Value Investor Blog

A Different Perspective On Risk – Part 1

Posted in Theory by aaronstackhouse on August 27, 2009

Many fundamental analysts estimate value by projecting cash flows and then discounting at a rate determined by measuring the beta of the stock. The CAPM and many analysts who use betas to discount cash flows are assuming that risk can be summarized by one number, and that that one number can be determined by observing how the stock price historically correlated with the returns of other stocks.

But let’s do a quick thought experiment to see how ridiculous this is….

Is investing in the stock of a small biotech company with only one drug under develoment risky?

Not enough information, right?

Now let’s pretend the company’s drug has a 50% chance of total failure, in which case the stock will go to zero in 1 year, and a 50% chance of success, in which case the stock will go to $100 in 1 year.

Now is the stock of this biotech company a risky investment??

In the framework of betas, this simplified stock would be determined a very risky investment with huge volatility.

However, look at how dramatically the risk characteristics of the investment vary depending on the purchase price (“stock price today”).

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In each scenario, you own the same company with the same 50% chance that the stock is worth $0 in 1 year and 50% chance that it is worth $100 in 1 year. In each scenario this translates to a 50% chance of losing your entire investment, but dramatically different possible returns on the upside.

This is obviously a grossly oversimplified example but it has a clear implication – price must be considered when discussing the risk of owning a stock!

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