Risk & Diversification Analysis

Risk Minimization and Diversification Analysis

The risk/return relationship is a fundamental concept in not only financial analysis, but in every aspect of business. If decisions are to lead to benefit maximization, it is necessary that individuals/institutions consider the combined influence on expected (future) return or benefit as well as on risk/cost. The requirement that expected return/benefit be commensurate with risk/cost is known as the "risk/return trade-off" in finance.

ValueScope addresses the trade-off and, using conventional statistical tools, provides a method for quantifying risk. Foe example, two categories of risk borne by the firm's stockholders, business risk and financial risk, are discussed and demonstrated, as is the concept of leverage. We examine risk reduction via portfolio diversification and what requirements need to be met for firms to experience the benefits of diversification. The Capital Asset Pricing Model (CAPM) is used to demonstrate the risk/return trade-off by relating the required return on the firm's investments to its beta (or market) risk.

The Risk/Return Trade-off in Financial Analysis

It is widely accepted that the major determinant of the required return on the asset (or the rate to be applied to a stream of receipts to capitalize its value) is its degree of risk. Risk refers to the probability that the return and therefore the value of an asset or security may have alternative outcomes. Risk is the uncertainty (today) surrounding the eventual outcome of an event which will occur in the future.

Example: When tossing a coin, one is uncertain as to the outcome. With a fair coin, the outcome is equally likely to be either heads or tails, thus encompassing the concept of uncertainty or risk. In a football match, three outcomes can be experienced: win, lose or draw. In business, the same can happen regarding the expected return on the investments in various sectors.

In financial analysis, the risk/return trade-off states that financial decisions that subject stockholders to more risk must offer a higher expected return. Risk aversion is the tendency to try to avoid risky situations unless adequate compensation is offered.

Example: The risk averse individual faced with two events, each having the same expected outcome, will choose the outcome with the lower level of risk.

Categories of Risk and Leverage Faced by the Company and Stockholders

This type of risk is magnified by the degree to which the firm relies on fixed operating expenses in producing sales. In many cases there is not much the firm can do about this type of risk; some industries have more volatile sales and higher fixed operating expense than others.

Operating leverage results when the firm has fixed operating expenses in its cost structure

• These expenses do not disappear when sales drop, nor do they increase when sales increase
• Operating leverage tends to magnify any change in sales on Earnings Before Interest and Taxes (EBIT)
• Stockholders are the ultimate bearers of the risk that results from leverage and they are the residual recipients of higher EBIT should sales increase

Financial risk

This type of risk arises primarily because of the fixed interest payments firms must make to their long-term creditors (debt capital).

• This type of risk is reflected in volatile Net Income and Earnings Per Share
• Financial leverage results when the firm finances some portion of its assets with borrowed funds
• Financial leverage means that changes in EBIT will magnify changes in net income and Earnings Per Share
• As a firm increases its degree of financial leverage, its expected return (net income and Earnings Per Share) increases as does its risk
• The financial manager has some discretion in determining the extent of financial leverage

Risk and Diversification

Diversification occurs when different assets make up a portfolio. The benefit of diversification is risk reduction; the extent of this benefit depends upon how the returns of various assets behave over time. Diversifying among different kinds of assets is called asset allocation. Ways to reduce risk include the use of the following strategies:

• Mass advertising to reduce erratic sales and hence to increased profit
• Entering into long-term sales or purchase contracts
• Recapitalizing toward more equity and less debt so as to reduce the burden of fixed financial expenses
• The use of temporary labor instead of permanent employees