By Robert Reilly, a managing director of our firm, and Connor Thurman, a senior associate in our Portland office, published in the December 9, 2020, December 16, 2020, December 30, 2020, and January 6, 2021 issues QuickRead. Reproduced with permission from the QuickRead (December 9, 2020, December 16, 2020, December 30, 2020, and January 6, 2021). Published by the National Association of Certified Valuators and Analysts® (NACVA®). All rights reserved.
The income approach is one of the three generally accepted approaches to valuation. All income approach methods typically include the application of either a present value discount rate or a direct capitalization rate. One consideration in just about every discount rate measurement method is a component related to investment-specific risk. This risk component is called by many names in the professional literature, including unsystematic risk, asymptomatic risk, nondiversifiable risk, nonsystematic risk, project-specific risk, residual risk, investment-specific risk, and company-specific risk. This risk component is also sometimes called alpha. The identification and quantification of alpha—or the subject-specific risk component—is sometimes a controversial issue in the private company valuation. Robert and Connor summarize best practices on what should be considered in the analysis of this unsystematic risk component. Part 1 of Robert and Connor’s article focuses on the factors that analysts may consider in developing the alpha estimates when selecting the cost of equity capital for a private company valuation. Part 2 of their article describes the differences between systematic and unsystematic risk in the private company valuation. In Part 3, Robert and Connor present empirical evidence that analysts may consider when estimating the company-specific risk as part of the private company cost of capital measurement. Finally, in Part 4, they summarize best practices related to the functional analysis in developing the company-specific risk premium estimate.