“By the time you arrive in business school, you’re already brainwashed about how you describe risk,” Aswath Damodaran (NYU Stern School of Business) told attendees at the AICPA National Business Valuation Conference in DC yesterday. “It’s a number—the standard deviation. It’s variance.” But, perhaps this isn’t the right view. Damodaran asks “let’s say you buy Google at $500 a share, hoping for 20% return. Perhaps it doubles, or perhaps it goes down 70%.” All of the risk is in the future, he points out, yet all our data is in the past.
He also is concerned that valuation methods as generally practiced gloss over the fact that the cost of equity changes over time. An extreme example: a venture-capital financed company startup. It’s reasonable, given the probability of default in the early stages, that the cost of equity goes from 20% for round one financing to 8% in round three. “We’re stuck in this model of one discount rate, and I think we may have to let go of that idea. It can be very dangerous,” Aswath warns.