Risk coverage approach

The risk coverage approach is a method for valuing companies . In practice, the mistake is often made that value and capital market orientation are equated.

The risk coverage approach is often used instead of the capital market-oriented method of the Capital Asset Pricing Model (CAPM) or other risk-based valuation approaches, as it eliminates essential capital market imperfections by taking rating and financing restrictions into account. For this reason, the risk-related capital requirement (can be operationalized as Value-at-Risk or Conditional Value-at-Risk) as a special downside risk measure forms the basis of a risk-based assessment . The scope of the earnings risk determines the value and the risk-appropriate financing structure at the same time.

In particular, the focus on information located in the company instead of historical capital market data distinguishes the risk coverage-oriented cost of capital determination from the CAPM. For this reason, the risk coverage approach can also be used in particular by non- listed companies .

Risk concept

The concept of risk is essential in the context of risk-based assessment procedures. In general, risk can be described with a broader and a narrower definition. Because of this, it can be interpreted as both an opportunity and a threat. The terms aim at the positive or negative deviation of the plan from the expected value . In connection with the risk coverage concept, the downside risk measure is often used. This means that the risk is only limited to a possible loss, i.e. to a negative deviation from the plan.

The risks in connection with future payment series ( ) are taken into account in 2 different ways. The first option is the risk premium method , which is used to add a premium to the risk to the risk-free interest rate . The discount rate for discounting future expected time series is . In simplified terms, the present value corresponds to: ${\displaystyle {\tilde {Z}}}$ ${\displaystyle k=r_{z}+r_{f}}$

${\displaystyle W({\tilde {Z}}_{1})={\frac {E({\tilde {Z}}_{1})}{1+r_{f}+r_{z}}}={\frac {E({\tilde {Z}}_{1})}{1+r_{f}+\lambda _{RZ}R({\acute {Z}}1)}}}$

The disadvantage of this method is that positive and negative payments are subject to valuation errors, which is why the value of the discounting increases in the case of negative payments.

The security equivalent method, on the other hand, takes into account risk aversion, which results in a lower value for insecure payments than for secure payments. The present value of this procedure is calculated as follows:

${\displaystyle W({\tilde {Z}}_{1})={\frac {S{\ddot {A}}}{1+r_{f}}}={\frac {E({\tilde {Z}}1)-\lambda _{S{\ddot {A}}}R({\tilde {Z}}1)}{1+r_{f}}}}$

Problems of the CAPM

In practice, the valuation of companies is often based on theories which assume a perfect capital market (e.g. CAPM). The application of the CAPM is prone to errors, particularly in the area of ​​unlisted companies, since historical data based on the capital market (e.g. time series of stock returns) cannot be used. At the same time, only backward-looking data is used in CAPM, but the future of a company (for example with impending bankruptcy) is ignored.

The company's individual informational advantage with regard to the risks is not considered, there is complete information efficiency . It is therefore assumed that the capital market is just as well informed about the development of the company as the company management. Only systematic risks that cannot be eliminated through diversification are recorded in the CAPM . Company-specific risks are not used in the calculation. Furthermore, perfectly risk-diversified portfolios of the investors are assumed. This fact is taken ad absurdum, especially with German medium-sized companies, since investors there invest a large part of their capital in their own company. In its conventional rate of return equation, the CAPM is still associated with the “ circularity problem ”.

Objectives and benefits of the risk coverage approach

The risk coverage approach follows the principle of the input-oriented evaluation method. The method is particularly used for valuation objects that cannot or can hardly be traded. A valuation of companies can therefore also be carried out without capital market data. In contrast to the CAPM and other capital market-oriented valuation methods, imperfections in the capital market and risk-based capital costs (or risk discounts) are also taken into account. In the risk coverage concept, rating and financial restrictions of the creditors as well as the possibility of bankruptcy ( in the sense of the insolvency risk ) are included in the calculation.

With this approach, the risks relevant for the assessment are derived from the cash flows of the planning period and are consistent with planning. It is therefore controlled in a future-oriented manner instead of insisting on historical data in a past-oriented manner. At the same time, it becomes clear that company-internal information is preferred to market-oriented data, since the company management (inside information) can assess the specific risks better than the capital market.

In the risk coverage approach, both systematic and unsystematic, i.e. H. company-specific risks recorded. This is particularly advantageous if you start from a portfolio that is not perfectly diversified, which often corresponds to reality. 

Process of the risk coverage approach

The process from risk to value of a company is as follows:

Process of the risk coverage approach

In imperfect markets, the equity requirement is operationalized using the value at risk using simulations ( risk aggregation ). The cost of capital rates are then determined depending on the equity requirement. The following principle applies: more risk implies a higher need for “expensive” equity capital, leads to higher capital costs and a falling company value.

risk

The first step in the process up to the determination of the company value is the identification of significant individual risks as well as the storage with probability distributions (e.g. normal or triangular distribution) of the positions, which can lead to deviations from the plan in the future. Risks can therefore be seen as causes for deviations from the plan. Both systematic and company-specific, unsystematic risks are recorded. With the help of B. the Monte Carlo simulation a representative sample is generated. This large number of risk-related simulation runs make fluctuations in company development clear. From this, in turn, conclusions can be drawn about the extent of the risk.

Based on the scope of the risk, it can be deduced which equity capital is required to cover the risks in order not to exceed a certain probability of insolvency.

Capital requirements

The equity requirement is therefore the result of the company's internal planning data, which result from the quantification of the systematic, unsystematic and unsystematic risks (risk aggregation). A functioning, integrated risk management system is essential for quantification .

When considering the insolvency and financing restrictions, it makes sense to use the equity requirement (EKB _p ) as a downside risk measure. The equity requirement is operationalized using the value at risk (VaR) measure. It therefore describes the scope of possible risk-related losses that will not be exceeded in a planning period with a given probability p . The maximum acceptable probability of insolvency ( p ) is specified by the creditors. At the same time, the equity requirement shows how large the risk-related potential consumption of equity is and the extent to which additional funding is required if there is insufficient liability limitation. This is followed by a conceptual separation of the equity into a risk-bearing part (EKB) and a part necessary to cover risk-related losses. The company therefore needs as much equity as losses can occur that can use up the equity. A comparison of equity with the need for equity is understood as the degree of the threat to the company's existence. From this relationship, conclusions can be drawn about the extent of the risk, which in turn allows statements about the probability of insolvency. This probability of insolvency is derived from the rating.

Risk-adjusted cost of capital

The cost of capital rates are then determined depending on the equity requirement. In general, the cost of capital is understood to be a minimum requirement for the expected return on an investment, which is why it can also be interpreted as a value driver for the company. They are therefore the benchmark that must be exceeded by the expected return in order for the company to generate value. In practice nowadays the cost of capital rates are often not differentiated enough and assumed to be constant over a longer period of time, which is why it is hardly possible to weigh up the returns and risks. Therefore, there is a tendency to conduct riskier business.

The calculation of the total cost of capital depending on the equity requirement as a risk measure is carried out by weighting the equity and borrowing costs:

${\displaystyle k_{WACC}=k_{EK,p}{\frac {EKB_{p}}{GK}}+k_{FK,p}{\frac {GK-EKB_{p}}{GK}}(1-s)}$

In contrast to the CAPM, the weighting in this approach is not based on market prices, but on the basis of the equity capital required to cover the risk. There are two components that determine the total cost of capital: risk premium and risk scope. The risk premium corresponds to the price per unit of risk and is based on a real economic foundation. The scope of risk is calculated from internal company data and is consistent with planning.

A higher requirement for “expensive” equity capital is determined by an increasing (aggregated) risk. This requirement, which is used to cover possible future losses, is the cause of increasing total capital costs, since k _EK <k _FK . This means that more risk leads to more expensive equity capital and this to a higher cost of capital.

Value of a company

The cost of equity can be represented as  r _EK = r _{z, p} + r _f . The risk premium is therefore dependent on the rating as well as information on the return and risk of an alternative investment on the capital market.

${\displaystyle r_{z,p}=\lambda _{VaR}={\frac {Marktrisikopr{\ddot {a}}mie}{VaR_{p}({\tilde {r}}_{m})}}={\frac {E({\tilde {r}}_{m})-r_{f}}{VaR_{p}({\tilde {r}}_{m})}}={\frac {(r_{m}^{e}-r_{f})}{-(r_{m}^{e}+q_{p}\cdot \sigma _{m})}}}$

For the assessment of a company, the risk coverage approach by means of replication of as r _{z, p} (for 1 period) results :

${\displaystyle W({\tilde {Z}}_{1})={\frac {E(Z_{1})-r_{z,p}EKB_{p,t=1}}{1+r_{f}}}}$

The calculated security equivalent corresponds to the amount of money that corresponds to the same economic benefit for the evaluator as in the case of uncertain payment. The risk discount is made up of the multiplicative capital requirement and the risk premium rate and can be interpreted as imputed additional costs of equity and, in the case of the expected additional return from the risk assumption of the equity capital versus the lenders. The equity requirement and the risk premium depend on the insolvency probability p .

If you are in the field of real investments, the net present value after deducting the initial investment in t = 0 is often of interest:

${\displaystyle C_{0}=W({\tilde {Z}}_{1})-I_{0}}$

Individual evidence

1. ↑ Werner Gleißner: Fundamentals of Risk Management With well-founded information for better decisions. 2016, p. 374 .
2. ^ K. Spremann: Valuation: Basics of modern company valuation. Oldenburg 2004, p. 253 ff .
3. ↑ Werner Gleißner: Risk analysis and replication for company valuation and value-oriented company management . In: Wist Scientific Studies . 7th edition. 40th year 2011, p. 346 .
4. ↑ L. Kruschwitz, A. Löffler: A new approach to the concept of discounted cash flow . In: Journal for Business Administration . 1st edition. 55th year 2005, p. 24-28 .
5. ↑ Werner Gleißner: Cost of Capital: The weak point in company valuation and value-based management . In: Finanzbetrieb . 4th year 2005, p. 218-219 .
6. ↑ F. Kerins, JK Smith, R. Smith: Opportunity cost of capital for venture capital investors and entrepreneurs. Journal of Financial and Quantitative Analysis . 2nd Edition. 39th year 2004, p. 385-405 .
7. ↑ A. Shleifer: Inefficient markets: An introduction to behavioral finance . Oxford University Press, 2000.
8. ↑ Werner Gleißner: Cost of Capital: The weak point in company valuation and value-based management . In: Finanzbetrieb . 4th year 2005, p. 223 .
9. ↑ Werner Gleißner: Fundamentals of Risk Management With well-founded information for better decisions . 2016, p. 375 .
10. ↑ K. Petersen, C. Zwirner, G. Brösel: Handbook company valuation . Bundesanzeiger Verlag, 2013, p. 714-715 .
11. ↑ Werner Gleißner: Risk-based cost of capital rates as value drivers in investments . In: ZfCI magazine for controlling and innovation management . 4th year 2006, p. 56 .
12. ↑ Werner Gleißner: Cost of Capital: The weak point in company valuation and value-based management . In: Finanzbetrieb . 4th year 2005, p. 220-221 .
13. ↑ Werner Gleißner: Risk-based cost of capital rates as value drivers in investments . In: ZfCI magazine for controlling and innovation management . 4th year 2006, p. 58 .
14. ↑ Werner Gleißner: Value-oriented corporate management and risk-adjusted capital costs: risk analysis instead of capital market data as an information basis . In: Controlling . 23rd year, no. 3 , 2011, p. 171 .
15. ↑ Werner Gleißner: Company valuation and value-oriented controlling: risk analysis and risk coverage approach — a concept for imperfect capital markets and also non-listed companies . In: Assessment Practitioner . 4th year 2009, p. 18 .
16. ↑ Werner Gleißner: Risk analysis and replication for company valuation and value-oriented company management . In: Wist Scientific Studies . 7th edition. 40th year 2011, p. 349 .
17. ↑ Werner Gleißner: Risk-based cost of capital rates as value drivers in investments . In: ZfCI magazine for controlling and innovation management . 40th year 2006, p. 54-55 .
18. ↑ Werner Gleißner: Fundamentals of Risk Management With well-founded information for better decisions . Vahlen, 2016, p. 375 .
19. ^ Werner Gleißner: Capital costs. The weak point in company valuation and value-based management . In: Finanzbetrieb . 4th year 2005, p. 220 .
20. ↑ Werner Gleißner: Fundamentals of Risk Management With well-founded information for better decisions . Vahlen, 2016, p. 377 .
21. ↑ Werner Gleißner: Risk analysis and replication for company valuation and value-oriented company management . In: Wist Scientific Studies . 7th edition. 40th year 2011, p. 350 .