# Corporate Finance Valuation, Risk Term Paper

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The probability distribution is often an object of study in risk valuation, thus having an important role in the risk-return relationship and in the overall valuation process. Instruments such as the standard deviation and variance measure how dispersed all these different probabilities, reflecting different scenarios, are. The degree of dispersion shows the risk of the investment. This is has a logical explanation: the more dispersed the probabilities are, the more there are different scenarios, which implies a greater degree of uncertainty, hence of risk.

Going back to the relationship between risk and return, there is the general understanding that "higher expected returns require taking higher risks" (Womack, Zhang, 2003). This type of accepted relationship comes from the logical assumption that, in order to accept a higher degree of risk, the investor needs a higher rate of return.

Perhaps one of the best ways to exemplify this is by thinking of the different types of securities. Securities such as U.S. T-Bills, guaranteed by the U.S. Government, have a low level of risk, primarily because there is little chance that the U.S. Government will fail to make a payment for them. At the same time, they also have a low rate of return, because it is a certain rate of return. The risk that the investor is assuming is very low and his pay for that risk is equally low.

On the other side of the spectrum, we have the junk bonds. The risk here is very high: it is often that junk bonds are related to failing companies, so the risk that the investor will lose his money is very high as well. At the same time, the rate of return for junk bonds is very high, because the investors is paid to accept a much higher level of risk than, for example, when he purchases T-bills.

One can thus understand the relationship between risk and return as a relationship of direct correlation: the two measures move together and this is logically explained by the fact that the investor needs to be paid in order to assume a certain level of risk, otherwise he would simply chose a lower risk investment, if it were to provide the same rate of return as the risky one, following the principle that at the same level of risk, it is logical to select the best paid investment.

The relationship between the risk-return pair and valuation becomes clearer now. When making an investment, as this paper has previously shown, the investor uses a valuation method in order to determine what the respective company or asset is worth. The investor may use one of the methods that implies using future cash flows to evaluate the present day value of that asset, investment or corporation. The problem is that these future cash flows have a probability of actually occurring. A proper valuation will attempt to have a result that is as close to the truth as possible, but, in the end, it remains an estimation and a forecast based on probabilities.

There is another element of particular interest, something that Lopez, Marhuenda and Nieto (2009) analyze in their work, namely an element that often plays a fundamental role in the valuation process and in the entire relationship valuation-risk-return: information. The conclusion of their study is that "the market prices the risk of disinformation" (Lopez, Marhuenda, Nieto, 2009). What this means is that information (or disinformation) is factored into the valuation process.

Again, this appears logical: information tends to reduce uncertainty and, as a consequence, it tends to reduce risk. If there is more knowledge surrounding a certain acquisition process or during the development of a certain project, this will likely positively be reflected as lower risk and lower uncertainty.

Another recognized way to minimize risk that can be included in the valuation process is diversification. The generally accepted theory is that portfolio diversification, namely having different investments rather than investing all the funds in the same asset, decreases risk. This is probably linked to the fact that the risk of losing money decreases when there are different assets: some of these asset prices may grow, while others may decrease, and the portfolio will have greater chances of moving in a positive direction.

Conclusion

From this extensive analysis, there are several conclusions to be drawn. First of all, valuation, whether asset, equity or corporate valuation, is a complex process. The main reason for this complexity is the fact that a valuation fundamentally aims to determine how much something is worth by evaluating how much it could produce in the future (certainly, there are also valuation methods that are based on solely adding the value of present day elements that are in the books -- this paper consider that these methods give an incomplete evaluation).

In order to determine how much an investment can produce, cash flows (when referring to a project) or returns (when referring to an investment) are used. The rate of returns is calculate as a percentage of the return from the initial investment and is usually used in the calculation instead of the actual absolute return.

The problem arises here: a return is something that occurs in the future and the future cannot be determined, only estimated. The analyst works with different forecasts in order to determine what the likely returns are. However, the analyst needs to build a set of scenarios, each with a certain probability of occurring. In combining these probabilities with the rate of return in each case, the analyst will have a reasonable estimate of the rate of return for the investment.

Bibliography

1. N.a. (2005). Valuation techniques. Vault Guide to Finance Interviews. On the Internet at http://www.bc.edu/clubs/bcfa/docs/vault/Valuation%20Techniques.pdf. Last retrieved on July 31, 2014

2. Giddy, Ian (2006). Methods of Corporate Valuation. On the Internet at http://people.stern.nyu.edu/igiddy/valuationmethods.htm. Last retrieved on July 31, 2014

3. Womack, Kent; Zhang, Ying, (2003). Understanding Risk and Return, the CAPM,

and the Fama-French Three-Factor Model. Tuck School of Business at Dartmouth. No. 03-11

4. Penman, Stephen, (2011). Accounting for Risk and Return in Equity Valuation. Journal of Applied Corporate Finance. Volume 23,…
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