Chapter 2 - Risk and Return

Nobody knows what the future holds. So whenever we talk about future returns, we should be humble. Always and inevitably, there is an element of uncertainty or risk. Perhaps the returns won't materialize; perhaps they will exceed our expectations. We can't be sure.

In chapter 1, we finessed the question of risk, but now the time has come. To focus on the mechanics of time value calculations, we made generalizations like “The discount rate or cost of capital depends on the risk of the project.” Now we will put aside these vague statements and define risk—in isolation and combined with other risks—and consider how it relates to the opportunity cost of capital.

The study of risk and return is not a mechanical one. Anticipating returns in the future and recognizing risks have even religious dimensions. See Vogel and Hayes, Islamic Law and Finance: Religion, Risk and Return (The Hague & Boston 1998).

The study of risk and return, however, is fundamental to valuation. Our study of these concepts sets the stage for valuing investment instruments (Chapter 4 - Securities Valuation) and whole businesses (Chapter 5 - business valuation). Once we have more clearly identified and quantified risk, we can plug it into methodologies that combine returns and risk to calculate present value of investment and business returns.

Rain is good - no?