As a professional risk manager, I feel that equity analysts pay
inadequate attention to the risk information in financial
statements. An earnings per share (EPS) surprise of a few cents can
make a stock price jump, and equity analysis reports are filled
with ratios and projections about future revenues, costs, cash flow
and other accounting numbers. But who notices whether value-at-risk
(VaR) went up or down? Who counts the VaR breaks -- i.e., the days
when trading losses were greater than the VaR amount?
VaR has received insufficient attention paid partly because risk
disclosures are buried in the notes. That's not the whole story,
however, because analysts have learned to delve into the fine print
for details about option plans, leases, reserve changes, etc. I
think analysts also are deterred because the presentation of risk
information is technical. Unless you're in the business, you
probably don't have time to learn what you need to translate the
financial note into a sophisticated understanding of the firm's
risk strategy.
In an effort to address this problem, I propose two simple risk
metrics that anyone can understand: a risk price to earnings (RPE)
ratio and risk beta. Like other financial statement analysis
metrics, such as price/earnings (PE) ratio or debt/equity (DE)
ratio, these are indicators, not conclusive determinants. Not every
low PE ratio stock is a good buy, and there are highly levered
firms with low stated DEs.
The risk metrics I propose do not always point to the correct
picture of risk. But most of the time, these ratios give you some
good general information and help you ask questions. They let you
do quick comparisons of many firms, even firms in different
businesses.
I'm going to concentrate on VaR, because it underlies most risk
reporting at financial firms (see "Flabby VaR" sidebar, pg. 14).
The blue line in Figure 1 (above, right) shows the average one-day
95% VaRs reported by Goldman Sachs over the last eight years. I
computed the red line, which I call "market-implied VaR."
I used the implied volatility of short term, deep
out-of-the-money puts on Goldman Sachs stock to estimate the amount
the market thought the firm's value could decline in one day, 5% of
the time. I hereby name the ratio between market-implied VaR and
reported VaR the risk price to earnings (RPE) ratio. For Goldman,
it ranged from a low of 14 to a high of 48 over the eight-year
period.
The numerator of the RPE ratio, market-implied VaR, is measured
in terms of market capitalization, while the denominator, reporting
VaR, is measured in terms of P&L or earnings. Therefore, the
RPE ratio is a form of a PE ratio.
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