The art of double counting risk in Valuation
Blame it on the bias during the valuation process, one tends to favor its value depending on which side of the negotiation table he or she is. One of the tools used to push the value up or down is the discount rate/cost of equity ( assuming the project is funded only with equity). Before we delve into how the discount rates are used, we first understand who sets up the hurdle rate in a company/project. Is it a small stockholder, all the stockholders, managers of the firm with no stock/few stocks or the marginal investors?
The risk is always seen through the eyes of marginal investors. They are those who set the hurdle rate or the discount rates of the project or company. In case of private firms, the marginal investors are the owners or business angels or VCs and in general they are not diversified. Many VCs tend to diversify in one specific sector and few could claim to be diversified in all sectors . Hence, depending on how much they are diversified, they care not only about the market risk but also all of the risks of the company and hence the hurdle rate of the private firm is high. On the other hand, the marginal investors ( Institutional Investors, pension funds etc ) of public firms are diversified. They care only about the market risks as they have already diversified the firm specific risks and hence the hurdle rate of public companies are lower than that of the private firm.
One important property of hurdle rate is that it is continuous and it does not take into account discrete risks such as failure, nationalization, distress etc. Those risks are better dealt with using probabilities and expected values than in the discount rates.
Hence, if you are valuing an early stage biotech product, the other party would be tempted to push up the discount rate as it has more risks of failure in the early stage but it is very difficult to encapsulate the risk of failure in the discount rate. The best option is to calculate the discount rate based on your exposure to the market risks and the risk premium your investors would demand for the product and adjust the cash flows with the probabilities. If you have already adjusted the cash flows with probabilities, pushing up discount rates to count for the failure of the product, would be double-counting the risks.
However, these arguments are valid if the company works in CAPM world. If it uses rule of thumb to calculate the discount rates, then that’s another story.