What it means
A promise of $500,000 in a year is worth less than $500,000 today, for two reasons. Money today can be invested, and the promise might not be kept.
The second reason is the risk discount: the riskier the promise, the less it is worth now. The usual way to apply it is to add a risk premium to the discount rate.
A safe cash flow is discounted at the risk-free rate, such as the yield on a government bond. A riskier cash flow is discounted at the risk-free rate plus a premium, which lowers its present value (its worth in today's money).
Valuation professionals build the premium from several sources. A young company, a small company, a single-customer business or a project in an unstable country will all attract a larger premium.
Analysts judge these risks from experience and from comparisons with similar investments. Another form is a direct discount to the price.
Examples include discounts for lack of marketability, where shares cannot be sold quickly, or for a minority stake with no control. In deal negotiations a buyer may also ask for a lower price because of legal, environmental or tax risks that are not fully known.
The risk discount can be abused. A seller may argue for a small discount to push up the price, while a buyer may argue for a large one to push it down, so it is wise to document the reasoning.
Sensitivity analysis, which shows how value changes under different discount rates, makes the debate more concrete. For managers, the lesson is that a risky project must earn more than a safe one to be worth doing.
Investment decisions that ignore the risk discount tend to overvalue uncertain ventures and lead to disappointing results.
In practice
Real-world examples.
Example
A venture investor values a start-up's expected $500,000 payout in a year. She uses a 10% discount rate, 6% above the risk-free rate, because the company has no track record. She tests a range of rates to see how the value changes.
Example
A buyer purchasing a family business agrees to pay a 15% lower price because one customer accounts for most of the sales. The loss of that customer would hurt the business badly. The seller accepts a lower price in return for a faster sale.
Example
A shareholder in a private company is offered a price for her minority stake. The buyer applies a discount because the shares cannot easily be sold and she cannot control the company. Her adviser checks that the discount is in line with similar deals.
Formula
Calculation
Risk-adjusted value = Expected cash flow / (1 + Risk-free rate + Risk premium)
Risk discount = Value at the risk-free rate - Risk-adjusted value
Suppose a project is expected to pay $500,000 in one year. The risk-free rate is 4% and a risk premium of 6% is added for the project's uncertainty.
Value at the risk-free rate: $500,000 / 1.04 = $480,769
Risk-adjusted value: $500,000 / 1.10 = $454,545
Risk discount: $480,769 - $454,545 = $26,224
The market would pay about $454,545 today for the risky cash flow, compared with $480,769 if it were safe.Case study
Seen in the real world.
Redwood Mining is a fictional company used in an illustrative scenario. It is considering a new mine expected to produce a cash inflow of $500,000 next year and similar amounts afterwards.
The finance team starts with a risk-free rate of 4% and adds 6% for commodity price risk and a further 2% for political risk in the mine's country, giving a discount rate of 12%. At that rate the first year's cash flow is worth $446,429, compared with $480,769 at the risk-free rate.
The board compares the full project value with the investment cost and finds it falls short. It asks the team to test the 2% political premium, and a risk insurance policy reduces it to 1%. The project becomes marginally attractive, which shows how sensitive decisions are to the size of the risk discount.
Watch out
Common mistakes.
- Using the risk-free rate for risky cash flows. This overstates their value and can lead to bad investments.
- Adding a premium without explaining it. Each element of the premium should have a clear reason.
- Counting the same risk twice. If a forecast is already cautious, adding a large premium on top can undervalue the project.
Questions
People also ask.
What is a risk premium?
It is the extra return investors require for taking on more risk than a risk-free investment. It is added to the risk-free rate to get the discount rate.
Is a risk discount the same as a discount rate?
Not exactly, because the discount rate includes the risk-free rate, while the risk discount is the part of the markdown caused by risk.
When are direct discounts used?
In valuing private company shares, minority stakes and deals where specific risks affect the price. The size of the discount is usually negotiated and documented.
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