1.4 EVALUATION OF RISKY CASH FLOWS
A stock entitles you to a stream of risky future cash flows. The first step in the investment decision is to place a value on these cash flows.
At the start of our journey toward this goal, let us consider some of the factors that affect these cash flows and therefore the stock price. For example, you saw that the price of Chrysler in Figure 1.1 fluctuated during the first four years of the 1990's. Let us list some of the factors that you may think affect the price.
1. Chrysler's ability to produce cars and trucks efficiently, to meet consumer demand, and market its products effectively in today's global economy.
2. The performance of other domestic and foreign car and truck manufacturers.
3. The general state of the economy (e.g., recessionary, normal, or expansionary).
4. The current level of interest rates and exchange rates.
5. Chrysler's access to capital markets to finance its future design, manufacturing, and marketing programs.
Place yourself in the shoes of an investor in the capital markets. What are some of the factors that would influence your decision to buy or sell Chrysler stock? Clear influences are
1. Your current level of wealth.
2. Your tolerance for risk.
3. Your expectations of return from investing in Chrysler, and the perceived risk.
4. The current level of interest rates.
5. Your other investment opportunities.
To see why the last one is critical, consider the following. Suppose you expect the return from Chrysler to be 5% per year, but you discover that you can get 6% per year from another (slightly less risky) security. If you prefer more return to less and less risk to more, would you buy Chrysler?
On the face of it, it would appear that neither you (nor anyone else) would buy Chrysler stock. If this is the case, the price will fall to attract buyers, thereby raising the expected return.
This illustrates that by investing in any security you are always incurring some opportunity cost. That is, you are forgoing the opportunity to invest the same amount of capital in some other investment opportunity. As a result, the expected return from a security will depend in some way on the return offered by other securities.
There is a reason why you might buy Chrysler anyway. Suppose you have a large position in the Japanese car company, Toyota, and you are worried about risk from fluctuations in the dollar/yen exchange rate. If the dollar is cheap relative to the yen, Chrysler has a competitive advantage in the U.S., while if the yen is cheap relative to the dollar, Toyota has a competitive advantage in the U.S. market. In this case, buying Chrysler may well reduce the riskiness of your portfolio, even though another asset provides a higher return. If the reduction in risk compensates you sufficiently, you may be willing to buy Chrysler and forego the additional return. As a result, the decision to buy Chrysler, and thus the demand for Chrysler, and thus the expected return from Chrysler, also depends on how it affects the riskiness of your portfolio.
We describe how buying Chrysler affects the riskiness of a portfolio in the topic Portfolio Diversification.
(C) Copyright 1999, OS Financial Trading System