Value and Risk: Beyond Betas

Risk can be both a threat to a company’s financial health and an opportunity to get ahead of the competition. Most analysts, when referring to risk management, focus on the threat and emphasize protecting against that threat (i.e., risk hedging). The risk associated with an investment is generally reflected in the discount rate used in conventional discounted cash flow models, and because analysts also assume that only market risk affects discount rates, the firms that spend time and resources on hedging company-specific risk may well lose value. But risk management can increase firm value—by altering investment policy and creating competitive advantages, which can have consequences for expected growth rates and excess returns. Risk can be both a threat to a company'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, the risk associated with an investment is almost always reflected in the discount rate used in conventional discounted cash flow models.The article begins with analyzing the classic methods for judging the riskiness of a firm—discounted cash flow analysis and relative comparisons. Many corporate executives believe that conventional valuation models take too narrow a view of risk, however, so I then turn to ways in which the discussion of risk in valuation can be expanded—simulations, considering the specific effects of risk hedging and risk management on the inputs to DCF models and on whether the markets price riskiness in the relative firm valuation, and option-pricing models.Firms that expend time and resources on hedging firm-specific risk will lose value to the extent that this part of risk management is expensive. In contrast, risk management can increase firm value. Risk management affects expected cash flows by altering investment policy and creating competitive advantages, which in turn, can have consequences for expected growth rates and excess returns.Risk reduction is only a part of risk management. Risk management has to be defined far more broadly to include actions that are taken by firms to exploit uncertainty. While risk hedging is product based and financial (involving the use of options, futures, and insurance products), risk management is strategic.