DE-RISKING OPERATIONS GREATLY IMPACTS THE VALUE OF A BUSINESS
A business with minimal Operational Risk will command a much lower Total Cost of Risk (TCOR) than otherwise, which will have a significant impact on enterprise value and share price. For example, buyers can/will link Risk to the Cost of Equity in a projected discounted cash flow (DCF) analysis (the higher the risk, the greater the discount rate, and therefore the lower the valuation).
Another example is that of a private equity firm using an investment hurdle rate (derived from its commitments to its funding partners) to establish a valuation and then assessing its likelihood of achieving that return. This process can also include the impact of Risk.
Value creation is more sensitive to de-risking operations than it is to either increasing sales or improving margins for companies over a certain size. This is shown in the table below illustrating the sensitivity of Risk, Sales, and Margin to Valuation of a company with $15 million in sales and a 10% cash flow margin:
In this example, de-risking operations resulted in doubling the value of the business!
Notes to consider
- The figures above are for illustrative purposes only and actual changes in Terminal Value depend on each company's operations and capital structure.
- The author of the Table above illustrates measures for ‘Company-Specific Risk’, which we replace with Total Cost of Risk (TCOR) simply due to the fact that using ‘Company-Specific Risk’ assumes that the latter can be managed/controlled unlike what traditional finance calls ‘Systematic’ or Market Risk (as traditionally measured by Beta). However, that is a common misconception as both ‘Company-Specific’ as well as ‘Systematic’ risks can be managed/controlled through Operational Risk. We therefore use TCOR to quantify the overall level of Risk of a particular business. TCOR drops significantly when de-risking operations through Operational Risk & Structured Insurance, which reduces Cost of Equity, which then reduces Weighted Average Cost of Capital (WACC).
- Because TCOR should be used instead of ‘Company-specific Risk’, the impact of de-risking operations on Valuation is actually much larger than what is illustrated in the table above. Moreover, the same concept applies to valuation that is done through a 'risk-adjusted multiple'.
The bottom line is that it is simply more effective to achieve a higher value for the Business through de-risking its operations than through increasing sales or improving profits! (for a certain sized business). In fact, attempting to boost sales, or expand margins, without first reducing risk will likely increase risk (and reduce value accordingly).
De-risking operations, as a first step, followed by attempts to increase sales and profit margins will achieve a leveraged impact on value due to a lower discount rate applied to higher cash flow.