risk - bfa.docx

Risk In this module, we're going to talk about Risk, or what's also called the cost of capital or the weighted average cost of capital. Risk is not about losing money. I’ll be very clear about that. If you lose money, there's no risk in that. If you are expected to lose money and you lose money - th...

Risk In this module, we're going to talk about Risk, or what's also called the cost of capital or the weighted average cost of capital. Risk is not about losing money. I’ll be very clear about that. If you lose money, there's no risk in that. If you are expected to lose money and you lose money - there is no risk in that. If you are expected to los money and you made money, well, what do you mean? Why did you make money? You said you were going to lose money. That is risk. So the point is, in finance risk is surprise. It is uncertainty. Risk is standard deviation. In the case described if you were expected to lose money and you made money you didn't do what you said you were going to do. Risk is the range of outcomes. So in finance, this represents a distribution of potential outcomes. The distribution of outcomes doesn't always have to look like a bell curve, but that's the idea, is we think about a project, we think about a company, and we think about how certain are we about what's going to happen? What is that range of outcomes of what could happen here? What could that look like? That distribution of potential outcomes equals the risk. And mathematically how wide that distribution is, is the standard deviation. And that basically is what we use in finance for risk. What does a curve look like? To price an option in Finance we use a formula called Black Scholes. In the formula the one assumption it does not use is ROI. The main driver of an options price – standard deviation. When things are certain – options are cheap. When things are uncertain – options are valuable. The second thing we look at is the concept of risk premium. And this is an oversimplified view of a Nobel-winning economics theory. This is 90 years worth of data, from 1928 to 2018, year by year distribution of returns on 3 types of investments in the US.. The S&P 500 index, which is the 500 largest companies in the US. The 10-year US government treasuries, and three-month US government treasuries. Looking at the distribution of the S&P 500 annual returns over 90 years, some years you lost 30%-40%, some years you made 30%-40%. This happened very infrequently. But most of the time you made 0-15% in a year. Generally, you made more than you lost, but you had a lot of variation. In fact, in August 2020, you made 30% in one month alone. So the market was all over the place. It zigged, it zagged, but over time you did okay. If you invested in government three-month treasury bills during this 90 year period of time, you never lost money, and you always made a little bit. So the distribution of this return was skewed to the right, and it was never negative. Whereas the distribution of stocks were skewed a little to the right, but it very much looked more like a bell curve. And so here's the point. The way that we started to think about risk and finance, is we looked at this distribution, and we said, "Aha. More uncertainty, more distribution for the S&P 500 than treasury bills, more risk." So risk is uncertainty. More uncertainty, more risk. Number two, for this uncertainty, I should get paid for that -this is called risk premium. The more uncertainty, the more cost of money, cost of capital, higher hurdle rates. And so we started to look at risk premiums. And so those are really the two things that drive the cost of capital – the level of uncertainty and the premiums investors demand for the uncertainty. Let’s use two companies as an example: Verizon and Tesla. We will focus on revenue for simplicity. On 2022 Verizon reported $136.8b in revenue. The professionals who are specialists in telco called the sell side analysts have predictions for Verizon revenue through 2026. There are 33 of them and their guesses are averaged to create what is called the consensus earnings estimate. It is a wisdom of the crowd approach that becomes the baseline forecast for the company by Wall Street. In 2026 the forecast currently for Verizon is to grow to $141.9 billion in revenue. That works out to be a 1% growth rate per year for 4 years. But what is interesting is the range of gueses for revenue in 2026 of the 33 professionals. The high revenue guess is $145.8b and the low guess is $135.7b with the average of $141.9b. That is a pretty narrow range for 4 years out. The reason – Verizon has a stable predictatble business. For that level of risk Verizon has a current cost of capital of 5.2% In 2022 Tesla reported revenue of $81.5b. By 2026 the average revenue guess by analysts is that Tesla will grow to $187.5b in revenue – more than doubling in size. But what is interesting is the range. The low guess for 2026 Revbenue is $140b and the high revenue estimate is $286b. That’s a potential revenue range of $146b from the low to the high. That range is bigger than all of Verizon’s revenue. What this means is the market expects Tesla to grow dramatically. It’s just that the market can’t agree on how much. This puts a level of uncertainty into Tesla. For that uncertainty the market is charging Tesla 12.9% annually as its cost of capital. A financial interpretation of the above data is that Tesla is much more risky than Verizon. To compensate for the added uncertainty, investors expect to earn a better return – as reflected by the higher hurdle rate of 12.9%. For the more predictable Verizon, investors should expect to earn a lower rate of return. One hurdle rate is not necessarily better than the other – it is simply a function of the level of uncertainty. Investors can then apply their risk tolerance and decide whether the likely cost and benefit make investing worthwhile. So how does this apply internally at a company? When I was the interim CFO of a San Francisco physician IPA that was a subsidiary of Blue Shield of California– one of my team’s responsibilities was to create the annual budget. For 2022 this was done with a great deal of uncertainty. Our actuary had no idea what our health care costs were going to be based on projections of utilization by patients which was key to the budget. At the end of covid there was not good data to establish how much patient’s were going to access health care. If utilization was high we would need much higher staffing levels than if utilization was low. If we guessed wrong with the budget it could have grave consequences financially. Staff too high and we might need to do layoffs. Staff too low and patients may not be able to access the care they needed. So I went to my leaders and told them we needed a contingent budget for 2022. Basically plan for a lower budget but also create a plan if conditions merited a higher budget. If conditions warranted – additional funds would be released. They grumbled because of the extra work and their uncertainty. But here is the point. Let’s say we only did one budget and we guessed wrong. Half way through the year we would be in crisis meetings to scramble to adjust. Optimal choices would not be made and the organization would be in pain as we made cuts. But if we did it while planning then the choices would be thought through and any adjustments would not have to be made since we would start with the lower budget. We were going to have the same conversation on the budget – the only question from my perspective was when to have it – during planning or after implementation. Let’s look at another internal example. On the screen is a table of two years worth of budget vs actual for a department. The line represents the approved budget for each period (also called the plan) in millions of dollars. The bars represent actual spend by period in millions of dollars. I want you to put your risk hat on and looking at the data tell me how they were performing. Is this good? You might want to pause the video to give you more time to look at the data before proceeding. The first thing you're going to notice is that this department was not very accurate at forecasting what actually happened. The standard that we use is did you do what you said you were going to do? Or how close is to the whole what's your forecast? In this case this organization did not do what it was said it was going to do it was consistently off in both directions. Some periods it overspent and some periods it underspent. This volatility is the definition of risk. What are some people think is that underspending a plan is good. But let's think about that. From a financial perspective at most organizations there are more requests then approvals. So if you didn't spend the resources finance people are thinking that is money that could have been used to do something else. They could have given it to another organization for their budget and that was a lost opportunity. During a budget review you're going to be asked to explain why you were underspending. Regardless of what you say you're going to end up giving one of two answers. One of your answers is going to involve something unexpected happening. Basically an unplanned variance. From the financial perspective what you're going to be describing is risk that there was more uncertainty in what you were forecasting then you realized and that ultimately the underspending just meant that you either were lucky or unlucky. And we don't like to bet on luck. The other answer you could give is that you were conservative. Which is another way of saying that you're dishonest and you're not telling me what you really think. Guess what happens the next time you have a budget and I think that you're conservative your budget is going to be arbitrarily cut and once you realize this let the games begin. We are going to hold you to an impossible standard. We want you to predict the future as accurately as possible and we don't like it when you're off. Because any off is considered risk. Every budget review you ever go to will be two questions. The same two questions are always asked. Question one is why are you off? Explain. Question two: what are you going to do about it? How do you get back on plan. The answer might be we can’t get to plan but we still want the question addressed. That's it. That's a budget review. What we're going to do is we're going to look at the forecast and we're going to look at the budget actual. And typically there's going to be a third column called variance. A positive variance means you did better than the plan and a negative variance means you did worse than the plan. If you don't have any variance on a budget item we don't need to talk about that. I can tell you the first thing that you're going to have to talk about is the place where you see the biggest variance and that's where the questions are going to start. The challenge with this conversation at the budget review is we're also often looking at the past and it's too late to do anything about it. So the next point addresses the question of when should we talk about why we're going to be off. Ideally instead of at the end of the period during a budget review we should be highlighting this during the period when we start to notice any variance. Because at that point we can still do something about. Or at least we will be better prepared when the variance occurs. But it even more ideal time to talk about the variance is before the period even begins during the planning process. That's when we need to identify that there might be some uncertainty in our budget and how much uncertainty we see. I know we don't want to hear this because we want it to be one number and we want it to always be right but that's not realistic. And even though I'm unhappy hearing that there's variance during the planning process I can plan for that uncertainty. We can take a reserve. We can set up steps to mitigate that. From a risk perspective the worst type of risk is the unplanned surprise. Donald Rumsfeld a former Secretary of Defense in the United states used to put risk into three categories. He called them the known knowns, the known unknowns, and the unknown unknowns. The third category of the unknown unknowns you can't really plan for. But the other two you can. And that is what is helpful to communicate. That is what makes you a better risk manager for the organization. The question comes up how do I communicate risk? I'm not a finance person. I'm not sure I know how to answer that question. Let's take an example here. Let's assume that you are the person that funds projects and you have the choice to fund two projects. Both projects tell you that they are one year in length and that they will make $1,000,000 cash at the end of the year. Project will make $1,000,000 and project B will make $1,000,000. Which one do you give the money to? If you're just looking at the profit and the cash pick one - fund both - they seem to have equal performance. But now let's ask each project manager a risk question. We ask them the question - over the course of that year what is your best case scenario and your worst case scenario with a reasonable probability? Project A says our reasonable range in a worst case scenario is that we will make zero but in the best case scenario we'll double our money we'll make $2 million. You ask the same question to project B. Project B says in a very worst case scenario if everything goes wrong we'll make $900,000 next year and if everything is executed to perfection we'll make $1.2 million next year. Based on this information which project has more risk? Again feel free to pause the video if you want to think about it for a second to answer the question. Clearly project A is more risky. If you give them the money you could end up with double or nothing. If you think about how you knew that project A was more risky it's because you knew the range. And that is the answer to the question about how you communicate risk to finance. Start talking in ranges. If you give a narrow range for something what you're saying is you're pretty certain. If you give a wide range for something what you're saying is you're pretty uncertain. The range is the risk. It's the definition that we started with at the beginning of month of the module that we use in finance. Tell me about the distribution of the investment - what could happen. The final point I'd like to make about risk -and this is often something that people failed to completely understand - is that there are two ways that we evaluate performance at a business. One way is absolute performance and simultaneously we also evaluate performance on a relative basis. Absolutely we have to make money. We have to generate cash flow. We have to generate a return on investment overtime that exceeds our cost of capital. Which means we have to have a positive spread overtime. However anytime a budget, forecast, or plan gets involved the performance evaluation changes. We define value as exceeding expectations. And an approved budget is an expectation. Then the performance evaluation shifts in the short run to a relative performance evaluation. Did you do what you said you were going to do? How accurate were you with what you said you were going to do versus the plan? That is a relative of valuation. Any deviation in that relative valuation is considered risk. And we don't like risk. So remember as leaders we will have to work with both types of evaluation. When we deal with the future we deal with uncertainty which is another word for risk. As we try to manage this uncertainty the first step is to understand what that uncertainty could be and, where possible, to communicate that effectively as we try to make better decisions.