A key aspect of business valuation when adopting an income approach is determining an appropriate equity discount rate. The discount rate represents the return an investor requires from their investment, based on the perceived level of risk associated with that investment.
Regardless of the method used to determine the equity discount rate, a fundamental consideration is the level of company-specific risk associated with the enterprise being assessed. This risk comprises both systematic and unsystematic elements. Understanding that risk is critical to determining the equity discount rate, yet it is generally accepted that there is no direct data source for quantifying a company’s specific risk. As a result, it is typically left to the professional judgment of the business valuer.
How can valuers support their conclusions regarding the specific company risk factors they have assumed?
Australian data company Bstar Pty Limited (Bstar) has deeply examined the key specific risk and value drivers impacting Australian SMEs.
By way of background, the Australian business landscape is dominated by Small and Medium Enterprises (SMEs). According to the Australian Bureau of Statistics (ABS), 97.2% of all businesses are classified as small, 2.6% as medium, and just 0.2% as large. The ABS defines small businesses as those employing 0–19 employees, medium businesses as employing 20–199 employees, and large businesses as employing 200 or more employees.
Bstar, through a survey of 16,810 Australian SME owners, identified seven key risks commonly faced by Australian small business owners. The survey, based on Porter’s Five Forces, asked business owners to respond to 80 questions covering ten key risk areas that impact their businesses and to rate their level of concern for each risk.
Survey Results
The survey revealed that the two greatest risks facing the Australian SME sector are owner reliance and the impact on business goodwill if the owner were to depart:
- 2,791 SME owners surveyed rated owner reliance as their biggest concern.
- Only 5% of business owners believe their business would operate effectively without them.
The remaining five risks, in order of significance, are:
profitability, cash reserves, owners’ value gap, customer sensitivity and penetration, and cash flow.
Given the structure of the Australian business landscape, it is unsurprising that owner dependence emerges as a key company-specific risk – one that should be carefully considered when determining the specific company risk component of an equity discount rate. This experience is likely mirrored across the global SME economy.
A common issue identified when reviewing SME valuations is that valuers often do not examine key company risks, financial and non-financial KPIs, or benchmark these against comparable businesses. Understanding a SME’s key risks, profit, and value driver benchmarks helps valuers justify their discount rate assumptions with greater confidence and evidence.
Beyond the valuation report itself and perhaps more importantly for recipients of valuation services, understanding key company risks and both financial and non-financial KPIs, presents an opportunity for business valuers to collaborate with business owners to reduce risk and ultimately grow business value.
Bstar’s data shows that 84% of Australian business owners have a value gap risk, and 42% require more information on what their business is worth, despite their business being one of their most significant assets.
Strategically addressing company-specific risks therefore presents a significant opportunity for business valuation professionals. By moving beyond the traditional valuation report, valuers can partner with SME owners to develop targeted strategies that directly address identified risks – ultimately enhancing and growing the value of their businesses
About Azimuth Partners
At Azimuth Partners, our experienced business valuers understand the critical role of company-specific risk in determining accurate and defensible business valuations. Whether you require an independent company valuation, a small business valuation, an accounting practice valuation, or a family business valuation, our team applies data-driven insights and professional judgment to deliver reliable, evidence-based outcomes.
To learn more about how Azimuth Partners can support your valuation needs, contact our team for a confidential discussion.
