25. Return Concepts Flashcards
Required Return (cost of equity, cost of debt)
The minimum level of expected return that an investor requires in order to invest in the asset over a specified time period, given the asset’s riskiness. It represents the opportunity cost for investing in the asset— the highest level of expected return available elsewhere from investments of similar risk.
The required return on a security is therefore the issuer’s marginal cost for raising additional capital of the same type.
Expected Alpha
The difference between the expected return and the required rate of return on an asset is the asset’s expected alpha (or ex ante alpha) or expected abnormal return:
Ex ante
Before the event
Ex post
After the event
Discount Rate
A general term for any rate used in finding the present value of a future cash flow. A discount rate reflects the compensation required by investors for delaying consumption— generally assumed to equal the risk-free rate— and their required compensation for the risk of the cash flow.
Internal Rate of Return
The discount rate that equates the present value of the asset’s expected future cash flows to the asset’s price— i.e., the amount of money needed today to purchase a right to those cash flows.
Equity Risk Premium
The incremental return (premium) that investors require for holding equities rather than a risk-free asset. Thus, it is the difference between the required return on equities and a specified expected risk-free rate of return.
The analyst’s major decisions in developing a historical equity risk premium estimate include the selection of:
the equity index to represent equity market returns;
the time period for computing the estimate;
the type of mean calculated;
and the proxy for the risk-free return.
Historical equity risk premium
The mean value of the differences between broad-based equity-market-index returns and government debt returns over some selected sample period.
Forward-Looking Estimates (ex ante), definition and examples
Because the equity risk premium is based only on expectations for economic and financial variables from the present going forward, it is logical to estimate the premium directly based on current information and expectations concerning such variables.
Examples:
Constant growth dividend discount model or Gordon growth model
Macroeconomic Model Estimates
Survey Estimates
Beta Estimate for Thinly Traded/Nonpublic Companies
The procedure must take into account the effect on beta of differences in financial leverage between the nonpublic company and the benchmark. First, the benchmark beta is unlevered to estimate the beta of the benchmark’s assets— reflecting just the systematic risk arising from the economics of the industry. Then, the asset beta is re-levered to reflect the financial leverage of the nonpublic company.
Multifactor Models
Whereas the CAPM adds a single risk premium to the risk-free rate, arbitrage pricing theory (APT) models add a set of risk premia. APT models are based on a multifactor representation of the drivers of return.
Examples:
Fama-French
Extensions of Fama-French (Pastor-Stambaugh)
Macroeconomic and Statistical Multifactor Models
BIRR Factor 1: Confidence Risk
the unanticipated change in the return difference between risky corporate bonds and government bonds, both with maturities of 20 years. To explain the factor’s name, when their confidence is high, investors are willing to accept a smaller reward for bearing the added risk of corporate bonds.
BIRR Factor 2: Time Horizon Risk
the unanticipated change in the return difference between 20-year government bonds and 30-day Treasury bills. This factor reflects investors’ willingness to invest for the long term.
BIRR Factor 3: Inflation Risk
the unexpected change in the inflation rate. Nearly all stocks have negative exposure to this factor, as their returns decline with positive surprises in inflation.
