The Analysis of Equity

Risk and Return for

LINKS
Active Investing
Link to previous chapters

Chapter 3 (and its

appendi x) rev iewed
standard beta technologies
to measure the cost of
capital. Chapter 14
di stingui shed operating ri sk
and fin anci ng ri sk.

0 ~
This chapter

Thi s chapter analyzes the

fundamental determinants
0
of operating and fin ancing What are the What are the What is price How is ri sk
risk in equity investing. It problems with fund amental risk? handl ed in
sta ndard beta determin ants of active
al so outlines ways to
incorporate risk when tec hnologies? ri sk? investing?
valuing firm s and trading
in their shares.

Link to next chapter
Chapter 20 analyzes the
ri sk of firm s' debt.
Link to Web page
Go to the text's Web site at
www.mhhe.com/penman5e
for furth er di scu ssion
of risk.
Valuation involves both risk and expected return, so we have referred to risk at many points
in this text. Risk determines an investor's required return, and expected payoffs must
cover the required return before an investment can be said to add value. As the book has
proceeded, we have seen that, to value investments and to measure value added, expected
payoffs must be discounted for the required return. Indeed, Step 4 of fundamental analysis
requires expected payoffs to be discounted using the required return to arrive at a valuation.
But we also have seen that valuations can be quite sensitive to estimates of the required
return. In many applications in the book, we have estimated the required return using the
standard capital asset pricing model (CAPM). But we have done so with considerable dis-
comfort because of problems in measuring the inputs into the model. Alternative multifac-
tor models have been proposed (as discussed in the appendix to Chapter 3), but these beta
technologies only compound the measurement problems. These models are speculative.
So-called asset pricing models seemingly do not refer to fundamentals . They are com-
posed of betas and risk premiums. Betas are defined by expected correlations between
 Chapter 19 The Analysis of EqLLity Risi< and Return for Active Investing 643

After reading this chapter you should understand: After reading this chapter you should be able to:

• The difference between the requ ired return and the
expected return.
• That precise measures of the cost of capital are difficult
to calculate.
• How business investment can yield extreme (h igh and
low) returns.
• How diversification reduces risk.
• Problems w ith using the standard capital asset pricing
model and other beta technologies.
• The fundamental determinants of risk.
• The difference between fundamental risk and price risk.
• How pro forma analysis can be adapted to prepare
value-at-risk profiles.
• How the investor finesses the problem of not knowing
the required return.
• How to be sensitive to the risk associated with growth.
• Identify a firm's risk drivers.
• Generate a va lue-at-risk profile.
• Incorporate value-at-risk analysis in strategy formulation.
• Deal w ith the uncertainty about the requ ired return.
• Apply value-at-risk profiles to evaluate implied ex-
pected returns estimated with reverse engineering.
• Assign firms to a risk class.
• Carry out pairs trading .
• Estimate the expected return from buying a stock at
the current market price.
• Generate growth-return profiles.
• Engage in re lative value investing and pairs trading.
• Invest with a margin of safety.

investment returns and market returns, and risk premiums are defined in terms of expected
returns. Typically betas and risk premiums are measured from past stock returns. However,
risk, like return, is driven by the fundamentals of the firm , the type of business it is engaged
in, and its leverage; in short, a firm 's operating and financing activities determine its risk.
This chapter analyzes the fundamental s that determine ri sk, so that you can understand why
one firm would have a higher required return than another.

THE REQUIRED RETURN AND THE EXPECTED RETURN

The required return , also referred to as the cost of capital , is the return that an investor
demands to compensate him for the risk he bears in making an investment. Both asset pric-
ing models like the CAPM and the fundamental analysis of risk aim to determine what this
required return should be. If markets are efficient, the market price will reflect this funda-
mental risk: The price will be set such that the expected return to buying the shares will
equal the required return for risk.
This book, however, has entertained the notion that prices may not be efficient. That is,
prices might be set to yield a return different from the required return that compensates for
risk. If the price is lower than that indicated by the fundamentals , the investor expects to
earn a return higher than the required return; ifthe price is set higher than that indicated by
fundamentals , the investor expects a lower return than the required return. Active investors
attempt to identify such mispricing; in other words, they attempt to identify when the
expected return is different from the required return. Hence, we distinguish the expected
return from the required return. The expected return is the return from buying a share at
644 Part Five Tli e Analysis of Risk and Return

the current market price. The expected return is equal to the required return only ifthe mar-
ket price in efficient.
This chapter analyzes fundamental risk with the aim of determining the required return
that compensates for that risk. But it also rejoins the earlier active investing analysis of
Chapter 7 that determines the expected return. That analysis involves reverse engineering:
Given forecasts of profitability and growth , what is the expected return to buying at the cur-
rent market price? The comparison of this implied expected return with the required return
indicates a buy, sell, or hold position.
Despite an enormous amount of research on the issue, measures of the required return
(the cost of capital) remain elusive. To be blunt, you will not find a way to estimate the
required return with assured precision in this chapter. You will find the material here to be
more qualitative than quantitative; the chapter will give you a feel for the risk you face but
will not transform that into a percentage return number. It is just too much to think that risk
can be reduced to one number like a beta. But the expected return is the focus of the active
investor, so the chapter concludes with ways to finesse the difficulties of estimating the re-
quired return .

THE NATURE OF RISK

Every year, up to 2007, The Wall Street Journal published a "Shareholder Scorecard," which
ranked the 1,000 largest U.S. companies by market capitalization on their stock return perfor-
mance. The year 2007 was a below-average year for stocks, with the S&P 500 stocks earning
a retmn of 5.5 percent. But there was considerable variation around this average. Table 19. 1
gives the top and bottom 2Y, percent of performers among the 1,000 stocks that year.
The historical average return to investing in U.S. equities has been about 12.5 percent
per year. Table 19. I gives you some idea of how actual returns vary from average returns.
There is a chance of doing better than 12.5 percent- very much better as the best perform-
ers in the table indicate- and a chance of "losing one's shirt"- as the negative returns in
the table indicate. This variation in possible outcomes is the risk of investing.
The investor's perception of this variation determines the return she requires for an
investment- how much she will charge in terms of required return to invest- and the
return required by investors is the firm's cost of capital. If no variation in returns is ex-
pected, the investment is said to be risk free . So the required reh1rn for a risky investment
is determined as
Required return= Risk-free return+ Premium for risk
United States government securities are seen as risk free, and the yields on these securities
are readily avai lable. The difficult part of determining a required return is calculating the
premium for risk.

The Distribution of Returns

The set of possible outcomes and the probability of outcomes that an investor faces is
referred to as the distribution of returns. Risk models typically characterize return distri-
butions in terms of probability distributions that are familiar in statistical analysis . A prob-
ability distribution assigns to each possible outcome a probability, the chance of getting
that outcome. The average of all outcomes, weighted by their probabilities, is the mean of
the distribution, or the expected outcome. The investor is seen as having an expected return
but also is aware of the probabilities of getting outcomes different from the expected return.
And the risk premium she requires depends on her perception of the form of the distribu-
tion around the mean.
 Chapter 19 The Analysis of Equity Risk and Return for Active Investing 645

TABLE 19.1 Best and Worst 2007 Stock Return Performance for the 1,000 Firms in The Wall Street Journal's
Shareholder Scorecard

The Best Performers The Worst Performers

One-Year One-Year
Company Return,% Company Return,%
First Solar 795.2 Countrywide Financial - 78.4
Onyx Pharmaceuticals 425.7 MBIA - 74.1
Mosaic 341 .7 Ambac Financial Group -70.6
CF Industries Holdings 330.0 Washington Mutual - 68.2
Terra Industries 298.7 Pulte Homes - 68.0
Sun Power 250.8 Lennar - 65 .2
Intuitive Surgical 236.8 MGIC Investment - 63 .6
Foster Wheeler 181.1 Office Depot - 63.6
AK Steel Holding 173.6 Advanced Micro Devices -63. 1
Owens-Illinois 168.3 SLM - 58.5
Bally Technologies 166.2 Sepracor - 57.4
Priceline.com 163.4 KB Home - 56.7
GrafTech Internationa l 156.5 CIT Group - 55 .9
National Oilwell Varco 140.1 Centex - 54.9
Chipotle Mexican Grill 136.6 First Horizon National -54.9
Amazon.com 134.8 Sovereign Bancorp -54.4
Jacobs Engineering Group 134.5 AMR -53.6
Apple 133.5 Liz Claiborne -53.0
McDermott International 132.1 National City - 52.7
Alpha Natural Resources 128.3 Lexmark International -52.4
MEMC Electron ic Materials 126.1 Rite Aid -48.7
GameStop 125.4 D.R . Horton -48.6
Consol Energy 124.2 Freddie Mac -48.6
FTI Consulting 121 .0 Moody's -48 .1
MGI Pharma 120.2 Micron Technology -48.1

Note: The best pe rfor mers listed are 2 ~ percen t of the tota l, as are the worst perform ers. Stock return includes cha nges in share prices, reinvestment ofdivldends, rights and
warrant offeri ngs, and cash equivalents (s uch as stock received in spi noffs).
Source: The Wall Street Journal , February 25, 2008. Analysis performed by L.E. K. Consulting LLC. Copyright 2008 by Dow Jones & Co. Inc. Reproduced with permission
of Dow Jones & Co. Inc. in the format textbook via Copyright Clearance Center.

Figure 19.la plots the familiar bell-shaped curve of the normal distribution. If returns
were distributed according to the normal distribution, approximately 68 percent of outcomes
would fall within 1 standard deviation of the expected return (the mean) and 95 percent
within 2 standard deviations, as depicted. The typical standard deviation of annual returns
among stocks is about 30 percent. So, with a mean of 12.5 percent, we expect returns to fa ll
between - 47.5 percent and +72.5 percent exactly 95 percent of the time ifreturns follow a
normal distribution.
But look at Table 19.1. The stocks listed there are 5 percent of the Shareholder
Scorecard's 1,000, that is , 2Yz percent with the best performance and 2Yz percent with the
worst, so their returns are those outside 95 percent of outcomes. The top performers have
returns considerably greater than 72.5 percent. Most of the worst performers have 2007
returns below -4 7 .5 percent. Far worse returns are not uncommon; in 2002, for example,
al I the bottom 2Yz percent of stocks had returns worse than -69 percent, in 2001 they all
had returns of less than -66 percent, and in the year of the bursting of the bubble, 2000,
the 2Yz percent worst performers all returned less than - 74 percent. Even in a good year,
646 Part Five The Analysis of Risk and Return

FIGURE 19.1 Probability

(a) The Normal
Distribution and
(b) the Typical
Distribution of Actual
Stock Returns. I
'I + - - 68.26%
____, I

(c) The Hypothetical I

I
Normal Distribution I
I
I
of S&P 500 Returns
and (d) the Empirical
95.44%
Distribution of S&P
500 returns
-3 sd -2 sd -I sd 0 sd sd 2 sd 3 sd
The actual distribution
of returns indicates
(a) The normal distributio n. With a normal di stribution , there is a 68.26% probability that a
that the chance of
return will be within I standard deviation (sd) of the mean and a 95.44% probability that a
getting very low return will be within 2 standard deviations of the mean.
returns or very high
returns is higher than
indicated by the
normal distribution. Probability
Even for a large
portfolio, like the S&P
500, there are more
extreme negative and
positive returns than
are likely under the
normal distribution .
Source for Figure 19. 1(d):
© CRSP Ce111erfor Research in
Security Prices. The University
of Chicago, Booth School of - 2 sd 0 sd 2 sd
Business. Used with pennis-
sion. All rights reserved.
-100% -47.5% 12.5% 72.5 % 100%

(b) The empirical distribution of annual stock returns.

Probability

- 2 sd 2 sd

-47.5% - 27.5% - 7.5 % 12.5 % 32.5% 52.5% 72.5% Return

(c) The normal distribution of annual returns on the S&P 500 stock portfolio with a mean of 12.5%
and a standard deviation of 20%.
 Chapter 19 Th e Analysi.1 of Equit)' Risk and Return for Active lm1esting 647

FIGURE 19.1 12
(concluded)

9
"O
<.>
;>
il
~
c
""'E 6
4-.
c
ii
_o
E
::l
z
3

0
- 50% -40% - 30% - 20% - 10% ()% I 0% 20% 30% 40% 50%

(d) The empirical di stributi on of annual return s on the S& P 500 stock portfoli o 1926- 1998,
superimposed on the normal distribution.

large negative returns are not uncommon : [n 1998 , when the average return was 24.2 per-
cent, the bottom 212 percent all returned less than -55 percent.
Figure J 9.1 b compares the actual distribution of annual stock returns to the normal
distribution in Figure 19.1a . You notice two things. First, stock returns can't be less than
-100 percent, but there is significant potential for returns greater than +100 percent, as
Table 19. J also indicates. 1 Second, the probability of getting very high or low returns is
greater than if rehirns were normally distributed. In statistical terms, the first observation
says that returns are skewed to the right. The second observation says that the distribution
of returns is fat-tailed relative to the normal ; that is, there is a higher probability of falling
into the tails (the extremes to the left and right of the 2 sd points) of the di stribution, as the
comparison of Figures 19 .1 a and b indicates.
This all says that in evaluating ri sk we should be apprehensive of models that rely on the
normal distribution . There is a chance of being badly damaged in equity investing : The
probability of getting very bad returns (greater than 2 standard deviations from the mean,
say) cannot be taken lightly. This is sometimes referred to as downside risk. Correspond-
ingly, equity investing has the potential of yielding very large rewards- on the order of
100 percent and greater. This is sometimes referred to as upside potential. 1ndeed, we
might view equity investing as buying a significant chance oflosing a considerable amount
but with the compensation of upside potential. Amazon, in the best performers of the
Shareholder Scorecard with a 134.8 percent return in 2007 , experienced a large negative re-
turn of - 80.2 percent in 20.00.
The mean and standard deviation do not capture this feature of investing entirely. In
assessing ri sk premiums, the investor might require a higher premium for downside risk
and a lower premium for upside potential. His required return for a start-up biotech firm

1 With limited liability, returns cannot be less than - 100 percent because losses are limited to the amount

invested. That is, stock prices cannot drop below zero. But investing in ventures not protected by lim ited
liabil ity can yield returns less than - 100 percent because creditors can make claims against assets outside
the business.
648 Part Five The Analysis of Risk and Return

FIGURE 19.2
The Effect on the
Standard Deviation
of Return from
Adding More
Securities to a
Portfolio
The standard deviation
declines as the number
of securities in the
portfolio increases, but
the amount of the
decline from adding
yet more securities is
less as the number of
securities in the 5 10 15
portfolio grows. Number of securities

that has a significant probability of losing l 00 percent of value but also a significant prob-
ability of generating 200 percent returns may be different from his required return for a
mature firm like the consumer products firm Procter & Gamble, which has a small chance
of either.

Diversification and Risk

A major tenet of modern finance states that the investor reduces risk by holding stocks
(or any other investment) in a portfolio with other stocks (or investments). Positive returns
cancel negative returns in a portfolio, just like the positive returns in Table 19.1 compen-
sate for the negative returns for anyone holding the 1,000 stocks covered by the Share-
holder Scorecard. And if returns on the different investments in the portfolio are not
perfectly correlated, the standard deviation of the portfolio return is less than the average
standard deviation of return for stocks in the portfolio.
This reduction in the variation of returns in a portfolio is the reduction of risk through
diversification. Figure 19.2 shows how the standard deviation of return on a portfolio
declines as the number of securities in an investment portfolio increases. An investor hold-
ing one or two investment assets (stocks, for example) exposes himself to considerable
standard deviation of return, but by adding more assets he reduces this variation. At some
point, however, adding more investments reduces the standard deviation of return only
slightly; there is little further gain to diversification. If the investor holds all available
investment assets, he is said to hold the market portfolio and the variation of return for this
portfolio is variation that cannot be further reduced. The variation that remains after being
fully diversified is nondiversifiable risk, or systematic risk; it is risk that affects all
investments in common. Risk that can be diversified away is called diversifiable risk or
unsystematic risk.
The S&P 500 stocks are typically seen as approximating the market portfolio. The his-
torical standard deviation of returns for the S&P 500 has been about 20 percent per year,
around a mean of 12.5 percent. Figure 19 .1 c depicts a normal distribution with a mean of
12.5 percent and a standard deviation of 20 percent. With a standard deviation of 20 per-
cent, we expect returns to fall between - 27.5 percent and 52.5 percent (within 2 standard
deviations of the mean) 95 percent of the time if they are distributed normally, as
Figure 19 .1 c shows. Compare this normal distribution with the distribution of individual
 Chapter 19 The Analysis of Equity Risk and Return for Active Investing 649

stock returns in Figure 19.l b. The probability of returns falling between - 27 percent and
53 percent in Figure 19. le is greater than that in 19. 1b because the standard deviation of re-
turn on a portfolio is less than that of the average standard deviation for individual stocks.
This comparison illustrates the benefits of diversification.
Figure 19. ld gives the actual empirical distribution of annual returns for the S&P 500
from 1926 to 1998. You'll notice that the actual distribution of returns in the history does
not follow the normal distribution in Figure 19.lc exactly. As in the case of individual
stocks, some returns are more extreme than would be the case if returns were normally dis-
tributed. So portfolios, while giving the benefit of diversification, do not entirely eliminate
the chance of getting extreme returns. And that chance is greater than would be predicted
by the normal distribution. In 1930 the stock market dropped by 25 percent, followed by a
43 percent drop in 1931anda35 percent drop in 1937. In 1974 it dropped by 26 percent,
and on "Black Monday" in October 1987 it dropped by 29 percent in one day. On the other
hand, 1933 yielded a return of 54 percent, 1935 a return of 48 percent, 1954 a return of
53 percent, 1958 a return of 43 percent, 1995 a return of 38 percent, and 1997 a return of
34 percent. For 2008, the S&P 500 index was down 37.0 percent for the year, another left-
tai 1outcome. Look at Box 1. 1 in Chapter 1 for stock market returns since 1999.
What do we learn from these observations? The investor can reduce risk through diver-
sification, and if this can be done without much transaction cost, the market will not reward
the investor for bearing diversifiable risk. The investor will be rewarded only for the risk
that has to be borne in a well-diversified portfolio. So we must think of risk in terms of
factors whose effect on returns cannot be diversified away. But we should also realize that
diversification does not entirely eliminate the possibility of getting large (positive and
negative) returns.

Asset Pricing Models

An asset pricing model translates the features of the return distribution into a risk premium,
and so calculates a required return. Review the material on asset pricing models and beta
technologies in the appendix to Chapter 3; for more detail , go to a corporate finance or
investments text. 2
The capital asset pricing model (CAPM), which is widely used, recognizes the diversi-
fication property. It says that the only nondiversifiable risk that has to be borne is the risk in
the market as a whole. Accordingly, the risk premium for an investment is determined by a
premium for the (systematic) risk of the market portfolio and by an investment's sensitivity
to that risk, the investment's beta. But the CAPM assumes that returns follow a normal dis-
tribution,3 like that in Figure 19.la. That is, it assumes that if you think about the standard
deviation ofreturn, you will have captured all aspects of an investment's ri sk. But we have
seen that the standard deviation underweights the probability of extreme returns (and it is
the extreme downside returns that really hurt!).
Even if we accept the CAPM assumptions, we run into severe problems applying it.
Warren Buffett, the renowned fundamental investor, claims that the CAPM is "seductively

2 See, for example, R. A. Brealey and S. C. Myers, and F. Allen, Principles of Corporate Finance, 10th ed.

(New York: McGraw-Hill, 2011 ); and S. A. Ross, R. W. Westerfield, and J. Jaffe, Corporate Finance, 9th ed .
(New York: McGraw-Hill, 2010)
3 On a technical point, the CAPM is also valid if investors have quadratic utility for any form of the ret urn
distribution. But we don't know enough about people's utility functions to test if they are quadratic (and
they probably are not), w herea s w e know someth ing about the actual distribution of returns .
650 Part Five The Analysis of Rish and RetLtrn

precise." It uses fancy machinery and looks as if it gives you a good estimate of the required
return. But there are significant measurement problems:
• The CA PM requires estimates of firms' betas, but these estimates typically have errors.
A beta estimated as 1.3 may, with significant probability, be somewhere between 1.0 and
1.6. With a market risk premium of 5.0 percent, an error in beta of0.1 produces an error
of 0.5 percent in the required return.
• The market risk premium is a big guess. Research papers and textbooks estimate it in the
range of 3.0 percent to 9.2 percent. Pundits keen to rationalize the "high" stock market
at the end of the 1990s were brave enough to state that it had declined to 2 percent. With
a beta of 1.3 , the difference between a required return for a market risk premium of
3.0 percent and one for a market risk premium of9.2 percent is 8.06 percent.
Compound the error in beta and the error in the risk premium and yo u have a consider-
able problem. The CAPM, even if true, is quite imprecise when applied. Let's be honest
with ourselves: No one knows what the market risk premium is. And adopting multifactor
pricing model s adds more risk premiums and betas to estimate. These model s contain a
strong element of smoke and mirrors.
Warren Buffett made another observation on asset pricing model s.4 The CAPM says that
if the price of a stock drops more than the market, it has a high beta: It's high risk . But if
the price goes down because the market is mispricing the stock relative to other stocks, then
the stock is not necessarily high risk: The chance of making an abnormal return has
increased, and paying attention to fundamenta ls 1nakes the investor more secure, not less
secure. The more a stock has "deviated from fundamentals," the more likely is the " return
to fundamentals" and the less risky is the investment in the stock.
Buffett's point is that risk cannot be appreciated without understanding fundamentals .
Ri sk is generated by the firm , and in assessing risk, it might be more useful to refer to those
fundamental s rather than estimating risk with betas based on (possibly inefficient) market
prices.
To see the difficulty in relying on market prices to estimate the required return , consider
the weighted-average cost of capital (WACC) calculation for operations (or the cost of cap-
ital for the firm) , PF, that we outlined in Chapter 14:

Cost of capital for

. =
( Value of equity .
x Eqmty f . J
cost o capita 1
(19. 1)
operations Value of operations

+(
Value of debt
.
.
x Cost of debt capital
J
Value of operations
VE VD
0 0
pF = V NOA • p£ + VNOA . pD
0 0

Thi s weighted-average cost of capital requires a measure of the equity cost of capital, PE,
as an input. This is often estimated from market prices using the CAPM without reference
to fundamentals , producing the reservations that Buffett expresses. But, further, the cost of

4
Buffett's commentary on asset pricing model s, along with other aspects of corporate finance, can be
found in L. A. Cunningham, ed., The Essays of Warren Buffett: Lessons for Corporate America (New York :
Cardozo Law Review, 1997).
 Chapter 19 The Analysis of £ quit)' Risk and Rec.urn for Active Inves ting 651

capital for equity and the after-tax cost of capital for debt, pn, are usually weighted not with
intrinsic values as in equation 19. l but with the market prices of equity and debt. This is
odd. We want to estimate the cost of capital fo r operati ons in order to get the value of the
firm and the value of the equity. We do this to see if the market price is correct. But if we
use the market price as an input to the calculation- and assume it is correct- we are
defeating our purpose. ln valuation we must always try to estimate fundamental value in-
dependently of prices to assess whether the market price is a reasonable one. To break the
circularity in the WACC calcul ation , we mu st assess ri sk by reference to fundamentals, not
market prices.

FUNDAMENTAL RISK
Fundamental risk is the risk that an investor bears as a result of the way a firm conducts
its activities. The firm conducts its activities through financin g, investment, and operations,
as we have seen. The ri sk from investing and operating activities, combined, is called
operating risk or business risk. If a firm invests a nd operates in countri es with political
uncertainty, it has high operating risk. It has hi gh operating ri sk if it chooses to produce
products for which demand drops considerably in recessions. Financing activities that
determine financial leverage produce additional risk for shareholders, called financial risk
or leverage risk.
We introduced these two ri sk components in Chapter 14. We saw that the required return
for an equity investor is made up as fo llows:
Required return for equity= Required return for operations (19.2)
+(Market leverage x Required return spread)
vn
PE =P F + - 0-(PF - Pn)
Vl
(1) (2)
The two components, operating risk (1) and financial risk (2), are the bas ic fimdamental
determ inants of equity risk. But just as payoffs are determined by drivers, so these risks are
also driven by further fundamental determinants. Indeed, you see in the expression that
fi nancing ri sk is decomposed into two drivers, market financial leverage and the spread of
the required return for operations over the after-tax cost of debt.
To understand the determinants of operating and financing risk, appreciate fi rst what is
at risk . Well , shareholder value is at ri sk, and shareholder value is driven by expectations of
future residual earnings:

RE1 RE2 RE3

vt =CSEo + - - + - - + - - +·· ·
PE P~ Pt
This valuation is based on expected residual earnings (RE). So value is at risk because
expected residual earnings are at ri sk: The firm might not earn the earnings relative to book
value that are expected, so anticipated value might not be delivered. Indeed, instead of earn-
ings adding to current book va lues, the book values might be used up with losses in opera-
tions. Accordingly, expected RE are "discounted" for thi s possibility with a required return,
PE, that incorporates the risk. As a consequence, the calculated value reflects risk as well as
expected return.
The same drivers that yield RE also can drive RE away from its expected level. Thus, the
analysis of risk determinants closely follows the analysis of RE drivers in Chapters 12 and 13 .
652 Part Five The Analysis of Risk and Return

FIGURE 19.3
Fundamental risk
The Determinants of
Fundamental Risk
Risk of not earning an
ROCErisk Growth risk
expected ROCE is
(Operating risk 2)
determined by the risk ROCE = RNOA + FLEV x (RNOA - NBC)
of not earning the Growth in NOA= Growth in [sales x l/ATO]
expected return on
operations (operating
risk 1), compounded
Operating risk 1
by the risk of financial
leverage turning
unfavorable (financing
Asset turnover Operating liability Financial Borrowing
risk). The risk of not
risk leverage risk leverage risk cost risk
earning expected
residual earnings is OL/NOA
the ROCE risk
compounded by
growth risk (operating Expense Operating
risk 2). risk leverage risk

Expense/ Fixed cost/

Sales Variable cost

Key: ROCE = rate of return on common equity

RNOA =rate of return on net operating assets
FLEV = financial leverage
NBC =net borrowing cost
01 =operating income
OL =operating liabilities
NOA =net operating assets
ATO = asset turnover
NFE =net financial expense
NFO = net financial obligations
CSE =common shareholders' equity

Residual earnings are generated by return on common equity (ROCE) and growth in
investment. So risk is determined by the chance that a firm will not earn the forecasted
ROCE or will not grow investments to earn at the ROCE. We deal with these determinants
in turn.5
Figure 19 .3 depicts how the drivers of return on common equity and growth determine
fundamental risk. Follow this diagram as we proceed. The risk determinants are expressed
in terms of financial statement drivers, but just as economic factors drive residual income,
so risk determinants are driven by economic risk factors. Analyzing risk amounts to
identifying these economic factors and attaching them to observable features in the finan-
cial statements. And identifying economic risk factors amounts to "knowing the business."

5 If value is calcu lated as discounted free cash flows, the same drivers of risk apply: Free cash flow is just

an accounting t ransformation of residual earnings, as we have see n, so the factors that drive residual
earnings also drive free cash flow over t he long term. But one w ould not want to view the variat ion of
free cash flow in the short term as indicative of risk: A negative free cash flow may be ca used by large,
low-risk investments rather than a bad outcome.