Mr. Seth Klarman, a known value investor stated “In capital markets, the price is set by the most panicked seller; value, which is determined by cash flows and assets, is not. This is both the challenge and the opportunity of investing: to carefully sift through the markets to find the greatest divergence between price and value, and to concurrently avoid the extreme emotions of the crowd and, indeed, to take a stand against them.” Warren Buffett is also known to state frequently “Price is what you pay and Value is what you get.”
The risk in Investments refers to the possibility that the expected return from an investment or the capital invested may be eroded in some manner. The risk in investment is defined as the possibility that actual returns from the investment will be different from expected returns. Whenever there are returns, there will be a risk; so all investments are exposed to risk to some extent. Risk refers to both positive and negative deviations of actual returns from expected returns. To understand the risk in an investment, it is necessary to measure its actual and expected returns. The expected return is estimated depending on the type of investment product. For some investments, the expected return may simply be the returns defined by the investment provider.
Difference between Measure & Metrics
A “measure” is a number that is derived from taking a measurement, in contrast, a “metric” is a calculation between two measures. For example, Free Cash Flow generated is a measure, where as, Enterprise Value (EV) of the firm is a metric derived by discounting Free Cash Flows at the appropriate discount rate.
As we discussed earlier Fundamental Analysts keenly observe the measures like Income, Cash Flows, Net Sales, Direct Costs, Interest Costs, Other Income, Current Assets, Liabilities, Profit Before Tax etc. They then calculate Ratio metrics to better understand the health of the company. Some of the popular metrics are EBITDA Margin, Net Profit Margin, Return on Equity, Return on Capital Employed, Debt to Equity Ratio etc.
Risks and Return are an Integral part of Investing
The return that an investment generates cannot be seen in isolation from the risk that has to be assumed to earn it. A high return can be earned only if the investor is willing to take higher risk. Risk in an investment is the volatility and uncertainty in the returns and in the extreme case, the loss of capital invested. An investment is also deemed to be risky if the actual returns earned are different from the expected returns. All investments are subject to risks. The nature and extent of the risk may differ. It is important for an investor to be able to identify the type of risk in an investment to be able to decide whether it is suitable to their situation. Some of the common risks that are seen in investments are captured here: