How can the analysis of risk be integrated into the valuation of common stock? What should happen to the value of common stock if its beta increases?

Expert Solution

there are basically two types of risk that affect stock prices:-

1) Systematic risk- the risk which occurs due to large macro economic changes and which cannot reduced by any normal means. The whole industry or the market may get affected due to this type of risk. for example in govt changes its policy regarding import/export of certain goods pertaining to certain type of industry, it will be a systematic risk.

2) Unsystematic risk- these are company/stock specific risk, which mainly depends on the operations and administrative policy changes of the company. these risks are specific to the company only. this type of risk can be managed by diversifying the portfolio of stocks which the investor is investing. for example if due to certain reason stocks of one company falls, other stocks of investor's portfolio may not fall or some may rise. So, the fall in price of the stock is negated by the rise of other stocks in the portfolio. therefore, this type of risk can be minimised by diversification of portfolio.

Both the type of risks are taken into account when the valuation of common stocks are made using different valuation principles. It depends on the exposure to the risks mentioned, that how much will it effect the value of common stock/equity. But mainly the company's OPERATIONAL and FINANCIAL risk are taken into account while considering valuation.

BETA- Beta of a common stock measures the volatility of the price movement of that stock in relation to the volatility of the whole index. So, higher the value of beta means higher volatility of the respective stock relative to the benchmark index and vice versa. So, increase in beta will result in more premium demanded by the shareholders of that stock in order to mitigate their risk due to higher volatility. So, according to CAPM model increase in beta will increase the cost of equity during valuation because cost of equity equals to the risk free rate of return + beta * (risk premium- Risk free rate).

jeff jeffy answered 2 years ago

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