Volatility versus Risk
by MaestriBefore closing this chapter, we should note that volatility does not necessarily imply risk. For example, suppose a company’s sales and earnings fluctuate widely from month to month, from year to year, or in some other manner. Does this imply that the company is risky in either the stand-alone or portfolio sense? If the earnings follow seasonal or cyclical patterns, as for an ice cream distributor or a steel company, they
can be predicted, hence volatility would not signify much in the way of risk. If the ice cream company’s earnings dropped about as much as they normally did in the winter, this would not concern investors, so the company’s stock price would not be affected. Similarly, if the steel company’s earnings fell during a recession, this would not be a surprise, so the company’s stock price would not fall nearly as much as its earnings. Therefore, earnings volatility does not necessarily imply investment risk.
Now consider some other company, say, Wal-Mart. In 1995 Wal-Mart’s earnings declined for the first time in its history. That decline worried investors—they were concerned that Wal-Mart’s era of rapid growth had ended. The result was that Wal-Mart’s stock price declined more than its earnings. Again, we conclude that while a downturn in earnings does not necessarily imply risk, it could, depending on conditions.
Now let’s consider stock price volatility as opposed to earnings volatility. Is stock price volatility more likely to imply risk than earnings volatility? The answer is a loud yes! Stock prices vary because investors are uncertain about the future, especially about future earnings. So, if you see a company whose stock price fluctuates relatively widely (which will result in a high beta), you can bet that its future earnings are relatively unpredictable. Thus, biotech companies have less predictable earnings than water companies,
biotechs’ stock prices are volatile, and they have relatively high betas.
To conclude, keep two points in mind: (1) Earnings volatility does not necessarily signify risk—you have to think about the cause of the volatility before reaching any conclusion as to whether earnings volatility indicates risk. (2) However, stock price volatility does signify risk.
Does earnings volatility necessarily imply risk? Explain.
Why is stock price volatility more likely to imply risk than earnings volatility?
Taken From : Five-Minute MBA – Corporate Finance
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