return concepts presenter venue date. why focus on return concepts? to evaluate expected and past...
TRANSCRIPT
![Page 1: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/1.jpg)
RETURN CONCEPTS
PresenterVenueDate
![Page 2: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/2.jpg)
WHY FOCUS ON RETURN CONCEPTS?
To evaluate expected and past performance
To understand risk premiums
To estimate discount rates for valuation
![Page 3: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/3.jpg)
HOLDING PERIOD RETURN
0
0
0 0
1H H
HH
D Pr
P
P PDr
P P
![Page 4: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/4.jpg)
OTHER RETURN CONCEPTS
Required Return
Return from Convergence
of Price to Intrinsic Value
Discount Rate
Internal Rate of Return
![Page 5: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/5.jpg)
EQUITY RISK PREMIUM
Current expected risk-free return
Equity risk
premium
Required return on
equity
![Page 6: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/6.jpg)
EQUITY RISK PREMIUM ESTIMATES
•Historical Estimates
•Forward-Looking Estimates
-Gordon growth model estimates
-Macroeconomic model estimates
-Survey estimates
![Page 7: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/7.jpg)
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
![Page 8: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/8.jpg)
HISTORICAL EQUITY RISK PREMIUM ESTIMATES
1% to 2%
2% to 3%
3% to 4%
4% to 5%
5% to 6%
6% to 7%
1
4
1
6
4
1
Equity Risk Premiums
Nu
mb
er o
f M
arke
ts
![Page 9: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/9.jpg)
FORWARD-LOOKING EQUITY RISK PREMIUM ESTIMATES
Gordon growth
model risk premium
Dividend yield
Earnings growth rate
Government bond yield
![Page 10: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/10.jpg)
FORWARD-LOOKING EQUITY RISK PREMIUM ESTIMATES
Macroeconomic Model Equity Risk Premium (ERP)
ERP (1 EINFL)(1 EGREPS)(1 EGPE) 1 EINC FR
![Page 11: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/11.jpg)
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%
![Page 12: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/12.jpg)
EXAMPLE: FORWARD-LOOKING EQUITY RISK PREMIUM
1 Treasury Bond YieldExpected Inflation
1 TIPS Yield
1 0.038Expected Inflation 1 2.0%
1 0.018
![Page 13: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/13.jpg)
EXAMPLE: FORWARD-LOOKING EQUITY RISK PREMIUM
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%
![Page 14: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/14.jpg)
EXAMPLE: FORWARD-LOOKING EQUITY RISK PREMIUM
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%
FR
![Page 15: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/15.jpg)
ESTIMATING THE REQUIRED RETURN ON AN EQUITY INVESTMENT
Capital Asset Pricing Model
Multifactor Models• Fama–French model
• Pastor–Stambaugh model• Macroeconomic models
• Statistical models
Build-Up Method
![Page 16: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/16.jpg)
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 mean–variance optimization
- Relevant risk is systematic risk
( ) [ ( ) ], i F i M FE R R E R R
![Page 17: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/17.jpg)
BETA ESTIMATION ISSUES
• S&P 500 and NYSE Composite are common choices in the United States
Choice of Market Index
• Five years of monthly data is most common choice
Length & Frequency of Data
• Betas move towards 1.0 over timeAdjusted Betas
• Adjust comparable betas for leverageThinly Traded and Private Firms
![Page 18: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/18.jpg)
MULTIFACTOR MODELS:FAMA–FRENCH MODEL
Required Return
on Equity
Value Premium
Size Premium
Market Risk
Premium
Risk-Free
Return
![Page 19: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/19.jpg)
FAMA–FRENCH MODEL
• where
- SMB = The return to small stocks minus the return to large stocks
- βsize = The sensitivity of security i to movements in small stocks
- HML = The return to value stocks minus the return to growth stocks
- β value = The sensitivity of security i to movements in value stocks
PASTOR–STAMBAUGH MODEL
• where
- LIQ = The return to illiquid stocks minus the return to liquid stocks
- β liq = The sensitivity of security i to movements in illiquid stocks
mkt size valueβ RMRF β SMB β HML, i F i i ir R
mkt size value liqβ RMRF β SMB β HML β LIQ, i F i i i ir R
![Page 20: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/20.jpg)
EXAMPLE: FAMA–FRENCH 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
![Page 21: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/21.jpg)
EXAMPLE: FAMA–FRENCH MODEL
mkt size valueβ RMRF β SMB β HML
3% 1.20(5%) 0.12(2.2%) 0.34(3.8%)
10.56%
i F i i ir R
![Page 22: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/22.jpg)
BUILD-UP METHODS
• For Private Firms
- Typical risk premiums
- size
- firm-specific risk
- Other risk premiums
- marketability
- control
• Bond Yield plus Risk Premium Method
- Useful if firm has public debt
- YTM on long-term debt + risk premium
Required Return on Equity
Risk-Free Rate
Equity Risk
Premium
Other Risk
Premiums
Other Risk
Discounts
![Page 23: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/23.jpg)
INTERNATIONAL CONSIDERATIONS FOR REQUIRED RETURNS
Exchange Rates
Emerging Markets• Country spread model• Country risk rating
model
![Page 24: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/24.jpg)
WEIGHTED AVERAGE COST OF CAPITAL
Weighted Average
Cost of Capital
Debt
Cost of Debt Market Value of Debt Tax Rate
Equity
Cost of Equity Market Value of Equity
![Page 25: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/25.jpg)
WEIGHTED AVERAGE COST OF CAPITAL
• 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 1 – Tax rate)
- re = Cost of equity
MVD MVCE(1 Tax Rate) ,
MVD MVCE MVD MVCE
d er r
![Page 26: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/26.jpg)
EXAMPLE: WEIGHTED AVERAGE COST OF CAPITAL
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%
![Page 27: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/27.jpg)
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
![Page 28: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/28.jpg)
CHOICE OF DISCOUNT RATE
• WACCCash Flows to the Firm
• Required return on equityCash Flows to Equity
• Nominal discount ratesNominal Cash Flows
• Real discount ratesReal Cash Flows
![Page 29: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/29.jpg)
SUMMARY
• Holding period return, realized return, expected return, required return, discount rate, return from convergence of price to intrinsic value, and IRR
Return Concepts
• = Required return on equity – Risk-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
![Page 30: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/30.jpg)
SUMMARY
• Capital asset pricing model• Multifactor models• Fama–French model• Pastor–Stambaugh 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
![Page 31: RETURN CONCEPTS Presenter Venue Date. WHY FOCUS ON RETURN CONCEPTS? To evaluate expected and past performance To understand risk premiums To estimate](https://reader035.vdocuments.us/reader035/viewer/2022062417/551aa501550346761a8b6266/html5/thumbnails/31.jpg)
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