Value or Risk?
Valuation and risk analysis are distinct concepts that are sometimes confused. There is an interdependence between the two, but failing to understand the differences between the elements of this symbiotic relationship can create confusion among investors and those charged with protecting their interests.
Valuation is a measure on any given date of the future benefits, including opportunities, that an owner will derive from an asset, either through continued ownership or from a sale. A proper measurement of value will take into account future risks, for example that the benefits may decline because of a deterioration in performance or a reduction in demand. For example, the balance of risk and reward is fundamental to determining the appropriate discount rate used to measure the value of future benefits, and therefore to the value of an asset.
Risk analysis is a measure of the probability of future losses arising from ownership of an asset. It is something that most prudent market participants will consider when making buy or sell decisions, whether consciously or unconsciously. This analysis may be heuristic, based on observations and experience, or stochastic, based on statistical analysis of past price fluctuations. However, while risk analysis can inform and influence decisions to buy, hold or sell, unlike valuation it does not determine the value at any given time, because it does not consider the benefits and opportunities alongside the risks.
From time to time there emerge advocates for a new type of valuation that produces a figure that smooths out price fluctuations over time. They argue that this figure will be in some way more "sustainable" and therefore more useful to investors than an estimate of the value current at any given time. However, this involves conflating the measurement of value on the one hand and risk of that value reducing on the other. So if the current value is 100 but a risk analysis indicates that this is 25% above the long term trend, the value is adjusted to 80. What purpose would this serve? At the date of valuation the asset could be neither bought nor sold for this figure, and at any future date the figure of 80 is also unlikely to coincide with market prices as it is based on an average. Those who support such an approach are motivated by the need to protect investors or lenders from the consequences of market fluctuations. However, there are more straightforward and intellectually sound ways of achieving this that do not involve manipulating the valuation, such as stipulating a maximum percentage of the current value of underlying assets that may be included in a bond issue, or that may be advanced as loan against the value of the security provided.
This issue has recently flared into life again in the RICS Property Journal, and my contribution to the debate featured in the May/June edition on pages 12-13 (for link, click on image). Also related to this topic are the deliberations of the European Banking Authority on Mortgage Lending Value which featured in my recent Blog "Square Peg Found in Round European Hole".