According to academia, the cost of equity can be calculated using the CAPM, a central model to modern financial theory. But even Damodaran critizes this as a statistical approach usually considered too narrowly. Damodaran tends to and recommends to think about business risk in a more general sense first, without applying sophisticated and data-heavy statistical methods (which might have its place).
The general framework
According to Damodaran, a firms risk (unlevered beta) is dependent on the variability of the (i) top line and its (ii) profit margins
i) The cyclical nature of the product or service sold by the business depends on its very much nature. In general the riskiness of a business is higher when it offers discretionary products compared to one offering basic goods which are usually bought on a daily basis. At this point you might discover the appeal (and value) of truly recurring revenues. More broadly, the first risk factor is about the question:
- How likely and to what extend is the business at risk to experience a severe revenue shock, i.e. due to an economic downturn?
ii) Operational leverage refers to the share of fixed costs relative to total operational costs. High fixed costs relative to variable costs or high operational leverage will result in strongly expanding (depressed) profit margins when revenues are growing. This feature results in higher overall company-risk. The general question is
- How will costs and thus profit (margins) react in an adverse scenario with shrinking (or falling) revenues?
iii) Financial leverage in the form of financial debt leverages the firms operational risk when using a higher share of debt relative to equity capital. Debt adds another (non-operational) fixed cost, called interest, that has to be payed in good and bad times, amplifying returns on equity. Additionally it restricts the capacity to borrow during a stress scenario. A more stable operational business (i, ii) can support more leverage at a given level of risk. Questions to consider for an adverse scenario are: Can the company …
- survive a shock with its level of liquidity?
- pay interest expense?
- repay borrowings due out of its (stressed) operational cashflow?
- operate without breaching credit covenants?
- get new credit?
I believe there are two more aspects to pay attention to when thinking about the longer-term riskiness of a company’s business.
iv) Flexibility can comprise a bunch of optional possibilities how a company might react in challenging times as decribed here and here. It is related to (ii) but includes much more options, which might partially not be available in the short-term but only become available mid-term. The investment flexibility allows for speedier investment payoffs. Listed subsidiaries might be spun of within a short period.
v) Disruption risk needs to be considered in todays time, I believe. I would like to define the term as longer term competitive risks or structural market changes that could hurt the top line and profit margins. This includes technological disruption risk (i.e. traditional TV disrupted by streaming), health trends (i.e. old cigarettes). Intermidiaries might be replaced by way more efficient platforms. Thinking about disruption risk requires a certain degree of creativity and an open mind!
To be continued …