Discounting for risk

Simply discounting back the value of income payments according to the interest expected from a safe investment does not allow for the element of risk. The discount rate has to be suitably chosen so as to allow for all possible risks in the particular investment under consideration.

Consider the example above, where there are two ways of saving money for ten years: under the mattress or safely invested. For the invested money, the risk will be minimal if the funds are put into safe and secure bonds. For the money put under the mattress there is the risk of theft or burglary. If there is a ten percent chance of the money under the mattress being stolen during the ten years, the effective value will be reduced by ten percent because there is only a ninety percent chance of realising the anticipated future amount at the end of the period.

Note

Any risk of loss can be allowed for in this way, simply by adjusting the future value. The fact that there is a risk of the money being stolen means that any expectation as to its future value cannot be as great as if it were locked up in the vaults of an impregnable bank. This lesser value is calculated by multiplying the future value by the probability that the money will not be stolen. So, if there is a ten percent chance of the money being stolen there is a ninety percent chance that it won't be stolen. The future value is then determined as being only ninety percent of the full value of the money. It is these kinds of calculations that are used to calculate the future values of revenue streams and share price valuations.

Investors always have a standard upon which to base their income valuations. This usually takes the form of a current market valuation placed upon an income which is more or less guaranteed, i. e., long term bonds of a large and stable government. This provides them with the market value of a relatively risk free investment. Knowing the price of a risk free investment, enables them to adjust this price appropriately downwards to discount for any perceived risks in any riskier investments.

Risk can also be allowed for by adjusting the expectations of an income. As capital amounts can be converted into income equivalents, risks can be discounted by increasing the income required to justify a particular amount of investment. In other words, a higher rate of return would be needed to compensate for any added risk. This effectively increases the discount rate needed to be applied to the calculation of future values.

For example, if there were twice the risk, the investor would be discounting any projected income back at twice the rate. This can be seen from figure 3.3. If an income of $100 per annum from a safe bond returning 5% is valued at $1,985, then an investment with a five percent risk would have to be discounted back at 10%. So, the value of a $100 dollar per year of income with 5% risk would be worth only $995: about half as much.

If the risks were judged such that there might be a fifteen percent chance of the projected income not being realised, then the discount rate for the projected income would need to be raised from 5% to 20%, reducing the value of this riskier income to $498. It is by using this kind of calculation that an investor can look at the projected income of a business, assess the risk and so be able to give a valuation to the business.

This has great relevance to an investor's or a business angel's expectations of the returns they were looking for in an e-business venture. For example, the early dotcoms that went on to be listed on the market had a failure rate of 80%. If this risk factor is taken into account it would be madness for the valuation of any new dotcom's projected earnings to be based upon a 5% discount rate. A more sensible view would use a discount rate of between 20% and 50%. This would see an investor valuing a business with projected earnings of one million dollars per annum at only between $5 million and $2 million. That is a P/E ratio (share price/earnings ratio) of between 5 and 2.

It is these realistic valuations that would see Venture Capital companies and business angels appearing to be extremely greedy when it appears that they want to see their money returned within only two or three years. The fact is they are not being greedy at all, they are simply discounting appropriately for the risks involved in the investment. After all, if venture capital or angel finance didn't allow for the risks involved they would be far better off investing their money in safe government bonds.