One of the most important considerations in determining the value of any investment, asset or business, is to look at returns of comparable investment that share similar risk and return profiles. In the case of private investments, the return of a company is the amount necessary to compensate its shareholders for the business and financial risks they bear; the return on invested capital is the return they expect to earn through a combination of dividends and capital appreciation. The expected return of an investment can be considered using the different investments and their risk and return profiles. There are various ways of determining the expected return of a private investment. Each method has its benefits and pitfalls. One of the recognized methods is by building up the risk profile of various investment opportunities and their returns to arrive at the appropriate return of the subject investment.
The first comparison is that of investments that are considered safe investments. These investments are often referred to as risk free investments. In this case, US government bonds, also known as U.S. Treasury marketable securities, which are bonds issued by the government over time, generally with a promise to pay periodic interest payments and to repay their face values on their specified maturity dates – are generally considered risk free. U.S. Treasury securities are debt instruments issued to raise money needed to operate the federal government and pay off maturing obligations. These investments are often considered risk free for the simple reason that the US federal government will honor all its obligations at all times.
Given that private investments are certainly more risky than government bonds, you have to add on additional risk to compensate the investor for investing in a private company. Given that the financial markets have thousands of companies that one can draw inferences from, the returns associated with these publicly reported companies suggest that they would be a good proxy when comparing to an investment in a private company.
Studies suggest that the market returns of the company less the risk free investments, also known as the “market premium”, is somewhere in the range of 5% to 7%. These studies report that diversified markets should compensate for market a premium over the risk free rate at any given point in time.
Other factors to consider are premiums associated with the size of the private company when compared to the publicly traded companies in the exchanges and other risk factors that are specific to the subject investment being considered.
While each method uses logical reasoning to arrive at a rate of return conclusion, there are proven flaws with each method, and can produce various returns and therefore outcomes when determining a value for the company. Appraisers should pay significant attention to the use of each method and understand their directional biases, should also consider disclosing them in their report. In the end, appraisers with good continuing education, solid valuation and business experience and judgment are often necessary when making their conclusions to each of the factors discussed above.
UNDERSTANDING PRIVATE INVESTMENT EXPECTED RETURNS
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