HOLT
Money On The Table: How should corporate
boards and executives assess idiosyncratic risk?
12 May 2015
David Holland
Senior Advisor
+27 76 400 9054
david.a.holland@credit-suisse.com
credit-suisse.com/holtmethodology
Market Commentary
Summary
“In theory there is no difference between theory and practice. In practice there is.”
– Yogi Berra
 Companies should not expect to be rewarded for idiosyncratic risk
 Do not add fudge factors to the cost of capital to account for idiosyncratic risk
 Do not add fudge factors to the cost of capital to counterbalance biased forecasts
 Assess corporate risk tolerance and calculate the Certainty Equivalent for BIG, highly
risky investments
 Increase enterprise value by improved risk modelling and understanding of the
relationship between investment decisions, risk-bearing capacity and risk appetite
CLARITY IS CONFIDENCE
1
This is market commentary and not a research document.
HOLT
What rate should be used to discount future cash flows?
The capital asset pricing model (CAPM) is the simplest and best known approach for
discounting risk.
𝑟𝑒 = 𝑟𝑓 + 𝛽 × 𝐸𝑅𝑃
The cost of equity re equals the risk-free rate rf (time-component) plus a stock-specific
risk premium, β×ERP, where β is a measure of how a stock co-varies with the market,
and ERP is the equity risk premium.
𝛽𝐴 =
𝜌𝐴𝑀 𝜎𝐴
𝜎𝑀
βA is the asset beta
ρAM is the correlation between changes in asset and market prices
σA is the volatility of the asset
σM is the volatility of the market
CLARITY IS CONFIDENCE
2
This is market commentary and not a research document.
HOLT
Companies should not expect to be rewarded for idiosyncratic risk
45%
40%
Volatility
35%
Corr=0
30%
25%
Market
20%
15%
10%
Corr=1
5%
0%
0
5
10
15
20
25
30
Number of stocks
35
40
45
50
Investors can do it themselves by owning a portfolio of stocks. You’re not helping them
by doing it for them and you might be leaving money on the table. Investors want you to
take risk if the expected NPV > 0.
CLARITY IS CONFIDENCE
3
This is market commentary and not a research document.
HOLT
Connection between intrinsic value and capital budgeting decisions
Goal
Investors prefer more value to less. A core principle of modern finance is the net
present value (NPV) rule, and that managers should aim to maximize the NPV of their
firm’s present and future investments.
𝐹𝑖𝑟𝑚 𝑣𝑎𝑙𝑢𝑒 = 𝑃𝑉 𝑎𝑙𝑙 𝑓𝑢𝑡𝑢𝑟𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 = 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙0 +
𝑁𝑃𝑉𝑖
𝑃𝑟𝑜𝑗𝑒𝑐𝑡𝑠
Penalty
Portfolio theory and general investment experience indicate a wonderful property of
company-specific, idiosyncratic risk: it can be diversified away!
Company managers should only expect to be compensated for non-diversifiable risk. Do
not include arbitrary risk premiums or fudge factors in corporate hurdle rates.
CLARITY IS CONFIDENCE
4
This is market commentary and not a research document.
HOLT
Do not add fudge factors to the cost of capital (1)
Forecasts tend to be inflated by 10%, so you increase the hurdle rate by 10% and reject the project.
Inputs
Revenue
Fudge
WACC %
Hurdle rate %
IRR
Year
Revenue
- Cost
EBITDA
- Depreciation
EBIT
- Tax
NOPAT
Results
NPV at WACC
NPV at Hurdle Rate
1,000
0%
13%
23%
17%
Gross Fixed Assets
- Depreciation
Net Fixed Assets
+ WC
Net Assets
Gross Cash Flow
Investment
ΔWC
FCF
PV of FCF
NPV
PV of FCF (hurdle rate)
NPV (hurdle rate)
CLARITY IS CONFIDENCE
238
-233
0
1
1,000
-820
180
-100
80
-50
130
2
1,060
-869
191
-100
91
-53
137
3
1,124
-921
202
-100
102
-57
146
4
1,191
-977
214
-100
114
-60
154
5
1,262
-1,035
227
-100
127
-64
164
6
1,338
-1,097
241
-100
141
-67
173
7
1,419
-1,163
255
-100
155
-71
184
8
1,504
-1,233
271
-100
171
-76
195
9
1,594
-1,307
287
-100
187
-80
207
10
1,689
-1,385
304
-100
204
-85
219
1,000
1,000
-100
900
250
1,150
900
-100
800
265
1,065
800
-100
700
281
981
700
-100
600
298
898
600
-100
500
316
816
500
-100
400
335
735
400
-100
300
355
655
300
-100
200
376
576
200
-100
100
398
498
100
-100
0
0
0
230
237
246
254
264
273
284
295
307
319
-1,000
-1,000
-250
-20
-18
-15
222
174
-16
230
159
-17
238
146
-18
246
133
-19
254
122
-20
264
112
-21
274
103
-23
284
95
398
717
211
-1,000
-17
147
123
104
87
73
44
91
1,000
1,000
-1,000
238
Error compounds!
62
52
-233
5
This is market commentary and not a research document.
HOLT
Do not add fudge factors to the cost of capital (2)
Forecasts tend to be inflated by 10%, but you only increase the hurdle rate by 5% and still reject the project.
Inputs
Revenue
Fudge
WACC %
Hurdle rate %
IRR
Year
Revenue
- Cost
EBITDA
- Depreciation
EBIT
- Tax
NOPAT
Results
NPV at WACC
NPV at Hurdle Rate
1,000
0%
13%
18%
17%
Gross Fixed Assets
- Depreciation
Net Fixed Assets
+ WC
Net Assets
Gross Cash Flow
Investment
ΔWC
FCF
PV of FCF
NPV
PV of FCF (hurdle rate)
NPV (hurdle rate)
CLARITY IS CONFIDENCE
238
-37
0
1
1,000
-820
180
-100
80
-50
130
2
1,060
-869
191
-100
91
-53
137
3
1,124
-921
202
-100
102
-57
146
4
1,191
-977
214
-100
114
-60
154
5
1,262
-1,035
227
-100
127
-64
164
6
1,338
-1,097
241
-100
141
-67
173
7
1,419
-1,163
255
-100
155
-71
184
8
1,504
-1,233
271
-100
171
-76
195
9
1,594
-1,307
287
-100
187
-80
207
10
1,689
-1,385
304
-100
204
-85
219
1,000
1,000
-100
900
250
1,150
900
-100
800
265
1,065
800
-100
700
281
981
700
-100
600
298
898
600
-100
500
316
816
500
-100
400
335
735
400
-100
300
355
655
300
-100
200
376
576
200
-100
100
398
498
100
-100
0
0
0
230
237
246
254
264
273
284
295
307
319
-1,000
-1,000
-250
-20
-18
-15
222
174
-16
230
159
-17
238
146
-18
246
133
-19
254
122
-20
264
112
-21
274
103
-23
284
95
398
717
211
-1,000
-17
160
140
123
107
94
64
137
1,000
1,000
-1,000
238
Error compounds!
83
73
-37
6
This is market commentary and not a research document.
HOLT
Improvised hurdle rates don’t save money, they distort capital budgeting
If forecasts tend to be inflated by 10%, you should de-bias them by 10%. Hurdle rate errors compound. The only
remedy is to de-bias and improve forecasts.
Inputs
Revenue
Fudge
WACC %
Hurdle rate %
IRR
Year
Revenue
- Cost
EBITDA
- Depreciation
EBIT
- Tax
NOPAT
Results
NPV at WACC
NPV at Hurdle Rate
1,000
-10%
13%
23%
16%
Gross Fixed Assets
- Depreciation
Net Fixed Assets
+ WC
Net Assets
Gross Cash Flow
Investment
ΔWC
FCF
PV of FCF
NPV
168
0
1
900
-738
162
-100
62
-45
117
2
954
-782
172
-100
72
-48
124
3
1,011
-829
182
-100
82
-51
131
4
1,072
-879
193
-100
93
-54
139
5
1,136
-932
205
-100
105
-57
147
6
1,204
-988
217
-100
117
-61
156
7
1,277
-1,047
230
-100
130
-64
165
8
1,353
-1,110
244
-100
144
-68
175
9
1,434
-1,176
258
-100
158
-72
186
10
1,521
-1,247
274
-100
174
-77
197
1,000
1,000
-100
900
225
1,125
900
-100
800
239
1,039
800
-100
700
253
953
700
-100
600
268
868
600
-100
500
284
784
500
-100
400
301
701
400
-100
300
319
619
300
-100
200
338
538
200
-100
100
359
459
100
-100
0
0
0
217
224
231
239
247
256
265
275
286
297
-225
-8
-7
-14
210
165
-14
217
150
-15
224
137
-16
231
125
-17
239
115
-18
247
105
-19
256
96
-20
266
88
359
656
193
1,000
1,000
-1,000
-1,000
-1,000
168
The de-biasing factor should actually be -9.09% in this case, i.e., 1/1.10 - 1 = -9.09%
CLARITY IS CONFIDENCE
7
This is market commentary and not a research document.
HOLT
How can idiosyncratic risk be assessed and managed?
Risk dilemma
The risk premium for diversifiable risk is zero. This point is too often forgotten when
evaluating investments. The addition of arbitrary risk premiums to conjure hurdle rates
might turn value creating projects into value destroying projects that get rejected. It can
also lead to fallacious forecasts meant to counter unjustifiably high hurdle rates, thus
subverting the entire capital allocation exercise. Money is often left on the table.
Risk tolerance can help
Assess a company’s risk tolerance and incorporate it into a utility function:
𝑢 𝑥 =1−
𝑥
−𝑅
𝑒
Risk tolerance (R) is a preference and reflects an individual’s risk aversion, while x is the
specific dollar value of interest.
CLARITY IS CONFIDENCE
8
This is market commentary and not a research document.
HOLT
Calculate Certainty Equivalent (CE) using PrecisionTree
Certainty equivalent for bet #1
Would you take this bet if your risk tolerance were R10,000?
Payoff of 2X
TRUE
Invest X
-8 000
75%
75%
16 000
8 000
EV
4 000
Payoff of zero
25%
0
25%
-8 000
EV
Invest in venture?
4 000
Invest nothing
FALSE
0
0%
0
Certainty equivalent for bet #2
Would you take this bet if your risk tolerance were R10,000?
Payoff of 2X
75%
24 000
TRUE
Invest X
-12 000
EV
6 000
Payoff of zero
25%
0
Invest in venture?
75%
12 000
25%
-12 000
EV
6 000
Invest nothing
FALSE
0
CLARITY IS CONFIDENCE
0%
0
9
This is market commentary and not a research document.
HOLT
WhizKidz has a potential project called “Showtime”
About WhizKidz
WhizKidz is a toy manufacturer with a market cap of $10bn and beta of one, i.e., its
fortunes tend to track those of the market. It has $2bn in cash and a chance to invest it
in a project with a present value of $3bn resulting in an NPV of $1bn. Should WhizKidz
proceed?
Two scenarios
Let’s assume two scenarios for the introduction of a product “Showtime”. It has a 50%
chance of being a success and generating an NPV of $2bn (PV = $4bn), and a 50%
chance of breaking even with NPV of $0 (PV = $2bn). The expected NPV, E[NPV], is
$1bn and there is no reason not to proceed unless management is irrationally riskaverse.
If it rejected the investment and the market realized the decision was irrational, we would
expect to see shareholder activists, private equity investors and competitors express
keen interest in shaking up the board or taking over the firm.
𝐸 𝑁𝑃𝑉 = 0.50 × $4𝑏𝑛 + 0.50 × $2𝑏𝑛 − $2𝑏𝑛 = $1𝑏𝑛
CLARITY IS CONFIDENCE
10
This is market commentary and not a research document.
HOLT
WhizKidz has another potential project called “Blockbuster”
Let’s make the problem more interesting by making it an absolute blockbuster with a
present value of $6bn or a total failure with a present value of nil.
𝐸 𝑁𝑃𝑉 = 0.50 × $6𝑏𝑛 + 0.50 × $0 − $2𝑏𝑛 = $1𝑏𝑛
The expected value remains $1bn but the standard deviation jumps to $3bn. The
blockbuster project is 3 times riskier than the first project.
Summary
• Both projects have a NPV of $1bn
• “Showtime” has a standard deviation of ±$1bn and “Blockbuster” ±$3bn
• A rational manager would choose “Showtime” if they were mutually exclusive
• Is there a single magical number we can calculate for each project?
CLARITY IS CONFIDENCE
11
This is market commentary and not a research document.
HOLT
Calculate the Certainty Equivalent
Certainty equivalent for “Showtime” (1)
Expected value of $1bn and CE of $760m if risk tolerance is $2bn
Success
TRUE
Invest
50%
50%
4 000
2 000
Success
EV
-2 000
50%
Failure
2 000
Failure
50%
2 000
50%
50%
2 000
0
0
CE
Invest in project 1?
760
1 000
Invest nothing
CE
760
50%
EV
Invest in project 1?
TRUE
-2 000
Invest
1 000
50%
4 000
FALSE
0%
0
FALSE
Invest nothing
0%
0
0
0
Certainty equivalent for “Blockbuster” (2)
Expected value of $1bn and CE of ($711m) if risk tolerance is $2bn
Success
TRUE
Invest
50%
50%
6 000
4 000
Invest
1 000
50%
Failure
0
Invest in project 2?
6 000
EV
-2 000
CE
-711
50%
50%
Failure
0
EV
Invest in project 2?
0%
4 000
0%
-2 000
CE
0
FALSE
0
CLARITY IS CONFIDENCE
FALSE
-2 000
-2 000
1 000
Invest nothing
50%
Success
0%
Invest nothing
TRUE
0
0
12
This is market commentary and not a research document.
100%
0
HOLT
How sensitive is CE to changes in probability and risk tolerance?
1 000
100 000
90 000
80 000
70 000
60 000
50 000
40 000
30 000
20 000
-500
10 000
0
0
CE ($'m)
500
-1 000
-1 500
-2 000
Risk tolerance ($'m)
Relationship between CE and p(success)
• EV = CE when uncertainty is zero
• From CE perspective, “Blockbuster”
becomes attractive if p(success) > 65%
• From risk neutral perspective, the
project is attractive if p(success) > 33%
CLARITY IS CONFIDENCE
Relationship between CE & risk tolerance
• CE ≈ EV if value <<< risk tolerance
• CE > 0 if risk tolerance > $4bn for
“Blockbuster”
• Risk can be shared with other parties
and apportioned according to risk
tolerance
13
This is market commentary and not a research document.
HOLT
Risk Appetite, Risk Bearing Capacity and Enterprise Value
Risk-bearing Capacity
(able)
High
Leaving Money on the Table
Diamond
Limited willingness to pursue
upside of good risk management
Significant strategic ambition and
plans, coupled with ability to
execute
Material chance of
underperformance due to lazy
corporate balance sheet (higher
investment risk premium)
Strong potential for large rewards
with reduced uncertainty if well
aligned
Safe in the Harbour
Irrational Exuberance
Limited strategic growth ambition,
but commensurate with ability to
execute on the associated plans.
Strategic ambition but inadequate
ability to support risk.
High potential for overextension or
catastrophic event (higher equity
risk premium or have to get lucky)
Strong chance of financial and
share price underperformance.
Low
Low
MARSH RISK CONSULTING
Source: Marsh Risk Consulting
Risk Appetite
(willing)
High
Market-implied real discount rate for listed South African non-Financials
CLARITY IS CONFIDENCE
This is market commentary and not a research document.
HOLT
Summary
“In theory there is no difference between theory and practice. In practice there is.”
– Yogi Berra
 Companies should not expect to be rewarded for idiosyncratic risk
 Do not add fudge factors to the cost of capital to account for idiosyncratic risk
 Do not add fudge factors to the cost of capital to counterbalance biased forecasts
 Assess corporate risk tolerance and calculate the Certainty Equivalent for BIG, highly
risky investments
 Increase enterprise value by improved risk modelling and understanding of the
relationship between investment decisions, risk-bearing capacity and risk appetite
CLARITY IS CONFIDENCE
16
This is market commentary and not a research document.
HOLT
Global Market Commentary Disclaimer
References to Credit Suisse include all of the subsidiaries and affiliates of Credit Suisse AG operating under its investment banking division. For more information on our structure, please follow the attached link:
https://www.credit-suisse.com/who_we_are/en/what_we_do.jsp
This material has been prepared by individual traders or sales personnel of Credit Suisse and not by Credit Suisse's research department. The information contained in this document has been provided as general
market commentary only and does not constitute any form of regulated financial advice, legal, tax or other regulated financial service. It is intended only to provide observations and views of these traders or sales
personnel, which may be different from, or inconsistent with, the observations and views of Credit Suisse research department analysts, other Credit Suisse traders or sales personnel, or the proprietary positions
of Credit Suisse. Observations and views expressed herein may be changed by the trader or sales personnel at any time without notice. Credit Suisse accepts no liability for losses arising from the use of this
material.
This material does not purport to contain all of the information that an interested party may desire and, in fact, provides only a limited view of a particular market. It is not investment research, or a research
recommendation for regulatory purposes, as it does not constitute substantive research or analysis. The information provided is not intended to provide a sufficient basis on which to make an investment decision
and is not a personal recommendation or investment advice. While it has been obtained from or based upon sources believed by the trader or sales personnel to be reliable, each of the trader or sales personnel
and Credit Suisse does not represent or warrant its accuracy or completeness and is not responsible for losses or damages arising from the use of this material.
This material is provided for informational purposes and does not constitute an invitation or offer to subscribe for or purchase any of the products or services mentioned. It is directed exclusively at Credit Suisse's
market professional and institutional investor clients (e.g. QIBs) as defined by the rules of the relevant regulatory authority, and must not be forwarded or shared with retail customers or the public. It is not intended
for private customers and such persons should not rely on this material. Moreover, any investment or service to which this material may relate will not be made available by Credit Suisse to such private customers.
This material may have previously been communicated to the Credit Suisse trading desk or other Credit Suisse clients. You should assume that the trading desk makes markets and/or currently maintains positions
in any of the securities mentioned above. Credit Suisse may, from time to time, participate or invest in transactions with issuers of securities that participate in the markets referred to herein, perform services for or
solicit business from such issuers, and/or have a position or effect transactions in the securities or derivatives thereof. Information provided on any trades executed with Credit Suisse will not constitute an official
confirmation of the trade details, and all preliminary trade report information is subject to our formal written confirmation.
FOR IMPORTANT DISCLOSURES on companies covered in Credit Suisse Investment Banking Division research reports, please see www.credit-suisse.com/researchdisclosures. To obtain a copy of the most
recent Credit Suisse research on any company mentioned please contact your sales representative or go to http://www.credit-suisse.com/researchandanalytics.
Past performance should not be taken as an indication or guarantee of future performance, and no representation or warranty, expressed or implied is made regarding future performance. Backtested, hypothetical
or simulated performance results have inherent limitations. Simulated results are achieved by the retroactive application of a backtested model itself designed with the benefit of hindsight. The backtesting of
performance differs from the actual account performance because the investment strategy may be adjusted at any time, for any reason and can continue to be changed until desired or better performance results
are achieved. Alternative modeling techniques or assumptions might produce significantly different results and prove to be more appropriate. Past hypothetical backtest results are neither an indicator nor a
guarantee of future returns. Actual results will vary from the analysis.
Investment principal on securities can be eroded depending on sale price or market price. In addition, there are securities on which investment principal may be eroded due to changes in redemption amounts.
Care is required when investing in such instruments.
HOLT Disclaimer
The HOLT methodology does not assign ratings or a target price to a security. It is an analytical tool that involves use of a set of proprietary quantitative algorithms and warranted value calculations, collectively
called the HOLT valuation model, that are consistently applied to all the companies included in its database. Third-party data (including consensus earnings estimates) are systematically translated into a number
of default variables and incorporated into the algorithms available in the HOLT valuation model. The source financial statement, pricing, and earnings data provided by outside data vendors are subject to quality
control and may also be adjusted to more closely measure the underlying economics of firm performance. These adjustments provide consistency when analyzing a single company across time, or analyzing
multiple companies across industries or national borders. The default scenario that is produced by the HOLT valuation model establishes a warranted price for a security, and as the third-party data are updated,
the warranted price may also change. The default variables may also be adjusted to produce alternative warranted prices, any of which could occur. The warranted price is an algorithmic output applied
systematically across all companies based on historical levels and volatility of returns. Additional information about the HOLT methodology is available on request
CFROI, CFROE, HOLT, HOLT Lens, HOLTfolio, HOLTSelect, HS60, ValueSearch, Signal Flag, Forecaster, “Clarity is Confidence” and “Powered by HOLT” are trademarks or registered trademarks of Credit
Suisse Group AG or its affiliates in the United States and other countries.
HOLT is a corporate performance and valuation advisory service of Credit Suisse.
© 2015 Credit Suisse Group AG and its subsidiaries and affiliates. All rights reserved.
For region specific disclosures, including information about applicable registrations and certain regulatory disclosures, please follow the links below:
Americas: https://www.credit-suisse.com/legal/en/ib/market_commentary.jsp
Europe: https://www.credit-suisse.com/legal/en/ib/europe.jsp (Credit Suisse Securities (Europe) Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and
the Prudential Regulation Authority in the United Kingdom)
Asia: https://www.credit-suisse.com/legal/en/ib/market_commentary_disclaimer_asia.jsp
General investors in Japan should open the following link and read it:
https://www.credit-suisse.com/jp/investment_banking/ja/disclaimer/
CLARITY IS CONFIDENCE
17
This is market commentary and not a research document.
HOLT