Damodaran on Valuation

2.1. WHAT IS RISK?

Risk, for most of us, refers to the likelihood that in life's games of chance, we will receive outcomes that we will not like. For instance, the risk of driving a car too fast is getting a speeding ticket, or worse still, getting into an accident. Webster's dictionary, in fact, defines risk as "exposing to loss or damage." Thus, risk is perceived almost entirely in negative terms.

In valuation, our definition of risk is both different and broader. Risk, as we see it, refers to the likelihood that we will receive a return on an investment that is different from the return we expected to make. Thus, risk includes not only the bad outcomes, (returns that are lower than expected), but also good outcomes (returns that are higher than expected). In fact, we can refer to the former as downside risk and the latter is upside risk; but we consider both when measuring risk. In fact, the spirit of our definition of risk in finance is captured best by the Chinese symbol for risk, which is reproduced here:

The first symbol is the symbol for "danger," while the second is the symbol for "opportunity," making risk a mix of danger and opportunity. It illustrates very clearly the trade-off that every investor and business has to make—between the higher rewards that come with the opportunity and the higher risk that has to be borne as a consequence of the danger.

Much of this ...