Reading 21: Return Concepts

Question 1

Holding Period Return

Answer 1

r = (P1 - P0 + CF1)/P0

or

r = (CF1/P0) + (P1-P0)/P0

cash flow price
yield appreciation

Question 2

Realized vs Expected Returns

Answer 2

• realized: historical return based on past prices and cash flows
• expected: based on forecasts of future prices and cash flows.

Question 3

Required return

Answer 3

-the minimum return an investor requires given the asset’s risk

Question 4

Price convergence

Answer 4

-if expected return is not equal to required return. “Return from convergence of price to intrinsic value”

expected return = required return + (V0 - P0)/P0

Question 5

Discount Rate

Answer 5

the rate used to find the present value of an investment

Question 6

Internal Rate of return

Answer 6

-rate that equates the value f the discounted cash flows to the current price of the security

Question 7

Equity Risk Premium

Answer 7

required return on equity index - risk free rate

*risk-free rate should correspond to the time horizon for the investment.

Question 8

Required return on stock

Answer 8

risk-free return + Beta * (equity risk premium)

Question 9

Gordon Growth Model

Answer 9

-Forward looking estimate of risk premium

GGM = (1-year forecast dividend yield) +(consensus long-term earnings growth rate) - (long-term govt bond yield)

-Weakness: forward looking estimates need to be changed through time and updated. Assumes stable growth rate, but there are multiple stages of growth: rapid, transition and mature

Question 10

Supply-side estimates (macro models)

Answer 10

-based on relationship between macro and financial variables

Ex: ibbotson chen

[1 + i] x [1+rEg] x [1+PEg] - 1 + Y - RF

rEg = expected real growth in EPS (approx equal to real GDP growth) 
PEg = expected changes in the P/E ratio. Over or undervalued? 
Y = expected yield on index 

i = [(1 + YTM of 20 year T-bonds) / (1+ YTM of 20-year TIPS)] - 1

Strength: use of proven models and current information
Weakness: estimates are only appropriate for developed countries where public equities represent large part of economy

Question 11

Survey estimates

Answer 11

-consensus opinion from people

Question 12

CAPM

Answer 12

you know

Question 13

Fama French

Answer 13

required rate of return of stock = RF + B(Rmk-Rf) + B(Rsmall - Rbig) + B(RHbm - RLbm)

Question 14

Pastor-Stambaugh Model

Answer 14

-adds liquidity factor to the Fama-French model (less liquid assets have a positive beta)

Question 15

Macro multifactor models

Answer 15

-use factors associated with economic variables that can be believed to affect cash flows and/or appropriate discount rates.

Question 16

Burmeister, Roll and Ross

Answer 16

• macro model
• uses five factors:
  1) confidence risk: unexpected change in return difference of risky corporates and government bonds
  2) Time horizon risk: unexpected change in return diff. b/w long term govt bonds and t-bills
  3) Inflation risk: unexpected change in inflation risk
  4) business cycle risk: unexpected change in level of real business activity
  5) market time risk: equity market return not explained by prev. 4 factors

Question 17

Build-up method

Answer 17

require return = RF + equity risk premium + size premium + specific-company premium

Question 18

Bond-yield plus risk premium model

Answer 18

• build-up method that is appropriate if the company has publicly traded debt.
• simply adds a risk premium to the YTM of company’s long-term debt (Usually 3-5%)

*YTM includes the effects of inflation, leverage and the firm’s sensitivity to the business cycle

Question 19

Adjusted beta for public companies

Answer 19

-drift = beta reverts to 1.0 over time
-Blume method can be sued to adjust beta estimate:
(2/3 x regression beta) + (1/3 x 1.0)

Question 20

4-step process to private or thinly traded stock

Answer 20

1) Identify a similar, benchmark company
2) Estimate the beta of benchmark company (XYZ)
3) Unlever the beta

unlevered beta for XYZ = (beta of XYZ) x [1/ (1+ debt of XYZ/equity of XYZ)]

4) Lever up the unlevered beta for XYZ

estimate of beta for ABC = (unlevered beta of XYZ) x [1 + (debt of ABC/equity of ABC)]

Question 21

Strengths/Weaknesses of Models

Answer 21

CAPM:
S = very simple
W = choosing the appropriate factor, low explanatory power in some cases

Multifactor models:
S = high explanatory power
W = more complex and expensive

Build-up models:
S = simple and can apply to closely held companies
W = typically use historical values as estimates

Question 22

Country Spread Model

Answer 22

• Use developing market benchmark and add premium for EM markets
• use yield difference between country bonds

Question 23

Country Risk Rating Model

Answer 23

• estimates a regression equation using country risk rating model.
• model estimates a regression equation using the equity risk premium for developed countries as the dependent variable and risk ratings for those countries as the independent variable.

Question 24

WACC

Answer 24

(market value of debt/market value of D & E) x rd x (1-t) + (market value of equity/ market value of D & E) x re