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Chapter III Valuation Concepts
I. Risk and Returns
Risk and return is a complex topic. There are many types of risk, and many ways to evaluate and measure risk. In the theory and practice of investing, a widely used definition of risk is: “Risk is the uncertainty that an investment will earn its expected rate of return.” Note that this definition does not distinguish between loss and gain. Typically, individual investors think of risk as the possibility that their investments could lose money. They are likely to be quite happy with an investment return that is greater than expected - a “positive surprise.” However, since risky assets generate negative surprises as well as positive ones, defining risk as the uncertainty of the rate of return is reasonable. Greater uncertainty results in greater likelihood that the investment will generate larger gains, as well as greater likelihood that the investment will generate larger losses (in the short term) and in higher or lower accumulated value (in the long term.)
In financial planning, the investment goal must be considered in defining risk. If your goal is to provide an acceptable amount of retirement income, you should construct an investment portfolio to generate an expected return that is sufficient to meet your investment goal. But because there is uncertainty that the portfolio will earn its expected long-term return, the long-term realized return may fall short of the expected return. This raises the possibility that available retirement funds fall short of needs - that is, the investor might outlive the investment portfolio. This is an example of "shortfall risk." The magnitude and consequences of the potential shortfall deserve special consideration from investors. However, since the uncertainty of return could also result in a realized return that is higher than the expected return, the investment portfolio might "outlive" the investor. Therefore, considerations of shortfall risk are subsumed by considering risk as the uncertainty of investment return. 1
Understanding the relationship between risk and return and how it’s affected by time is probably one of the most important aspects of investing your super or pension. It plays a big role in how much super you’ll have when you retire or how much pension income you can draw. So, understanding how they work and your attitude to risk can help you make investment decisions that best meet your financial needs and goals.
A. Risk as the uncertainty of returns The uncertainty inherent in investing is demonstrated by the historical distributions of returns in three major asset classes: cash, bonds, and stocks. The term cash often is used to refer to money market securities and money in bank accounts. Vanguard refers to these types of assets as short-term reserves. There is very high certainty in the return that will be earned on an investment in money market securities such as Treasury bills (T-Bills) or short-term certificates of deposit (CDs). Similarly, there is fairly high certainty in the return that will be earned over a short period in a money market fund. Money market fund holdings consist of T-Bills, CDs, and other money market securities. For an individual investor, a federally-insured bank account also
1 https://www.bogleheads.org/wiki/Risk_and_return:_an_introduction <accessed July 23, 2016>.
provides a high degree of certainty in the short-term return. Even over longer time periods, the returns earned by money market securities fall into a relatively narrow range. 2
B. Relationship between risk and return
Investors are risk averse; i.e., given the same expected return, they will choose the investment for which that return is more certain. Therefore, investors demand a higher expected return for riskier assets. Note that a higher expected return does not guarantee a higher realized return. Because by definition returns on risky assets are uncertain, an investment may not earn its expected return. This demonstrates one of the most fundamental axioms of investing: “ Risk and return are inextricably related. Higher returns generally can be achieved only by taking more risk, but because the risk exists, the higher expected returns may not result in higher realized returns .”
If inflation is considered, even money market securities have some risk. They may not achieve the expected real (inflation-adjusted) return. Unexpected inflation may reduce the real return below the expected return of the money market investment. Uncertainty in real returns can be eliminated by investing in inflation-indexed securities, such as Treasury Inflation Protected Securities (TIPS) and Series I Savings Bonds (I Bonds). In return for this reduction of uncertainty, investors must accept lower expected returns. Even inflation-linked securities have risks; e.g., TIPS have interest-rate risk, re-investment risk, and liquidity risk. No investment is truly risk-free. 3
C. Specific types of risk
Below are descriptions of different types of investment risks. These types of risk are often cited in a mutual fund prospectus. Portfolio theory makes an important distinction between two types of risks:
- Unsystematic risk : the measure of risk associated with a particular security; also known as diversifiable risk. This risk can be mitigated by holding a diversified portfolio of many different stocks in many different industries.
- Systematic risk: also known as market risk. Systematic risk is faced by all investors due to market volatility. This risk cannot be diversified away. This is the type of risk most people are referring to when they casually use the term "risk" when discussing investments. Some additional risks faced by all investments include:
- Liquidity risk --the risk that an asset cannot be sold when desired or in sufficient quantities because opportunities are limited. Treasury securities (with the exception of inflation protected Treasury bonds) have the least liquidity risk.
- Political risk --the risk to an investment due to changes in the law or political regime. Potential changes in tax law or changes in a country's structure of governance are sources of political risk.
2 Ibid., 3
Ibid.,
investment. Volatility is measured in the form of the investment's standard deviation from the mean return, thus the coefficient of variation is this standard deviation divided by expected return. A lower coefficient of variation indicates a higher expected return with less risk.
•.a. Coefficient of Variation The coefficient of variation, an example of which is plotted in this graph, can be used to measure the ratio of volatility to expected return. The coefficient of variation is a dimensionless number, meaning it is independent of the unit in which the measurement has been taken. For this reason, it becomes useful to us in finance to measure the risk of an investment in a way that it is not dependent upon other types of risk, such as that of the overall market. 5
III. The Relationship Between Risk and Rates of Return
Generally speaking, risk and rate-of-return are directly related. As the risk level of an investment increases, the potential return usually increases as well. The pyramid of investment risk illustrates the risk and return associated with various types of investment options. As investors move up the pyramid, they incur a greater risk of loss of principal along with the potential for higher returns.
Pyramid of Investment Risk
- Security Market Line (SML) or the CAPM Equation:
k (^) j = kRF + (kM – k^ RF)^ j
… the SML shows the relationship between risk as measured by beta and the required return for individual securities
5 Boundless. “Overview of How to Assess Stand-Alone Risk.” Boundless Finance. Boundless, 08 Aug.
- Retrieved 25 Oct. 2016 from https://www.boundless.com/finance/textbooks/boundless-finance- textbook/the-role-of-risk-in-capital-budgeting-12/assessing-stand-alone-risk-97/overview-of-how-to- assess-stand-alone-risk-424-5193/.
… kj is the required rate of return on stock j; kRF is the risk-free rate of return (U.S. Treasury securities); k M is the required rate of return on the market portfolio and^ j is the beta coefficient of stock j
Risk Analysis
Risk is made up of two parts: the probability of something going wrong, and the negative consequences if it does. Risk can be hard to spot; however, you can prepare and manage it. If you're hit by a consequence that you hadn't planned for, costs, time, and reputations could be on the line. This makes Risk Analysis an essential tool when your work involves risk. It can help you identify and understand the risks that you could face in your role. In turn, this helps you manage these risks, and minimize their impact on your plans.
A. What is Risk Analysis?
Risk Analysis is a process that helps you identify and manage potential problems that could undermine key business initiatives or projects. To carry out a Risk Analysis, you must first identify the possible threats that you face, and then estimate the likelihood that these threats will materialize. Risk Analysis can be complex, as you'll need to draw on detailed information such as project plans, financial data, security protocols, marketing forecasts, and other relevant information. However, it's an essential planning tool, and one that could save time, money, and reputations.
B. (^) Types of Risk
B.1. Stand-Alone Risk
This risk assumes the project a company intends to pursue in a single asset that is separate from the company's other assets. It is measured by the variability of the single project alone. Stand-alone risk does not take into account how the risk of a single asset will affect the overall corporate risk.
B.2. (^) Corporate Risk
This risk assumes the project a company intends to pursue is not a single asset but incorporated with a company's other assets. As such, the risk of a project could be diversified away by the company's other assets. It is measured by the potential impact a project may have on the company's earnings.
- Procedural – Failures of accountability, internal systems, or controls, or from fraud.
- Project – Going over budget, taking too long on key tasks, or experiencing issues with product or service quality.
- (^) Financial – Business failure, stock market fluctuations, interest rate changes, or non-availability of funding.
- Technical – Advances in technology, or from technical failure.
- Natural – Weather, natural disasters, or disease.
- Political – Changes in tax, public opinion, government policy, or foreign influence.
- Structural – Dangerous chemicals, poor lighting, falling boxes, or any situation where staff, products, or technology can be harmed.
You can use a number of different approaches to carry out a thorough analysis:
- Run through a list such as the one above to see if any of these threats are relevant.
- (^) Think about the systems, processes, or structures that you use, and analyze risks to any part of these. What vulnerabilities can you spot within them?
- Ask others who might have different perspectives. If you're leading a team, ask for input from your people, and consult others in your organization, or those who have run similar projects.
Tools such as SWOT Analysis and Failure Mode and Effects Analysis can also help you uncover threats, while Scenario Analysis helps you explore possible future threats.
B.5. Estimate Risk
Once you've identified the threats you're facing, you need to calculate out both the likelihood of these threats being realized, and their possible impact. One way of doing this is to make your best estimate of the probability of the event occurring, and then to multiply this by the amount it will cost you to set things right if it happens. This gives you a value for the risk:
Risk Value = Probability of Event x Cost of Event
As a simple example, imagine that you've identified a risk that your rent may increase substantially.
You think that there's an 80 percent chance of this happening within the next year, because your landlord has recently increased rents for other businesses. If this happens, it will cost your business an extra P500,000 over the next year.
So the risk value of the rent increase is:
0.80 (Probability of Event) x P500,000 (Cost of Event) = P400,000 (Risk Value)
Tip: Don't rush this step. Gather as much information as you can so that you can accurately estimate the probability of an event occurring, and the associated costs. Use past data as a guide if you don't have an accurate means of forecasting.
E. How to Manage Risk
Once you've identified the value of the risks you face, you can start to look at ways of managing them.
Tip: Look for cost-effective approaches – it's rarely sensible to spend more on eliminating a risk than the cost of the event if it occurs. It may be better to accept the risk than it is to use excessive resources to eliminate it.
Be sensible in how you apply this, though, especially if ethics or personal safety are in question.
- Avoid the Risk
In some cases, you may want to avoid the risk altogether. This could mean not getting involved in a business venture, passing on a project, or skipping a high-risk activity. This is a good option when taking the risk involves no advantage to your organization, or when the cost of addressing the effects is not worthwhile.
B.7. Plan-Do-Check-Act is a similar method of controlling the impact of a risky situation. Like a Business Experiment, it involves testing possible ways to reduce a risk. The tool's four phases guide you through an analysis of the situation, creating and testing a solution, checking how well this worked, and implementing the solution.
G. Risk-Analysis Methods
It is important to keep in mind that when a company analyzes a potential project, it is forecasting potential not actual cash flows for a project. As we all know, forecasts are based on assumptions that may be incorrect. It is therefore important for a company to perform a sensitivity analysis on its assumptions to get a better sense of the overall risk of the project the company is about to take.
There are three kinds of methods used for determining the level of risk of our business. The methods can be: Qualitative Methods – Quantitative Methods – Semi-quantitative Methods.
B.8. (^) Qualitative Methods
This is the kind of risk analysis method most often used for decision making in business projects; entrepreneurs base themselves on their judgment, experience and intuition for decision making. These methods can be used when the level of risk is low and does not warrant the time and resources necessary for making a full analysis. These methods are also used when the numerical data available are not adequate for a more quantitative analysis that would serve as the basis for a subsequent and more detailed analysis of the entrepreneur’s global risk.
The qualitative methods include:
- Brainstorming
- Questionnaire and structured interviews
- (^) Evaluation for multidisciplinary groups
- Judgment of specialists and experts (Delphi Technique)
B.9. Semi-Quantitative Methods
Word classifications are used, such as high, medium or low, or more detailed descriptions of likelihood and consequences. These classifications are shown in relation to an appropriate scale for calculating the level of risk. We need to give careful attention to the scale used in order to avoid misunderstandings or misinterpretations of the results of the calculation.
B.10. Quantitative Methods
Quantitative methods are considered to be those that enable us to assign values of occurrence to the various risks identified, that is, to calculate the level of risk of the project. A quantitative risk analysis and modeling technique used to help determine which risks have the most potential impact on the project. It examines the extent to which the uncertainty of each project element affects the objective being examined when all other uncertain elements are held at their baseline values. There are three quantitative risk analysis techniques:
3.1 Sensitivity Analysis Sensitivity analysis is simply the method for determining how sensitive our NPV (Net Present Value) analysis is, to the changes in our variable assumptions. To begin a sensitivity analysis, we must first come up with a base-case scenario. This is typically the NPV using assumptions we believe are most accurate. From there, we can change various assumptions we had initially made based on other potential assumptions. NPV is then recalculated, and the sensitivity of the NPV based on the change in assumptions is determined. Depending on our confidence in our assumptions, we can determine how potentially risky a project can be.
- Scenario Analysis Scenario analysis takes sensitivity analysis a step further. Rather than just looking at the sensitivity of our NPV analysis to changes in our variable assumptions, scenario analysis also looks at the probability distribution of the variables. Like sensitivity analysis, scenario analysis starts with the construction of a base case scenario. From there, other scenarios are considered, known as the "best-case scenario" and the "worst- case scenario". Probabilities are assigned to the scenarios and computed to arrive at an expected value. Given its simplicity, scenario analysis is one the most frequently used risk-analysis techniques.
- Monte Carlo Simulation Monte Carlo simulation comes up with infinite calculations (expected values) given a number of constraints. Constraints are added and the system generates random variables of inputs. From there, NPV is calculated. Rather than generating just a few iterations, the simulation repeats the process numerous times. From the numerous results, the expected value is then calculated. The method was given this name in reference to the Principality of Monaco, which is famous as “the capital of games of chance”. This method seeks to represent reality through a mathematical risk model, in such a way that by assigning values randomly to the variables of the model, different scenarios and results are obtained. The Monte Carlo Method is based on making a sufficiently high number of iterations (assignments of values in a random fashion), so that the sample of results obtained is
