Equity #30 - Return Concepts Flashcards
1
Q
equity risk premium (ERP)
A
LOS 30.b
- equity risk premium (ERP) - additional return above risk-free rate investors require for holding risky equity securities
ERP = Rreq - Rf
2
Q
required return for a stock
A
LOS 30.b
- use ERP and beta (i.e. level of systematic risk component for the stock) to determine the required return for the stock
Ri = Rf + ß(RM - Rf)
- risk-free rate should be equal to the investor’s investment horizon
- T bills for short horizon
- T bonds for longer holding periods
3
Q
IRR (def)
A
LOS 30.a
IRR is the discount rate needed to make DCF equal the current price
4
Q
required return for stock “j”
A
LOS 30.b
required return for stock “j” = risk-free premium + equity risk premium + other adjustments for j
Rj = Rf + ßRprem + b(other factor)
5
Q
what does “ex ante” mean?
A
LOS 30.b
“forward-looking”
6
Q
3 types of ex ante estimates of the equity risk premium
A
LOS 30.b
- Gordon Growth Model (GGM)
- macroeconomic models - use current info, but are appropriate only for developed countries where public equities represent a relatively large share of the economy
- survey estimates - easy to obtain, but can have wide disparity between opinions
7
Q
models used to estimate the required return on equity
A
LOS 30.c
- CAPM: Rj = Rf + ßRprem
- Multifactor model: Rj = Rf + Rprem1 + Rprem2 + … + Rpremn
- Fama-French model:
Rj = Rf + ßmkt,j(Rmkt - Rf) + ßSMB,j(Rsmall - Rbig) + ßHML,j(RHBM - RLBM),
HML = “high minus low B/M value”, HBM = “high B/M”, LBM = “low B/M” - Pastor-Stambaugh model: Fama-French plus a liquidity factor and prem
- Build-up method: Rj = Rf + equity Rprem + size prem + firm-specific prem
8
Q
steps for estimating beta for thinly-traded and non-public companies
A
LOS 30.d
For analyzed company “j”:
- identify publicly-traded benchmark company: “k”
- estimate beta of the benchmark company: ßk
- unlever the benchmark company’s beta:
ßunl,k = ßk[1/(1+Dk/Ek)], Dk/Ek = debt-to-equity ratio for k - relever beta using capital structure of the company being analyzed:
ßj = ßunl,k(1+Dj/Ej), Dk/Ek = debt-to-equity ratio for j
