk free rate
  2. The systematic risk premium applicable to the asset comprising the risks that cannot be mitigated by diversification
  3. The unsystematic risk applicable to the asset comprising the risks that could be mitigated by diversification but were not

Risk Free Rate

The estimated rate on long dated government bonds at xxx for a maturity period of xx years is x,x% p.a. This rate has been reduced by the marginal rate of tax of the investor as the principle in valuations is to discount post-tax cash flows at an after tax rate.

Systematic risk premium

The average systematic risk premium for a listed company in RSA today is considered to be 8% p.a. arrived at by deducting the after tax return earned on long term government bonds (approximately 5% p.a.) from the after tax return expected to be earned from listed shares (approximately 13% p.a.).

Unsystematic risk premium

This premium accounts for the risks that could, theoretically, be mitigated by placing the asset in a diversified portfolio of assets. Where this is not the case, or where it is not possible to mitigate such risks, account is taken of these risks.

General Risks

The typical risks to which business entities are exposed are:

  1. The impact that interest rate increases could have on the entity's cash flows
  2. The impact of changes in exchange rates on cash flows
  3. Whether the entity can pass inflation increases onto its customers
  4. Whether the entity has available liquid resources to meet its commitments and obligations
  5. The extent to which the company is exposed to credit risk, e.g. defaulting debtors or borrowers
  6. The impact that new competition could have on its business
  7. The possibility of labour unrest and the impact on the entity's future cash flows
  8. The extent to which government interference in the entity's operations could affect profitability
  9. The risk of Tax Revenue's attacks on the entity and the possible consequences thereof
  10. The effects of non-compliance with legislation
  11. The possibility of losing a major customer
  12. The reliability of supplies of raw material and product to the entity
  13. The vulnerability of the entity's brand to legal and other attacks
  14. The impact on the profitability of the company resulting from changes in commodity prices
  15. The effect of product obsolescent on the future cash flows and sustainability of the entity
  16. Provisions for succession of key managers
  17. The effect of skills shortages on the operations of the entity
  18. The impact of an economic downturn on the profits of the entity
  19. Accounting risk due to poor internal controls
  20. The risk of deception in the reported numbers
  21. The lack of control over the operations of the entity
  22. The restrictions on transferability of the holding
  23. The marketability of the holding, i.e. the ability to sell the holding when needed
  24. Constraints placed on the holder by the constitution of the entity
  25. The possibility of being called upon to meet the liabilities of the entity

Specific Risks

I then set out the specific risks identified with the help of management.

Conclusion

I then conclude as to what a fair beta and unsystematic risk premium is without trying to attribute the various risks to the systematic risk premium and the unsystematic risk premium. Why? Because I have no idea which is which!!