Risk Return Analysis

Topics: Fundamental analysis, Risk, Discounted cash flow Pages: 49 (17104 words) Published: March 3, 2013

Value and Risk: Beyond Betas
Aswath Damodaran Stern School of Business adamodar@stern.nyu.edu November 2003



Value and Risk: Beyond Betas
Risk can be both a threat to a firm’s financial health and an opportunity to get ahead of the competition. Most analysts, when they refer to risk management, focus on the threat posed by risk and emphasize protecting against that threat (i.e. risk hedging). In keeping with this narrow definition of risk management, the risk associated with an investment is almost always reflected in the discount rate in conventional discounted cash flow models. Since we also assume that only market risk affects discount rates, it follows that firms that expend time and resources in hedging firm-specific risk will lose value to the extent that risk management is expensive. Firms that reduce exposure to systematic risk will see no effect on value, if risk-hedging products are fairly priced. In this paper, we consider ways in which we can broaden both the definition of risk management to include ways of exploiting risk to gain a competitive advantage and the analysis of the effects on value. We argue that risk management can affect expected cash flows by altering investment policy and creating competitive advantages, which in turn can have consequences for expected growth rates and excess returns. This offers the potential for a payoff to risk management for many firms that may not benefit from risk hedging. In the closing part of this paper, we consider the steps involved in developing a comprehensive strategy for dealing with risk.


3 Does the risk associated with an investment affect value? While the answer is obviously yes, risk is narrowly defined in most financial analyses as systematic or nondiversifiable risk and its effects on value are isolated to the discount rate. Generally, the costs of equity and capital are set higher for riskier companies and the resulting value is considered to be risk adjusted. In conjunction, risk management is considered to be primarily defensive where firms protect themselves against risks using risk-hedging products like derivatives and insurance. In this paper, we argue for both a more expansive analysis of risk in valuation and a much broader definition of risk management. We argue that effective risk management can sometimes include aggressively seeking out and exploiting risk and that it can alter investment policy and affect expected cash flows. If we adopt this broader view of risk management, we can make the argument that while risk hedging itself can create value for certain kinds of firms – smaller, closely held firms with significant financial leverage - risk management can have a much larger impact on value for a bigger subset of firms.

Risk Management versus Risk Reduction
The Chinese symbol for risk is a combination of two symbols – one for danger and one for opportunity. While risk can have very negative consequences for those who are exposed to it, risk is also the reason for higher returns to those who use it to advantage. Risk management, as defined by in practice, misses this important duality and focuses on the negative consequences of risk. In fact, when risk management is discussed in corporate offices, consulting firms and investments banks, it is risk reduction, usually through the use of derivatives and insurance, that is being talked about. While risk reduction is a part of risk management, it is only a part. Risk management has to be defined far more broadly to include actions that are taken by firms to exploit uncertainty. In fact, risk management may involve increasing, rather than decreasing exposure, to at least some types of risks where a firm feels that it has advantages over its competitors. To provide a sense of the difference between risk reduction and risk management, consider the following examples: Pfizer buys foreign currency options to protect itself against exchange rate risk; this is risk...
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