Page 30 - RMAI Bulletin July 2024

RMAI BULLETIN JULY 2024

Unsystematic Risk: Asset-specific or company-spe- Risk Adjustment
cific uncertainty. Since different investments have different degrees of
Political/Regulatory Risk: The impact of political uncertainty or volatility, financial analysts will "adjust"
decisions and changes in regulation. for the level of uncertainty involved. Generally speak-
Financial Risk: The capital structure of a company ing, there are two common ways of adjusting: the dis-
(degree of financial leverage or debt burden). count rate method and the direct cash flow method.
Interest Rate Risk: The impact of changing inter-
est rates.
Country Risk: Uncertainties that are specific to a
country.
Social Risk: The impact of changes in social norms,
movements, and unrest.
Environmental Risk: Uncertainty about environ-
mental liabilities or the impact of changes in the
environment.
1. Discount Rate Method: The discount rate method
Operational Risk: Uncertainty about a company's of risk-adjusting an investment is the most com-
operations, including its supply chain and the de- mon approach, it's as fairly simple to use and is
livery of its products or services. widely accepted by academics. The concept is that
Management Risk: The impact that the decisions the expected future cash flows from an invest-
of a management team have on a company. ment will need to be discounted for the time value
Legal Risk: Uncertainty related to lawsuits or the of money and the additional risk premium of the
freedom to operate. investment. To learn more, check out CFI's guide
to Weighted Average Cost of Capital (WACC) and
Competition: The degree of competition in an in- the DCF modelling guide.
dustry and the impact choices of competitors will
have on a company. 2. Direct Cash Flow Method: The direct cash flow
method is more challenging to perform but offers
Time vs. Risk a more detailed and more insightful analysis. In
this method, an analyst will directly adjust future
The farther away into the future a cash flow or an cash flows by applying a certainty factor to them.
expected payoff is, the riskier (or more uncertain) it The certainty factor is an estimate of how likely it
is. There is a strong positive correlation between time is that the cash flows will actually be received.
and uncertainty. From there, the analyst simply has to discount the
cash flows at the time value of money in order to
get the net present value (NPV) of the investment.
Warren Buffett is famous for using this approach
to valuing companies.

Financial Risk
Risk Financial risk is the possibility of losing money on an

investment or business venture. Some more common
and distinct financial risks include credit risk, liquidity
risk, and operational risk.

Financial risk is a type of danger that can result in the
Time loss of capital to interested parties. For governments,

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