Valuation Beyond CAPM: How to Calculate With Earnings Risk and Insolvency

A cash flow’s value depends on its (1) expected amount, (2) risk and (3) time of occurrence. This applies especially to uncertain payments that are generated by a company for its stake-holders. However, a cash flow’s risk is not adequately considered when it comes to valuation by the traditional DCF method. This is owed to the fact that historical stock return fluctuations, rather than the risk of cash flows, are the subject of the beta factor in Capital Asset Pricing Models (CAPM).

To summarise the dark, likely-to-be-hidden secret of corporate valuation practice (see also Damodaran, 2018): a company’s true opportunities and threats (risks) are currently ignored. The failure to explicitly consider, or ‘typify’, threats and opportunities (see Henselmann, 2006, pp. 144ff., Berger and Gleißner, 2018 and Gleißner 2019e) can lead to the undervaluation of a company which, in fact, has (1) good opportunities, (2) low cashflow volatility and (3) a very good rating.

This working paper clarifies the significance and effects of earnings risk, in general, and of insolvency risk, more precisely.