Understanding the risk-reward ratio is vital for anyone planning to acquire ownership of a business via private equity investment. When acquiring a business as an investment, there are some considerations that need to be assessed before deciding to proceed with the acquisition to ensure your money is protected and that the company you acquire is profitable.
What is a Risk-Reward Ratio?
Risk-reward ratios are used as a measurement of a business’s financial health and indicate whether or not it is a worthwhile investment and will be profitable in the long term.
Although risk-reward ratios are essential for risk management, merely understanding how the risk-reward ratio is calculated is not enough to make a smart investment. An understanding of the industry the company operates in is also needed, and its impact on the risk-reward ratio.
To make a sound decision, investors need to be fully aware of the level of the potential risk they are taking on when they are making a business acquisition. A thorough understanding of the company’s debt level and how that impacts on its potential profit and prospects for further reinvestment in the business needs to be understood.
How Risk-Reward Ratio is Calculated
There are a few different risk-reward ratio methods used when assessing how good a private equity investment is likely to be. Different investors may have a preference over which method of calculation that they use. However, these are the most widely used methods for calculating an investment’s risk-reward ratio: debt to equity ratio, debt to capital ratio, interest coverage ratio, and the degree of combined leverage.
Risk-Reward Calculation Methods
Debt to equity ratio – Calculated through how much a company is financed through debt versus funds received by the business.
Debt to capital ratio – Calculated by taking a company’s debt and dividing it by the total capital.
Interest coverage ratio – Calculated by the number of times that a company can cover it’s annual interest payments for debt through its current earnings.
The degree of combined leverage – Calculates the financial and business risks of a company’s earnings per share as a result of increased or decreased sales.
Businesses with a lower debt to capital ratio and lower debt to equity ratio are the preferred choice for investors. Companies with higher debt to capital ratios and higher debt to equity ratios are seen as a less attractive investment opportunity as they offer little security or reassurance of a company’s long term profitability.
Risk-reward for private equity investments applies similar rules as those used in trading stocks and shares. Investors use the ratio to manage how much capital they are investing and manage the risk of loss. Using the ratio also helps investors to calculate how much return they can expect from the money they invest and will help to show how risky the investment is.
Determining the Value of a Business
No one wants to spend more than they need to acquire a business. Therefore, calculating the value of a company is essential. It is crucial to remember that the value of a business will change over time, so finding a data-based, objective way to establish its value is ideal, rather than relying on the price that the seller wants to charge.
The value of a business is influenced by both internal and external factors, which means that the value can fluctuate by conditions both in the business’s control and those that it has no control over.
Internal factors such as investment in the future of the business and management changes can influence the value. External factors such as the economy or changes to the legislation can also impact value.
There are three main approaches used to calculate the value of a business: the asset approach, the income approach, and the market approach.
Asset approach – the asset approach calculates a company’s value based on its assets and liabilities. However, this approach overlooks assets that aren’t tangible and therefore, almost impossible to value things like patents, intellectual property, and reputation.
Income approach – the income approach to business valuation is based on a company’s cash flow minus the legitimate expenses that it incurs. Looking at a few years of the company’s cash flow information and taking an average will help you to estimate the business’s future earnings.
Market approach – the market approach is based on comparison and determines a business’s value based on data from companies operating in the same or related industries. This offers a reliable method of valuing a business as it is based on real-world examples of what a business is realistically worth.
Using the Market Approach to Evaluate Industry-Specific Investment Risks
To gain a thorough understanding of a business’s potential profit versus its potential risk, it is essential to understand the industry in which it operates. This can be achieved by examining comparable companies operating in the same industry for guidance and utilizes the market approach to business valuation.
Investors that are considering the acquisition of a private company can refer to publicly traded companies in the same industry or that provide similar offerings and use this to evaluate the risk of their potential investment.
To ensure that the prospective investment will provide a worthwhile return, a risk-reward ratio can be seen in these similar businesses over the timeframe that you plan to hold onto the company before selling it to realize their return.
This information is extremely valuable in the decision-making process for business investments, as it takes objective data from the real world as the basis of the decision-making process.
Whether you’re an individual looking to acquire a business, the experts at DVS group can help you every step of the way. If you are ready to get started, call us at (913) 701-3475 or use the contact form to set up a consultation. You can also click below to view our Acquisition Workbooks and resources.Check Out Our Acquisition Workbooks!