Risk and return relationship

Lecture 2

Lecture outline What is risk? How risk is measured? Types of risk Risk Characteristics of Technology Start-ups Risk and return trade-off Risk and project life cycle Risk management framework Conclusion: Questions to ask.

What is risk?

Risk presents when the possible outcomes may deviate from the expected outcomes.

More than one possible outcomes Actual outcome may be different from expected. Can have both upside and downside risks Heavy focus on the downside risks

But remember there is a potential upside otherwise why should anyone take risks?

Let’s go an example

You are interested in a venture in the chemical industry. You have researched for the price to earnings ratios of the listed firms in the industry.

These P/E ratios provide a ground to estimate the possible P/E value for your prospect firm.

P/E ratios of 80 Bio-chemical firms

25 34 16 49 45 14 15 10

41 37 27 10 12 25 49 19

39 13 29 7 23 31 44 39

49 22 14 32 15 15 45 43

33 45 5 13 47 28 22 12

31 6 26 46 23 40 50 29

41 39 9 39 43 40 44 40

13 14 32 7 35 34 34 9

25 20 21 20 47 30 30 25

37 45 32 42 31 24 23 41

These price to earnings ratios can be organised in the form of an array…

5 6 7 7 9 9 10 10

12 12 13 13 13 14 14 14

15 15 15 16 19 20 20 21

22 22 23 23 23 24 25 25

25 25 26 27 28 29 29 30

30 31 31 31 32 32 32 33

34 34 34 35 37 37 39 39

39 39 40 40 40 41 41 41

42 43 43 44 44 45 45 45

45 46 47 47 49 49 49 50

A probability distribution can be derived for the data set…

Price/Earnings Ratio

Frequency

(# of stocks)

Relative Frequency

0 to 10 8 0.16

11 to 20 15 0.30

21 to 30 18 0.36

31 to 40 20 0.40

41 to 50 19 0.38

Data are grouped into classes and the number of observations.

A frequency distribution can be presented using histograms and frequency polygons…

Histogram

20

15

10

10

5

20 30 40 50 P/E Ratio

0

20

15

10

10

5

20 30 40 500 P/E Ratio

Frequency Polygon

Important parameters

A population can be measured by its: Central tendency (average performance)

Mean Mode Median

Dispersion (range of possible outcomes) Range Standard Deviation Variance

Mean value (Expected value) The arithmetic mean gives the

expected value of a population, denoted as E(X):

Example: The price/earnings ratios (X) of

six company stocks are: 10, 11, 12, 14, 14, 50 The expected value (mx) of

price/earnings ratios of this group of stocks is given by:

N

XXEx

)(

5.186

501414121110)(

XEx

Notes on using mean value (expected)

Arithmetic mean is defined by all values in a data set. “Outliers” may result in a distorted measure of central tendency Need to consider other values such as modes and median. Modes and median are not affected by the outliers.

In the previous example: 10, 11, 12, 14, 14, 50 Mode is 14. Median is 13

So what can we say about the expected P/E?

Risk measured by dispersion Range – simplest measure of dispersion

The range is the difference between the highest and lowest values in the population.

In the previous example: 10, 11, 12, 14, 14, 50 The range of the price/earnings ratios of the 6

stocks is Rx = 50 – 10 = 40

Risk measured by dispersion Variance:

a common measure of risk Variance of a population is: N

X Xx

22 )(

The variance of the price/earnings ratio of the five stocks is calculated as follows:

X X-X (X-X )2

10 10 - 18.5 = -8.5 72.25

11 11 - 18.5 = -7.5 56.25

12 12 - 18.5 = -6.5 42.25

14 14 - 18.5 = -4.5 20.25

14 14 - 18.5 = -4.5 20.25

50 50 – 18.5 = 31.5 992.25

111 1203.5

58.2006

5.12032 x

Risk measured by dispersion Standard deviation

The standard deviation of a population is the square root of its variance…

Very sensitive to extreme values

2xx

16.1458.2002 xx

For a continuous normal random variable, the probability distribution has the following characteristics…

Standard Deviation From The Mean

Interpreting the results

Expected value = 18.5 Standard deviation = 14.2

68% chance: P/E falls into the range: 4.3 – 32.7 95% chance: P/E falls into the range: 0 – 46.9 99% chance: P/E falls into the range: 0 – 61.1

Note the impact of the outliers in this calculation.

Using probability distribution….

EXAMPLE

If a company is expected to earn $1.50 per share with a standard deviation of $0.20, the confidence limits on the actual earnings are:

Probability Range of actual earnings

68% $1.50 +/- $0.20 i.e.

$1.30 to $1.70

95% $1.50 +/- 1.96*$0.20 i.e.

$1.11 to $1.89

99.7% $1.50 +/- 3*$0.20 i.e.

$0.90 to $2.10

Class quiz

If a company share price is expected to be $10 and its daily standard deviation is $2. What is the chance of having the price to go up to $20 in one day?

Measuring Risk

Standard deviation

High risk project

Low risk project

Expected returns

-ve +ve0

Please comment:

Expected Rate of Return

Rate ofReturn (%)100150-70

Firm X

Firm Y

Risk: Portfolio vs Stand-Alone

There are two aspects of risk to be considered

in examining a technology venture in relation

to the portfolio and to individual projects

Risk: Portfolio vs Stand-Alone

Stand-alone: not diversifiable Portfolio risk: diversifiable

Portfolio Risk Implications: Risk analysis may imply that the multi project

start-up, be able to spread its risk over a number of project might be more willing to take on higher financing costs, whereas the single project start-up is more conservative in its financing strategy

Risk tolerance of the start-up will depend on the risk aversion of the owners.

Types of project risk

Three typical types of project risks: stand-alone risk, corporate risk and market risk

Project stand-alone risk

What is the project’s stand-alone risk? Project risk relates to the uncertainty about

future operating income (EBIT), How well can we predict operating income?

Corporate risk How the project fits in with the current

corporate strategy and structure Financial aspects Human resource aspects (esp. management) Marketing and strategy

If the project fails, will it affect the other business of the firm?

If the firm fails in any other business, how this project is going to be influenced?

Market risk

How the market may impact on the project Commodity markets Financial markets Interest rate market Foreign exchange markets

An indicator of market risk is BETA. Beta: systematic (market) risk of the business Note: Firm beta vs. project beta

Company BetasCNET Networks 2.27

EDS 0.61

Nokia 2.05

Oracle 1.76

SAP 1.56

CISCO 2.00

Microsoft 1.80

AOL-Time Warner 2.57

Source: Yahoo Finance, 24 April 2002

How to estimate BETA?

How to interpret BETA value?

Australian E-Commerce Returns

and Volatility   

Company Std. Deviation Beta1 My Casino 59.59% 0.032 Sausage Software 28.58% 5.293 Solution 6 38.43% 5.574 Reckon Group 19.54% 2.965 Swish Group 22.55% 4.056 Pocketmail 296.52% 3.707 131.shop.com 24.06% 4.818 B2B.Net.Technology 801.31% -23.519 Coms 21 19.22% 1.46

10 Etrade Australia 19.57% 0.0911 AOL 82.44% 6.2412 Candle 11.25% 2.6113 Liberty One 31.17% -1.1614 Spike Networks 45.45% 7.5015 Webjet 29.67% 2.7116 Travel.com 67.28% 2.8117 Ecorp 33.03% 4.3118 Wine Planet 56.22% 11.95

How to estimate Beta? Regression

Stock returns against market returns firm’s beta If the project is funded with the same D/E structure as

the current structure use the firm beta as the project beta

If the project is funded with equity only find the unlevered beta from the firm beta.

EDL

U

1

How to estimate Beta?

What if it is not a public company? Find beta of a comparable firm Adjust for leverage level

What if there is no comparable company? Entrepreneurial venture Use earnings beta (find by regression)

Why take risks?

Risk – Return Trade-Off

Therefore the decision

to proceed with a new

project development,

i.e. commitment of

resources, should be

based on an assessment

of expected returns

from the project against

its risk exposures.

Risk – Return Trade-Off

In this context, management should ask the

following risk related questions:

1. Is the new project crucial to the firm’s performance and how does it fit with the firm business strategy?

2. Does the startup possess or have access to the necessary expertise/experience to successfully complete the project?

3. What is the level of resources to be committed?

4. What is the expected risk-return trade off in the project?

Risk and return trade-off

The greater the risk the greater the potential to create value – but also the greater potential to destroy value.

Risk Characteristics of Technology Start-ups extremely risky Depends on the level of experience and

technical skills Track record Risk to future firms’ revenue and profitability More difficult to estimate cash flow More difficult to estimate discount rate Risks change over project life cycle

Risk and Technology Start-ups

A highly risky project may achieve a certain degree of market success, but with considerable costs, such as:

longer PLC higher costs lower profit margins loss of market share

Risk and Technology Start-ups Factors influencing risk level of technology

start-ups: The potential market size; The type of financing available and cost; The technical and scientific basis and support for

the project; The degree of previous experience with the

technology, both within the firm and in other companies;

Proximity of the performance and physical specifications to the limits of the technology;

Risk and Technology Start-ups

Critical management decisions:

1. what risk to take

2. what investment to make

3. when to proceed to the next step in the cycle

4. when to terminate a program

Risk and Technology Start-ups

The relationship between the degree of risk exposure a firm may be willing to take in relation to level of technological innovation or advancement was analysed by Hayes (1985).

Risk and Technology Start-upsHayes looked at how big a technical quantum leap

a start-up should take in the technology, issues are:

The size of the leap will determine the direction, cost and risk of the technology start-up

If the goals are too ambitious resulting in a wide gap between the old and new technology and process, this may result in a weak technical base or inadequate skills to support such a leap

On the other hand, by aiming for marginal technological change may reduce the risk exposure but lose the market to more aggressive competitors.

Risk and Technology Start-ups

Hayes likens the different technology adoption strategies to the tortoise and the hare:

the first method is more logical, predictable and less risky

the second approach is a technological revolution strategy, which is very risky

Risk and Technology Start-ups

Hayes comments that:

US companies do, however, tend to adopt approaches toward the strategic leap end

US two most powerful competitors, Germany and Japan, tend to seek incremental improvements within an existing structure and technology

Risk and Technology Start-upsThe following table presents the different levels of

risk to technology adoption strategy:

Evolutionary

1. Evolutionary – Low risk

        Small dimensional changes

        Addition of few standard components

Risk and Technology Start-upsIncremental

2. Incremental – Moderate risk  Introduction of one or two significant new inventions, important process

changes, design features    Addition of major new sub-system    Significant increase in density of parts, size reduction 3. Incremental – High risk  Introduction of four or five significant new inventions, major process

changes, design features   Addition of two or three major new sub-systems   Major change in materials of several key components

Risk and Technology Start-upsRevolutionary

4. Revolutionary – Very high risk

        Major change in principles of operation

        Major change in technology

(The Internet, fiber optics, genetic

engineering, 3-G broadband technology etc.)

Risk and the Project Life Cycle The uncertainties associated with a project

decline over its life cycle the technical uncertainties pertaining to the

viability of the project and the market uncertainties associated with consumer acceptance of the project are relatively higher in the early stages

they decline in later stages of the project

Risk and the Project Life Cycle

The early planning phase is a critical point in the project life cycle in terms of:

project feasibility evaluation; resource allocation, and financing strategy

and this sets the stage for the ensuing economic performance of the project

Risk and the Project Life Cycle the planning stage that requires the least amount

of resources and therefore the lowest risk in the project life cycle

The development stage has the highest risk because of the resources committed to the project against the high level of uncertainties associated with the project

These uncertainties (risks) will start to diminish as the project evolves and more information is available for assessing the technical feasibility of the project

4 strategies to deal with risks Accept Transfer Mitigate Avoid

The application depends on the risk aversion and experience level of the business.

Risk Management Framework

Risk Management Framework

Identify the project’s critical/ source of risk exposure; Quantify the exposure Assess the impact of the risk exposure

Strategically (market, HR…) Financially

Prepare a strategy/plan for resolving each risk; Monitor and update the risk management, plan, and

results periodically; Highlight risk-item status in reviews; and Initiate appropriate corrective actions.

ConclusionsA broad risk identification framework is for

managers and investors to ask the following

questions about a start-up firm:

1. What do you do to create value?

2. What can happen to destroy value?

3. What probability do you assign to the estimated distribution of outcomes?