2. Return Concepts Flashcards
Explain estimates of the equity risk premium based on ‘historical estimates’.
A historical estimate of the equity risk premium consists of the difference between the historical mean return for a broad-based equity-market index and a risk-free rate over a given time period. Its strenght is its objectivity and simplicity. Also, if investors are rational, then historical estimates will be unbiased. A weakness of the approach is the assumption that the mean and variance of the returns are constant over time (i.e. that they are stationary).
Explain estimates of the equity risk premium based on ‘forward-looking estimates’. Which are three main categories?
Forward-looking or ex ante estimates use current information and expectations concerning economic and financial variables. The strenght of this method is that it does not rely on an assumption of stationarity and is less subject to problems like survivorship bias.
There are three main categories of forward-looking estimates:
a) based on Gordon growth model
b) supply-side models
c) estimates from surveys
Explain estimates of the equity risk premium based on Gordon Growth Model.
The assumptions of the model are reasonable when applied to developed economies and markets wherein there are typically ample sources of reliable forecasts for data such as dividend payments and growth rates.
This method estimates the risk premium as the expected dividend yield plus the expected growth rate minus the current long-term government bond yield:
GGM Equity Risk Premium = (1-year forecasted dividend yield on market index) + (consensus long-term earnings growth rate) - (long-term government bond yield)
=(D1/P) + LT_Earnings_g - r(LT-debt)
Another weakness is the assumption of a stable growth rate, which is often not appropriate in rapidly growing economies. Such economies might have three or more stages. For example, equity index price = PC(rapid) + PV(transition) + PV(mature)
= Soma(PVs) - r(LT-debt)
Explain estimates of the equity risk premium based on Supply-side Estimates (macroeconomic models).
Macroeconomic models of the equity risk premium are based on the relationships between macroeconomic variables and financial variables. A strenght of this approach is the use of proven models and current information. A weakness is that the estimates are only appropriate for developed countries where public equities represent a relatively large share of the economy, implying that is reasonable to believe there should be some relationship between macroeconomic variables and asset prices.
One common model (Ibbotson-Chen 2003) for a supply-side estimate of the risk premium is:
Equity Risk Premium = (1+expected inflation)*(1+expected changes in the P/E ratio)-1+(expected yield on the index)-(expected risk-free rate)
Explain estimates of the equity risk premium based on Survey Estimates.
Survey estimates of the equity risk premium use the consensus of the opinions from a sample of people. If the sample is restricted to people who are experts in the area of equity valuation, the results are likely to be more reliable. The strenght is that survey results are relatively easy to obtain. The weakness is that, even when the survey is restricted to experts in the area, there can be a wide disparity between the consensuses obtained from different groups.
Explain ‘Fama-French Model’ to estimate the required return on an equity investment.
The Fama-French model is a multifactor model that attempts to account for the higher returns generally associated with small-cap stocks. The model is:
Required Return of Stock j = Rf + B(mkt-j)[R(mkt)-Rf]+B(smb-j)R(small)-R(big)+B(hml-j)*r(hmb)-R(lbm)
The baseline value for B(mkt-j) is one, and the baseline values for B(smb) and B(hml) are zero.
Explain ‘Pastor-Stambaugh Model’ to estimate the required return on an equity investment.
. The Pastor-Stambaugh model adds a liquidity factor to the Fama-French model. The baseline value for the liquidity factor beta is zero. Less liquid assets should have a positive beta, while more liquid assets should have a negative beta.
Explain ‘Macroeconomic Multifactor models’ to estimate the required return on an equity investment.
Macroeconomic multifactor models use factors associated with economic variables that can be reasonably believed to affect cash flows and/or appropriate discount rates.
For example:
1) Confidence risk: unexpected change in the difference between the return of risky corporate bonds and government bonds
2) Time horizon risk: unexpected change in the difference between the return of long-term government bonds and Treasury bills
3) Inflation risk: unexpected change in the inflation rate
4) Business cycle risk: unexpected change in the level of rea business activity
5) Market timing risk: the equity market return that is not explained by the other four factors
As with the other models, to compute the required return on equity for a given stock, the factor values are multiplied by a sensitivity coefficient for that stock; the products are sumed and added to the risk-free rate.
Explain ‘Build-Up Method’ to estimate the required return on an equity investment.
The build-up method is similar to the risk premium approach. It is usually applied to closely held companies where betas are not readily obtainable.
One popular representation is:
Required Return = Rf + Equity Risk Premium + Size Premium + Specific-company Premium
The size premium would be scaled up or down based on the size of the company. Computing the required return would be a matter of simply adding up the values in the formula. Some representations use an estimated beta to scale the size of the company-specific equity risk premium but typically not for the other factors. The formula could have a factor for the level of controlling versus minority interests and a factor for maketability of the equity; However, these latter two factors are usually used to adjust the value of the company directly rather than through the required return.
Explain ‘Bond-Yield Plus Risk Premium Method’ to
estment.
The bond-yield plus risk premium method is a build-up method that is appropriate if the company has publicly traded debt. The method simply adds a risk premium to the YTM of the company’s long-term debt. The logic here is that the yield to maturity of the company’s bond includes the effects of inflation, leverage, and the firm’s sensitivity to the business cycle. Because the various risk factors are already taken into account in the YTM, the analyst can simply add a premium for the added risk arising from holding the firm’s equity. That value is usually estimated at 3-5%, with the specific estimated based upon some model or simply from experience.
Explain ‘beta drift’.
When making forecasts of the equity risk premium, some analysts recommend adjusting the beta for beta drift. Beta drift refers to the observed tendency of an estimated beta to revert to a value of 1,0 over time.
To compensate, the Blume metgod can be used to adjust the beta estimate:
Adjusted Beta = (2/3)*Regression Beta + (1/3)
Explain beta estimates for thinly traded stocks and nonpublic companies.
Beta estimation for thinly traded stocks and nonpublic companies involver 4-step procedure. If ABC is the nonpublic company the steps are:
1) Identify a benchmark company, which is publicly traded and similar to ABC in its operations
2) Estimate the beta of that benchmark company, which we will denote XYZ. This can be done with a regression analysis
3) Unlever the beta estimate for XYZ with the formula: Unlevered Beta XYZ = (beta XYZ)[1/(1+D/E)]
4) Lever up the unlevered beta for XYZ using the debt and equity measures of ABC to get an estimate of ABC’s beta for computing the required return on ABC’s equity: Estimate of Beta ABC = (unlevered beta XYZ)[1+(D/E)]
Describe the strengths and weaknesses of methods used to estimate the required return on an equity investment.
The CAPM has the advantage of being very simple in that it uses only one factor. The weakness is choosing the appropriate factor. If a stock trades in more than one market, for example, there can be more than one market index, and this can lead to more than one estimate of required return. Another weakness is low explanatory power in some cases.
A strength of multifactor models is that they usually have higher explanatory power, but this is not assured. Multifactor models gave the weakness of being more complex and expensive.
A strength of build-up models is that they are simple and can apply to closely held companies. The weakness is that they typically use historical values as estimates that may or may not be relevant to current market conditions.
Explain ‘country spread model’ in the context of estimate the required return on an equity investment.
One method for adjusting data from emerging markets is to use a corresponding developed market as a benchmark and add a premium for the emerging market. The premium to use is the difference between the yield on bonds in the emerging market minus the yield on corresponding bonds in the developed market.
Explain ‘Country Risk Rating Model’ in the context of estimate the required return on an equity investment.
This model estimates a regression equation using the equity risk premium for developed countries as the dependent variable and risk ratings (published by Institutional Investor) for those countries as the independent variable. Once the regression model is fitted (i.e. we estimate the regression coefficients), the model is then used for predicting the equity risk premium for emerging markets using the emerging markets risk-ratings.
