Risk Premium | Lewis Hurst

As I watched share prices fall today, I’ve been considering how my previous calculations were all based around an expected minimum return of 5% pa after tax and whether or not this is valid anymore. The reason for this consideration is that there are some defensive stocks that I believe will continue to be profitable during the oncoming fray which appear as bargains using my previous formulae.

Before discussing this further I will share how I arrived at the value of an expected minimum return of 5% for my calculations. The value of 5% was basically the sum of the Risk Free Rate (which is the rate you can invest your money with theoretically zero risk – in my case my mortgage rate) plus a generic Risk Premium (representative of risks to the economy, outside of those factored into expected future return for the specific company) plus the amount I would like to make for taking that risk after considering tax (because my investment proposition is based on the return I want to make for myself, not the IRD).

In the derivation of the value of the 5% lies the problem, which is that the Risk Free Rate has increased and is set to increase in the coming year or more; hence the cause for concern over inflation for investors. Additionally the Risk Premium has also increased to reflect the level of uncertainty and negative sentiment for the future economy. Therefore it seems obvious that shares cannot be valued using my previous calculations.

I’ve already talked about how PE is no longer a good way to value stocks because it assumes a linear, constant progression of company earnings, but as you can see, there are some fundamental components to the way PE should be used that are also falling apart because it’s harder to assign a Risk Premium and Risk Free Rates are changing and unpredictable in the term that I look to invest in (years).

There are two components to calculating value in a company using PE: Firstly calculating the PE, then calculating what PE is appropriate for that particular company.
Lewis Hurst

The problem with investing in your Risk Free Rate option is that there’s also no risk of upside. This may change my financial models if we spend too long in these doldrums. Whatever the state of my modelling, it seems that I have no other course of action than to wait until the future of OCR changes becomes clearer, which will be preceded by tamed inflation; inflation being a sign of how the Risk Premium will be affected, also.

As an Angel Investor one of the most common hurdles I see private companies struggling with when trying to raise capital is valuing their business. Specifically, company owners tend to have a disconnect between what they think the company is worth verses what investors are willing to pay.

Too many times I see the valuation set at what the value of the company will be after growth, which leaves no profit in the future for any investor with the risk of losses if the company doesn’t succeed.

I also see valuations being set based on what the owner feels like it’s worth, with no financial justification.

I also see valuations from accountants which are typically based on a DCF methodology. While a DCF is a valid way to calculate a business’s worth, it’s more used to calculate the value in a business rather than the market value, or what somebody would actually pay for a company. This is because it doesn’t leave any room for profit for the investor in the short / medium term, and the discounted rate doesn’t reflect the opportunity cost from an investor’s perspective. An accountant would typically not be in a position to negotiate the level of risk and will typically accept the level of risk given to them by the company owner, giving a more minor discount value.

Finally this brings me to the last type of valuation I see, which is a comparables market valuation. As company owners typically don’t have access to sale data of private companies, they often compare their business to those listed on the stock market. Which brings me to the subject of the article…

Why Do Private Companies Sell For Less Than Publicly Listed Companies?

It seems fair that similar companies should be priced similarly, right? Yet you’ll never get the same price for your company selling it privately than you would selling it publically. The answer to the titular question lies not just in the benefit of liquidity of listing a company, but also in the public nature of listed companies.

When buying a private company, there is a much larger risk premium to overcome due to the fact that there is less data available about the company, that data has not been held to the same public rigor (or sometimes laws) that a public company has. There are also years of documented performance forecasts that can be contrasted against their following year’s results to determine their accuracy, and of course a bunch of laws that must be adhered to in order to fit with the bourse’s requirements, which are perpetually scrutinized by large institutional investors with a copacetic interest to any smaller investor – safeguarding demand. All of which contributes to a lower risk premium for public companies.

There are also aspects of demand that push up the share price of public companies, as not only are such companies easier to buy into, but some institutions may have to buy those stocks to fit allocation requirements.

The benefit of liquidity is also seen in the opportunity for exit. In other words, as public companies are easy to sell, investors don’t need to worry about finding a buyer. This brings supply side pressure on the price of non-listed companies, pushing the share price down.

The nature of sale of private companies also comes with problems, in that any buyer is likely to buy the company in its entirety. This changes the calculation on how much a company is worth, because it’s no longer a silent investment that pays you regular dividends, it’s a job for someone to get their money from the company. Consequently, an investor of a public company might be happy with a 5% dividend because it’s better than the return from the bank, but an owner operator doesn’t want to buy a business, then work all day for the same amount of money they would get from putting their money in the bank.

Finally, there are additional risks and costs related to investing in private companies. For example, one might spend anything from 2 to 30 days researching the company and going through legal processes, incurring costs of thousands of dollars just to make the purchase of the shares.

All of the above make angel investing and owner-operator company purchases less attractive, which makes private companies sell for less than publicly listed companies.