riskvalue - 1 Value and Risk: Beyond Betas Aswath Damodaran...

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1 Value and Risk: Beyond Betas Aswath Damodaran Stern School of Business adamodar@stern.nyu.edu November 2003
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2 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.
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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 non- diversifiable 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.
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This note was uploaded on 12/01/2011 for the course FINANCE 350 taught by Professor Aswath during the Summer '10 term at NYU.

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riskvalue - 1 Value and Risk: Beyond Betas Aswath Damodaran...

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