Chapter 7

Risk, Return, and Valuation

7.1 RISK DEFINED

Risk (or uncertainty) refers to the variability of expected returns associated with a given investment.
Risk, along with the concept of return, is a key consideration in investment and financial decisions. This
chapter will discuss procedures for measuring risk and investigate the relationship between risk, returns,
and security valuation.

Probability Distributions
Probabilities are used to evaluate the risk involved in a security. The probability of an event taking
place is defined as the chance that the event will occur. It may be thought of as the percentage chance of a
given outcome.

EXAMPLE 7.1 A weather forecaster may state, ‘‘There is a 30 percent chance of rain tomorrow and a 70 percent
chance of no rain.’’ Then we could set up the following probability distribution:

Outcome Probability
Rain 30% = 0.3
No rain 70% = 0.7
100% = 1.00

Expected Rate of Return

Expected rate of return ðrÞ is the weighted average of possible returns from a given investment,
weights being probabilities. Mathematically,
n
X
r ¼ ri pi
i¼1

where ri = ith possible return

pi = probability of the ith return
n = number of possible returns

EXAMPLE 7.2 Consider the possible rates of return that you might earn next year on a $50,000 investment in
stock A or on a $50,000 investment in stock B, depending upon the states of the economy: recession, normal, and
prosperity.
For stock A:
State of Economy Return (ri) Probability (pi)
Recession 5% 0.2
Normal 20% 0.6
Prosperity 40% 0.2

For stock B:
State of Economy Return (ri) Probability (pi)
Recession 10% 0.2
Normal 15% 0.6
Prosperity 20% 0.2

174
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CHAP. 7] RISK, RETURN, AND VALUATION 175

Then the expected rate of return (r) for stock A is computed as follows:

n
X
r ¼ ri pi ¼ ð5%Þð0:2Þ þ ð20%Þð0:6Þ þ ð40%Þð0:2Þ ¼ 19%
i¼1

Stock B’s expected rate of return is:

r ¼ ð10%Þð0:2Þ þ ð15%Þð0:6Þ þ 20%ð0:2Þ ¼ 15%

Measuring Risk: The Standard Deviation

The standard deviation (), which is a measure of dispersion of the probability distribution, is
commonly used to measure risk. The smaller the standard deviation, the tighter the probability distribu-
tion and, thus, the lower the risk of the investment.
Mathematically,
sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
X n
¼ ðri  rÞ2 pi
i¼1

To calculate , take the following steps:

Step 1. Compute the expected rate of return ðrÞ.
Step 2. Subtract each possible return from r to obtain a set of deviations ðri  rÞ.
Step 3. Square each deviation, multiply the squared deviation by the probability of occurrence for its
respective return, and sum these products to obtain the variance ( 2):

n
X
2 ¼ ðri  r Þ2 pi
i¼1

Step 4. Finally, take the square root of the variance to obtain the standard deviation ().
To follow this step-by-step approach, it is convenient to set up a table.

EXAMPLE 7.3 Using the data given in Example 7.2, compute the standard deviation for each stock and set up the
tables as follows for stock A:

Step 1 Step 2 Step 3

Return (ri) (%) Probability (pi) rip (%) ðri  rÞð%Þ ðri rÞ2 ðri rÞ2 pi ð%Þ
5 0.2 1 24 576 115.2
20 0.6 12 1 1 0.6
40 0.2 8 21 441 88.2
r ¼ 19  2 = 204

Knowing  2 = 204, we proceed with Step 4 and

pffiffiffiffiffiffiffiffi
¼ 204 ¼ 14:28%
176 RISK, RETURN, AND VALUATION [CHAP. 7

For stock B:

Step 1 Step 2 Step 3

2
Return (ri) (%) Probability (pi) rip (%) ðri  rÞð%Þ ðri rÞ ðri rÞ2 pi ð%Þ
10 0.2 2 5 25 5
15 0.6 9 0 0 0
20 0.2 4 5 25 5
r ¼ 15  2 = 10

Knowing  2 = 10, we take Step 4 and

pffiffiffiffiffi
¼ 10 ¼ 3:16%

Statistically, if the probability distribution is normal, 68 percent of the returns will lie in ±1 standard deviation,
95 percent of all observations will lie between ±2 standard deviations, and 99 percent of all observations will lie
between ±3 standard deviations of the expected value.

EXAMPLE 7.4 Using the results from Example 7.3,

Stock A Stock B
Expected return ðrÞ 19% 15%
Standard deviation () 14.28% 3.16%

For stock A, there is a 68 percent probability that the actual return will be in the range of 19 percent plus or
minus 14.28 percent or from 4.72 percent to 33.28 percent. Since the range is so great, stock A is risky; it is likely to
either fall far below its expected rate of return or far exceed the expected return. For stock B, the 68 percent range is
15 percent plus or minus 3.16 percent or from 11.84 percent to 18.16 percent. With such a small , there is only a
small probability that stock B’s return will be far less or greater than expected; hence, stock B is not very risky.

Measure of Relative Risk: Coefficient of Variation

One must be careful when using the standard deviation to compare risk since it is only an absolute
measure of dispersion (risk) and does not consider the dispersion of outcomes in relationship to an
expected value (return). Therefore, when comparing securities that have different expected returns, use
the coefficient of variation. The coefficient of variation is computed simply by dividing the standard
deviation for a security by expected value: =r. The higher the coefficient, the more risky the security.

EXAMPLE 7.5 Again, using the results from Example 7.3:

Stock A Stock B
r 19% 15%
 14.28% 3.16%
=r 0.75 0.21

Although stock A is expected to produce a considerably higher return than stock B, stock A is overall more
risky than stock B, based on the computed coefficient of variation.