gcc equity risk premium - gulfbase · 2 aswath damodaran the simplest way to compute erp is to...

Kuwait Financial Centre “Markaz” R E S E A R C H

GCC Sovereign Equity Risk Premium A Search for the Elusive Proxy Number

Valuation in emerging markets is mostly considered as a futile exercise due

to several difficulties which include data availability, regulatory & political

risks, and a totally different capital market in terms of efficiency, liquidity,

and participants. Due to the absence of financial models developed

specifically for emerging markets, models which work in the West are

adopted in the developing countries as well. One key input in such models

is the Cost of Equity which is arrived at using the Equity risk premium

(ERP).

Equity risk premium is the extra return that investors collectively demand

for investing in stocks instead of holding it in a risk less investment. Equity

risk premiums are a central component of every risk and return model in

finance and are a key input into estimating costs of equity and capital in

both corporate finance and valuation1.

Credit Suisse Research Institute compiles historical equity risk premium

from the year 1900 to 2011 for 19 markets across the world. Due to the

volatile nature of equities, historical returns are not a reliable measure of

equity risk premiums. It becomes doubly challenging in emerging markets

where such a long history is not available. The challenge for GCC is all the

more glaring in the absence of a yield curve.

This note is an attempt to contemplate different ways of calculating equity

risk premium for GCC markets which can be used in valuation and capital

budgeting. We acknowledge that each of the methods discussed in the

report has its own merits & demerits, and there is no foolproof method to

find out equity risk premium. The method to be practiced depends really on

the purpose and availability of data points. We intend to have this report

updated on a quarterly basis so that regional investors are kept informed

about the changing market dynamics.

Equity Risk Premium for GCC Countries

Country

ERP based on Rating

Spreads

ERP based on

CDS Spreads

Implied ERP based on

Stock Indices

Bahrain 7.6% 9.1% 7.6%

Kuwait 6.6% NA 7.8%

Oman 7.0% 7.8% 8.1%

Qatar 6.6% 6.8% 7.1%

Saudi Arabia 6.8% 6.8% 7.4%

Abu Dhabi 6.6% 6.8% 8.0%

Dubai NA 6.8% 6.8% Source: Markaz Research

1 Aswath Damodaran - Equity Risk Premium Report

October 2012

Markaz Research is available on

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M.R. Raghu CFA, FRM

Head of Research +965 2224 8280

[email protected]

Kuwait Financial Centre S.A.K. “Markaz”

P.O. Box 23444, Safat 13095, Kuwait

Tel: +965 2224 8000 Fax: +965 2242 5828

markaz.com

mailto:[email protected]

MARKAZ RESEARCH October 2012

Kuwait Financial Centre “Markaz”

2

Equity Risk Premium - Findings

The simplest way to compute Equity risk premium is to calculate the actual

long term returns earned by the country‟s stocks over risk free investments

(probably Sovereign bonds). At first sight, this calculation seems easy. But

the method has inherent problems (discussed below) especially for markets

like the GCC.

Not all GCC countries have instruments which can be considered risk

free. This is either because sovereign bonds were not issued (Ex.

Kuwait) or because governments may have default risk (Ex. Dubai).

Most GCC indices are still below their levels reached in 2004 implying

negative historical equity returns for an 8 year period. And even if

returns improve, the risk premiums may not be large enough to reflect

the true picture accounting for volatility of the regional equities.

The oldest stock market in the GCC was established a little more than

30 years ago (Kuwait) and the recent one (UAE) being only 12 years

old. Almost all GCC exchanges are still undergoing a lot of

transformation in terms of regulations, trading platforms, instrument

availability, and corporate disclosures. This coupled with nascent

secondary market for bonds will make the risk premiums calculated with

historical numbers inaccurate.

Equity markets are volatile and risk premiums calculated with short

historical data experience significant estimation errors

Estimating ERP using Default Spreads

Method 1 - Sovereign Rating: Taking the latest US market equity risk

premium of 6.1%2, the ERP of GCC countries are arrived at by adding the

default spread based on their credit rating.

ERP for GCC Countries based on Credit Rating

Country Rating Total Equity Risk Premium

Bahrain Baa1 7.6%

Kuwait Aa2 6.6%

Oman A1 7.0%

Qatar Aa2 6.6%

Saudi Arabia Aa3 6.8%

Abu Dhabi Aa2 6.6% Source: Moody‟s, Aswath Damodaran, Markaz Research

Method 2 – Estimating ERP using CDS spreads: Rating agencies are

generally considered to be slow in updating their ratings. So, instead of

arriving at default spread based on rating, we can use CDS spreads as a

proxy. In this method, the CDS spread of a country‟s bond (adjusted for

spread of risk free country) is considered as default spread instead of

looking at the yield differentials of similarly rated bonds.

2 Aswath Damodaran

The simplest way to compute ERP is to

calculate the long term returns earned

by stocks over risk

free investments

Not all GCC

countries have

instruments which can be considered

risk free



3

ERP for GCC Countries based on CDS Spread

Country

5Yr

CDS

Adjusted

CDS

Total Equity Risk

Premium

Bahrain 3.5% 3.0% 9.1%

Oman 2.2% 1.7% 7.8%

Qatar 1.2% 0.7% 6.8%

Saudi Arabia 1.1% 0.7% 6.8%

Abu Dhabi 1.1% 0.7% 6.8%

Dubai 3.4% 2.9% 9.0%

United States 0.5%

Source: Thomson Reuters Eikon, Markaz Research

Note: Refer Methodology section for explanation

Method 3: Implied Equity Risk Premium

Implied equity risk premium is an alternative approach to estimating risk

premiums. Assuming that stocks are correctly priced in, if we can estimate

the expected cash flows from buying stocks, then we can estimate the

expected rate of return on stocks by computing an internal rate of return

(IRR). Subtracting out the risk free rate from IRR should yield an implied

equity risk premium.

The inputs required for calculation of Implied ERP were not readily available

for GCC countries. Absence of sovereign bonds for some countries made the

estimation of risk free rate and perpetual growth rate difficult. Also, the lack

of consensus earnings growth estimate makes it hard to determine the

market‟s view on growth for the next 5 years.

Implied Risk Premium for GCC Countries

Country Index Level* Implied Equity Risk Premium

Saudi Arabia 6,952 7.36%

Kuwait 5,724 7.81%

Qatar 8,332 7.08%

Abu Dhabi 2,508 8.04%

Dubai 1,551 6.79%

Oman 5,465 8.11%

Bahrain 1,098 7.64% Source: Thomson Reuters Eikon, Zawya, Markaz Research * As of 04-Aug-2012

Implied equity risk

premium is an alternative approach

to estimating risk premiums

Inputs required for calculation of Implied

ERP were not readily

available for GCC countries.



4

Concepts & Methodology

Weighted Average Cost of Capital (WACC)

Normally a company‟s assets are financed by debt or equity or a

combination of both. WACC is the company's cost in which, every source of

capital is weighted in proportion to how much capital it contributes to the

company.

A firm's WACC gives an idea about the overall return that the firm as a

whole needs to generate in order to pay its sources of capital. Hence, this is

normally the hurdle rate which is used by the company‟s management for

capital budgeting decisions. WACC is also used for discounting the firm‟s

cash flows so as to arrive at the firm‟s overall value.

For a company with only debt and equity funding, WACC will be calculated

as

WACC = (After Tax Cost of Debt * (Debt/(Debt + Equity))) + (Cost

of Equity (Equity/(Debt + Equity)))

In the above equation, practitioners normally use the terms „Cost of Equity‟

and „Required Return to Equity‟ interchangeably. Although there is a subtle

difference between the terms, it is usually computed using the Capital Asset

Pricing Model (CAPM)

Capital Asset Pricing Model (CAPM)

CAPM is often used to theoretically determine the required rate of return or

cost of equity. While CAPM is often criticized for its assumptions and flaws,

it is still the most widely used model for calculating cost of equity.

Cost of Equity = Risk free Rate + Equity Beta * (Equity Risk

Premium)

Government bond yields are used as risk free rates

Historical risk premiums are used for Equity risk premium

Beta is estimated by regressing stock returns against market returns

Risk Free Rate

On a risk free asset, the actual return should be the same as expected

return. Usually government bond rates are used as risk free rates but not all

government securities are risk free. Some governments face default risk

and hence their bonds are priced so as to include the default risk premium.

In such cases, we need to negate out the effect of default risk premium to

find out the local currency risk free rate.

CAPM is used to

theoretically determine the required rate of

return or cost of equity

Usually government

bond rates are used as

risk free rates but not all government bonds

are risk free



5

Calculating Risk Free Rate

Beta

Beta is a measure of a company‟s systematic risk (non-diversifiable risk). It

is often computed by regressing stock returns against market returns.

Usually, the most followed equity market index is used as a proxy for

market returns. Beta is easily available from most database providers.

Beta is difficult to calculate for emerging market companies where the

market is illiquid and often lacks depth. Restrictions on historical data also

pose a problem.

One way to mitigate the errors in beta computation is to take the global

industry beta based on the firm‟s business and adjust it according to firm‟s

operating leverage and capital structure.

Equity Risk Premium

Equity risk premium is the extra return that investors collectively demand

for investing in stocks instead of holding it in a risk less investment. To put

it differently, equity risk premium reflects what investors expect to earn on

equities over and above the risk free rate.

Equity risk premium (ERP) is one of the most important factor in any

investment decision and yet it is the most elusive as well. The reasons

being – practitioners use different methods for calculating ERP, it is affected

by investor sentiments which are not always rational and there is an

element of approximation especially for emerging market countries due to

problems of data availability. Pablo Fernandez reviewed 150 textbooks on

corporate finance and valuation and noted that equity risk premiums varied

widely across books from 3% to 10%3.

Equity risk premium can be determined based on either historical data,

assuming that the future will be like the past or by using estimates that

attempt to forecast the future. Both methods have their proponents and

critics.

3 Pablo Fernandez, 2010, The Equity Premium in 150 Textbooks

Beta is a measure of a company‟s systematic

risk (non-diversifiable risk)

Equity risk premium is

the extra return that investors demand for

investing in stocks instead of holding it in

a risk less investment



6

Equity Risk Premium – Uses

Equity risk premium finds usage in several important steps of investing. ERP

ascertains the expected return on all risky investments and consequently

affects the value of those investments.

At a broader level, ERP is used in asset allocation decisions to determine

how much of the portfolio is allocated to different asset classes. ERP is also

used to determine how much is allocated to various geographies.

After narrowing down on asset allocation, risk premiums come into play for

valuing individual companies. The most common method for valuing

financial assets is to discount the expected cash flows from the asset to

determine its present value. Since the expected cash flows carry some risk,

the discount rate is adjusted to account for the risk. ERP is an important

component of the determining the discount rate. When investors perceive

higher risk, equity risk premiums rise, and will therefore lead to lower

prices.

Equity risk premium also plays a part in capital budgeting decisions. The

worthiness of a new investment / expansion is determined by whether the

project can generate higher returns than the cost that is attached to the

invested capital. Equity risk premium moves the cost of equity and cost of

capital which are used for project evaluations.

Corporations and governments set aside contributions for future pension

and health care obligations based on their expectations of equity market

returns. Assuming a higher equity risk premium will lead to smaller amounts

being set aside to cover future obligations and vice versa.

Country Risk Premium

Doing valuation in emerging markets is a bit difficult as investors have to

deal with additional risks which include macroeconomic volatility, capital

controls, regulatory changes, and political risks. There are two ways in

which these emerging market risks can be captured while valuing

companies or evaluating projects. The first is to incorporate the risks in cash

flow projections and the other is to add the extra risk premium to the

discount rate.

There are arguments favouring both the methods and selecting which one

to use really depends on the purpose and availability of data points.

Arguments FOR adjusting cash flows:

1. The basic argument against adding country risk premium to the

discount rate is that country risks are diversifiable and theory indicates

that the cost of capital should reflect only non-diversifiable risk. So by

holding a geographically diversified portfolio, country risks can be

eliminated. Also, diversifiable risks are better handled in cash flows.

ERP is used in asset allocation decisions to

determine how much

is allocated to different asset classes

Equity risk premium

also plays a part in capital budgeting

decisions



7

2. Many risks in a country don‟t apply equally to all the industries in that

country. So using the same country risk premium for all the companies

in a country leads to incorrect valuations.

Arguments AGAINST adjusting cash flows:

1. Geographical diversification might reduce some country specific risk but

as correlation between markets increase, country risk becomes non-

diversifiable and can hence command a premium.

2. Accounting for country risk in the cash flows through probability-

weighted scenarios may be difficult to do because many of the risks are

not quantifiable and hence requires a lot of qualitative inputs. It is hard

for someone doing valuation to estimate GDP growth, inflation, forex

rates etc and assign probabilities so as to find out its effect on the

company‟s cash flows. There is also a problem of accounting for low

probability, high impact „Black Swan‟ events.

Estimating ERP using Default Spreads

In this section, we will discuss about computing equity risk premium using

the country default spreads, for markets which have data limitations. This

method keeps the mature market premium (say US) as a base, and then

augments it by adding a country risk premium (default spread) for the

country.

ERP Emerging market = ERP Mature market + Country risk premium

That country risk premium can be computed using the following methods:

Dollar denominated sovereign bond: If a country has a US dollar

denominated bond, then the bond‟s spread over US treasuries will give an

indication about the country‟s default risk.

Sovereign Rating: If the country doesn‟t have a USD denominated bond,

then the default spread can be estimated from the country‟s sovereign

rating. Using similarly rated countries as a proxy; we can get the spread of

the proxy country‟s dollar denominated bond (against US Treasuries) and

use it as an approximate measure of country risk.

The pitfall with this method is that:

1. Rating agencies are generally considered to be slow in updating their

ratings.

2. Using credit risk of a country as a proxy for the risk faced by equity

investors overlooks the fact that equity investments can often be more

risky than bonds.

CDS spreads: The inaccuracy caused due to delayed rating action can be

rectified using the country‟s CDS spread as a proxy for default risk. Credit

default swap market allows one to buy insurance against default risk of the

bond. The values are market-driven and current thus reflecting a more

accurate picture. Taking the CDS spread of the country in question and

Emerging market

investors have to deal with additional risks

while doing valuation

There are two ways in

which emerging market risks can be

captured while valuing

companies



8

adjusting it with the CDS spread of a country like US or Germany will give

us the default risk specific to that country.

The problem of credit risk not being a good indicator of riskiness of a

country‟s equities can be tackled by multiplying the default spread of a

country by relative volatility of equities over bonds.

Adjusted Default Spread

= Default Spread

X S.D. of Country's Equities

S.D. of Country's Bonds

S.D. = Standard Deviation

Implied Equity Risk Premium

Implied equity risk premium is an alternative approach to estimating risk

premiums that does not require historical data or corrections for country

risk but assumes that the market, overall, is correctly priced.

If we assume that stocks are correctly priced in and if we can estimate the

expected cash flows from buying stocks, then we can estimate the expected

rate of return on stocks by computing an internal rate of return. Subtracting

out the risk free rate should yield an implied equity risk premium.

We can use a simple one stage dividend discount model or can extend the

model to allow for dividends to grow at high rates for short periods and

then make assumptions for perpetual growth rate.

The advantage of implied premium approach is that it is market-driven and

current, and it does not really require historical data except for making

estimates about the future.

Implied ERP - Methodology & Calculation

Average dividend yield over the last 7 years was considered for

calculations.

Yield on 10 year government bonds adjusted for default risk is taken as

risk free rate. For countries without sovereign bonds, yield on quasi-

sovereign issues or yield of countries with similar credit rating is

considered as a proxy for arriving at risk free rate.

Expected growth rate over the next 5 years is computed by a

combination of earnings growth over the last few years and our

expectations for the next 5 years.

Perpetual growth rate is deduced using IMF‟s growth forecast, interest

rate and our assessment of the economy.

Let us consider the following information for the Saudi Arabian market:

TASI index level = 6,952

Dividend Yield = DY%

Expected dividend growth rate for next 5 years = 17.6%

Expected perpetual growth rate = 4%

Local currency risk free rate = 2.4%

Implied equity risk

premium approach assumes that stocks

are correctly priced in

The advantage of

implied premium approach is that it is

market-driven and

current



9

Solving for R, we get R = 9.8%

Implied Risk Premium = 7.4% = (9.8% – 2.4%)

D1 D2 D3 D4 D5 D5 /(R - 0.04)

(1+R) (1+R)2 (1+R)3 (1+R)4 (1+R)5 (1+R)56952



10

Appendix 1: Historical Risk Premiums - Premium vs Bonds (% p.a.)

Country 2002–2011 1987–2011 1962–2011 1900–2011

Australia -1.2 -1.7 2.8 5.6

Belgium -5.4 -1.2 0.6 2.5

Canada -1.8 -1.5 0.8 3.4

Denmark -0.9 -0.4 0.2 1.6

Finland -7.4 1.5 3.8 5.2

France -5.7 -2.0 -1.6 3.0

Germany -5.0 -2.0 -0.5 5.1

Ireland -6.7 -1.3 3.0 2.8

Italy -6.3 -5.2 -2.5 3.5

Japan -4.9 -7.3 -2.3 4.7

Netherlands -6.9 0.7 2.8 3.3

New Zealand -2.0 -7.1 2.0 3.6

Norway 2.5 0.8 2.2 2.2

South Africa 3.9 0.7 6.5 5.3

Spain 0.7 1.7 2.6 2.1

Sweden -1.1 0.9 4.1 3.5

Switzerland -3.3 1.5 1.0 1.9

U.K. -2.4 -0.6 2.7 3.6

U.S. -4.7 0.2 1.7 4.1

World-ex U.S. -4.5 -1.9 0.4 3.5

World -3.5 -3.1 -0.1 3.5

Europe -3.9 -0.7 0.6 3.7 Source: Credit Suisse Global Investment Returns Yearbook 2012



11

Appendix 2: Market Risk Premium used for 82 countries – Survey Results

Source: Fernandez et al (2012) - Market Risk Premium used in 82 countries in 2012: a survey with 7,192 answers

Country Average Median

Number of

answers Country Average Median

Number of

answers

USA 5.5 5.4 2,223 Pakistan 9.5 9.5 24

Spain 6.0 5.5 958 Egypt 9.2 8.0 23

Germany 5.5 5.0 281 Singapore 6.0 5.7 23

United Kingdom 5.5 5.0 171 Thailand 8.1 8.1 22

Italy 5.6 5.5 120 Malaysia 5.9 6.4 21

Canada 5.4 5.5 94 Saudi Arabia 6.5 6.5 21

Mexico 7.5 6.8 87 Kazakhstan 7.5 8.0 20

Brazil 7.9 7.0 86 Philippines 7.4 6.1 18

France 5.9 6.0 85 Kuwait 6.8 6.6 17

China 8.7 7.1 82 Nigeria 10.1 8.5 17

Australia 5.9 6.0 73 Romania 7.7 8.0 17

South Africa 6.5 6.0 73 UAE 8.0 8.0 17

Netherlands 5.4 5.5 72 Ecuador 13.5 15.9 16

Russia 7.6 7.0 70 Bahrain 7.3 8.3 14

Switzerland 5.4 5.3 68 Croatia 7.8 9.0 14

India 8.0 8.0 66 Oman 6.6 7.3 14

Chile 6.1 5.6 63 Bulgaria 8.3 8.6 13

Norway 5.8 5.5 58 Qatar 7.1 7.0 13

Sweden 5.9 6.0 58 Bolivia 10.2 10.5 12

Austria 5.7 6.0 57 Lebanon 9.0 9.0 12

Colombia 7.9 7.5 57 Morocco 7.3 7.3 12

Belgium 6.0 6.0 54 Senegal 11.0 11.0 12

Portugal 7.2 6.5 53 Vietnam 10.8 12.0 12

Argentina 10.9 10.0 50 Panama 9.2 9.0 11

Greece 9.6 7.4 47 Venezuela 12.2 12.0 11

Poland 6.4 6.0 45 Malta 6.6 7.5 10

Denmark 5.5 5.0 43 Slovenia 6.5 7.3 10

Japan 5.5 5.0 41 Zimbabwe 10.5 12.5 10

Peru 8.1 8.0 41 Costa Rica 8.5 9.0 9

New Zealand 6.2 6.0 40 Cyprus 7.9 9.0 9

Czech Republic 6.8 7.0 38 Iran 17.2 19.5 9

Finland 6.0 6.0 37 Kenya 6.2 7.0 9

Turkey 8.4 9.0 37 Slovakia 6.9 7.3 9

Luxembourg 6.0 6.0 35 Uruguay 9.3 9.6 9

Taiwan 7.7 7.1 32 Zambia 7.2 7.0 9

Ireland 6.6 6.0 31 Albania 11.1 12.0 8

Israel 6.0 5.8 30 Trinidad&Tobago 9.8 8.3 8

Korea (South) 6.7 7.3 30 Guatemala 10.1 9.6 7

Indonesia 8.1 8.0 28 Honduras 13.9 13.5 7

Hungary 7.4 7.0 26 Lituania 7.9 8.3 7

Hong Kong 6.4 6.2 24 Ghana 9.6 10.0 5



12

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