Firm-Specific Risks in New Zealand SME Valuations

Certain valuation methods in New Zealand often, not always, employ a discount rate derived from the Capital Asset Pricing Model (CAPM).  Discounted Cash Flows (DCF) and Multi-Period Excess Earnings Methods (MEEM) are examples of such methods.  In this article we will discuss the discount rate from CAPM and, for non-valuation experts, shed some light on its primary components.

When the valuation practitioner says that the discount rate was derived using CAPM, there are a number of concepts you need to be aware of.

First: Risk Free Rate

As a starting point, the CAPM makes the observation that the investor’s[1] required return from investing in risk-free securities is not necessarily 0%.  I.e. an investor would demand a positive return to invest funds, even if there was no risk facing that particular investment. [2] Suffice to say that a reasonable proxy for this “risk-free-rate” may tend to be the interest on long-term government debt. [3]

Second: Investing in businesses / “Market Risk Premium”

On top of the risk-free-rate, we add a risk component to compensate the investor for investing in shares (i.e. businesses or equities).  We estimate this additional risk component as the product of the subject business’ “equity beta” and a “market risk premium” (MRP).[4]

Within the CAPM, the discount rate reflects the perspective of a diversified portfolio wherein all of the “un-systematic” risks have been diversified away and only the systematic risk remains.  Systematic risk is the only market risk which the classic CAPM allows for.  According to the CAPM then, this is where we should stop.  That is because, in a pure CAPM sense, the CAPM has at this stage encapsulated all of the risks necessary to derive the discount rate.

To illustrate, imagine that you are valuing Honda.  It is important to note that the MRP assumes the perspective of an investment into all of the available car manufacturers.  That means that the first two components we discussed (risk-free-rate and MRP) produce the discount rate facing someone with an investment into a portfolio of shares in Ford, Holden, Ferrari, Honda etc.[5] Graphically, we could depict the following factors as follows:

  • Required return on the y-axis
  • The risk-free-rate as the intercept on the y-axis
  • Equity beta on the x-axis
  • Slope as the MRP
  • Holding a diversified investment into all car manufacturers at the indicated marker discount rate (say 8%).


In theory, this is where the valuation practitioner should stop.  That is because the classic CAPM assumes that all the un-systematic risks have been diversified away.

Third: Investing in this particular business / “Un-systematic Risks”

If we believe that un-systematic risk factors are present (at Honda) which are not present at the other car manufacturers, and which we want to reflect in the valuation; the theoretically[6] appropriate place to reflect those un-systematic risks, is within the cash flows.  Yet, this does not always happen.  Instead, what valuation practitioners may tend to do is to add a third component to the discount rate to reflect firm-specific, un-systematic risks in New Zealand SME valuations.

In that case, these particular risks would manifest as an increase to the discount rate as depicted below.


This manner of adjusting the discount rate gave rise to the use of the “Modified” CAPM (MCAPM) and the Build-Up Model.  Both of these models have become widely used in New Zealand for SME valuations.

This additional ‘premium’ (or modification) reflects the valuation practitioner’s subjective adjustment for Honda specific risk factors.  Common examples of why one might make this adjustment are when the entity being valued:

  • is a significantly smaller firm (i.e. with no corporate governance, not subject to financial audits and has less access to resources)
  • has additional volatility in its performance outlook due to being an undiversified investment
  • has un-listed shares
  • has a heavy reliance on key staff
  • has a heavy reliance on certain suppliers or customers.

This is not an exhaustive list and counsel will find that many others often surface.


  1. It is worth reminding counsel that, when the valuation practitioner makes these un-systematic risk adjustments to the discount rate, they are fundamentally subjective (just as they would be if they were applied to the cash flows). You would do well to scrutinise these adjustments carefully in your next valuation matter.
  2. We do not bemoan the making of firm-specific adjustments to the discount rate. It has become accepted in valuation practice as well as in financial reporting.[7]
  3. Finally, we remind other valuers that if these adjustments are made in the discount rate (i.e. in %), you should be able to quantify and articulate the same impact into your cashflows (i.e. in $). If you find the latter difficult to support or articulate, you may need to re-assess your discount rate adjustment.

    [1] Or the person whose valuation perspective is of relevance
    [2] We do not in this article discuss theories on the term-structure of interest rates
    [3] That of course depends on the country, and governments are certainly capable of not being “risk-free” and subject to default risk.  Nevertheless, we suspect the concept is sufficiently apparent for our purposes here
    [4] Most commonly we would use the tax-adjusted MRP (TAMRP) in New Zealand within the Brennan-Lally version of the CAPM.
    [5] These are of course not listed car-manufacturers in New Zealand and used arguendo only
    [6] For the classic CAP.
    [7] See NZ-IAS36, paragraph 55(b) and Appendix A generally, and A1 and A16 in particular.