Risk and Uncertainty in Finance

Understanding Risk and Uncertainty in Finance

• Options prices are driven by standard deviation, with uncertainty making options more valuable.
• Risk premium is an oversimplified view of a Nobel-winning economics theory, reflecting the concept of higher cost of capital for higher uncertainty.
• The distribution of returns on S&P 500, 10-year US treasuries, and three-month US treasuries over 90 years shows varying levels of risk and uncertainty.
• The distribution of S&P 500 annual returns over 90 years had significant fluctuations, while government treasuries showed consistent, albeit lower, returns.
• Risk in finance is linked to uncertainty, with more uncertainty leading to higher risk and cost of capital.
• Comparing Verizon and Tesla, the former has a stable and predictable business with a narrow revenue range, resulting in a lower cost of capital (5.2%).
• Tesla's wide revenue range for 2026 indicates higher uncertainty, leading to a higher cost of capital (12.9%) compared to Verizon.
• The market expects Tesla to grow dramatically, but the uncertainty results in a wider range of revenue estimates.
• Investors expect a better return for the added uncertainty in Tesla, reflected in the higher hurdle rate of 12.9%.
• The level of uncertainty determines the hurdle rate, and investors can decide based on their risk tolerance and the potential cost and benefit.
• In a company, uncertainty in budgeting can have significant financial consequences, and having a contingency plan can mitigate risks.
• Planning for uncertainty in budgeting allows for optimal choices and adjustments without causing financial crisis, compared to scrambling to adjust after an incorrect guess.

Effective Risk Management in Budgeting

• The department's budget vs. actual spend data reveals inconsistency in forecasting accuracy.
• The inconsistency in spending, both overspending and underspending, indicates volatility, which is a sign of risk.
• Underspending on a budget is not necessarily positive, as it represents lost opportunities for utilizing resources elsewhere.
• During a budget review, explanations for underspending often involve unexpected events or conservative estimates, both of which indicate risk.
• Being perceived as conservative in budgeting can lead to arbitrary budget cuts and unrealistic expectations in future budgeting processes.
• Budget reviews typically involve analyzing forecasts, budget actuals, and variances, with positive variances indicating better performance than planned and negative variances indicating worse performance.
• The focus of budget review discussions often centers around addressing the largest variances and determining actions to get back on track.
• Ideally, discussions about potential variances should occur during the planning process or as soon as variances are noticed, rather than waiting until a budget review when it may be too late to take corrective action.
• It is essential to acknowledge uncertainty in budgeting and plan for it, potentially by setting up reserves or mitigation strategies.
• Effective risk management involves understanding and communicating different categories of risk, including known knowns, known unknowns, and unknown unknowns.
• Communicating risk involves considering best and worst-case scenarios with reasonable probabilities, as demonstrated in the example of funding projects based on their risk profiles.
• Project B, despite having the same profit potential as Project A, demonstrates a more favorable risk profile, making it a better choice for funding due to its lower downside risk.

Nike Financial Analysis Metrics

• Nike's interest expense as a percentage of sales is a key indicator of the company's financial health, showing how much of its revenue is spent on interest.
• The company's pretax margin, as a percentage of sales, reflects its profitability before taxes compared to its peers.
• Nike's tax rate, as a percentage of sales, is crucial for evaluating its tax efficiency, with lower rates being more favorable.
• The balance sheet, in conjunction with the income statement, helps assess investment and financing stages of the cash cycle.
• Receivables, measured as day sales outstanding (DSO), indicates how long Nike takes to collect cash from customers and the cash tied up in each day of receivables.
• Inventory days reveal how long Nike takes to sell its inventory and the cash tied up in each inventory day.
• Property Plant and Equipment (PPE) efficiency, evaluated by dividing net PPE by sales, shows how much Nike spends on facilities to generate a dollar of sales.
• Nike's invested capital productivity, calculated by dividing invested capital by sales, indicates how much financing is required to generate a dollar of sales.
• The length of Nike’s cash cycle, and how it compares to its peers, is crucial for understanding the company's financial cycle time.
• Return on Invested Capital (ROIC) measures how much profit Nike makes for every dollar of investment and should exceed the weighted average cost of capital (WACC) for value creation.
• Nike's interest coverage, indicating how many times it can repay interest with business profits, and its ability to pay short-term obligations with current assets, are important for assessing solvency.
• Comparisons to peers are essential for understanding Nike's financial performance in each metric.

Analyzing Company Financials: A Detailed Overview

• Positive profit indicates more cash generated than spent, while negative profit indicates the opposite
• Net income, also known as return on sales (ROS), measures the profit made on final sales after deducting all expenses
• Expenses include cost of goods sold (COGS) representing direct expenses associated with a product or service
• Gross profit, the difference between revenue and COGS, is used to calculate gross margin
• Indirect costs of running operations, known as selling, general, and administrative (SG&A) costs, are not directly related to a product or service
• Companies often spend more on indirect expenses to achieve a higher gross margin
• Earnings before interest, tax, depreciation, and amortization (EBITDA) represents the cash profit from operations
• Depreciation and amortization are non-cash costs that are subtracted from EBITDA to calculate EBIT, or operating income
• EBIT margin as a percentage of sales indicates the profit generated from normal business operations
• The goal of understanding EBIT is to comprehend a business's performance based on recurring revenue and expenses
• Financing costs, such as interest expenses on debt, are subtracted from EBIT to calculate pretax profit
• Analyzing Nike's financials includes examining profit margins, expenses, and performance in comparison to peer groups