Reading 21: Return Concepts Flashcards
Holding Period Return
r = (P1 - P0 + CF1)/P0
or
r = (CF1/P0) + (P1-P0)/P0
cash flow price
yield appreciation
Realized vs Expected Returns
- realized: historical return based on past prices and cash flows
- expected: based on forecasts of future prices and cash flows.
Required return
-the minimum return an investor requires given the asset’s risk
Price convergence
-if expected return is not equal to required return. “Return from convergence of price to intrinsic value”
expected return = required return + (V0 - P0)/P0
Discount Rate
the rate used to find the present value of an investment
Internal Rate of return
-rate that equates the value f the discounted cash flows to the current price of the security
Equity Risk Premium
required return on equity index - risk free rate
*risk-free rate should correspond to the time horizon for the investment.
Required return on stock
risk-free return + Beta * (equity risk premium)
Gordon Growth Model
-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
Supply-side estimates (macro models)
-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
Survey estimates
-consensus opinion from people
CAPM
you know
Fama French
required rate of return of stock = RF + B(Rmk-Rf) + B(Rsmall - Rbig) + B(RHbm - RLbm)
Pastor-Stambaugh Model
-adds liquidity factor to the Fama-French model (less liquid assets have a positive beta)
Macro multifactor models
-use factors associated with economic variables that can be believed to affect cash flows and/or appropriate discount rates.
Burmeister, Roll and Ross
- 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
Build-up method
require return = RF + equity risk premium + size premium + specific-company premium
Bond-yield plus risk premium model
- 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
Adjusted beta for public companies
-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)
4-step process to private or thinly traded stock
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)]
Strengths/Weaknesses of Models
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
Country Spread Model
- Use developing market benchmark and add premium for EM markets
- use yield difference between country bonds
Country Risk Rating Model
- 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.
WACC
(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
