Specific Company Risk Premium

The standard way to work out what return an equity investor needs is the CAPM. It has one measure of risk in it: beta, which captures how much the stock moves with the market. That is market risk, shared by everybody.

A start-up's risk is not like that. It has no track record. It may have no revenue. It may simply die. None of that is market risk, and none of it shows up in a beta.

So analysts add a slice by hand. It is called the specific company risk premium, or SCRP. It goes into the discount rate, on top of the CAPM answer, to pay for the risks that belong to that one company.

A bigger discount rate means a smaller present value. So the SCRP is the point at which a valuer's judgement about how fragile a business is turns into rupees off the valuation.

Where it enters the chain. Chapter 11 builds the discount rate as a WACC — the post-tax cost of debt and the cost of equity, weighted by the debt-to-equity mix. The cost of equity is usually based on the CAPM:

Cost of Equity = Rf + Equity beta x (ER - Rf)

  Rf        = risk free [rate of return](/glossary/return)
  ER        = market rate of return on equity
  ER - Rf   = the [market risk premium](/glossary/market-risk-premium) ([systematic risk](/glossary/systematic-risk))

But the workbook then adjusts it, and the adjustment is the exam point. The CAPM cost of equity is adjusted to reflect the illiquidity premium of alternative assets and further specific risk premium if any applicable to the given company. The stated consequence: the cost of equity of an unlisted company will be higher than that of a comparable listed company.

Where it is named. Annexure 11.1, on valuing start-ups. The discounting rate used for start-ups should not only include the systematic risk (beta) but the unsystematic risk of investing in start-ups, and analysts tend to apply a specific company risk premium (SCRP) to reflect the additional risk, though there are other more complicated alternatives.

What the SCRP is paying for. Annexure 11.1 lists the five reasons a start-up is hard to value, and they are the same five reasons the SCRP exists:

1. No previous track record, so growth and earnings cannot be extrapolated.
2. Small or no revenues, or a loss-making phase, so maintainable revenue, EBITDA and PBT are hard to find.
3. Equity comes from private sources — founders, family, associates, angels, VCs — so the cost of holding it cannot be the same as holding market risk from listed companies.
4. High mortality rate. Many start-ups never reach Series A, and many do not go far beyond it.
5. Illiquidity. Small-company stock attracts an illiquidity discount because the holding pipeline is very long.

The one number the workbook does NOT give. XIX-A never quantifies the SCRP and never breaks a discount rate into its parts. Its start-up illustration simply applies a 20% discounting factor and moves on. So there is no examinable SCRP percentage — only the reason it exists and where it sits in the build-up.

Do not double-count the illiquidity. In the workbook's own illustration, illiquidity is handled twice over in different places: once as an illiquidity premium inside the cost of equity in section 11.6, and once as a separate illiquidity discount of around 10% applied to equity value at the end of the start-up valuation. Know which one a question is asking about.

The workbook's own start-up illustration, in rupee lakh. A seed-stage company with a 3-year forecast, discounted at 20%:

Revenue multiplier                          2
Terminal value               80 x 2  =    160
Discounted terminal value (B)        =     93
Enterprise value (A + B)             =  187.75
Less outstanding debt                =    0.00
Equity value                         =  187.75
Less illiquidity discount (~10%)     =   18.75
Equity valuation of the company      =  169.00

The alternative the workbook runs, using a 5% long-term growth rate for the terminal value instead of a multiple:

Terminal value  =  46.4 x (1 + 0.05) / (0.20 - 0.05)  =  325
Discounted terminal value (B)                         =  188
Enterprise value (A + B), also the equity value       =  282.75
Less illiquidity discount (~10%)                      =   28.00
Equity valuation of the company                       =  254.75

The workbook's comment: assuming a long-term growth rate gives a significantly higher valuation, and this is particularly appropriate for companies that are making losses or lesser revenues presently, where the terminal value forms the bulk of enterprise value.

Where the SCRP is hiding in that 20%. The workbook does not decompose it, so the split below is ours, purely to show the position of the SCRP in the build-up — none of these three inputs is in the workbook:

Risk free rate                             7.0%
+ Equity beta 1.2 x market risk premium 6%  7.2%
= CAPM cost of equity                      14.2%
+ illiquidity premium and SCRP              5.8%   <- the hand-added slice
= discount rate actually used              20.0%

And this is why it matters in rupees. Hold everything else and drop the discount rate from 20% to 15% — that is, take out most of the SCRP — and the Year 3 discounted earnings alone rise from Rs 46.40 lakh towards Rs 52.6 lakh, with the terminal value rising with them. The premium a valuer picks by judgement moves the answer by tens of lakhs.

Chapter 11 (Valuation), section 11.6 on Discounted Cash Flow valuation, with Box 11.1 (the CAPM) and Box 11.2 (WACC), and then Annexure 11.1, Valuation Approaches for Start-Ups and Internet Businesses, where the SCRP is named and the worked illustration sits.

The examinable claims are qualitative, and they are the ones to memorise. The cost of equity of an unlisted company is higher than a comparable listed company's. The start-up discount rate must cover unsystematic risk as well as beta. The SCRP is what analysts tend to apply for that, and the workbook says there are more complicated alternatives without naming them. On the arithmetic side, the illustration is a favourite source of questions: the 3-year forecast horizon, the revenue multiple used to build terminal value, and the around 10% illiquidity discount.

• SCRP is unsystematic risk; the market risk premium is systematic risk. The published Market Risk Premium page is the ER minus Rf term shared by every company. SCRP belongs to one company and sits outside the CAPM. Confusing the two is the mistake this page exists to prevent.
• It is not the generic risk premium either. That published page is the whole block of extra return demanded over the risk-free rate in a required-rate-of-return build-up. SCRP is one named component of it, added by hand for company-specific fragility.
• It is also not the illiquidity risk premium, and not the illiquidity discount. The workbook mentions an illiquidity premium inside the cost of equity and an illiquidity discount of around 10% off the final equity value. Three different adjustments, and a question will name one of them.
• XIX-A gives no SCRP percentage. If an option offers a specific figure for it, that figure is not from this workbook.
• Higher SCRP means a higher discount rate and a LOWER valuation. The direction gets reversed under exam pressure.
• Beta does not capture start-up risk. The workbook's own third factor says the cost of holding equity funded by founders, family and angels cannot be the same as holding listed market risk.