How Risk Return and Valuation Correlate Term Paper

Download this Term Paper in word format (.doc)

Note: Sample below may appear distorted but all corresponding word document files contain proper formatting

Excerpt from Term Paper:

Corporate Finance

Valuation, risk and return are closely linked, from different perspectives. Primarily, risk determines, to some degree, the level of returns, while both need to be seriously considered when conduction a valuation. In many occasions, the analysts work with information from the present, creating forecasts about risk and return that allows them to give, with a reasonable probability, expectations about future events.

This paper aims to look into more details at aspects related to valuation, risk and return. It will look, in the beginning, at different valuation techniques, detailing each of them and presenting their advantages and disadvantages. It will then focus on the analysis of risk and return, as a fundamental component of the valuation process. The paper will conclude with an overview of the methods and techniques described and ideas on best practices.

Valuation techniques

Valuation is the process of putting value on something, of analyzing what something is worth. It is important to note that, while valuation is often associated to a business (analyzing what a business is worth), there are many other cases when valuations need to be undertaken, including asset and liability valuations or the valuation of a particular project (in order to determine its viability).

Valuation comes as a necessity in different situations, particularly when a company will be sold. The group that sells the company needs to know a fair value for the company, depending on which it can settle on an appropriate price for the organization. As theory discusses (Vault, 2005), in its basic form, the value of the company is given by the sum of its debt and equity. A future investor who purchases a company assumes both its equity and its debt.

The debt is easier to calculate than the equity, because it is, in fact, the accounting value for the debt. However, equity is more complicated to evaluate and there are different valuation techniques that are applied exactly so as to best value equity. The four major valuation techniques are the discounted cash flow (DCF) analysis, the multiples method, the market valuation method and the comparable transactions method. This paper will briefly look at each of these.

Discounted cash flow (DCF) analysis. This is considered the most thorough way to complete the valuation of a company (Vault, 2005). With this method, there are two techniques that can be implemented: the adjusted present value method and the weighted cost of capital method. The former focuses on the free cash flows that a company or project can generate over the next period of time. The latter looks at the market value of debt or equity. In its very simple form, as described by Penman (2011), the discounted cash flow analysis forecasts the future cash flows (or future rates of return), factors a growth rate into the equation and then discounts these cash flows to obtain their present-day value. The discount rate is usually the cost of capital, namely how much does it cost to borrow the funds that will finance this investment.

The multiples method. The multiples method takes into consideration the fact that, quite often, there is not enough information to complete the valuation process. With this method, the evaluator takes known indicators, such as EBITDA, and compares this to other indicators of relevant competitors in the market.

The market valuation method. This is considered the simplest of the four techniques, but is only applicable to companies that are publicly traded, at the stock exchange. The method implies multiplying the total number of shares by the price per share and the result is the market value of the equity. However, this is usually not the price that someone would pay if he were to acquire the company: the market value receives a discount or a premium, depending on the economic conditions, on supply and demand or on the way an acquisition is made (as a hostile takeover, for example).

The comparable transactions method. This method proposes a comparison with similar transactions that occurred on the market, under similar conditions, and uses discounts or multipliers to adjust the respective value. The method needs to analyze the way the previous valuation was completed, particularly as to what method was used and what the key valuation parameter was.

Strictly in terms of corporate valuation, professor Giddy (2006) proposes a different categorization approach that includes five general categories of methods. These include asset-based methods, comparables, free cash flow methods, option-based valuations and special applications. Since some of these have been previously described, the paragraphs below will focus only on those that have not yet been mentioned.

Asset-based methods are those methods that look at the book value of the company. Basically, this technique is an accounting approach that takes into consideration what the different assets of the companies are worth, according to their book value. This means adding up everything from cash to equipment and to inventory. From this, the existing debt of a company is subtracting, resulting an estimate value of the company.

There are at least two problems with this approach. On one hand, it appears rather static. Evaluating something from its book value may not take into consideration the fact that the respective asset may have devalued in time or, in fact, may have grown in value from the moment it was recorded in the books. This brings about the second problem: a true and correct evaluation of many of the company's assets is often complex. An important asset, for example, is the company's brand name or the company's reputation, but it is often difficult to put an immediate value on this.

In terms of special applications, Giddy looks at particular situations where the valuation may differ than one in a situation with no constraints. For example, he is referring to the valuation of a company in distress, which may result in results that are different than if the company were not in distress. Other special applications include the valuation of a company in a merger and acquisition context or the valuation of a company facing corporate financial restructuring (Giddy, 2006).

The options-based methods were left towards the end of this description because these methods link well with the risk and return discussion that will follow. As Giddy (2006) points out, one of the big challenges of executives is the way to properly include risk and uncertainty in the valuation process, particularly during investments or acquisitions. Many of the methods previously mentioned, including the adjusted present value, use several instruments in order to minimize this problem, but it is not always enough. Option-based methods take into consideration the fact that decisions are made in a way that leaves some alternatives on the table and that consider a more flexible environment.

Option-based methods use, as their fundamental assumption, the fact that the future value of an investment or a project is uncertain. Options allow the possibility of either investing in the project at a future time or stopping the project altogether. Depending on these scenarios, the valuation changes accordingly.

Risk and return

It is now a good time to introduce risk and return into the discussion. As mentioned, the first connection between risk, return and valuation is that the valuation of a company, of a security or of anything else is related to things that will happen in the future. The analyst is trying to determine how something will behave, from a financial and economic perspective, in the future. As such, he is trying to make assumptions and use them in models in order to have a prediction about the future. Risk plays an important role in making this prediction.

The work of Van Horne and Wachowicz (2011) are the best place to start in the process of understanding how the relationship between risk and return operates. They define the return as the difference between the initial investment and the price of the final sale, in the case of an asset. They mention that the rate of return is usually used, transforming the difference described above in a percentage by dividing it to the initial investment.

They argue that, with uncertainty being present, risk has an impact on the projected return. This also means that each return occurs with a certain degree of probability. They introduce the probability distribution as "a list of possible returns from investment together with the probability of each return" (Van Horne, Wachowicz, 2011). As such, some returns are more probable than others. In order to calculate the expected return of the investment, one connects the probability rates with the rates of return by weighting each return with the probability that it will occur and adding everything to give the expected return.

Again, one needs to emphasize that the existence of such things as probability distributions is related to uncertainty about the future: the investors cannot fully evaluate, given the instruments from the present, what the return is likely to be in the future. He is making educated guesses about these returns and these educated guesses are…[continue]

Some Sources Used in Document:


Cite This Term Paper:

"How Risk Return And Valuation Correlate" (2014, July 31) Retrieved December 10, 2016, from

"How Risk Return And Valuation Correlate" 31 July 2014. Web.10 December. 2016. <>

"How Risk Return And Valuation Correlate", 31 July 2014, Accessed.10 December. 2016,

Other Documents Pertaining To This Topic

  • Risk Management in British Hedge Funds

    Risk Management in Hedge Funds A research of how dissimilar hedge fund managers identify and achieve risk The most vital lesson in expressions of Hedge Fund Management comes from the inadequate name of this kind

  • Managing Market Risk There Are

    Critical Evaluation Chincarini's analysis of the Amaranth collapse contains five key lessons for portfolio managers and regulators with respect to managing market risk. Of the ones applicable to firms, the first is that liquidity risk must be accounted for. Liquidity risk in Amaranth's case compounded an already-bad situation. The second recommendation is that liquidity risk measures should be developed that are common -- the way that VaR is common -- so

  • Stock Valuation

    Stock Valuation Scholastic Corporate (NASDAQ: SCHL) is an educational publishing firm based in the United States. In order to make an investment recommendation on this stock, a number of different techniques can be used to analyze its financial performance. These include ratio analysis, for which three ratios will be chosen, and trend analysis for the past three years. The stock is currently trading at $26.41, its lowest level since August of

  • Capital Requirement and Risk Behavior Arab African

    Capital Requirement and Risk Behavior Arab African International Bank Midan ElSaray El Koubra, Garden City Caoro The research will mainly dwell on the capital requirements and risk behavior of banks, more in particular the credit risk. The purpose of this research is to identify and analyze the relationship between capital requirements and the risk behavior of banks in Egypt more in particular the Arab African International Bank, which is the case study for this

  • Popular Cost of Equity Models Problems and

    Popular Cost of Equity Models: Problems and Potentials in Current Theory and Practice It is important for any publicly traded business organization to understand and accurately estimate its cost of equity capital, in order to make effective capital-raising resource allocation decisions. There are several models for determining a supposedly accurate valuation for the current cost of equity capital for a given firm, however each of these models is imperfect in

  • Banking Sample the Banking Industry Over the

    Banking Sample The banking industry, over the last decade has undergone significant change. Industry regulation such as Dodd-Frank, Basel 3, and international capital requirements have now made the industry safer and more transparent. However, due primarily to the crisis of 2008, some banks are more stable than others. In many instance, due to unethical practices of the past, many banks are now suffering as they struggle to attract market share and

  • Investment Project Overview As Part Analyze Performance

    INVESTMENT PROJECT (OVERVIEW): As part, analyze performance potential industry BEVERAGE INVESTMENT PROJECT (DETAILS): Assignment: You analyze beverage industry companies coca cola,(KO) monster (MNST) . Assess industry performance years assess expected future performance, , years. Investment project The modern day business environment is continually challenged by emergent threats from both within and outside its immediate environment. In other words, the micro and macro environments of economic agents raise both opportunities and threats, to

Read Full Term Paper
Copyright 2016 . All Rights Reserved