Course 210:
Operating Risk versus Price Risk
In this course
1 Introduction
2 Low Operating Risk and High Price Risk
3 High Operating Risk and Low Price Risk
4 Low Operating Risk and Low Price Risk
5 High Operating Risk and High Price Risk

In investing, as in life, risk comes in many forms. When it comes to stocks, two particularly important types of risk are operating risk and price risk. Operating risk is the risk to the company as a business. That includes anything that might adversely affect the company's market or its profitability, such as volatile raw-materials costs or rising labor costs. A debt load that is high compared with industry or market averages would also make for higher operating risk because it would magnify the bottom-line effects of a drop in demand. Basically, anything about the business that makes its earnings less certain or more unstable qualifies as operating risk. Price risk has more to do with the stock than with the business. There are different ways to look for price risk, but probably the most common is comparing a stock's valuation measures, such as its price/earnings or price/book ratio, against that of the industry, the market, or any other index that will yield a meaningful comparison. A stock with comparatively high multiples carries more price risk than one with lower multiples. When looking at a stock, it is a good idea to figure out how its operating risk balances its price risk. To see why that might be important, imagine a company in a turnaround situation--that is, one that carries a fair amount of operating risk. If the stock is expensive, you may not be interested because much of the potential improvement in earnings is already figured into the price. And if those earnings don't materialize, chances are good that the stock will tank. But if the stock is cheap, you might be inclined to take a chance on those theoretical and risky future earnings. The upside potential is great if the company comes through, and the downside risk--or price risk--is comparatively limited. It is helpful to visualize the balance between operating risk and price risk as a four-box matrix, with stocks fitting into one of four categories: low operating risk and high price risk, high operating risk and low price risk, low operating risk and low price risk, and high operating risk and high price risk.

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