Risk & Return – how risk determines the return

Value is a function of expected cash flows and the risks attached to those cash flows.  The discount rate reflects risk and is the rate of return required by investors and financiers to compensate them for that risk.

The higher the risk attached to the earnings (the higher the uncertainty), the higher the return required to compensate investors for that risk.

Companies raise finance from a variety of sources which are either equity-based, debt based or a hybrid of the two. A company’s cost of capital is the combined rate of the return required by equity holders and debt holders.

Risk-free investments

Typically, the least risky investments are treasury bonds.  The government guarantees you will get your money back.

The key risk would be if the government got into difficulty and defaulted on the debt.  Treasury bonds in stable countries are low risk.  Consequently, the annual rate of return on a treasury bond is low. The current German ten-year bond yield (the annual return) is negative. As an investor, you have to pay to keep your money invested in the government; it is so safe!

The more unstable the country and the government, the higher the return required. The current South African ten-year bond yield is 0%. Investing in South Africa is perceived as riskier than investing in Germany.

The current Australian ten-year bond rate is 2.63%; this is an indicator of a “risk-free” rate.

Investing in stocks

A riskier investment is in investing in traded stocks.  There is no guarantee that the business and so the shares will be successful. Historically, listed stocks in Australia have earnt, on average, a premium over the risk-free rate of approximately 6.6%.

The risks attached to earnings in listed stocks varies dramatically.  A large, international blue chip stock with established earnings driven by a large and reliable customer base has a relatively low level of risk attached to its earnings. Conversely, a new entrant to the market, with a new product and early growth, has far more risk attached to the earnings.

Portfolio theory

Portfolio theory states that investors can construct a portfolio of diverse stocks and effectively eliminate the specific risk exposure.  The investors are then just exposed to systematic risk.  Systematic risk is the risk inherent in the market

Investing in a private business

A 100% investor in a private company can not diversity away specific risk with a portfolio.  As a consequence, investors require a higher return that reflects both systematic market risk and also the specific risk.

An advantage of investing in listed companies is that shares can be easily bought and sold. They are liquid. An investment in a private business is not liquid.  It takes time to take a private business to market, and there are significantly fewer buyers than for a listed stock. There are also strict information disclosure requirements for listed companies, whereas there is limited financial disclosure for a private business.

Factors that drive the risk and return

Some key factors that drive risk in a business include:

  • contracts with customers and suppliers;  long-term contracts with customers provide security of earnings
  • exclusivity agreements with suppliers, provide a competitive advantage.
  • the threat of new competition or reductions in competitors
  • changes in technology and threats to (or opportunities for) the business
  • changes in legislation, restricting or improving the market, eg. changes to environmental legislation
  • changes in customer’s habits and culture
  • any limiting factors, such as limited natural resources, skilled labour or production capacity

Conclusion

The discount rate is a function of risk.  The higher the risk of the investment, the higher return the investors demand, which implies a higher discount rate.

Simon Cook, Valuations, Forensic Accounting, Virtual CFO. CA Accredited Business Valuation expert, Chartered Accountant and Certified Fraud ExaminerSimon is a CA Accredited Business Valuation expert, Chartered Accountant and a Certified Fraud Examiner. Simon specialises in providing valuation services. Prior to founding Lotus Amity, he was a Corporate Finance and Forensic Accounting partner with BDO Australia. Simon provides valuation services in disputes, for raising finance, for restructuring, transactions and for tax purposes.

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