A Conceptual Framework for Practical Risk Measurement in Small Businesses

Small businesses are financial assets. Placing a value on these small businesses often is based on a specific perspective. Pricer, Vos, and Dixon (1987) discuss 11 approaches to business valuation. These include book value, adjusted book value, liquidation value, replacement value, capitalization of earnings, the fundamental pricing method, and the probabilistic fixed-horizon methods, among others. Each of these methods has its advantages and disadvantages, depending on who is doing the valuation and why. Traditional financial valuation acknowledges the existence of subjective (i.e., who and why) valuation, but suggests that in efficient liquid markets, all of these subjective measures are captured by the utility function of the investor. This investor, being risk averse, will choose to invest so that the expected return from the investment compensates sufficiently for the amount of exposure to risk due to that investment. The investor has the ability to invest in more than one asset, and thereby spreads out the risk exposure and is left with a "market portfolio" of assets. Therefore, the investor is interested in the amount of systematic (nondiversifiable) risk inherent in the investment, since the unique risk of the individual investment can be reduced simply by owning a moderate number (12 to 18) of different investments. Small businesses, as a class of financial assets, should fit into this neat theoretical valuation framework. Unfortunately, there are practical difficulties in applying these theories to small businesses. After recalling the basic understandings of uncertainty and risk, three basic characteristics of a small business are used to offer a conceptual framework that reconciles theoretical and subjective approaches to small business valuation. Keeping this framework in mind, previous approaches to the small business valuation problems are reviewed and a new approach is offered using accounting betas. Finally, further research needs are discussed. UNCERTAINTY, RISK, AND VALUE Risk, unlike uncertainty, is measurable. This distinction is important in a search for a risk-based asset value. Often, where small businesses are considered, it is uncertainty that is thought to include the more important factors in determining its price. While it may be appropriate to concentrate on uncertainty, which is done in more depth later, it is useful at this time to set aside concerns with such chance factors as technological obsolescence, qualities of the competitors, potential governmental rule changing, adverse macroeconomic possibilities, and natural disasters. These concerns are just a few legitimate examples of the very real uncertainties facing small businesses. While they do play an important part in the asset valuation process, and therefore must be considered, they are not readily measurable; therefore, they are considered to be uncertainty not risk. Once the amount of risk inherent in a small business can be measured, the required rate of return from that business can be determined. The Capital Asset Pricing Model (CAPM) suggests a simple linear relationship between risk and return, namely: |E.sub. (r)~ = |r.sub. f~ + |beta~(|r.sub.m~ - |r.sub.f~), where: |E.sub. (r)~ is the expected return from an asset, |r.sub. f~ is the risk-free minimum expected return, |beta~ is the measure of risk, and |r.sub. m~ is the return provided by the entire market. With risk defined and measured in a CAPM context, and an expected rate of return determined, the financial process of small business valuation proceeds by discounting the expected future cash flows by the risk-adjusted rate of return to arrive at the present value of the firm. Measurements of risk rest on the concept of variability. Complete certainty--as in the risk-free rate of return--implies that the amount expected as a return is beyond doubt. When returns are not certain, by definition they become risky. …