When valuing a business using the income approach, one of the most significant inputs is the discount rate, which is used to discount future cash flows to present value. In this piece, we focus on one of the components of the discount rate: the company specific risk premium (“CSRP”).
For further detail about all of the components of the discount rate, see Mercer Capital’s article: Understand the Discount Rate Used in a Business Valuation.
CSRP is an additional premium that captures unique risks to the subject company, above and beyond market, industry, and size risks accounted for in the other ‘build-up’ components to developing a discount rate.
In simple terms, the CSRP captures the unique risk profile of the subject company. As the CSRP is specific to the company at hand, it can be subjective in nature – there is no direct observable market evidence, or data, that can be directly tied to one’s assumption, i.e. chosen premium. Therefore, in determining the CSRP, one should consider: What is the return required by investors to invest in the subject company over an alternative investment? Also, what are the qualitative elements of the business that reduce or increase risk – this could be strengths or weaknesses of the business, and even threats and/or opportunities for the business and its industry. The table below provides a few common factors and questions that may influence and support a CSRP assumption.
| Geographic Concentration |
|
| Customer/ Supplier Concentration |
|
| Competitive Environment |
|
| Earnings Volatility |
|
| Depth and Quality of Management |
|
| Key Person Risk |
|
| Operations |
|
| Technological Obsolescence |
|
There is no universal standard to estimating CSRP – each company has unique attributes and risks that are factored into the discount rate, among other areas in the business valuation analysis. Quantifying a CSRP requires a thorough understanding of the qualitative and quantitative factors that affect the subject company. Thus, a competent valuation expert is needed to ensure that the fundamentals of business valuation are applied in a reasonable and appropriate manner.
