Who are the marginal investors in your company?
Risk is an integral part of valuation. When we try to value a company or equity, we use the cost of capital or the cost of equity as the discount rate. For equity investors, the cost of equity is the expected return they need to make in the long term to compensate the risk that they have taken by investing in the equity of the firm.
However, if there are thousands of investors in a firm, whom should we listen to determine the cost of equity? It’s always the marginal investors. To qualify as the marginal investor, he needs to satisfy two criteria – 1. He should own significant portion of the equity 2. He should trade on that equity. If an investor owns 1000 shares of Novartis, he will have no impact on the stock price and neither if he owns millions of shares and never trades.
It is assumed that the marginal investors set the prices and hence their assessment of risk should define how we should think about the risk. If the marginal investors are diversified, the only risk they care about is the market risk i.e. the risk that they cannot diversify. If they are not diversified, they will care about all the risks in the company.