The Risk-adjusted Cost of Capital, Explained

Temasek Digital
10 Jul 201903:41

Summary

TLDRThis video explores how Temasek evaluates investments by balancing risk and returns. It starts by comparing two companies, A and B, considering both expected returns and the risk-adjusted cost of capital. By factoring in various risks, such as country, sector, and company-specific factors, the goal is to maximize the spread between return and risk. Even in a low-return environment, Temasek continues to invest with a long-term mindset while remaining mindful of global risks and disruptive trends. The approach emphasizes prudent investment in equities and balancing risks for sustainable portfolio growth over time.

Takeaways

  • 😀 Higher risk often leads to higher returns, but lower risk typically results in lower returns.
  • 😀 To evaluate investments, it's important to assess both the fundamentals and expected returns of different companies.
  • 😀 An investment in Company A may yield 10% return, while Company B could deliver 18% return at face value.
  • 😀 While higher returns are attractive, risk is a crucial factor to consider in investment decisions.
  • 😀 The risk-adjusted cost of capital accounts for various risks (country, sector, company) and allows for better comparisons.
  • 😀 Company A has a risk-adjusted return of 3% over its cost of capital, while Company B's is only 2%.
  • 😀 The spread between expected return and risk-adjusted cost of capital is critical; the goal is to maximize the spread.
  • 😀 Despite low return environments, investors still focus on identifying opportunities with positive returns, even if negative spreads exist.
  • 😀 Company X, despite having a negative spread of 1%, is prioritized over Company Y with a higher negative spread of 8%.
  • 😀 In a low-return environment, maintaining a long-term mindset and enough liquidity for unforeseen circumstances is key.
  • 😀 At Temasek, a focus on equities helps manage risk while aiming to balance returns and risks prudently for sustainable long-term growth.

Q & A

  • What does the saying 'higher risk, higher returns' mean in investing?

    -The saying means that investments with higher risks typically offer the potential for higher returns. Conversely, investments with lower risks generally provide lower returns.

  • How does Temasek assess investments with varying returns and risks?

    -Temasek assesses investments by evaluating the fundamentals of companies, projecting expected returns, and using the risk-adjusted cost of capital to account for different risks before making investment decisions.

  • What is the risk-adjusted cost of capital?

    -The risk-adjusted cost of capital is a measure that considers factors like country, sector, and company-specific risks to account for the level of risk associated with an investment.

  • Why is it important to consider the risk-adjusted cost of capital when comparing companies?

    -It's important because it helps to make like-for-like comparisons between companies with different risk profiles, allowing investors to assess the true potential of returns adjusted for risk.

  • In the example of Company A and Company B, which investment would be more attractive and why?

    -Company A would be more attractive because, despite its lower expected return (10%), its spread (the difference between expected return and risk-adjusted cost of capital) is higher (3%) compared to Company B's spread (2%).

  • What is the 'spread' in investment analysis?

    -The spread is the difference between the expected return on an investment and its risk-adjusted cost of capital. A larger spread indicates a more favorable investment.

  • What happens if investments have negative spreads?

    -If investments have negative spreads, investors prioritize those with the smallest negative spread, as they still offer positive returns, even if they are below the risk-adjusted cost of capital.

  • How does Temasek approach investment during low return environments?

    -In low return environments, Temasek continues to deploy capital actively with a long-term perspective, while also maintaining enough cash for unforeseen circumstances and managing risks.

  • What are some additional risk factors Temasek considers when making investment decisions?

    -In addition to financial estimates, Temasek remains mindful of global event risks and long-term disruptive trends that may impact their investments.

  • Why does Temasek invest mostly in equities despite their inherent volatility?

    -Temasek invests mainly in equities because they offer higher growth potential. The risk-adjusted cost of capital helps to balance the risks associated with the volatility of these investments.

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Étiquettes Connexes
Investment StrategyRisk ManagementCompany EvaluationFinancial AnalysisRisk-adjusted ReturnInvestment DisciplineEquity InvestmentsCapital AllocationMarket TrendsSustainable Value
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