strange things happen…or do they?In April of this year a volcano in Iceland erupted. Nissan Motor temporarily had to close 3 assembly lines in Japan 5 days later. Nissan’s supplier was unable to deliver required parts as air travel was restricted due to volcanic ash (Ash is not good for gas turbine engines. I learned this in the Navy after Mount Pinatubo in the Philippines erupted). The same volcano wreaked havoc on a BMW plant in South Carolina for the same reasons. These, of course, are not the only examples.
They are, however, examples of our interconnected world and the risks we all face. Systematic risks faced by all businesses (volcano eruption, for example) can easily morph into idiosyncratic risks specific for individual companies (plant shutdown). Thus, maybe it is true that when a butterfly flaps its wings in China (or wherever), we get a tornado in Texas (or wherever). Although, given the number of butterflies in the world, we probably would have a lot more tornadoes.
What does this have to do with finance and valuation? Total beta (total risk) does not distinguish between the two (systematic and idiosyncratic) risks. Since private companies are valued as stand-alone assets, this new metric does not worry about the allocation between butterfly (systematic) risk and a plant shutting down (idiosyncratic risk), making it far more appealing for appraisers.