Reading 28 - return concepts

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holding period return : annualsing formula

(1+HPR) ^ 365 / period

equity risk premium : forward-looing : gordon approach

** assumption of stable rate of growth ** based on : dividends, earnings growth, gov bond yield

required return on equity : multifactor model - extended fama-french

- adding illiquidity risk (LIQ) also called the pastor-lambaugh model neutral beta is 0

required return on equity : build-up method for private business - definition

- adding premia, but beta not applied

required return on equity : multifactor model - types

- based on fundamentals ** fama-french ** extended fama-french - based on macroeconomics ** macroeconomic multifactor ** statistical multifactor

required return on equity : multifactor model - definition

- evidence suggests beta describes risk incompetely - in practice, R^2 of beta regressionss, sometiems very low (low significance) multiple factor models may be more accurate how : use of several factors, each with specific sensitivity

required return on equity : estimation issues

- exchange rates : premiums in other markets are expressed in their local currency, FX can deform true premium - emerging markets : adding a country premium for investing in emerging markets. country premium : yield on emerging sovereign debt - yield on developed sov debt

required return on equity : multifactor model - fama french

- expands upon CAPM, adding another two factors - over long period, seems small cap have better returns, whcih violates CAPM asumptions components * market premium (if neutral, beta : 1). RMRF * avg excesss return of small caps (if neutral, beta 0) * excess return high BTM value over low BTM (beta neutral value : 0)

equity risk premium estimation : approaches

- historical - forward looking ** gordon approach ** macroeconomic aproach

types of return

- holding period return - required return - expected return - discount rate - internal rate of return

CAPM assumptions for required return on equity

- in equilibrium : supply = demand - investors are risk averse - investors make decisions with regard to overall impact on portfolio

Required return on equity : CAPM adjusted beta

- it's the two-third, one-third rule

weighed average cost of capital - concept

- overall required return of capital by all suppliers - cost of capital for firm - but careful : most commonly after-tax, so interest expense can partially deducted

equity risk premium : forward-looking : macroeconomic approach - definition

- reliable when public companies represent large share of economy - components ** expected inflation : E-INFL ** expected growth rate in EPS: E-GREPS ** expected growth in P/E : E-GPE ** expected income from reinvestment : E-INC ** expected riskfree return

expected return vs required return

- the difference is the alpha - if asset efficiently priced, alpha = 0 expected return and required return are often used interchangeably, but are not necesarily the same. can happen when price <> perceived value

discount rate : definition

- the rate used for finding present value - compensation required for delaying consumption - compensation for the risk discount rate based on issuer (required return does not pour in)

Required return on equity : CAPM - peer beta

- use industry beta, but take into account financial leverage to find coppany beta - parameters needed : ** benchmark beta ** benchmark unlevered beta ** subjet company financial leverage ** subjected company levered beta

Required return on equity : CAPM - raw beta estimation

- using ordinary least sqqares reg : raw beta - most common obs period : 5y horizon

Peer beta : steps

1. select benchmark 2. estimate its beta 3. get leverage of benchmark 4. unlever the beta (eliminate the leverage) 5. lever the beta using subject company's financial leverage

Peer beta : subject company financial leverage

D'/E' if D : 40% E = 1 -D D/(1-D) = 40/60

expected and realised alpha (formula)

Expected apha = Expected return - required return Realised alpha = Actual HPR - cont. required return

expected return

If an asset is mispriced, what are the possible outcomes next : mispricing increases, stays same, partially corrected, corrected, overshoots investor's expected rate has thus two components : - required return (earned on market price) - return from convergence of price to value

weighed average cost of capital - formula

MVD - market value of debt MVCE - market value common equity MVD+MVCE - total market value

required return on equity : formula

RROE = E(riskfree rate) + beta (equity risk premium)

equity risk premium : adjustments for required return

beta, systematic risk - measures the market risk - sensitivity of asset return to market return if b > 1, then asset riskier than market

required return on equity : build-up method BYRPP

bond yield plus risk premium (BYPRP) : giving a quick estimate of required rate of return on equity

required return on equity : multifactor model - macroeconomic multifactor model

five factor BIRR model * confidence risk : unexpected change in exess return of risky asset * time horizon risk : investir willingness to invest longterm * inflation risk : unexpected change in inflation rate * business cycle risk : unexpected change in business activity * market timing risk : portion that remains unexplaiend

equity risk premium : historical approach

geometric mean : * alwas smaller than arithmetic mean. * always gives smallest estimate of ERP arithmetic mean : * better suited for single-period analysis but what riskfree rate * shortterm bill, or * longterm bond (think duration match)

models for estimating required return on equity

once you've got the equity risk premium, modelling required return on equity with : - CAPM - Multi-factor model (Fama-French) - Build-up method

holding period return : definition

return earned over specified time period. sum of two components * price appreciation * investment income HPR realised : ex post when prices known HPR expected : probability-linked

which rate to use as discount rate

senior claims have already been fulfilled, you are entitled to cashflow * required return on equity (for common shareholders) when cash is available to all providers of capital * cost of equity (wacc), basically free cash flow to firm

internal rate of return : definition

the discount rate that equates present value of future cash flows to current price

equity risk premium : definition

the incremental return for holding equity rather than riskfree assets linked to required return on equity (it's part of it)

required return : definition

the minimum level of return an investor expects for investing in an asset. basically it's the opportunity cost, highest return availabel elsewhere


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