Geographic Location & Company-Specific Risk

One of the more widely debated topics in the business valuation community is the concept of Company-Specific Risk (CSR) in calculating a firm’s cost of equity. For those unfamiliar, a firm’s cost of equity is the return that investors reasonably expect on their equity investment, and it is often a critical factor in capital budgeting and investment decisions, as well as the expectations of existing individual shareholders. In the business valuation industry, the cost of equity, along with the cost of debt, is a key component in computing the Weighted Average Cost of Capital (WACC). In most cases, valuation professionals calculate the cost of equity by summing a company’s systematic (industry risk, equity risk, size premium) and unsystematic (company-specific) risks. While some unsystematic risk factors are more broadly recognized, geographic concentration risk is often overlooked and underapplied. So why is this risk often ignored? Is it due to a lack of data, poor data quality, or the misrepresentation of comparable companies operating in different geographic regions? Often, so-called ‘comparable’ companies are purchased and sold at vastly different market values, with only minor, imperceptible differences in their history, financials, ownership structure, or management team. So, the question must be considered, “How does a company’s geographic location impact its cost of equity, and are there any steps that a business owner or the larger business community can take to mitigate the risk of geographic concentration?”

Introduction to Company-Specific Risk (CSR)

To fully understand the concept of CSR, we need to define the related terms and establish the relationship between them. As stated, a company’s cost of equity reflects the benefit rate that an investor expects to receive from the company in exchange for the riskiness of their investment. When using the discounted cash flow (DCF) or capital-asset pricing model (CAPM) assumptions, the cost of equity is calculated using a build-up model that includes the following components:

• Risk-Free Rate – the rate of return expected on an investment with no risk (typically, the 20-year US Treasury Yield approximates this rate).
• Equity Risk Premium - the premium that an investor would expect to receive for the risk of investing in companies’ equity, as opposed to risk-free assets. This premium assumes a perfectly diversified portfolio of equity investments.
• Industry Risk Premium – the premium an investor expects, or the discount they will accept, for investing in a particular industry versus the entire stock market. Specific sectors have either more or less risk than the entire stock market. This is defined as an industry’s Beta.
• Size Premium - the premium investors expect for their investment in smaller companies versus more prominent companies. This premium accommodates the risks involved with a smaller, less diversified company compared to a larger, more diversified and stable company.
• Company-Specific Risk - this premium measures the uncertainty of returns as they relate to the characteristics of a single company. These premiums are generally associated with concentrations not seen across an industry. These concentrations include customers, vendors, management, technology, and geography.

Either by itself in a capitalized cash-flow scenario or proportionately with the cost of debt (WACC) in a discounted cash flow model, the cost of equity can be applied to a defined benefit stream, such as future cash flows, to estimate a company’s value. A lower cost of equity results in higher business values and vice-versa, as investors would be willing to pay more for less risky investments and expect discounts for investments that carry additional risk.

Geographic Risk as a Subset of CSR

As a component of a company’s cost of equity, any change to company-specific risk has a corresponding effect on business value. Generally, as stated above, CSR factors include the strength of the firm’s management team, the concentration of suppliers for the firm’s inputs, the continuity and diversity of its customer base, the risk of the firm not achieving projected results, and geography. Put more simply, Breneman Advisors defines CSR as a concentration risk, where the less diversified a company is in those areas, the riskier any potential investment is.

Examples of Geographic Concentration Risk

Geographic risk, as a subset of CSR, arises from a company's reliance on regional economic conditions, weather patterns, regulatory environments, or local political stability. Franchise models, such as fast-food chains and multi-location retailers, naturally diversify geographic exposure, as some will inevitably be in more populated areas with greater access to supplies and a broad customer base, while others will be in more rural areas that require longer travel times for suppliers, customers, investors, and management, and will likely have a vastly different customer base makeup and regulatory landscape. In this way, franchise models allow the parent business to spread its geographic risk across the region and show success in urban and rural markets.

But what about single-location businesses, such as locally owned-and-operated manufacturing firms, restaurants, or commercial & retail service providers (HVAC, professional service firms)? They do not have the luxury of diversifying their customer or supplier base across geographic regions. They are more vulnerable to changing weather patterns (e.g., Gulf Coast or Eastern United States hurricane activity, Tornado Alley in the Central Midwest) and local political instability. As a Northern Michigan firm, we encounter and are familiar with many seasonal businesses whose revenue and bottom lines are predicated on predictable tourist seasons and snow patterns. Still, countless stories exist of building larger, successful companies from the ground up at one location. So, where does the data regarding geographic location risk show itself?

Case Study – Company A vs. Company B

To illustrate the impact of geographic risk in a real-world context, consider the following comparison between two closely matched companies for which we have received Indications of Interest (IOI). Both companies operate in nearly identical industries, with comparable management teams and customer/supplier bases. For additional context, Company A’s workforce was non-union, while Company B’s was partially unionized.

How Buyers Valued Geographic Location

With all other factors being equal, we anticipated similar offers for both companies, as the buyer pool was similar and contained a good deal of cross-over. Both firms had similar strengths, with one slightly outperforming the other or vice versa in different areas. As we dug into this case study, we focused keenly on the key differentiating factors between the two. One obvious discrepancy was the difference between union and non-union workforces, which drove some potential buyers away, but the other glaring difference we saw was the geographic location – Company A is located in the northern Lower Peninsula, while Company B operates in the central Upper Peninsula. When we asked buyers who declined to submit offers for Company B, the majority cited geographic location as a primary concern; Company B showed strong financial and operational performance, but the geographic location was too remote, too far from a major population center to justify a purchase consideration. As shown above, that translated to more interest in Company A, a higher purchase price, and, consequently, a lower cost of equity for Company A. In percentage terms, we estimate that Company A's cost of equity is roughly 4-5% lower than Company B's (on a capitalized EBITDA basis) based solely on geographic location.

Urban vs. Rural Location Risk

In our professional opinion, one key geographic factor driving this variance is the upside of a cluster benefit. In more populated urban areas, there is increased access to specialized labor, additional suppliers from which inputs can be purchased, and greater proximity to key customers and major transportation hubs. On the other hand, less populated rural regions are limited to the existing customer and labor pools, and they can become overdependent on a local industry or employer base. For example, in the Upper Peninsula, there appear to be several emerging cities and towns, such as Iron Mountain, Marquette, and Escanaba, with robust business environments that offer numerous benefits to current and potential residents. Digging deeper, we find that these economies tend to be limited, consisting primarily of mines, manufacturing, healthcare, lodging, insurance, banking, and education. While seeming to be somewhat diversified at first glance, these industries are symbiotic in nature in that if just one of those economic centers were to fail suddenly, others would follow, and the economy of the Upper Peninsula would struggle. Additionally, transportation to and from the Upper Peninsula via air travel is limited – the number of flights in and out of the Marquette Sawyer Regional Airport in a single day can be counted on one hand, and surrounding airports in the UP are even more limited in terms of daily flight volume.

Strategies to Mitigate Geographic Risk

Business Continuity & Expansion Planning

With this information, how can this problem be solved? Business owners and decision-makers should first prioritize working with their leadership teams and employees to develop business continuity plans that consider local vulnerabilities and establish risk assessments that can be directly tied to geographic stressors, such as increased foot traffic due to tourism or time of year. In other areas, it can largely depend on the industry in which the business operates. For example, not every business can (or should) establish satellite offices, distribution centers, or remote teams across regions. However, retail and product manufacturing businesses could separate their office headquarters from their distribution centers, establishing new supplier relationships in those new locations. Service providers can open new offices in different parts of the state, expanding their customer base beyond their current region.

Insurance and Risk Transfer Solutions

Some insurance carriers offer property and business interruption insurance designed to meet local businesses' needs, factoring in threats to the economy such as blizzards (or the lack thereof) and specialty coverages for cyber threats or various regulatory changes.

Community & Workforce Development

Secondly, a level of community-specific engagement can benefit a local economy, where chambers of commerce, economic development corporations (EDCs), and local governments work together to attract diverse businesses to the region. This will inevitably lead to additional infrastructure investment supporting different industries entering an area that does not already have them. Upskilling the existing workforce is another key strategy – talent and workforce development organizations (such as Upper Peninsula Michigan Works!) exist to help local businesses build robust workforces, cross-train employees, and develop younger professionals with the skills needed to succeed in any given industry. Economic clubs and service organizations also get local residents involved in community action, bringing together the existing business economy to work together on economic resilience planning that can help sustain regional viability. Furthermore, innovation hubs and incubators support diversification by assisting in the start-up space, often bringing in industries outside the dominant local sector.

Turning Risk into Opportunity

Geographic concentration risk is a real and measurable factor that investors and business owners must consider when evaluating a company’s value. Investors often view this type of risk as undiversified exposure, tying a company’s future too closely to a specific local economy, weather pattern, or regulatory environment, which can lead to higher discount rates, lower offers, and reduced interest in a deal altogether. For business owners, particularly those operating from a single location or within a tightly defined region, this shouldn’t be a cause for concern but rather a call to action. Proactively addressing geographic risk through strategic planning, operational flexibility, and clear communication can reduce a company’s cost of equity and enhance its attractiveness and marketability. As demonstrated through comparative analysis and firsthand experience, while companies in remote or economically narrow regions do face challenges in attracting investment and scaling operations, these challenges are not insurmountable. By recognizing geographic concentration as a legitimate component of company-specific risk and taking steps to mitigate it, both individual businesses and broader communities can increase resilience, drive long-term value, and position themselves more favorably in the eyes of investors, lenders, and potential acquirers.