Module 3 Risk Adjusted Value

Dr. Sankersan Sarkar

Some Questions
Value of What? Why do we require Risk Adjusted Value? What do we mean by the term Asset? How do we assess value?

Contents
DCF value of an asset DCF Value using risk adjusted discount rates DCF Value using certainty equivalent cash flows Risk adjusted discount rates versus certainty equivalent cash flows Hybrid Models DCF Risk adjustment: merits and demerits Post-valuation risk adjustment Relative valuation approaches DCF versus relative valuation Risk adjustment in practice

DCF value of an asset

Value of an asset is a function of the expected cash flows generated by the asset and is considered to be equal to the present value of the expected cash flows

generated by the asset.

Assets with predictable cash flows are likely to have

higher value than assets with unpredictable or

volatile (hence risky) cash flows

DCF value of an asset

Value of a risk-free asset should be the present value of the cash flows from it discounted at the risk-free rate If cash flows from the asset are likely to be affected by risk then the impact of risk can be factored into valuation either by adjusting the cash flows or by adjusting the discount rate. Thus a risky asset can be valued in either of the following ways: Using risk adjusted discount rates Using adjusted cash flows

DCF Value using risk adjusted discount rates

A higher discount rate is used to discount the expected cash flows arising out of more risky assets and lower discount rate for the less risky assets

Where
n=life of the asset in number of years E(CFt)=expected cash flow from the asset in the year t r =risk adjusted discount rate applicable to the asset.

How to decide the correct discount rate?

Correct Risk Adjusted Discount Rate 1. Risk-Return Models 2. Implied Discount Rates

Risk adjusted discount rates: Risk Return Models

The answer to the previous question can be provided by the use of risk return models e.g. CAPM, APM and Multifactor models According to CAPM: Expected rate of return = Risk-free rate + Beta x Market risk premium Where Risk-free rate is the market rate of interest on govt. securities The market risk premium (also called equity risk premium) is the excess return expected on the market index over the risk-free rate = RM RF Beta is the risk parameter that is specific to the asset

Risk adjusted discount rates: Risk Return Models

1. Risk-free rate of return: Yield on T-bills Yield on long term G-secs 2. Market risk premium: RM RF Historical premiums OR Prospective premiums 3. Beta: Historical beta OR Bottom up beta

Risk adjusted discount rates: Risk Return Models The APM and the multi-factor models are extensions of the CAPM Risk free rate would remain the same but risk premium and betas have to be calculated for each risk factor Each beta measures the exposure of the asset to the underlying risk factor Each beta can be historical/bottom up estimate In APM the factors are unspecified market risk factors while in Multi-factor models, these are specified macroeconomic factors Proxy models use firm specific factors as proxies for risk

Risk adjusted discount rates: Risk Return Models

Caveats: CAPM is simple but makes restrictive assumptions viz. quadratic utility function, normally distributed returns All risk-return models (CAPM & others) assume that investors maintain well diversified portfolios so the relevant measure of risk is not the total risk but the risk added on to a diversified portfolio by including the asset (Beta)

Risk adjusted discount rates: Implied Discount Rates

Implied discount rate can be calculated on the basis of the following relationship: Expected cash flow next year
Market Value Risk adjusted Discount Rate Growth rate

The implied discount rate does not require any assumptions on the investor utility and the return distributions as made in the riskreturn models. However it suffers from the following limitations due to which it has not been popular: 1. It cannot be applied in case of non-traded assets because it can be applied only if the asset is traded and has a market price. 2. Further even if the asset has a market price it assumes that the asset is correctly priced. However due to market imperfections an asset may not always be correctly priced.

Risk adjusted discount rates: Implied Discount Rates Two techniques to get around the second problem: 1. Calculate the implied discount rate for every asset belonging to same risk class at a specific point of time and average them out. Assumption: All assets belonging to the same risk class have the same risk and the average risk adjusted return should be applicable to all of them. 2. Calculate the implied discount rate for the same asset in several consecutive years over a long period of time and average them. Assumption: Risk adjusted discount rate does not change over time & averaging over several consecutive years is the best estimate.

Examples
1. The current level of S&P 500 index is 900, the expected dividend yield for the next period is 3 percent approx. the long term expected growth rate in dividends is 6 percent. Calculate the implied rate of return required on the market & implied market risk premium. Use this information to calculate the required rate of return for a stock having a beta of 1.20.

Examples
2. The S&P 500 index on January 1 of 2011 was at 1248 approx. The dividend yield on the index in the previous year was 3.34 percent approx. The market in general expects that the earnings & dividends of the companies in the index will grow at 8 percent for next five years followed by a constant growth rate of 4.39 percent thereafter. The yield on 10 year govt. bonds was 4.39 percent as on Jan 1, 2011. Calculate the implied rate of return required on the market and the implied market risk premium. Use this information to calculate the required rate of return for a stock with beta 1.50.

Examples
3. A commercial property is likely to generate cash flow of Rs. 3.20 lakh next year. The cash flows from the assets are growing at a long term rate of 6% and the asset has a market value of Rs. 88 lakh at present. Calculate the implied discount rate for the asset. 4. Over a 7 year period the Sensex has grown from 5000 to 15000. During the same period yield on 10 year govt. bonds have averaged 9%. Calculate the historical rate of return on the market and the historical risk premium.

Risk adjusted discount rates: General Issues

A. Single period models and multi-period cash flows Most of the models discussed earlier are single period models while the cash flows are generated over multiple periods in future, but the same risk adjusted discount rate is used for all future periods Underlying assumption: systematic risk & market risk premium will not change over time This assumption is violated when an asset has potential for growth a. systematic risk under growth conditions tends to be more than that in the absence of growth; b. systematic risk under growth conditions tends to change over time Thus systematic risks & growth potentials may change over time and so risk adjusted discount rates should be changed for each consecutive year. Que: By how much?

Risk adjusted discount rates: General Issues

B. Composite discount rate versus item-specific discount rate Expected cash flows used in the DCF models are the net of expected cash inflows & outflows in different years; moreover inflows/outflows will consist of several components If the inflows & outflows or the different components of cash flows have different exposures to systematic risk factors using the same risk adjusted discount rate for discounting all components of cash flows is not appropriate, even in any particular period

Risk adjusted discount rates: General Issues

C. Negative versus positive cash flows The same discount rates would affect the negative cash flows differently vis--vis the positive cash flows due to the discounting effect Due to the discounting effect the Negative cash flows will be smaller in negative terms The higher the discount rate the lower will be the magnitude of the present value of the negative cash flows This may increase the NPV of the asset

Risk adjusted discount rates: General Issues

C. Negative versus positive cash flows Some experts suggest using a lower discount rate for negative cash flows & higher rate for positive cash flows Using different discount rates for different components during the same periods will be internally inconsistent Using lower discount rate for the negative cash flows will be reasonable only if they are more predictable & stable than the positive cash flows; not just because they are negative

DCF Value Using Certainty Equivalent Cash Flows

An alternative technique is to adjust the expected cash flows for risk Expected cash flows which are uncertain due to the influence of risk are adjusted to derive cash flows which are certain to occur (and hence free from risk) These adjusted cash flows are called certainty equivalent cash flows Certainty equivalent cash flows may be considered to be risk-free guaranteed cash flows that are equivalent to the uncertain expected cash flows under risk. How do we estimate the Certainty Equivalent Cash flows?

Estimation of Certainty Equivalent Cash Flows

Three approaches: A. Utility based approach B. Risk-return model based approach C. Cash flow Haircuts

Certainty Equivalent Cash Flows (CECF)

A. Utility based approach: Because certainty equivalent is a risk-free cash flow that is certain to occur & it provides the same utility as the expected utility of the risky outcomes it is a function of the risk aversion of the decision makers The greater the risk aversion the lower the CECF & vice versa Issues: However risk aversion differs from individual to individual (or firm to firm) Utility functions may be different for different individuals Hence same investment may have different set of CECF for different investors

CECF
A. Utility based approach How do we derive a utility model for an individual / firm? Because the utility function is a mathematical function, CECF derived on the basis of such functions may turn out to be negative for positive risky cash flows for extremely risk averse individuals Many utility functions have failed to explain individual / firm behaviour in practice

CECF
B. Risk-Return Model based approach: This approach uses the risk premium embedded in the risk adjusted discount rate derived from the risk-return models to calculate the CECF For any year the compounded value of the risk premium is used to discount the uncertain cash flow in order to derive the CECF for that year hence the risk premium is also called Compounded Risk Premium

CECF
A. Risk-Return Model based approach: For any year t the CECF can be calculated as: CECFt t E(CFt) Where: CECFt = Certainty Equivalent Cash Flow for year t t = Certainty equivalent coefficient for year t = (1 r )
t f

(1 r) t

CECF
t = Certainty equivalent coefficient for year t
1 1 (1 rf ) = = (1 Risk Premium) (1 r) t (1 r) t (1 rf ) t
t

Risk premium embedded in the risk adjusted discount rate = (1 r) -1 (1 rf )

CECF
The effects of this type of adjustment are Uncertainty increases with futurity Hence Uncertainty has a compounding effect over time; so the cash flows that are further into the future will have lower certainty equivalents than the earlier cash flows The more uncertain cash flows have lower certainty equivalents.

DCF Value Using CECF

This approach essentially involves a twostep procedure Convert the uncertain cash flows from the project/asset/investment/firm to certainty equivalent cash flows Discount the certainty equivalent cash flows to obtain their present values using the risk-free rate (Why ?)

DCF Value Using Certainty Equivalent Cash Flows

(C) Trimming the Cash Flows Cash Flow Haircuts
Reduction of the uncertain cash flows by subjective judgment instead of adjusting the discount rate But reduction of cash flows may be subjective based on individual perception e.g. more risk averse investor would reduce the cash flows more as compared to less risk averse investor

Risk Adjusted Discount Rate Versus Certainty Equivalent Cash Flows

Adjusting the cash flow by the certainty equivalent, and then discounting the resulting cash flow by the risk-free rate is equivalent to discounting the uncertain cash flow by a risk adjusted discount rate However in some situations the two approaches will result in different outcomes When risk premiums change over time, certainty equivalent approach is better to use. Both approaches will give different outcomes , when certainty equivalents are derived through subjective judgments while risk adjusted rate is derived through risk return models. Negative cash flows are treated differently by the two approaches

Hybrid Models
Risk-Return based approach & CE approach have their own comparative merits It is easier to estimate the parameters of riskreturn models and so adjust the risk based discount rate for some market-wide risk factors Eg. Interest rate volatility, purchasing power risk, economic cycles & variations in economic growth The above risk factors tend to operate in a continuous manner and affect the investment returns on a continuous basis For such risks it is easier to adjust the discount rate instead of cash flows

Hybrid Models
There are other types of market risks sudden political changes, changes in govt. policies, economic disruptions etc. Further there can be market risk factors that can be contingent upon occurrence of definite events sudden price rise / fall due to sudden disturbances in supply-demand balance These are discontinuous market risk factors; they occur less frequently but can have a great impact on value It is generally easier to adjust the expected cash flows for such risks if the cost of protection is known

Hybrid Models
Continuous market risk factors: volatility of interest rates, economic cycles & inflation Discontinuous market risk factors: economic policy changes or political risks (change in govt. or others) Contingent market risk factors: sudden increase/decrease in commodity prices triggered by certain conditions Firm-specific risks: IR problems, Technology risks, Competition risk

Hybrid Models
Different types of risk factors can be more conveniently adjusted in different components of the fundamental valuation model Adjustment for continuous market risk factors can be conveniently done in discount rate Adjustment for discontinuous market risk factors & contingent risk factors can be conveniently done in cash flows Firm specific risks may be treated selectively

Hybrid Models: Caution

Adjusting both cash flows and discount rate subjectively can lead to double adjustment for the same risk factors To prevent this a 2-step procedure should be followed: 1. Classify the risks that an investment / asset / project faces 2. State explicitly how the risks will be adjusted for

Nature of Risk

Risk Adjustment to be Made in Valuation Continuous market risk: so Interest rate risk, Inflation Adjust the discount rate for buying protection against the risk, Economic cycles the risk consequences is not possible Discontinuous market risk: Political risk, Loss of income If insurance cover is available: probability of occurrence is or property, Terrorism risk treat cost of insurance as part small but economic of the operating expenses & consequences are large adjust the cash flows. If insurance cover does not exist: adjust the discount rate. Market risk that is Risk arising out of commodity Estimate cost of option contingent on the occurrence price rises/falls triggered by required to hedge against the of a definite event external events (sudden risk; include the cost of option oversupply / excess demand) in operating expense and adjust the cash flows. Firm specific risks Industrial Relations risk, Risk If investors in the firm hold of competition, Risk of diversified portfolios: no risk Technological obsolescence adjustment is needed. If investors do not hold diversified portfolios: follow the same rules as applicable for market risk.

Some Examples

Example: Damodaran
Table 5.2 (p 113), Table 5.3 (p 114), Table 5.4 (p 115), Table 5.5 (p 116)

DCF Risk Adjustment: Merits & Demerits

Use of risk return models for risk adjustment is more standardized, transparent, understandable for those who might examine the valuation methodology & are flexible to changes. Further they are explicit about the risks adjusted for & the risks that are not However these models are based on assumptions on how the investors & markets behave but the reality may be quite different The correct impact of risks may not be captured wholly in the discount rate and cash flows

Post-Valuation Risk Adjustment

An approach to risk assessment and adjustment is to find out the value of a risky asset / investment /project as if there were no risk involved and then to adjust the risk-free value for the risk involved Adjustments may be: Discounts / Premiums Common practice: Some risks adjusted in discount rate, others adjusted post-valuation 2 steps: 1. Calculate the risk-free value: Base case value 2. Adjust the base case value for the risks

Post-Valuation Risk Adjustment

Justification for Post-Valuation Adjustment

Downside Impact: Some assets/investments may not be very actively traded and hence involve an illiquidity risk; such risks can not be adjusted in discount rates Upside Impact: Similarly premiums may be applied in the post-valuation adjustment if there are concerns that the expected cash flows do not fully reflect the potential for upside benefits in some risky investments

Post-Valuation Risk Adjustment

Adjustment for Downside Risks: Most common downside risk: Illiquidity May be associated with following assets: a. Stocks of closely held cos. b. Real estate c. Precious metals bullion / jewelry d. Antique e. Fine art f. Stamps g. Private businesses/cos.

Post-Valuation Risk Adjustment

Adjustment for Downside Risks: Illiquidity Risk It may be measured through the implicit/explicit costs associated with liquidation of assets For publicly held stocks of listed cos. following are the liquidation costs: commission or brokerage to the broker Bid-ask spread of the broker Price impact of the stock when buy or sell order is placed by the investor - depends on the nature of stock & type of investor Opportunity cost timing & need to wait

Downside Risk Illiquidity Risk

These costs will vary based on the characteristics of

the assets The costs associated with liquidation of stocks of closely held companies (e.g. private limited companies and unlisted public limited companies) or real assets are much higher than those for publicly traded stocks (widely held cos.) Real assets include gold, real estate, fine art, stamps, antiques etc Transaction costs are least for assets such as gold & silver because they are traded in standardised units

Downside Risk Illiquidity Risk

Commissions payable on real estate depend on: a. Type of real estate residential or commercial b. Value of the property c. Location & local conditions Commissions will be far in excess of that payable on financial assets

Downside Risk Illiquidity Risk For assets such as fine art the commissions may be as high as 15-20 percent of the value because: Fewer intermediaries Fine art (& Real estate) are not standardised items Experts are involved in valuation, & they charge significant fee thus raising the transaction costs

Downside Risk Illiquidity Risk The transaction costs involved in buying & selling of private businesses tend to be very high Depend upon the size of business, quality of assets, nature of liabilities & profitability There is no organised market for buy/sell of business entities which entails further costs for searching the buyer or seller

Downside Risk Illiquidity Risk

Hence investors in private equity and venture capitalists have to provide for illiquidity of their investments while assessing the value of such investments. So transaction costs of illiquid assets can be substantial and are higher than those for the liquid assets.

Illiquidity Risk Empirical Evidences

Bond market: Liquidity matters for all types of bonds but it matters more for risky bonds than for safer bonds Liquidity differs across bonds issued by different entities and also across different bonds issued by same issuer

Illiquidity Risk Empirical Evidences

Stocks of Listed Companies: Transaction costs for listed companies stocks are more than those for risk-free assets Investors expect higher returns from stocks owing to their lower liquidity & higher risk

Illiquidity Risk Empirical Evidences

Venture Capital & Private Equity (PE) Investors provide funding & want a share in ownership of these businesses. These investments are highly risky and mostly illiquid Hence investors discount more on worth of the business Thus the higher the discount, the lower the intrinsic value & the larger the proportion of ownership claimed for the amount of funding provided An estimate of the amount of illiquidity discount: difference between the returns earned by PE investors & those who invest in listed cos.

Illiquidity Discount Common Practice

Fixed illiquidity discount for valuation of PE Or Range of discount with the exact amount of discount in that range being determined by the subjective judgment of the analyst

Other Types of Discount

Companies belonging to regulated industries are exposed to unfavourable regulatory changes Those that are subject to possible litigations will be discounted by the analysts during the valuation exercise Adjustments for such risks are typically in the form of post-valuation discounts because the same are generally difficult to be incorporated in the discount rate Extent of discount reflects the analysts own risk aversion

Post-Valuation Risk Adjustment: Premiums

This is particularly important in the context of corporate restructuring Adjustment for Upside Risks: Control premium Synergy Premium

Adjustment for Upside Risks

Control premium: The potential value that can be created if a competent & effective management replaces existing incompetent management, & controls the firm Adjusting for the control premium: Adding a premium to the existing value of the firm (status quo value) Assumption: functioning of the incumbent management team is not optimal & can be improved upon by a better management team.

Adjustment for Upside Risks Synergy premium: Synergy refers to the scope for additional value creation by a combination of several firms that leads to new opportunities otherwise not available to the firms operating independently Operating synergies & Financial synergies

Adjustment for Upside Risks

Synergy premium Operating synergies: Additional value creation from the operations of the combined firm & includes factors: economies of scale, better bargaining power vis--vis suppliers & customers and higher growth potential; generally reflected in increased expected cash flows after combination Financial synergies: Additional value that can be created as a result of tax benefits, diversification of risk, higher debt capacity & returns generated by the use of excess cash; generally reflected either in the form of increased cash flows or lower discount rate

Limitations of Post-Valuation Adjustments

Double counting: These risks (downside/upside) can be double counted, if the analyst has already taken them into consideration while estimating the discount rates and cash flows Basis of adjustment: Difficulty to arrive at the amount of the premiums or discounts that is to be used and the basis for the same Bias: Individual biases can creep into valuation process due to the subjectivity of the technique

Relative Valuation Approach

Does not assume a DCF framework Very popular approach owing to its apparent simplicity Assets are valued on the basis of how the market values similar assets Widely used in capital markets; can be applied in other markets as well

Relative Valuation: Basis

Value of an asset is arrived at from the value of 'comparable' assets, and this process is standardized by using a common variable Rests on two basic components: a. Concept of comparable assets b. Standardized price

Relative Valuation: Basis

a. Comparable/similar assets: Assets similar in terms of cash flows, risk and growth potential In corporate valuation it is assumed that other cos. in the same line of business as the one being valued are comparable cos.

Relative Valuation: Basis

b. Standardized price: A standardized price is calculated by dividing the market price by some quantity that can be logically related to that value; multiples can be compared across comparable companies Commonly used multiples in valuation of equity shares: Price/Earnings multiple, Price/Book value multiple, Price/Revenues multiple

Relative Valuation: Basis

This approach may be used in real asset valuation because it is easy to find out similar or identical assets For valuation of stocks of listed cos. this approach has following limitations: a. Non-availability of similar stocks every co. is unique in itself; so definition of comparable assets is extended to include companies that are different from the one under consideration b. Different multiples calculated with respect to different bases can result in different assessment for the same company

Relative Valuation: Risk Adjustment

Risk adjustment process is very unsophisticated Based on strong assumptions Adjustments are implicit & subjective

Relative Valuation: Risk Adjustment Issues

Sector Comparison Size / Market cap Ratio-based comparisons Statistical approach

Relative Valuation: Risk Adjustment Issues

Sector Comparison: Assumption: All firms in the same industry (FMCG, Technology) are in equivalent risk class; hence their P/E multiples are comparable As risk characteristics of firms in a sector tend to diverge increasingly this approach will give misleading estimates of firm value Thus firms with higher risks may be overvalued and those with lower risks may be undervalued

Relative Valuation: Risk Adjustment Issues

Firm Size: Generally firm size is estimated in terms of revenues or market cap If there are many firms within the same sector then generally analysts compare firms of similar size Assumption: Riskiness differs across firms of different sizes; firms of different size should be priced at different multiples of book value, earnings and revenues

Relative Valuation: Risk Adjustment Issues

Statistical approach: Regressing the P/E Multiples against some measure of risks e.g. Beta, market capitalization, S.D. of earnings or stock price etc. This approach could be used to find out whether valuation multiples differ for riskier cos. & safer cos.

DCF Valuation Versus Relative Valuation

Risk adjustment in DCF approach is explicit and systematic whereas it is ad hoc and arbitrary in the relative valuation approach Risk adjustment in DCF is more time and data intensive whereas relative valuation is less time consuming and requires less data DCF approach is less dependent on market efficiency while relative valuation critically depends on the assumption that market is efficient & prices the assets correctly (hence value multiples are a good measure of the equity value of a firm).

Risk Adjustment in Practice

Common practice is to make multiple adjustments using the four major approaches discussed so far. But it may become difficult to review and revise the risk adjustment due to various approaches used There is a possibility of multiple adjustments for the same risk being done in the value estimate