Return Concepts

adjusted beta

(2/3) * regression beta + (1/3)

forward looking estimates of equity risk premium

1. Gordon Growth Model 2. supply side models 3. estimates from surveys

steps to estimate beta for thinly traded stocks and non public companies

1. identify benchmark company 2. estimate beta of benchmark company 3. unlever beta = beta * (1/ 1+ (D/E)) 4. relever beta = unlevered beta * (1+D/E)

Burmeister, Roll and Ross macroeco multifactor model

5 factors: 1. confidence risk: <> betw. return of risky corporate bonds and government bonds 2. time horizon risk: unexpected change in diff. betw return long term bonds and treasury bills 3. inflation risk 4. business cycle risk 5. market timing risk

equity risk premium

= required return on equity index - risk free rate

methods to estimate return on equity

CAPM Fama and French model (FFM) Pastor - Stambaugh model (PSM) macroeco multifactor models build up method

pros and cons of methods used to estimate required return on equity

CAPM pro: simple cons: if stock in more than one market, there are more than one market index & low explanatory power Multifactor models pro: high explanatory power cons: complex and expensive Build up models pro: simple and can be applied to closely held companies cons: use historical values that may not be relevant to current market conditions

gordon growth model for equity risk premium

ERP = expected dividend yield + expected growth rate- current long term government bond yield pro: reasonable for developed economies and markets cons: needs continuous update, assumption of stable growth rate * r (equity index price= PVrapid (r) + PVtranstition (r) + PVmature (r)) - government bond yield for growing economies

supply side estimates (macroeconomic models) for ERP

Ibbotson - Chen ERP = (1+ expected inflation) * (1+real growth in GDP) * (1 + expected changes in P/E ratio) -1 + expected yield on index - expected RFR where: expected inflation = YTM of bonds - TIPS real GDP growth = labor productivity growth + labor supply growth pro: proven models and current info cons: only appropriate for developed countries

cost of capital

WACC using target weights for debt and equity

build up method

appropriate for closely held companies where betas not available required return = RFR + equity risk premium + size premium + specific company premium

bond yield + risk premium method

build up method appropriate for a company with publicly traded debt

survey estimates for ERP

consensus of opinions pro: easy to obtain con: wide disparity

international considerations for the required return

country spread model: use developed market as benchmark and add premium (yield bonds emerging - yield bonds developed) country risk rating model: estimates an equation for ERP for developed countries and uses it for emerging market

price convergence

expected return = required return + price convergence return price convergence return = (intrinsic value - price) / price

return concepts

holding period return = cash flow yield + return from price appreciation realized return = historical return expected return = based on forecasts of future prices required return = min. return an investor requires (also called opportunity cost) discount rate IRR

beta drift

observed tendency to revert to 1 over time

pros and cons historical estimate of equity risk premium

pros: objectivity, simplicity, unbiased cons: assumes mean variance stationarity, survivorship bias, geometric vs. arithmetic mean, long term vs. short term bonds

beta estimates

regress returns of company on returns of overall market popular: 2 yrs. of weekly data

historical estimate of equity risk premium

steps: 1. select equity index 2. select a time period 3. calculate mean return on index 4. select a proxy for RFR