Risk-averse investors will assign lower values to assets that have more risk associated with them than to otherwise similar assets that are less risky. The most common way of adjusting for risk to compute a value that is risk adjusted.
There are four ways in which we this risk adjustment can be made.
The first two approaches are based on discounted cash flow valuation, where we value an asset by discounting the expected cash flows on it at a discount rate. The risk adjustment here can take the form of a higher discount rate or as a reduction in expected cash flows for risky assets, with the adjustment based upon some measure of asset risk.
The third approach is to do a post valuation adjustment to the value obtained for an asset, with no consideration given for risk, with the adjustment taking the form of a discount for potential downside risk or a premium for upside risk.
In the fourth approach, we adjust for risk by observing how much the market discounts the value of assets of similar risk.
While we will present these approaches as separate and potentially self-standing, we will also argue that analysts often employ combinations of approaches. For instance, it is not uncommon for an analyst to estimate value using a risk-adjusted discount rate and then attach an additional discount for liquidity to that value. In the process, they often double count or miscount risk.
