equity chapter2

7/27/2019 Equity Chapter2

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RETURN CONCEPTS

PresenterVenueDate


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WHY FOCUS ON RETURN CONCEPTS?

To evaluate expectedand past performance

To understand riskpremiums

To estimate discountrates for valuation


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HOLDING PERIOD RETURN

0

0

0 0

1H H

HH

D Pr

P

P PDrP P


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OTHER RETURN CONCEPTS

RequiredReturn

Return fromConvergence

of Price toIntrinsicValue

DiscountRate

Internal Rateof Return


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EQUITY RISK PREMIUM

Currentexpectedrisk-freereturn

Equityrisk

premium

Requiredreturn on

equity


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EQUITY RISK PREMIUM ESTIMATES

Historical Estimates

Forward-Looking Estimates

-Gordon growth model estimates

-Macroeconomic model estimates

-Survey estimates


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ISSUES FOR USING HISTORICAL EQUITY

RISK PREMIUM ESTIMATES

Length of Sample Period

- Balancing long-term and short-term considerations

Geometric vs. Arithmetic Mean

- Geometric more accurately reflects future value

Choice of Risk-Free Return

- On-the-run long-term Treasuries

Survivorship Bias

- Using returns from surviving firms artificially inflates estimates of return

Strings of Unusual Events


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HISTORICAL EQUITY RISK PREMIUM ESTIMATES

1

4

1

6

4

1

1% to

2%

2% to

3%

3% to

4%

4% to

5%

5% to

6%

6% to

7%

NumberofMarkets

Equity Risk Premiums


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FORWARD-LOOKING EQUITY


Gordongrowth

model riskpremium

Dividendyield

Earningsgrowth rate

Governmentbond yield


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FORWARD-LOOKING EQUITY


Macroeconomic Model Equity Risk Premium (ERP)

ERP (1 EINFL)(1 EGREPS)(1 EGPE) 1 EINC F

R


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EXAMPLE:

FORWARD-LOOKING EQUITY RISK PREMIUM

Yield on treasury bonds 3.8%

Yield on Treasury inflation-protected securities 1.8%

Expected growth in labor productivity 1.5%

Expected growth in labor supply 1.0%

Expected growth in the P/E 0.0%

Expected dividend yield 2.7%

Return from reinvestment of income 0.1%


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EXAMPLE:


1 Treasury Bond YieldExpected Inflation

1 TIPS Yield

1 0.038Expected Inflation 1 2.0%

1 0.018


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EXAMPLE:


Real earnings growth Labor productivity Labor supply growth

1.5% 1.0%

2.5%

Expected income Dividend yield Reinvestment return

2.7% 0.1%

2.8%


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EXAMPLE:


Macroeconomic model equity risk premium

=

ERP (1 EINFL)(1 EGREPS)(1 EGPE) 1 EINC

(1 0.02)(1 0.025)(1 0) 1.0 0.028 0.038

3.5%

F

R


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ESTIMATING THE REQUIRED RETURN ON

AN EQUITY INVESTMENT

Capital Asset PricingModel

Multifactor Models FamaFrench model

PastorStambaugh model

Macroeconomic models

Statistical models

Build-Up Method


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CAPITAL ASSET PRICING MODEL

(CAPM)

Where

- E(Ri) = Required return on equity for security i

- RF= Current expected risk-free return

- i= Beta of security i

- E(RM) = Expected return on the market portfolio

- E(RM)RF= Equity risk premium

Assumptions- Investors are risk averse

- Investment is based on meanvariance optimization

- Relevant risk is systematic risk

( ) [ ( ) ], i F i M F E R R E R R


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BETA ESTIMATION ISSUES

S&P 500 and NYSE Composite arecommon choices in the United States

Choice of MarketIndex

Five years of monthly data is mostcommon choice

Length &Frequency of Data

Betas move towards 1.0 over timeAdjusted Betas

Adjust comparable betas for leverageThinly Traded andPrivate Firms


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MULTIFACTOR MODELS:

FAMAFRENCH MODEL

Required

Returnon

Equity

ValuePremium

SizePremium

MarketRisk

Premium

Risk-Free

Return


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FAMAFRENCH MODEL

where- SMB = The return to small stocks minus the return to large stocks

-size= The sensitivity of security ito movements in small stocks

- HML = The return to value stocks minus the return to growth stocks

- value= The sensitivity of security ito movements in value stocks

PASTORSTAMBAUGH MODEL

where

- LIQ = The return to illiquid stocks minus the return to liquid stocks

- liq= The sensitivity of security ito movements in illiquid stocks

mkt size value RMRF SMB HML, i F i i i

r R

mkt size value liq RMRF SMB HML LIQ, i F i i i i

r R


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EXAMPLE:

FAMAFRENCH MODEL

Risk-free rate 3.0%

Equity risk premium 5.0%

Beta 1.20

Size premium 2.2%

Size beta 0.12

Value premium 3.8%

Value beta 0.34


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EXAMPLE:

FAMAFRENCH MODEL

mkt size value RMRF SMB HML

3% 1.20(5%) 0.12(2.2%) 0.34(3.8%)10.56%

i F i i ir R


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BUILD-UP METHODS

For Private Firms

- Typical risk premiums

- size

- firm-specific risk

- Other risk premiums

- marketability

- control

Bond Yield plus RiskPremium Method

- Useful if firm has publicdebt

- YTM on long-term debt +risk premium

Required Returnon Equity

Risk-FreeRate

Equity

RiskPremium

Other

RiskPremiums

Other

RiskDiscounts


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INTERNATIONAL CONSIDERATIONS FOR

REQUIRED RETURNS

Exchange Rates

Emerging Markets

Country spread model

Country risk ratingmodel


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WEIGHTED AVERAGE COST OF CAPITAL

WeightedAverage

Cost of Capital

Debt

Cost of DebtMarket Value

of DebtTax Rate

Equity

Cost of EquityMarket Value

of Equity


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Where- MVD = Current market value of debt

- MVCE = Current market value of common equity

- rd= Before-tax cost of debt (which is transformed into the after-tax cost by

multiplying it by 1Tax rate)

- re= Cost of equity

MVD MVCE(1 Tax Rate) ,

MVD MVCE MVD MVCE

d e

r r


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EXAMPLE:


Risk-free rate 3 .0%

Equity risk premium 5 .0%

Beta 1 .20

YTM of long-term bond 6 .1%

Long-term debt/Total capital at market value 40 %

Tax rate 30 %


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EXAMPLE: WEIGHTED AVERAGE COST OF

CAPITAL

MVD MVCEWACC (1 Tax Rate)MVD MVCE MVD MVCE

0.40(6.1%)(1 0.30) 0.60(9.0%)7.11%

d er r

[ ( ) ]3% 1.2(5%) 9.0%

e F i m F

e

r R E R R

r


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CHOICE OF DISCOUNT RATE

WACCCash Flowsto the Firm

Required return on equityCash Flows

to Equity

Nominal discount ratesNominal

Cash Flows

Real discount ratesReal CashFlows


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SUMMARY

Holding period return, realized return, expected return,required return, discount rate, return from convergence ofprice to intrinsic value, and IRR

Return Concepts

= Required return on equityRisk-free return

Historical estimates

Issues in estimation: Sample period length, geometric vs.

arithmetic mean, risk-free return choice, survivorship bias,strings of unusual events

Forward-looking estimates: Gordon growth model estimates,macroeconomic model estimates, survey estimates

Equity Risk Premium


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SUMMARY

Capital asset pricing model

Multifactor models

FamaFrench model

PastorStambaugh model

Macroeconomic models

Statistical models Build-up method

Models for the Required Return on Equity

Choice of market index Length and frequency of data

Adjusted betas

Thinly traded and private firms

Beta Estimation Issues


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SUMMARY

Exchange rates

Emerging markets

International Considerations for Required

Returns

Use market values, marginal tax rates, current bond YTM,and equity required return

Weighted Average Cost of Capital

Use WACC for firm cash flows

Use equity required return for equity cash flows

Use nominal rates for nominal cash flows

Choice of Discount Rate

equity chapter2

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