Company Specific Risk Double Dipping in Cost of Capital?

Business valuation analysts use the cost of capital as the denominator in an equation (where annual cash flow or income available to equity is the numerator) to estimate entity value.  Cost of capital is sometimes loosely referred to as reasonable or fair return.  In the models that we use to develop cost of capital, we include risk premia for company size (based on equity or revenue) and company-specific factors.  The follow list of considerations for company-specific risk is not exhaustive but covers most of the primary factors:

• Small company
• Insufficient management depth
• Insufficient access to capital
• Customer concentration
• Customer pricing leverage
• Lack of product / service diversification
• Volatility of earnings and / or cash flow
• Technology life cycle
• New competitors
• Life cycle of current products or services
• Availability of labor

It can be argued that many of these company-specific risks are commonly found in smaller enterprises.  That being the case, the size premium most likely includes a component of risk that reflects most or all of these risks.   As such, due consideration must be given to the development of a company specific risk premium (CSRP) which will not double count some of the size premium.

There is not a quantitative formula to establish the CSRP.  As such, estimating a reliable CSRP is a highly subjective process.  Valuators will perform extensive qualitative analysis to develop the CSRP; but converting the qualitative analysis into a quantitative expression requires significant judgment.  Absent factors which are truly unique to the company or its industry (if industry specific risk has not been separately included in the cost of capital), I believe that the CSRP should rarely exceed 1%. 

I frequently perform valuations of medical practices or ancillary services (eg. ambulatory surgery centers, imaging centers, dialysis centers).  This industry is highly regulated and the regulations evolve over time.  The extent of regulation affects the revenue stream and allowable legal structures / ownership.  Furthermore, much of the technology is constantly evolving and obsolescence can be a concern.  In light of these factors, I will often use a high CSRP in valuing such operations.

Although there are valid exceptions, valuators need to use due professional care in developing the CSRP to ensure that the same risk is not accounted for twice.