Presenter
Venue
Date
DH PH
r
1
P0
DH PH P0
r
P0
P0
Historical Estimates
Forward-Looking Estimates
- Gordon growth model estimates
- Macroeconomic model estimates
- Survey estimates
2
1
FORWARD-LOOKING EQUITY
RISK PREMIUM ESTIMATES
FORWARD-LOOKING EQUITY
RISK PREMIUM ESTIMATES
Macroeconomic Model Equity Risk Premium (ERP)
EXAMPLE:
FORWARD-LOOKING EQUITY RISK PREMIUM
3.8%
Yield on TIPS
1.8%
1.5%
1.0%
0.0%
2.7%
0.1%
EXAMPLE:
FORWARD-LOOKING EQUITY RISK PREMIUM
EXAMPLE:
FORWARD-LOOKING EQUITY RISK PREMIUM
EXAMPLE:
FORWARD-LOOKING EQUITY RISK PREMIUM
E ( Ri )[RF( )i E RM], RF
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
Adjusted Betas
MULTIFACTOR MODELS:
FAMAFRENCH MODEL
Market
Risk
Premium
RiskFree
Return
Size
Premium
Required
Return
on
Equity
Value
Premium
FAMAFRENCH MODEL
ri RF imkt RMRF isizeSMB ivalue HML,
where
- SMB = The return to small stocks minus the return to large stocks
- size = The sensitivity of security i to movements in small stocks
- HML = The return to value stocks minus the return to growth stocks
- value = The sensitivity of security i to movements in value stocks
PASTORSTAMBAUGH MODEL
ri RF imkt RMRF isizeSMB ivalue HML liq
i LIQ,
where
- LIQ = The return to illiquid stocks minus the return to liquid stocks
- liq = The sensitivity of security i to movements in illiquid stocks
EXAMPLE:
FAMAFRENCH MODEL
Risk-free rate
3.0%
5.0%
Beta
1.20
Size premium
2.2%
Size beta
0.12
Value premium
3.8%
Value beta
0.34
EXAMPLE:
FAMAFRENCH MODEL
ri RF RMRF SMB
mkt
i
size
i
value
i
HML
BUILD-UP METHODS
Required Return
on Equity
Risk-Free
Rate
Equity
Risk
Premium
Other
Risk
Premiums
Other
Risk
Discounts
EXAMPLE:
WEIGHTED AVERAGE COST OF CAPITAL
Risk-free rate
3.0%
5.0%
Beta
1.20
6.1%
40%
Tax rate
30%
SUMMARY
SUMMARY
Models for the Required Return on Equity
Capital asset pricing model (CAPM)
Multifactor models
FamaFrench model
PastorStambaugh model
Macroeconomic models
Statistical models
Build-up method
SUMMARY
International Considerations for Required
Returns
Exchange rates
Emerging markets
Weighted Average Cost of Capital
Use market values, marginal tax rates, current bond YTM,
and equity required return
Choice of Discount Rate
Use WACC for firm cash flows
Use equity required return for equity cash flows
Use nominal rates for nominal cash flows