Shake Shack and Valuation Risk Factors
It wouldn’t be wrong to say that in the valuation world our number one goal is pricing risk. Â Afterall, no matter how you look at it, valuation is essentially looking at the likelihood of achieving a particular return on investment. Â Part of a valuation, then, is understanding Risk Factors that impact a business.
What Are Risk Factors?
Risk Factors are items or areas which expose the company to risks that might materially impact their worth in the market. Â The list of potential risk factors is wide and sundry, but examples include:
- Over-reliance on an employee or employees
- Over-reliance on a shareholder (common in very small businesses)
- Exposure to a single customer or vendor (one customer makes up 80% of sales…)
- Legislative Risk (example: Marijuana Dispensaries)
In part, the identification of risk factors help us understand how one particular company is different from it’s peer group. Â In the chart below, the difference from V0 and V1 is often the application of Risk Factors.
The Shack Shake: A Practical Example
The Shake Shack recently IPO’d, and as part of their offering memorandum helpfully included a discussion of Risk Factors to their business.
“We are subject to a number of risks, including risks that may prevent us from achieving our business objectives or that may adversely affect our business, financial condition, results of operations, cash flows and prospects.
- our long-term success is highly dependent on our ability to successfully identify and secure appropriate sites and timely develop and expand our operations in existing and new markets
- damage to our reputation could negatively impact our business, financial condition and results of operations
- food safety and food-borne illness incidents may have an adverse effect on our business by not only reducing demand but also increasing operating costs
- shortages or interruptions in the supply or delivery of food products
- risks related to our international operations and our international licensed Shacks; and
- we face significant competition for guests, and our inability to compete effectively may affect our traffic, Shack sales and Shack-level operating profit margins.
From a business valuation perspective, the question is how do these risks effect the company relative to their peers. Â Thus if we have established a baseline value for a company using market comps, that value is based broadly on that basket of peers.
Many risk factors are similar based on the industry. Â For instance in the restaurant industry, all participants will be subject to factors related to “food safety.” Â However, given the young nature of the Shake Shack, the company is more dependent on expanding its footprint and finding solid locations. Â Thus, as a risk factor, this is more risky than the peer group.
Takeaways
Valuation is about pricing risk. Â We do a lot of work to try and understand how a business fits into a certain industry or peer group…. but then we also spend a lot of time understanding how a company differs from the mean. Â Identifying and understanding risk factors is one tool in that tool box.
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