Business valuation and industry specific risk

One of the key factors that affects the value of a company is the industry in which it operates. So the question is why and by how much?

The answer is risk. In fact, the industry-specific risk premium is one of the elements that make up the discount and capitalization rates for your business. And here are the key factors that define the industry-specific risk:

• Overall industry growth prospects.
• Barriers to competitive entry such as initial capital investment, license requirements or unique know-how.
• Consolidation trends and degree to which large competitors dominate the industry segment.
• Technological changes that may require considerable investment to stay competitive.
• Regulatory compliance requirements that can suddenly drive up the costs of doing business in the industry.
• Emergence of new competitive threats domestically and internationally.

Industry risk makes a difference to business value

How much can the industry-specific risk affect the company valuation?

In 2009 the lowest risk industries such as the educational services under the SIC code 82 showed negative industry specific risk premia of around -4%. This means that the companies in this industry sector faced risks below the overall market!

On the other hand, the high risk industry segments, for example the transportation services under SIC code 47, called for the risk premia on the order of 4.3%.

Given the typical discount rates of some 25% for privately owned firms, this could make a difference of more than 8% and greatly affect the valuations of companies in these industries.

Example: effect of industry specific risk on company valuation

To demonstrate the effect of industry risk on company valuations, we will pick two firms with identical earnings forecasts for the next 5 years.

One of the firms is in the educational services sector, the other is a transportation company. To make the comparison easier, we will assume that both firms have the same company-specific risk profile that adds another 4.1% to their discount rates.

Here is the earnings forecast:

• First, Year 1: $150,000.
• Next, Year 2: $175,000.
• Year 3: 185,000.
• Year 4: 200,000.
• Finally, Year 5: $225,000.

Using the well-known Build-Up model, we calculate the discount rates for the two companies as follows:

• Educational services: 18.94%
• Transportation services: 27.47%

We apply the Discounted Cash Flow business valuation method to calculate the value of both companies. Here are the results:

The business value difference is amazing: with the same earnings prospects the educational services firm is worth almost twice as much as its transportation industry counterpart!

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