Topic 2 - return concepts Flashcards
What is the holding period return
HPR is the return earned from investing in an asset over a specified time
what does HPR mean (formula)
Dividend yield + capital gain yield
what is required return
THE MINIMUM LEVEL OF EXPECTED RETURN
what does expected alpha = expected return - required return mean
Expected abnormal return = intrinsic value - market price
what is equity risk premium
ERP is the incremental return investors expect above the risk free rate for taking risk
What estimation approaches are there
- Historical estimates
2. forward looking
what is the formula for erp
erp = mean value of (equity market return - risk free return)
what are issues when using historical estimates
- equity index to represent equity market returns
- the time period of computing the estimate
- the type of mean calculated
- the proxy for risk free return
what are issues when using historical estimates
issues with equity index to represent equity market returns
broad-based, market value weighted indexes are typically selected. Survivorship bias - poorly performing companies are removed
what are issues when using historical estimates
the time period of computing the estimate
extending the length to increase precision
including the distant past is hard to maintain the stationarity assumption
balance long term or short term choice
what are the two types of means and how can they effect results
Arithmetic - affected by extreme data
Geometric - more accurately provides the compounded future value of an investment
what are issues when using historical estimates
the proxy for the risk free return
- corporate bonds or government bonds
- short term treasury bills of long term government bonds
- match duration of the risk free rate measure to the duration of investment
- in practice, use recently issued government bonds because it is the most liquid
- the mainstream choice - geometric mean
relative to long term government bonds
Which mean should you favour for erp and why
Arithmetic as the average one-period return best represents the mean return ina single period. THe typical reason to favour this is the type of model in which the estimates are used and the other relating to a statistical property
What is the Gordon growth model GGM
The Gordon Growth Model is used to determine the intrinsic value of a stock based on a future series of dividends that grow at a constant rate.
Its a popular and more straight forward version of DDM
What is the formula for GGM risk premium
GGM Risk Premium = Forecasted dividend yield on a market index + Forecasted LT earnings growth rate - LT government bond yield
What are the assumptions of GGM
- Earnings, dividends, and prices are expected to grow at the same rate
This implies the constant dividend payout ratio and P/E ratio
What is the logic of GGM assumptions
earnings growth rate determines the capital gain because stock price will grow at same rate as earnings.
Most appropriate for mature developed markets
What is formula for CAPM
E(Ri) = Rf + Bi[E(Rm) - Rf]
Calculate CAPM required return
Current Rf 4.7%
Beta 1.04
Market risk Prem 5.5%
4.7%+1.04x5.5%
Systematic risk Definition
Uncertainty inherent to the entire market
Unsystematic risk
uncertainty peculiar to an individual security
How can diversification effect systematic risk
cannot be eliminated by diversification
How can diversification effect unsystematic risk
can be eliminated by diversification
what is a measure of systematic risk
Beta
what is a measure of unsystematic risk
error item
What does unlevered beta mean
the risk of an unlevered company relative to the risk of the market
what does levered beta mean
the risk of the company with equity and debt in its capital structure relative to the risk of the market
What is the formula for fama-french model
Current risk free return +Betamarket risk premium + Size betasize risk premium + value beta* value risk premium
how is pastor-stambaugh model (2003) different to the fama-french model
its the same but has a fourth factor of beta to illiquid stocks and market return to illiquid stocks
Name four types of risk premiums
- Size
- Frim-specific (underlying assumption is risk is difficult to be diversified away)
- lack of marketability
- Controlling or minority interests
What is the WACC formula
Value of debt * YTM of LT bond + (1-tax rate) + Value of equity * (Rf+beta * Equity risk premium)
What choice of discount rate do you use when
- CF to the firm
- CF to equity
- Nominal CF
- Real CF
- WACC
- Required return on equity
- Nominal discount rates
- Real discount rate
How to estimate a beta for a non traded company
- Select the comparable benchmark
- Estimate benchmarks beta
- Unlever benchmarks beta
- Lever the beta to reflect the subject company’s financial leverage
