Even as we agree to disagree about the usefulness or lack of the same of CAPM betas, let us reach consensus on a fundamental fact. To ignore risk in investments is foolhardy and not all investments are equally risky. Thus, no matter what investment strategy you adopt, you have to develop your own devices for measuring and controlling for risk. In making your choice, consider the following:
a. Explicit versus implicit: I know plenty of analysts who steer away from discounted cash flow valuation and use relative valuation (multiples and comparable firms) because they are uncomfortable with measuring risk explicitly. However, what they fail to recognize is that they are implicitly making a risk adjustment. How? When you compare PE ratios across banks and suggest that the bank with lowest PE ratio is cheapest, you are implicitly assuming that banks are all equally risky. Similarly, when you tell me to buy a technology firm because it trades at a PEG ratio lower than the PEG ratio for the technology sector, you are assuming that the firm has the same risk as other companies in the sector. The danger with implicit assumptions is that you can be lulled into a false sense of complacency, even as circumstances change. After all, does it make sense to assume that Citigroup and Wells Fargo, both large money center banks, are equally risky? Or that Adobe and Microsoft, both software firms, have the same risk exposure?
b. Quantitative versus qualitative: I am constantly accused of being too number oriented and not looking at qualitative factors enough. Perhaps, but I think the true test of whether you can do valuation is whether you can take the stories that you hear about companies and convert them into numbers for the future. Thus, if your story is that a company has loyal customers, I would expect to see the evidence in stable revenues and lots of repeat customers; as a result, the cash flows for the company will be higher and less risky. After all, at the end of the process, your dividends are not paid with qualitative dollars but with quantitative ones.
c. Simple versus complicated: Another mantra that I push is that less is more and to keep things simple. In fact, one reason that I stay with the CAPM is that it is a simple model at its core and I am reluctant to abandon it for more complex models, until I am given convincing evidence that these models work better.
So, find your own way of adjusting for risk in valuation but refine it and question it constantly. The best feedback you get will be from your investment mistakes, since they give you indicators of the risks you missed on your original assessment. As for me, I remain wedded to the fundamental principle that value is affected by risk but not to any risk and return model, which to mean just remains a means to an end.
The series on alternatives to the CAPM:
Alternatives to the CAPM: Part 1: Relative Risk Measures
Alternatives to the CAPM: Part 2: Proxy Models
Alternatives to the CAPM: Part 3: Connecting cost of equity to cost of debt
Alternatives to the CAPM: Part 4: Market-implied costs of equity
Alternatives to the CAPM: Part 5: Risk adjusting the cash flows
Alternatives to the CAPM: Wrapping up
a. Explicit versus implicit: I know plenty of analysts who steer away from discounted cash flow valuation and use relative valuation (multiples and comparable firms) because they are uncomfortable with measuring risk explicitly. However, what they fail to recognize is that they are implicitly making a risk adjustment. How? When you compare PE ratios across banks and suggest that the bank with lowest PE ratio is cheapest, you are implicitly assuming that banks are all equally risky. Similarly, when you tell me to buy a technology firm because it trades at a PEG ratio lower than the PEG ratio for the technology sector, you are assuming that the firm has the same risk as other companies in the sector. The danger with implicit assumptions is that you can be lulled into a false sense of complacency, even as circumstances change. After all, does it make sense to assume that Citigroup and Wells Fargo, both large money center banks, are equally risky? Or that Adobe and Microsoft, both software firms, have the same risk exposure?
b. Quantitative versus qualitative: I am constantly accused of being too number oriented and not looking at qualitative factors enough. Perhaps, but I think the true test of whether you can do valuation is whether you can take the stories that you hear about companies and convert them into numbers for the future. Thus, if your story is that a company has loyal customers, I would expect to see the evidence in stable revenues and lots of repeat customers; as a result, the cash flows for the company will be higher and less risky. After all, at the end of the process, your dividends are not paid with qualitative dollars but with quantitative ones.
c. Simple versus complicated: Another mantra that I push is that less is more and to keep things simple. In fact, one reason that I stay with the CAPM is that it is a simple model at its core and I am reluctant to abandon it for more complex models, until I am given convincing evidence that these models work better.
So, find your own way of adjusting for risk in valuation but refine it and question it constantly. The best feedback you get will be from your investment mistakes, since they give you indicators of the risks you missed on your original assessment. As for me, I remain wedded to the fundamental principle that value is affected by risk but not to any risk and return model, which to mean just remains a means to an end.
The series on alternatives to the CAPM:
Alternatives to the CAPM: Part 1: Relative Risk Measures
Alternatives to the CAPM: Part 2: Proxy Models
Alternatives to the CAPM: Part 3: Connecting cost of equity to cost of debt
Alternatives to the CAPM: Part 4: Market-implied costs of equity
Alternatives to the CAPM: Part 5: Risk adjusting the cash flows
Alternatives to the CAPM: Wrapping up
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