We have previously looked at profit as a return being measured by ROE. ROE is great for comparative assessments over various businesses to see which are best at converting sales into returns to investors. But ……..
ROE ignores risk. Obviously if your business is investing in lottery tickets, this is pretty high risk. However, you may have a golden streak and earn 1000% on your investment – but you know this is not sustainable. Other times you know you will just lose all money spent on buying lottery tickets. Common sense tells you that this is a very high risk strategy – unless you know the winning numbers in advance! You would consider very closely whether you want to take the risk of losing your entire investment for the potential of an extraordinary return should your numbers come up. In fact a rational investor would probably quarantine the investment to the “what they can afford to lose but don’t mind” bucket.
There must be a better way of bringing risk into the calculation. Well, as always, there are a number of ways it can be done but there are a couple of fundamental issues to grasp.
Risk is in fact often used erroneously instead of volatility. Think about the lottery example – the issue is the extreme volatility in return – from complete loss to 1,000% return.
Volatility is measured by what is called beta. The more volatile, the higher the beta – the less volatile, the lower the beta. By applying the appropriate beta to the return generated, you can then reflect the risk in the return. And by then dividing this risk adjusted return by your investment, you can effectively compare all investment opportunities on an “apples to apples” basis with risk adjusted in the comparison.
However, it is difficult to get a handle on what the beta is in the world of privately owned business. With ASX listed investments, the whole market has a beta of 1.0. If a share is calculated to have a beta of 0.8, this means it should move with less volatility than the overall market. One with a beta of 2.0 would move far more (up and down) then the overall market.
All sounds a bit pointy headed doesn’t it? What happens in the real world?
What is generally done in private business sales or purchases, is that the earnings multiple is adjusted to reflect the perceived or actual risk. This adjustment in the multiple a person is prepared to pay (because the business is seen as more, or less, volatile investment) “makes up” for the risk.
To put it in perspective, someone may pay a 2 times earnings multiple for a business reliant on luxury car sales whereas they may pay 5 times earnings for a business seen to be stable and recession proof (e.g. health based industry).
Marshall Vann – Realistic Business Solutions
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