Reading 31 - Return Concepts Flashcards
How do you caluclate a Holding per Return (HPR))?
If a daily return is 0.80%, how would you calculate an annualized return?
= (1.0008) ^365
Define the required rate of return…
The minimum level of expected return that an investor requires in order to invest.
How do you calculate Expected Alpha?
= Expected Return - Required Return
If an asset’s price equals the intrinsic value price, what is the expected alpha?
0
How do you calculate an expected return?
= Required return + a return from the convergence of price to value
What does Market Informational Efficiency mean?
Price is equal to current intrinsic value
Define the Equity Risk Premium….
The incremental return that investors require for holding equtiies rather than the risk free asset
Equity Risk Premium = required return on equity index - risk free rate
What are the steps to create a historical Equity Risk Premium estimate?
- Determine which equity index to represent market returns
- Chose the time period for computing the estimate
- Calculate the mean return on the index
- Select a proxy for the risk free rate
When estimating an Equity Risk Premium, explain when Arthimetic Mean and Geometric Mean are most appropriately used
- Arithmetic - when looking at a single period
- Geometric - the preferred method for use in historical estimates
Explain Survivorship Bias….
tends to inflate historical estimates of ERP because poorly performing or defunct companies have been removed from the index
How do you calculate the Gordon Growth Model (GGM) equity risk premium?
= (1 yr forecasted dividend yield on market index) + (consensus long term earnings growth rate) - (long term government bond yield)
What are two weakness of the GGM ?
- That forward looking estimates will change through time and need to be updated
- The assumption of a stable growth rate, which is often not appropriate in rapidly growing economies
What is the formula of the Macroeconomic Model created by Ibotson & Chan?
How do you calculate expected inflation (EINFL)?
= (1+YTM on 20 yr t-bonds) / (1+ YTM on 20 yr TIPS) - 1
How do you calculate the Expted Growth in Real EPS?
- Should approximately track the real GDP growth rate
- Real GDP = Σ Labor Productivity Growth + Labor Supply Growth rate
How do you calculate the expected growth in the P/E ratio?
- Base value is 0 to reflect the efficient markets view
- 1.05 would represent a view that the P/E would rise by 5%
What are the 2 key assumptions within CAPM?
- Investors are risk averse
- Make investments based on the mean return & variance of returns in their portfolios
What is the main insight of the CAPM model?
That investors evaluate the risk of an asset in terms of the asset’s contribution to the systematic risk of their portfolio
What is Beta ?
The measure of the level of systematic risk assumed from holding the security
What are 2 influences on Beta estimates?
- Choice of index for market portfolio
- length of data period and the frequency of observations
What is beta drift?
the observed tendency of an estimated beta to revert to a value of 1.0 over time
What is the formula for Adjusted Beta?
= (2/3 * regression beta ) + (1/3 * 1)
What time period is the industry standard for calculating betas?
5 Years
How do you calculate the WACC?
How is the Fama and French Model different from CAPM?
Fama and French is a multi factor model, while CAPM is a single factor model
What are the 3 factors within the Fama and French model?
- RMRF - the return on a market value weighted equity index in excess of the 1 month tbill rate
- SMB - small minus big. SMB is the average return of three small cap portfolios minus the average return of on three large cap portfolis. SMB represents a small cap return premium
- HML - high minus low. the average return on two high book to market portfolios minus the average return on two low book to market portfolios. HML represents a value return premium.
What is the equation for the FAMA and French Model?
How is the Pastor-Stambaugh Model different than the Fama and French model?
It encompass the compensation for the degree of liquidity of an equity investment
What is the formula for the Pastor - Stambaugh model?
What are the factors in the 5 Factor BIRR model?
- Confidence Risk - if confidence is high, the investor will accept a small reward to switch from gov’t to corporate bonds
- Time Horizon Risk - Unanticipated change difference between 20 gov’t bonds and tbills. Reflects investors willingness to invest for the long term
- Inflation Risk - Unexpected change in the inflation rate
- Business Cycle Risk - unexpected change in the level of real business activity
- Market Timing Risk - portion of total return not explained by the 1st 4 factors
When are Build Up Method estimates of the required return on equity used?
For closely held businesses
How is the Build Up Method Estimates of the Required Return of Equity calculated?
this methods parallels the risk premium approach embodied in the multi factor model with the difference that specific beta adjustments are not applied to factor risk premiums
How can the cost of equity be estimated for companies with publicly traded debt?
The Bond Yield Risk Premium
How do you calculate the Bond Yield Risk Premium?
What kind of free cash flow is after more senior claims (ie. promised payments on debt and taxes)?
Free cash flow to equity
When discounting back free cash flow to equity, what is the appropriate rate to use?
The required rate of return of equity
What the the appropriate discount rate to use when a cash flow is available to meet the claims of all of a companies capital providers?
The firm’s cost of capital
