How to Calculate Idiosyncratic Risk

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The value of a company varies with the level of profitability and expected growth. The level of risk in operations can influence the level of profitability. All things being equal, if you can reduce risk, you will increase your profitability. This is also true for stocks. Investment analysts divide risk into two groups: systematic (market) and unsystematic (idiosyncratic). For a public company, systematic risk, defined as the inherent risk of trading in the stock market, can be measured by beta ratios; however, no single measurement for idiosyncratic risk exists.

Review the meaning of idiosyncratic risk, which has four determinants: the macroenvironment, the industry, the size of the firm and the company.

Calculate the effect of size. In general, the smaller the company, the greater the risk. Measure the size of the company on a scale of 1 to 10 (1 being the smallest). A good measurement for company size is market capitalization (number of shares outstanding multiplied by stock price) or total revenues.

Calculate the effect of the macroenvironment and industry. The macroenvironment consists of economic, technological, sociocultural, demographic, international and political risks, which are also the primary determinants of industry. The best framework to assess the impact of these risks is called SWOT analysis (strengths, weaknesses, opportunities and threats), specifically the "OT," or the opportunities and threats portion of the framework. Measure the effect, on a scale from 1 to 10 (1 being high risk), of all the opportunities and threats on a given company.

Calculate the risk of the company. Generally, this is a function of the human capital of the company. It is also defined by the general belief systems of those who run a company. It's why human capital is one of the most important components to profitability. Leadership is a difficult thing to measure and is purely subjective. However, in general, higher salaries and brand are indicative of good leadership. Assign a rating from 1 to 10 for a company's leadership, with 1 being poor leadership and brand.

Add up the primary determinants of idiosyncratic risk. Take the sum of the macroenvironment, the industry, the size of the firm and the company. This is your measure for idiosyncratic risk. The higher the rating, the lower the risk.

Tips

• Diversifiable risk is that risk which can be eliminated by having a diverse group of companies in your portfolio. In most financial theory, idiosyncratic risk is diversifiable and therefore not a consideration in model assumptions, so there is little information on how to measure idiosyncratic risk as it is not a concern for academics. Practitioners of finance and accounting do not have this luxury.