Reading 28 - return concepts
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
