RETURN CONCEPTS

Presenter
Venue
Date

WHY FOCUS ON RETURN CONCEPTS?
To evaluate expected
and past performance
To understand risk
premiums
To estimate discount
rates for valuation
HOLDING PERIOD RETURN









0
0
0 0
1
H H
H H
D P
r
P
P P D
r
P P

OTHER RETURN CONCEPTS
Required
Return
Return from
Convergence
of Price to
Intrinsic
Value
Discount
Rate
Internal Rate
of Return


EQUITY RISK PREMIUM

Current
expected
risk-free
return
Equity
risk
premium
Required
return on
equity


EQUITY RISK PREMIUM ESTIMATES
Historical Estimates

Forward-Looking Estimates
-Gordon growth model estimates
-Macroeconomic model estimates
-Survey estimates



ISSUES FOR USING HISTORICAL EQUITY
RISK PREMIUM ESTIMATES

Length of Sample Period
- Balancing long-term and short-term considerations

Geometric vs. Arithmetic Mean
- Geometric more accurately reflects future value

Choice of Risk-Free Return
- On-the-run long-term Treasuries

Survivorship Bias
- Using returns from surviving firms artificially inflates estimates of return

Strings of Unusual Events



HISTORICAL EQUITY RISK PREMIUM ESTIMATES

1
4
1
6
4
1
1% to
2%
2% to
3%
3% to
4%
4% to
5%
5% to
6%
6% to
7%
N
u
m
b
e
r

o
f

M
a
r
k
e
t
s

Equity Risk Premiums


FORWARD-LOOKING EQUITY
RISK PREMIUM ESTIMATES

Gordon
growth
model risk
premium
Dividend
yield
Earnings
growth rate
Government
bond yield


FORWARD-LOOKING EQUITY
RISK PREMIUM ESTIMATES


Macroeconomic Model Equity Risk Premium (ERP)
ERP (1 EINFL)(1 EGREPS)(1 EGPE) 1 EINC
F
R


EXAMPLE:
FORWARD-LOOKING EQUITY RISK PREMIUM

Yield on treasury bonds 3.8%
Yield on Treasury inflation-protected securities 1.8%
Expected growth in labor productivity 1.5%
Expected growth in labor supply 1.0%
Expected growth in the P/E 0.0%
Expected dividend yield 2.7%
Return from reinvestment of income 0.1%


EXAMPLE:
FORWARD-LOOKING EQUITY RISK PREMIUM

1 Treasury Bond Yield
Expected Inflation
1 TIPS Yield
1 0.038
Expected Inflation 1 2.0%
1 0.018

EXAMPLE:
FORWARD-LOOKING EQUITY RISK PREMIUM

Real earnings growth Labor productivity Labor supply growth
1.5% 1.0%
2.5%
Expected income Dividend yield Reinvestment return
2.7% 0.1%
2.8%

EXAMPLE:
FORWARD-LOOKING EQUITY RISK PREMIUM

Macroeconomic model equity risk premium
=
ERP (1 EINFL)(1 EGREPS)(1 EGPE) 1 EINC
(1 0.02)(1 0.025)(1 0) 1.0 0.028 0.038
3.5%

F
R
ESTIMATING THE REQUIRED RETURN ON
AN EQUITY INVESTMENT
Capital Asset Pricing
Model
Multifactor Models
FamaFrench model
PastorStambaugh model
Macroeconomic models
Statistical models
Build-Up Method


CAPITAL ASSET PRICING MODEL
(CAPM)


Where
- E(R
i
) = Required return on equity for security i
- R
F
= Current expected risk-free return
-
i
= Beta of security i
- E(R
M
) = Expected return on the market portfolio
- E(R
M
) R
F
= Equity risk premium

Assumptions
- Investors are risk averse
- Investment is based on meanvariance optimization
- Relevant risk is systematic risk
( ) [ ( ) ],
i F i M F
E R R E R R


BETA ESTIMATION ISSUES
S&P 500 and NYSE Composite are
common choices in the United States
Choice of Market
Index
Five years of monthly data is most
common choice
Length &
Frequency of Data
Betas move towards 1.0 over time Adjusted Betas
Adjust comparable betas for leverage
Thinly Traded and
Private Firms
MULTIFACTOR MODELS:
FAMAFRENCH MODEL
Required
Return
on
Equity
Value
Premium
Size
Premium
Market
Risk
Premium
Risk-
Free
Return
FAMAFRENCH MODEL
where
- SMB = The return to small stocks minus the return to large stocks
-
size
= The sensitivity of security i to movements in small stocks
- HML = The return to value stocks minus the return to growth stocks
-
value
= The sensitivity of security i to movements in value stocks

PASTORSTAMBAUGH MODEL


where
- LIQ = The return to illiquid stocks minus the return to liquid stocks
-
liq
= The sensitivity of security i to movements in illiquid stocks


mkt size value
RMRF SMB HML,
i F i i i
r R
mkt size value liq
RMRF SMB HML LIQ,
i F i i i i
r R
EXAMPLE:
FAMAFRENCH MODEL
Risk-free rate 3.0%
Equity risk premium 5.0%
Beta 1.20
Size premium 2.2%
Size beta 0.12
Value premium 3.8%
Value beta 0.34
EXAMPLE:
FAMAFRENCH MODEL
mkt size value
RMRF SMB HML
3% 1.20(5%) 0.12(2.2%) 0.34(3.8%)
10.56%

i F i i i
r R
BUILD-UP METHODS
For Private Firms
- Typical risk premiums
- size
- firm-specific risk
- Other risk premiums
- marketability
- control

Bond Yield plus Risk
Premium Method
- Useful if firm has public
debt
- YTM on long-term debt +
risk premium

Required Return
on Equity
Risk-Free
Rate
Equity
Risk
Premium
Other
Risk
Premiums
Other
Risk
Discounts
INTERNATIONAL CONSIDERATIONS FOR
REQUIRED RETURNS
Exchange Rates
Emerging Markets
Country spread model
Country risk rating
model
WEIGHTED AVERAGE COST OF CAPITAL
Weighted
Average
Cost of Capital
Debt
Cost of Debt
Market Value
of Debt
Tax Rate
Equity
Cost of Equity
Market Value
of Equity
WEIGHTED AVERAGE COST OF CAPITAL




Where
- MVD = Current market value of debt
- MVCE = Current market value of common equity
- r
d
= Before-tax cost of debt (which is transformed into the after-tax cost by
multiplying it by 1 Tax rate)
- r
e
= Cost of equity

MVD MVCE
(1 Tax Rate) ,
MVD MVCE MVD MVCE


d e
r r
EXAMPLE:
WEIGHTED AVERAGE COST OF CAPITAL
Risk-free rate 3 .0%
Equity risk premium 5 .0%
Beta 1 .20
YTM of long-term bond 6 .1%
Long-term debt/Total capital at market value 40 %
Tax rate 30 %
EXAMPLE: WEIGHTED AVERAGE COST OF
CAPITAL
MVD MVCE
WACC (1 Tax Rate)
MVD MVCE MVD MVCE
0.40(6.1%)(1 0.30) 0.60(9.0%)
7.11%

d e
r r
[ ( ) ]
3% 1.2(5%) 9.0%
e F i m F
e
r R E R R
r


CHOICE OF DISCOUNT RATE
WACC
Cash Flows
to the Firm
Required return on equity
Cash Flows
to Equity
Nominal discount rates
Nominal
Cash Flows
Real discount rates
Real Cash
Flows
SUMMARY
Holding period return, realized return, expected return,
required return, discount rate, return from convergence of
price to intrinsic value, and IRR
Return Concepts
= Required return on equity Risk-free return
Historical estimates
Issues in estimation: Sample period length, geometric vs.
arithmetic mean, risk-free return choice, survivorship bias,
strings of unusual events
Forward-looking estimates: Gordon growth model estimates,
macroeconomic model estimates, survey estimates
Equity Risk Premium
SUMMARY
Capital asset pricing model
Multifactor models
FamaFrench model
PastorStambaugh model
Macroeconomic models
Statistical models
Build-up method
Models for the Required Return on Equity
Choice of market index
Length and frequency of data
Adjusted betas
Thinly traded and private firms
Beta Estimation Issues
SUMMARY
Exchange rates
Emerging markets
International Considerations for Required
Returns
Use market values, marginal tax rates, current bond YTM,
and equity required return
Weighted Average Cost of Capital
Use WACC for firm cash flows
Use equity required return for equity cash flows
Use nominal rates for nominal cash flows
Choice of Discount Rate