Business risk is the risk inherent in the operation of the business, which, apprently is the riskiness of the stock.
It does not depend, in any way, in the chart of the stock performance. I am sorry to the technical investors! You may say, ‘then why do stock go up after the cup-sign in the chart?’ Because you find out (or assume) the cup-sign after the stock goes up, not before!
Anyway, a firm’s business risk arises because of uncertainty associated with projection of return on invested capital.
Return on investment varies due to the number of factors such as variability in demand, the price of the product and cost of inputs, general economic condition, availability of the human resources, competency of managers, competition and so on.
Business risk is also called operating risk.
Therefore, business risk is popularly measured by its operating income. The stable the operating income over the period indicates a stable business risk. The firm’s business risk changes over time and it varies from firm to firm.
Some determinants of business risk are:
- Demand Volatility
- Selling Price Volatility
- Input Costs Volatility
- Efficiency of Price Adjustment
- Technological Changes
- Level of Fixed Operating Costs
Other biggest risks are legal issues and government regulations.
Below is the risk listed by Facebook Inc (2019 10K). Some are generic risks. It is obvious to understand that Facebook stock is risky because of the following reasons.
(If you don’t have time to read all, just read 1,2,3,13 and 14 (Bolded) you will get a feel of why the Facebook stock is risky)
- If we fail to retain existing users or add new users, or if our users decrease their level of engagement with our products, our revenue, financial results, and business may be significantly harmed.
- We generate substantially all of our revenue from advertising. The loss of marketers, or reduction in spending by marketers, could seriously harm our business.
- Our user growth, engagement, and monetization on mobile devices depend upon effective operation with mobile operating systems, networks, technologies, products, and standards that we do not control.
- Our business is highly competitive. Competition presents an ongoing threat to the success of our business.
- Actions by governments that restrict access to Facebook or our other products in their countries, or that otherwise impair our ability to sell advertising in their countries, could substantially harm our business and financial results.
- Our new products and changes to existing products could fail to attract or retain users or generate revenue and profits.
- We make product and investment decisions that may not prioritize short-term financial results and may not produce the long-term benefits that we expect.
- If we are not able to maintain and enhance our brands, our ability to expand our base of users, marketers, and developers may be impaired, and our business and financial results may be harmed.
- Security breaches and improper access to or disclosure of our data or user data, or other hacking and phishing attacks on our systems, could harm our reputation and adversely affect our business.
- We anticipate that our ongoing investments in safety, security, and content review will identify additional instances of misuse of user data or other undesirable activity by third parties on our platform.
- Unfavorable media coverage could negatively affect our business.
- Our financial results will fluctuate from quarter to quarter and are difficult to predict.
- We expect our rates of growth to decline in the future.
- Our costs are continuing to grow, which could reduce our operating margin and profitability. If our investments are not successful, our business and financial performance could be harmed.
- Given our levels of share-based compensation, our tax rate may vary significantly depending on our stock price.
- Our business is subject to complex and evolving U.S. and foreign laws and regulations regarding privacy, data protection, content, competition, consumer protection, and other matters. Many of these laws and regulations are subject to change and uncertain interpretation, and could result in claims, changes to our business practices, monetary penalties, increased cost of operations, or declines in user growth or engagement, or otherwise harm our business.
- We have been subject to regulatory and other government investigations, enforcement actions, and settlements, and we expect to continue to be subject to such proceedings and other inquiries in the future, which could cause us to incur substantial costs or require us to change our business practices in a manner materially adverse to our business.
- If we are unable to protect our intellectual property, the value of our brands and other intangible assets may be diminished, and our business may be adversely affected.
- We are currently, and expect to be in the future, party to patent lawsuits and other intellectual property rights claims that are expensive and time consuming and, if resolved adversely, could have a significant impact on our business, financial condition, or results of operations.
- We are involved in numerous class action lawsuits and other litigation matters that are expensive and time consuming, and, if resolved adversely, could harm our business, financial condition, or results of operations.
- We may incur liability as a result of information retrieved from or transmitted over the Internet or published using our products or as a result of claims related to our products.
- Our CEO has control over key decision making as a result of his control of a majority of the voting power of our outstanding capital stock.
- We plan to continue to make acquisitions, which could harm our financial condition or results of operations and may adversely affect the price of our common stock.
- We may not be able to successfully integrate our acquisitions, and we may incur significant costs to integrate and support the companies we acquire.
- If our goodwill or finite-lived intangible assets become impaired, we may be required to record a significant charge to earnings.
- Our business is dependent on our ability to maintain and scale our technical infrastructure, and any significant disruption in our service could damage our reputation, result in a potential loss of users and engagement, and adversely affect our financial results.
- We could experience unforeseen difficulties in building and operating key portions of our technical infrastructure.
- Our products and internal systems rely on software that is highly technical, and if it contains undetected errors or vulnerabilities, our business could be adversely affected.
- Technologies have been developed that can block the display of our ads, which could adversely affect our financial results
- Real or perceived inaccuracies in our user and other metrics may harm our reputation and negatively affect our business.
- We cannot assure you that we will effectively manage our growth.
- The loss of one or more of our key personnel, or our failure to attract and retain other highly qualified personnel in the future, could harm our business.
- We may not be able to continue to successfully maintain or grow usage of and engagement with mobile and web applications that integrate with Facebook and our other products.
- Payment transactions may subject us to additional regulatory requirements and other risks that could be costly and difficult to comply with or that could harm our business.
- We have significant international operations and plan to continue expanding our operations abroad where we have more limited operating experience, and this may subject us to increased business and economic risks that could affect our financial results.
- We face design, manufacturing, and supply chain risks that, if not properly managed, could adversely impact our financial results.
- We may face inventory risk with respect to our consumer hardware products.
- We may have exposure to greater than anticipated tax liabilities.
- Changes in tax laws or tax rulings could materially affect our financial position, results of operations, and cash flows.
- We cannot guarantee that our share repurchase program will be fully consummated or that it will enhance long-term stockholder value. Share repurchases could also increase the volatility of the trading price of our stock and will diminish our cash reserves.
If you have managed to come this far, congratulation! You are an excellent reader.
As Warren Buffett says all the time, “It is necessary to think stock as a business and not just the ticker sign”. I had to force myself to divert myself from the feeling of the ticker sign. Let me tell you, I am still not good at it.
It’s hard to understand business and the underline business risk. If you are good at it, you surely will be a better investor. Nevertheless, don’t stop trying to understand it.