Summary

This final element of the financial foundation part of the book concerns the subject of risk. Unlike the previous sections on accounting, economic value, etc. I will assume that readers already know a fair amount about risk. After all, risk is part of life and so we all grow up with it. Risk, however, is something where our own intuition can be very misleading should we need to take decisions on behalf of our companies. Growing up has taught us to cope with risk to ourselves and our close families. We need to learn a new set of skills when it comes to dealing with risk in the context of big publicly owned companies. This building block will introduce this new way of looking at risk. It is called portfolio theory and it provides one of the cornerstones of modern corporate finance.

It is portfolio theory that will allow us to return to the question of how it is that risk must influence the way we choose the appropriate CoC for our valuations. This theory will also help us decide what makes a good assumption to plug into our economic models. The building block, therefore, serves as a crucial integrator of the preceding four.

I must start off by defining what I mean by risk. My dictionary defines risk with words to the effect that it is a nasty event or outcome. This, I believe, is the view of risk that we have grown up with. Unfortunately, in the context of corporate finance, risk means something different. It means what I think would more properly be called uncertainty.