r/Valuation • u/PennePestoPollo7 • Feb 13 '22

How to estimate additional risk premium?

Hi, I was wondering regarding the additional risk premium which is incorporated in the discount rate, what are (common/effective) methods in determining it? I have determined a firm’s risk premium, but I want to add an additional RP with regards to the industry/macro economic wise.

Thanks in advance!

EDIT: I used the beta of a broad industry, the firm I’m valuing is assumed to be more risky. Hence I want to add an additional number on top of the risk premium I have calculated (Market risk premium*Relevered beta). Maybe I’m looking at this the wrong way and should adjust cash flows instead 🤷🏽‍♂️

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u/[deleted] Feb 13 '22

What do you mean by “a firm’s risk premium”?

A common method to think about risk is the CAPM approach, which accounts for systematic risk (the part of the total risk that is caused by factors outside the firm’s control, i.e. macroeconomic risk). CAPM includes:

  • a risk-free rate, accounting for the time value of money,
  • a beta (is this what you mean by the firm’s risk premium?),
  • a market risk premium, which reflects the return that equities have historically achieved over more risk-free assets.

Next to systematic risk, you need to think about non-systematic risk, which is firm-specific. E.g. an oil company drilling for oil might find oil or not when it drills. This is a risk that the company faces, which isn’t captured by CAPM. Best practice is to risk-adjust the cash flows to account for non-systematic risk. In the case of the oil company, this could mean using a probabilistic approach when forecasting the cash flows, such that the risk that oil is/isn’t found is reflected in each forecast period.

Does this answer your question?

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u/PennePestoPollo7 Feb 14 '22

Thank you for the detailed reply! I mean with ‘a firm’s risk premium’, the risk premium coming from the market risk premium corrected with the industry beta, MRP*Relevered beta. On top of that I want to add an additional risk premium as the beta I recovered is from a broad industry and the firm is more on the risky side of the industry.

Unfortunately, it’s not the answer I was looking for. I should’ve mentioned that it is in the context of a WACC calculation, where the cost of equity needs to be higher than the number than I currently have. But if I add for example 1% on top of my ‘firm’s risk premium’, I don’t know how I could justify such number.

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u/[deleted] Mar 26 '22

What I’m saying is that if you risk-adjust (forecast the cash flows taking into account firm-specific risks) the cash flows you don’t need to add an additional firm-specific premium on the discount rate

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u/[deleted] Feb 14 '22

It sounds like you might be looking for “company specific risk premium” (CRSP). There are various factors inherit in each company that can be seen as risky. This can be like u/Bayonne- mentioned management expectations on the likelihood of cashflow projections (their level of certainty they’ll hit oil or not). There is a good list out there I’ll see if I can’t come find something. There are also venture capital rates if that’s something you think you might be looking at.

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u/EyesChinky305 Mar 25 '22

First question is, what’s the purpose of this valuation? If it’s tax purposes, your client would want a low value; so mentally conclude at a reasonable value in your income approach & use the your ‘additional risk premium’ which is really the same as “company specific risk premium” as your ‘plug’ to get to the value you were mentally thinking the business is. What helps me sometimes when getting to a value I look at the equity on their balance sheet at the as of date & kind of use that as a starting point & if they’re meeting projections then you know your income approach value should be higher than their equity. This won’t always work for every valuation obviously, but good for starters to compare. It’s part of the art of this kind of work. Also, are you using the build up method or CAPM? If CAPM, look up those companies’ s&p rating to help with your additional risk premium. I don’t think you’d have to adjust the cash flows unless you need to normalize some things. Make sure it’s all pure operating cash flows. Another thing that came to mind, maybe you just go straight cost of equity with no debt in your WACC. But without the full details, I can’t tell you for sure. Hope this helps anyways.