July 12, 2018
IRS Revenue Ruling 59-60 is an essential building block of modern appraisal practice. It identifies “the condition and outlook of the specific industry” as one of the factors to consider when valuing a private business. But how do investors measure industry risk and how does it fit in the valuation paradigm? Value is a function of risk and return. Riskier investments require higher returns, which lowers their values. Some rates of return can be easily and objectivity measured. For example, the return on the overall market may be measured by returns on a diversified portfolio of public stocks that are traded actively on the New York Stock Exchange, NASDAQ and the American Stock Exchange.
However, private companies often participate in one industry, which may be more (or less) risky than a diversified portfolio of stocks. In a discounted cash flow analysis, the company’s discount rate must be adjusted (up or down) to reflect industry risk.For example, assume that a small publicly held company in the general public market has an annual rate of return of 15 percent (as measured by the market for similar sized public companies). If your business operates in an industry that’s less risky than the overall market, it may warrant a discount rate below 15 percent. Conversely, if your business operates in a volatile, high risk industry, investors may require a higher rate of return than the overall market.
To measure industry risk, valuators typically turn to outside research firms that compute industry risk premiums (commonly known as “betas”) for public stock and credit analysts. Duff & Phelps publishes over 200 industry risk premiums in its annual Valuation Handbook. These premiums are determined by measuring the betas of representative public companies within each industry classification code.
A beta compares the industry’s historic rate of return to the historic rate of return for the overall market. A beta of one means that the industry generally moves in tandem with the market. A beta greater than one means that the industry tends to be riskier than the market overall. A beta between zero and one means that the industry is less risky than the market. Betas below zero are rare and reserved for companies that move in an opposite direction than the market. In other words, the industry performs well in tough economic times and poorly in good times.
Industry betas based on public stocks don’t factor size or geographic location into the equation. Small industry participants may face different risk than larger players, especially conglomerates that participate in multiple industries. Small companies also tend to have fewer resources to weather temporary downturns in the economy.
So how do valuators determine the risk of operating a small private company? The industry premium (or discount) to apply to a required rate of return is a matter of professional judgment on the part of your appraiser. He or she might start with the industry beta, review industry trade publications and then make adjustments for size and company-specific risks.
Think Beyond the Valuation
Industry risk is an important consideration when valuing a private business. Valuators go to great lengths to support their risk assessments and conduct in-depth market research. Valuation reports often provide significant detail about industry risks and trends. This research has tremendous value beyond your company’s valuation. It can help owners and managers seize opportunities, anticipate threats and employ best practices to help build your company’s value.