Nobody knows what the future
holds. So whenever we talk about future returns, we
should be humble. Always and inevitably, there is an
element of uncertainty or risk. Perhaps the returns
won't materialize; perhaps they will exceed our expectations.
We can't be sure.
In chapter 1, we finessed the question of risk,
but now the time has come. To focus on the mechanics
of time value calculations, we made generalizations
like “The discount rate or cost of capital depends
on the risk of the project.” Now we will put aside
these vague statements and define risk—in isolation
and combined with other risks—and consider how
it relates to the opportunity
cost of capital.
The study of risk and return is not a mechanical one.
Anticipating returns in the future and recognizing risks
have even religious dimensions. See Vogel and Hayes,
Islamic Law and Finance: Religion, Risk and Return (The
Hague & Boston 1998).
The study of risk and return, however, is fundamental
to valuation. Our study of these concepts sets the stage
for valuing investment instruments (Chapter
4 - Securities Valuation) and whole businesses (Chapter
5 - business valuation). Once we have more clearly
identified and quantified risk, we can plug it into
methodologies that combine returns and risk to calculate
present value of investment and business returns.