It wouldn’t be wrong to say that in the valuation world our number one goal is pricing risk. Afterall, no matter how you look at it, valuation is essentially looking at the likelihood of achieving a particular return on investment. Part of a valuation, then, is understanding Risk Factors that impact a business.
What Are Risk Factors?
Risk Factors are items or areas which expose the company to risks that might materially impact their worth in the market. The list of potential risk factors is wide and sundry, but examples include:
- Over-reliance on an employee or employees
- Over-reliance on a shareholder (common in very small businesses)
- Exposure to a single customer or vendor (one customer makes up 80% of sales…)
- Legislative Risk (example: Marijuana Dispensaries)
In part, the identification of risk factors help us understand how one particular company is different from it’s peer group. In the chart below, the difference from V0 and V1 is often the application of Risk Factors.
The Shack Shake: A Practical Example
The Shake Shack recently IPO’d, and as part of their offering memorandum helpfully included a discussion of Risk Factors to their business.
“We are subject to a number of risks, including risks that may prevent us from achieving our business objectives or that may adversely affect our business, financial condition, results of operations, cash flows and prospects.
- our long-term success is highly dependent on our ability to successfully identify and secure appropriate sites and timely develop and expand our operations in existing and new markets
- damage to our reputation could negatively impact our business, financial condition and results of operations
- food safety and food-borne illness incidents may have an adverse effect on our business by not only reducing demand but also increasing operating costs
- shortages or interruptions in the supply or delivery of food products
- risks related to our international operations and our international licensed Shacks; and
- we face significant competition for guests, and our inability to compete effectively may affect our traffic, Shack sales and Shack-level operating profit margins.
From a business valuation perspective, the question is how do these risks effect the company relative to their peers. Thus if we have established a baseline value for a company using market comps, that value is based broadly on that basket of peers.
Many risk factors are similar based on the industry. For instance in the restaurant industry, all participants will be subject to factors related to “food safety.” However, given the young nature of the Shake Shack, the company is more dependent on expanding its footprint and finding solid locations. Thus, as a risk factor, this is more risky than the peer group.
Valuation is about pricing risk. We do a lot of work to try and understand how a business fits into a certain industry or peer group…. but then we also spend a lot of time understanding how a company differs from the mean. Identifying and understanding risk factors is one tool in that tool box.