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Risk #2

An investor that buys stock in a company expect to earn a return on their investments. However, it is possible that the project or investment may lose money for the company or investor. Exposure to a possible loss occurs at the time an investment is made. To compensate for this exposure to risk, an investor expects a higher possible return on investment.

For example. Suppose that economists predict a 40% chance for a boom economy in the coming year, a 20% chance for a normal economy, and a 40% chance for a recession. Suppose that in a boom economy, investor is expected to earn a 70% annual rate of return on investment, a 20% return in a normal economy and will have a negative 60% return in a recession. The question now becomes, what is the expected rate of return for Investor in the coming year? To calculate the expected rate of return E(k), we calculate a weighted average of the possible returns that investor could earn.


State of Economy       Probability     Possible Return Weighted Possible                                            Boom                                    0.4                      70%                        28%                                                            Normal                                 0.2                      20%                          4%                                                    Recession                             0.4                     -60%                       -24%
                                                            Expected Return  E(k)    =   8%

Risk #1

The standard by which any investment should be judged is not just how much can be made from it if all goes well. Rather, it is how much can be made in relation to the amount of risk involved.

There are several types of risk that can be included in the risk. Usually, it is difficult to quantify what percentage of the risk is associated with each type of risk.  There are three risks that affect the amount of the risk : counterparty risk, liquidity risk, and interest rate risk.

1. counterparty risk
Counterparty (default) risk is the chance that the borrower will not be able to pay the interest or pay off the principal of a loan. This risk can influence the level of interest rates. It is generally considered that U.S. Treasury securities have no default risk the U.S. government will always pay interest and will repay the principal of its borrowings. Therefore, the difference in price between a U.S. Treasury security and another corporate bond with similar maturity, liquidity, etc. may be the risk premium for assuming counterparty risk.

2. liquidity risk
Liquidity refers to the marketability of assets – the ease with which assets can be sold for cash on short notice at a fair price. Investors may require a premium return on an asset to compensate for a lack of liquidity.

3. interest rate risk
Interest rates indirectly impact stock prices through their effect on corporate profits. The payment of interest is a cost to companies – the higher the level of interest rates, the lower the level of corporate profits Interest rates affect the level of economic activity which, in turn, affects corporate profits.

The effect of interest rates on corporate profits is more important companies, especially those with high debt levels.

inflation factor

The threat of further inflation will continue to be of major importance to all investors. Because this whole matter has such great investment importance. When its true cause is understood, the investoris unlikely to be confused in his basic thinking by various dogmatic comments of some of our political leaders.

The first thing to consider,of course, is just what we mean by inflation. While there are many complex definitions,For practical purposes, it is sufficient to consider inflation as a condition where by (with only minor and temporary reversals) the total amount of things and services that can be obtained for the same number of money.

In a free economy, capital is allocated through the price system. An interest rate is the price paid by a borrower for the use of an investor's capital.

Interest rates provide the vehicle for allocating capital among firms. In a perfect free-market economy, firms with the most profitable investment opportunities attract capital away from companies with less inviting investment opportunities arising from problems such as inefficiency, low demand for products, poor management, etc. However, a perfect free-market economy doesn't exist. There are imperfections, usually introduced by governments, that lead to the allocation of capital to firms that do not necessarily have the most profitable investment opportunities.

Let's look at some of the factors that influence the level of interest rates

The stated or offered rate of interest (r) reflects three factors:
•Pure rate of interest (r*)
•Premium that reflects expected inflation (IP)
•Premium for risk (RP)

Each of these factors increases the stated interest rate. The resulting interest rate calculation is:

r = r* + IP + RP

Time value of money

The term time value of money refer to all aspects of converting the value of cash flows at one point of time to the equivalent values at another time. To facilitate the financial decision process, it is important that we know the value of current and future cash flows.

Every decision has future consequences that will affect the value of the firm. These consequences will generally include both benefits and costs.  A decision is good for the firm’s investors if it increases the firm’s value by providing benefits whose value exceeds the costs. But comparing costs and benefits is often complicated because they occur at different points in time, may be in different currencies, or may have different risks associated with them. To make a valid comparison, we must use the tools of finance to express all costs and benefits in common terms

The calculation for the present value of a series of cash flows may be used to find out how much an investor will be willing to pay for an investment. Because the investor has a specific required rate of return, it is unlikely that a rational investor will pay more than the present value for an investment.

The term net present value refers to an investor's position after making an investment. To calculate the net present value of an investment, we modify the present value formula by subtracting the initial investment from the present value calculation.

When we compute the value of a cost or benefit in terms of cash today, we refer to it as the present value (PV). Similarly, we define the net present value (NPV) of a project or investment as the difference between the present value of its benefits and the present value of its costs:

NPV = PV ( Benefits) - PV (costs)

NPV = CFt (1/(1+r))^t - CFo

Where ,
CFt =Cash flow in period t
R = Discount rate (required rate of return)
T = Number of cash flows generated by the project
CFo = Initial cash investment
A positive NPV means that the investor paid less than the present value for the stream of cash flows. A negative NPV means that the investor paid more than the present value for the stream of cash flows
Example:

Project A requires a capital investment of $2,000 and promises a payment of $1,000 at the end of Years One, Two, and Three. If the investor's required rate of return is 12%, what is the NPV of the investment? We can use the NPV formula with the values CF1, CF2, and CF3 = $1,000, CF0 = $2,000, T = 3, and R = 0.12.

NPV = $1,000[1 / (1.12)]1 + $1,000[1 / (1.12)]2 + $1,000[1 / (1.12)]3 - $2,000
         = $401.83

A positive NPV means that the investor paid less than the present value for the stream of cash flows. A negative NPV means that the investor paid more than the present value for the stream of cash flows.

Financial statements and "Cheap" Stock

Although the Financial statements is a one way to assess and evaluate the company's performance and the success of one company. Reading the printed financial records about a company is never enough to justify an investment. One of the major steps in prudent investment must be to find out about a company's affairs from those who have some direct familiarity with them.

The next logical step in this type of reasoning: it is also necessary to learn as much as possible about the people who are running the a company under investment considerations.

A worthwhile conclusion as to whether the particular company has outstanding potentialities for growth and development should be based on the examination of each subdivision of a company's organization and by detail of the executive personnel, its production, its sales, and each of its major function. In case of really outstanding company, all of these informations are so crystal clear that even a moderately experienced investor who knows what he is seeking will be able to tell which companies are likely to be enough interest to  him to take further investment decision.

Other major question that confronts every investor that are entrapped by the lure of market is whether to invest on the stocks that "are still cheap" and are worthwhile because "they had not gone up yet"'. Is it wise to invest among stocks which are still undervalued in the market?

While a stock could be attractive when it have a low price earning ratio, a low price earning ratio by  itself guaranteed nothing and is apt to be a warning indicator of the degree of weakness in the company.

What really counts in determining whether a stock is cheap or overpriced is not its ratio to the current year's earnings, but its ratio to the earning a few years ahead. If someone could built up in himself the ability to determine what those earning might be in a few years from now. He would have unlocked the key both to avoid losses and to making magnificient profits.