Return, Risk And The Security Market Line - Security Market Line And Beta

Basics
The security market line ("SML" or "characteristic line") graphs the systematic (or
market) risk versus the return of the whole market at a certain time and shows all
risky marketable securities. The SML essentially graphs the results from the capital
asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the yaxis represents the expected return. The market risk premium is determined from
the slope of the SML.
The security market line is a useful tool for determining whether an asset being
considered for a portfolio offers a reasonable expected return for risk. Individual
securities are plotted on the SML graph. If the security's risk versus expected return
is plotted above the SML, it is undervalued because the investor can expect a
greater return for the inherent risk. A security plotted below the SML is overvalued
because the investor would be accepting less return for the amount of risk
assumed.
Expected values for the SML are calculated with the following equation:

Es = rf + Bs(Emkt - rf)
Where: rf = the risk-free rate
Bs = the beta of the investment
Emkg = the expected return of the market
Es = the expected return of the investment
The beta is thus the sensitivity of the investment to the market or current portfolio.
It is the measure of the riskiness of a project. When taken in isolation, a project may
be considered more or less risky than the current risk profile of a company. By using
the SML as a means to calculate a company's WACC, this risk profile would be
accounted for.
Example:
When a new product line for Newco is considered, the project's beta is 1.5.
Assuming the risk-free rate is 4% and the expected return on the market is 12%,
compute the cost of equity for the new product line.
Answer:
Cost of equity = rf + Bs(Emkt - rf) = 4% + 1.5(12% - 4%) = 16%
The project's required return on retained earnings is therefore 16%, a number which
should be used in our calculation of weighted average cost of capital (WACC).
Estimating Beta

In risk analysis, estimating the beta of a project is quite important. But like many
estimations, it can be difficult to determine.
The two most widely used methods of estimating beta are:

1. Pure-play method
2. Accounting-beta method
1. Pure-Play Method
When using the pure-play method, a company seeks out companies with a product
line that is similar to the line for which the company is trying to estimate the beta.
Once these companies are found, the company would then take an average of those
betas to determine its project beta.
Suppose Newco would like to add beer to its existing product line of soda. Newco is
quite familiar with the beta of making soda given its history. However, determining
the beta for beer is not as intuitive since Newco as it has never produced it.
To determine the beta of the new beer project, Newco can take the average beta of
other beer makers, such as Anheuser-Busch and Molson Coors.
2. Accounting-Beta Method
When using the accounting-beta method, a company would run a regression using
the company's return on assets (ROA) against the ROA for market benchmark, such
as the S&P 500. The accounting beta is the slope coefficient of the regression.
The typical procedure for developing a risk-adjusted discount rate is as follows:
1. A company first begins with its cost of capital for the firm.
2. The cost of capital then must be adjusted for the riskiness of the project, by
adjusting the company's cost of capital either up or down depending on the risk of
the project relative to the firm.
For projects that are riskier, the company's WACC would be adjusted higher, and if
the project is less risky, the company's WACC is adjusted lower. The main issue in
this procedure is that it is subjective.
Capital Rationing
Essentially, capital rationing is the process of allocating the company's capital
among projects to maximize shareholder return.

When making decisions to invest in positive net-present-value (NPV) projects,

companies continue to invest until their marginal returns equal their marginal cost
of capital. There are times, however, when a company may not have the capital to
do this. As such, a company must ration its capital among the best combination of
projects with the highest total NPV.
Risk Premium
At its most basic level, risk premium is the return in excess of the risk-free rate of
return that an investment is expected to yield. An asset's risk premium is a form of
compensation for investors who tolerate the extra risk in a given investment
compared to that of a risk-free asset.

Think of a risk premium as a form of hazard pay for your investments. Just as
employees who work in relatively dangerous jobs receive hazard pay as
compensation for the risks they undertake, risky investments must provide an
investor with the potential for larger returns to warrant taking on the additional
liability.
For example, high-quality corporate bonds issued by established corporations
earning large profits have very little risk of default. Therefore, such bonds will pay a
lower interest rate (or yield) than bonds issued by less-established companies with
uncertain profitability and relatively higher default risk.
Market Risk Premium
Market risk premium is the difference between the expected return on a market
portfolio and the risk-free rate. Market risk premium is equal to the slope of the
security market line (SML). Three distinct concepts are part of market risk premium:
1) Required market risk premium is the return of a portfolio over the risk-free rate
(such as that of treasury bonds) required by an investor;
2) Historical market risk premium is the historical differential return of the market
over Treasury bonds; and
3) Expected market risk premium is the expected differential return of the market
over Treasury bonds.

The historical market risk premium will be the same for all investors since the value
is based on what actually happened. The required and expected market premiums,
however, will differ from investor to investor based on risk tolerance and investing
styles. The market risk premium can be calculated as follows:

Market Risk Premium = Expected Return of the Market Risk-Free Rate

The expected return of the market can be based on the S&P 500, for example, while
the risk-free rate is often based on the current returns of treasury bonds.
The Equity Risk Premium: More Risk for Higher Returns
In theory, stocks should provide a greater return than safe investments like Treasury
bonds. The difference is called the equity risk premium: the excess return that you
can expect from the overall market above a risk-free return. There is vigorous
debate among experts about the method employed to calculate the equity premium
and, of course, the resulting answer. In this section, we take a look at these
methods - particularly the popular supply-side model - and the debates surrounding
equity premium estimates.
Why Does It Matter?
The equity premium helps to set portfolio return expectations and determine asset
allocation policy. A higher premium, for instance, implies that you would invest a
greater share of your portfolio into stocks. Also, the capital asset pricing relates a
stock's expected return to the equity premium; a stock that is riskier than the
market - as measured by its beta - should offer excess return above the equity
premium.
Greater Expectations
Compared to bonds, we expect extra return from stocks due to the following risks:
Dividends can fluctuate, unlike predictable bond coupon payments.
When it comes to corporate earnings, bond holders have a prior claim while
common stock holders have a residual claim.
Stock returns tend to be more volatile (although this is less true the longer the
holding period).
And history validates theory. If you are willing to consider holding periods of at least
10 or 15 years, U.S. stocks have outperformed Treasuries over any such interval in
the last 200 years.
But history is one thing, and what we really want to know is tomorrow's equity
premium. Specifically, how much of a premium above a safe investment should we
expect for the stock market going forward? Academic studies tend to arrive at lower
equity risk premium estimations - in the neighborhood of 2-3%, or even lower! Later
in this article, we'll explain why this is always the conclusion of an academic study,
whereas money managers often point to recent history and arrive at higher
estimations of premiums.
Getting at the Premium

Here are the four ways to estimate the future equity risk premium:

What a range of outcomes! Opinion surveys naturally produce optimistic estimates,

as do extrapolations of recent market returns. But extrapolation is a dangerous
business: first, it depends on the time horizon selected, and second, we cannot
know that history will repeat itself. Professor William Goetzmann of Yale has
cautioned, "History, after all, is a series of accidents; the existence of the time
series since 1926 might itself be an accident." For example, one widely accepted
historical accident concerns the abnormally low long-term returns to bondholders
that started right after World War II (and subsequently low bond returns increased
the observed equity premium). Bond returns were low in part because bond buyers
in the 1940s and 1950s - misunderstanding government monetary policy - clearly
did not anticipate inflation.

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Risk and Return Measures - Dividend Growth Models
Dividend Growth Models - Equity valuation is a subject of great depth and
complexity. Valuation entails understanding a business; forecasting its performance,
selecting the appropriate valuation model; converting such forecasting to a
valuation and making a recommendation whether or not to purchase. Valuation
models are as nuanced as the companies to which their application would appear to
be best suited. For the purpose of the CFP examination, candidates are expected
to demonstrate proficiency in the basic mechanics and application of the dividend
discount model which utilizes a firm's cost of capital to discount dividends to arrive
at an approximate intrinsic value of the company.
Constant (Gordon) Dividend Growth Model:

P=D/k-g
Where:
P=security\'s price;
D=dividend payout ratio;
k=required rate of return (derived from the capital asset pricing model;
g=dividends\' expected growth rate.
The model's assumptions are that: (i) the dividend growth rate is constant; the
growth rate cannot equal or exceed the required rate of return; the investor's

required rate of return is both known and constant. In practice, a company's

earnings and growth rates are not known and not constant.
Multi-stage Dividend Discount Models:

P=D(1+g)/(1+k) + D(1+g)(1+g)/(1+r)(k-g)
Where:
P=security\'s price;
D=dividend payout ratio;
g=dividends\' expected growth rate;
k=required rate of return.
Multistage models can accommodate any number of patterns of future streams of
expected dividends. Spreadsheets enable the analyst to build and analyze many
permutations on such models. However, care must be taken when choosing the
model's inputs, lest the results become meaningless.Spreadsheets are susceptible
to data errors which can result in erroneous valuations.
Ratio Analysis - ratio analysis is also discussed in Chapter 7 "Portfolio
Development and Analysis", but more from the standpoint of evaluating the
company's financial health. The ratios to be discussed below, analysts use as
alternative valuation measures to the dividend discount models and fall under the
rubric of market-based valuation tools.
a. Price/Earnings: price per share/earnings per share. This is a relative valuation
model.
b. Price/Free Cash Flow (FCF): cash flow is less susceptible to manipulation than
earnings, when the appeal of this metric.
c. Price/Sales: how much an investor is paying for sales revenue. A drawback to
this ratio is that this considers price as a multiple of top line growth, whereas
net income (bottom line growth) may be negative.
d. Price/Earnings/Growth (PEG): used to compare firms with different growth
rates. PEG ratios can be used to determine possible value opportunities for
analysts.
Book Value - The company's equity after subtracting liabilities. Book value is an
inaccurate measure of a company's value as assets are recorded at historical cost
on the company's balance sheet and generally accepted accounting principles may
produce different company valuations, depending on the pronouncements that the
company follows.
Liquidation Value - The value of the business once discontinued when assets are
sold off. The actual value may be a distressed one or one in which the sum of the
parts is greater than the whole. The process can be quite subjective.

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DEFINITION of 'Discounted Cash Flow - DCF'

A valuation method used to estimate the attractiveness of an investment
opportunity. Discounted cash flow (DCF) analysis uses future free cash flow
projections and discounts them (most often using the weighted average cost of
capital) to arrive at a present value, which is used to evaluate the potential for
investment. If the value arrived at through DCF analysis is higher than the current
cost of the investment, the opportunity may be a good one.
Calculated as:

Discounted Cash Flow (DCF)

Also known as the Discounted Cash Flows Model.

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Bond Yield Plus Risk Premium Approach
The bond yield plus risk premium (BYPRP) approach is another method we can use
to determine the value of an asset, specifically, a company's publicly traded equity.
BYPRP allows us to estimate the required return on an equity by adding the equity's
risk premium to the yield to maturity on company's long-term debt
Bond Yield Plus Risk Premium Equation

States that the required return on an equity equals the yield of the company's longterm debt plus the equity's risk premium.
Bond Yield vs. Risk Premium
Simply put, the yield on a bond is the rate of return received from the investment. In
the BYPRP approach, we use a bond's yield to maturity, which is the discount rate at
which the sum of all future cash flows from the bond (coupon payments and
principal payments) are equal to the price of the bond. This is also referred to as the
internal rate of return (IRR).

Yield To Maturity Graph

A hypothetical graph showing yield to maturities (or internal rates of return) for
corresponding present values.
The equity risk premium is essentially the return that stocks are expected to receive
in excess of the risk-free interest rate. The normal historical equity risk premium for
all equities has been just over 6%. In general, an equity's risk premium will be

between 5% and 7%. Common methods for estimating the equity risk premium
include:
The Fed Model (forward operating earnings yield [earnings per share divided by
share price] minus the 10-year U.S. Treasury Bond yield)
The dividend yield plus projected earnings growth, minus the 10-year Treasury yield
The historical stock returns minus the 10-year Treasury yield
Estimating the value of an equity using the bond yield plus risk premium approach
has its drawbacks. We can only utilize the BYPRP approach if the entity has publicly
traded debt, and it does not produce as accurate an estimate as the capital asset
pricing model or discounted cash flow analysis.
Moreover, equity risk premium estimates can be highly inaccurate, while also
varying wildly depending on which model is used. It can be very difficult to get an
accurate estimate of the risk premium on an equity, having a duration of roughly 50
years, using a risk-free rate of such short duration as a 10-year Treasury bond
Example Equation

Required return = 6% + 4%
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