Risk & return: Is half the formula missing?

One thing investor relations people need to improve is disclosure of risks.

I’m not talking about legal disclosures – pages and pages of “risk factors” in the 10-K or Q, from the possibility of bumpy economic times to, God forbid, the unexpected demise of the CEO. These are risk notifications. Yes, they inform investors – especially if one compares the current period to prior years to see what new risk factors have bubbled up – but the language is so, well, lawyerly.

We need to work on explaining and quantifying the business risks that an investor should incorporate in his valuation of our companies’ shares. The market gurus say it’s all about risk and return. But our focus in IR – and the obsession of many analysts – is on the income statement, the return side.

In the classic financial models, risk has everything to do with valuing a company. The stream of future cash flows that people work hard to forecast is discounted by the cost of capital, a subjective number that most analysts simply plug in as a guess. The real cost of capital, or discount rate, is made up of the risk-free return (easy to estimate) plus the risk premium (much harder). You formula buffs, get out the old textbooks or see here or here – and consider what goes into the “d” or “re” term.

As a profession, investor relations people need to work on how to profile risk in a company. Uncertainty is uncertain, but we have some qualitative and even quantitative assessments of risk- from the macroeconomic uncertainties right down to the sensitivities in a product’s sales.

Three recent episodes have started me thinking about risk:

… The massive failure of financial institutions to manage the risks of lending and investing activities, as evidenced by mega-writedowns by banks and I-banks continuing through 2008.

… Another meltdown in a biopharma company’s share price after the FDA called into question the safety of a key product for diabetes.

… The reaction of global markets to Russia’s war-like actions in Georgia, which made investors ratchet up the geopolitical part of their risk premium.

The issue of “miscommunicating risk” was raised this month in the IN VIVO blog, an adjunct to a magazine of the same name that covers deals and business trends in the pharmaceutical and biotech industries. IN VIVO commented:

There seems to be a big disconnect between the seriousness of a safety issue from the regulatory perspective (where a safety “update” by FDA treated two deaths from pancreatitis as important information for prescribers, but not a call to action) compared to the reaction of investors (“The sky is falling!”).

IN VIVO wondered aloud whether the two biopharma companies involved might have headed off the market’s Chicken Little reaction by better disclosing their perspective on the risks in advance, before the FDA turned on its loudspeakers.

In any industry, companies need to work hard at properly communicating risk. IROs should make it a major focus – preferably before the roof starts to cave in.

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