Valuation of Securities

Investment Risk versus Return

Definition of Risk Relating to Investment in Securities

Risk is the probability a security will perform differently than its anticipated return. Overall risk comes from multiple sources, such as business risk, exchange rate risk, purchasing power risk, financial risk, and tax risk.

Risk has a unique definition as it relates to securities; it is the probability that the actual performance of a security will diverge from the anticipated return. Risks associated with securities come from multiple sources, such as business risk, exchange rate risk, purchasing power risk, financial risk, and tax risk. Business risk is the possibility that a venture will not generate the expected profits. The potential sources of the difference in operating income are changes in sales, contribution margins, and/or fixed costs. For example, Larry's Flower Company has actual sales revenue that fails to meet forecasted sales because of unexpected competition from a new florist.

Exchange rate risk is the uncertainty caused by fluctuations in relative value between two or more currencies. For instance, a U.S. investor chooses to convert the U.S. dollar to yen to purchase a Japanese-denominated asset. During the investment period, the yen reduces in value in comparison to the U.S. dollar. When the asset is sold, the investor will collect fewer U.S. dollars.

Purchasing power risk is the probability that a firm will be unable to compensate for increases in inflation and will experience inflated expenses and damaged profitability. For example, Larry's Flower Company operates in a highly competitive market and, as a result, may find it difficult to increase prices to reflect an increase in inflation without sacrificing market share and damaging profitability.

Financial risk is the potential that a firm will not be able to meet its debt obligations. Consider a firm whose sales are seasonal and whose debt begins to outweigh cash flow. If the firm goes bankrupt, investors may suffer losses because creditors will be paid before they are. In the event the firm is liquidated after bankruptcy, the firm's assets are sold to pay its debt. In this event, stakeholders are paid in the following order: secured creditors (e.g., bondholders), unsecured creditors (e.g., employees and the government), and shareholders.

Tax risk is the influence on income presented through changes to tax policy and various rates domestically or abroad. For example, since its inception, Larry's Flower Company has imported all of its raw materials from South America. Recently, the U.S. government has placed tariffs on all South American countries. The owner of Larry's is now confronted with a higher cost burden.

Investment Return and Time Value of Money

The primary driver of investment decisions is the risk of suffering losses on an investment in contrast to the potential returns.

The primary driver of all investment decisions is risk. Risk is the chance of suffering losses on an investment. An investment's level of risk is correlated with its potential returns. Investments with a low-risk profile have the opportunity to produce small gains. This is because the likelihood of loss is low, and thus investors do not require a great incentive to invest. Inversely, an investment with a high-risk profile has the opportunity to produce significant gains. The opportunity for significant gains is the incentive required for an investor to assume the higher risk of suffering losses. Investors must determine and develop proper risk thresholds and their desired rate of return and identify the amount of risk that is acceptable to them.

The risk-return trade-off principle is the idea that an investor has a preferred level of risk they are willing to take on to seek higher returns and earning potential. Depending on their individual risk-return trade-off, there are three common asset classes an investor may choose to invest in: stocks, bonds, and cash equivalents. Each of these classes possesses a different risk-return profile, which indicates the level of risk and expected return.

A stock is a share of ownership of a corporation, and stock ownership provides the investor with equity in the firm. For example, shares of Larry's Flower Company provide investors with a piece of equity, or ownership, in the company. This entitles the investor to a piece of Larry's Flower Company's gains should the company flourish. However, the investor is also exposed to losses should Larry's Flower Company's stock price decrease. Because stocks are ownership in a company that may or may not continue to be successful, stock investing presents the highest level of risk and has traditionally produced the highest returns.

A bond is a financial instrument representing a loan made to a governmental or corporate body by some entity that requires repayment of the initial loan price plus interest on a fixed schedule. Bonds pay the investor a fixed income determined by the rate of interest until maturity, or the date when the principal is due to be paid. Bond values vary, but bonds present less risk—and often lower returns—than stock investing. An investor that has purchased a bond issued by Larry's Flower Company has essentially provided a loan to the company. The investor will receive interest payments until the bond matures, when Larry's will repay the initial amount of the bond.

A cash equivalent asset is a highly liquid short-term investment having the ability to be readily converted into cash. Cash equivalents include cash and money market securities. These provide the lowest risk and the lowest return. Larry's Flower Company may issue commercial paper, which is a short-term debt security issued by a company with excellent creditworthiness. Creditworthiness is the likelihood that a borrower will repay a debt according to the initial terms.

Risk versus Return of Securities

An asset's risk is correlated to its potential return. For example, cash and cash equivalents present the lowest risk and have the lowest return potential.