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• During recession the short term rate is likely to be far below from the
expected long term level.
Estimation of Equity Premium
• One approach is using historical data – assume that investor’s equity risk
premium is stable over time.
• The average of yearly difference between the return on diversified market
index (S&P 500) and govt securities is the established way to compute the
historical premium.
• However, there is no agreement about the length of the period. [Blanchard
(1993) found a significant decrease in equity risk premium after 1970].
• The best estimate should include all periods such as market crash, bubble,
depression, world war, stagflation & other extraordinary phenomenon.
• The long term historical analysis of equity premium in US and other
developed countries is in between 3 to 5%.
STOCKS (S&P 500)
Nominal Return Real Return
AM GM AM GM
1802-2006 9.6% 8.2% 8.3% 6.8%
1900-2006 11.6% 9.7% 8.3% 6.3%
1926-2006 11.9% 9.9% 8.6% 6.7%
1982-2006 13.5% 12.5% 10.2% 9.0%
T-BONDS
Nominal Return Real Return
AM GM AM GM
1802-2006 5.2% 5.0% 4.0% 3.6%
1900-2006 5.3% 5.0% 2.3% 1.8%
1926-2006 5.9% 5.5% 2.9% 2.5%
1982-2006 12.1% 11.4% 8.7% 8.1%
EQUITY PREMIUMS
Nominal Return Real Return
AM GM AM GM
1802-2006 4.45% 3.09% 4.35% 3.13%
1900-2006 6.29% 4.47% 6.01% 4.43%
1926-2006 5.99% 4.18% 5.71% 4.03%
1982-2006 1.41% 0.92% 1.43% 0.90%
• Graham and Harvey (2006) surveyed the CEOs and asked their estimation
about ex-ante equity premium.
• They found the spread between the expected returns of the S&P 500 and the
10 years T-Bond yield was between 4.35% and 2.39% on 2000 and 2006
respectively.
Historical Return Bias
1926-2005 GM AM S.D.
Large 100 Companies 10.4% 12.3% 20.2%
Small 100 Companies 12.6% 17.4% 32.9%
Source: Ibbotson Associates
Over this period the average returns on long term bond was 5.8%.
Implying that the risk premium was 6.5% for large 100 firms using arithmetic
mean.
What is the problem?
The problem is far more severe for small stocks.
GM is more accurate when earnings growth is more erratic.
If earnings are zero or negative in the initial period, GM is not meaningful.
Revenue growth is more persistent than earning growth (Accounting choice).
Beta
• The individual stock beta has a tendency to regress towards the mean.
Hence, we need to adjust the estimated beta.
• Bloomberg estimates beta with 60 monthly observations.
• Ibbotson Associates computes by taking 104 weekly closing price.
• Adjusted beta = 0.33 + 0.67 × Estimated beta
• Beta & Leverage
• βL = [1+ (1-t)×D/E] × βU
• This is commonly used in practice in order to adjust the difference in
leverage.
• βL also called as equity beta.
Factor Model : Fama-French
• Fama & French found that two other factors accounts for most of the variance in
average stock returns.
1. Size (Mcap): Size can be interpreted as a proxy of liquidity. Average returns are
higher for small cap firms.
2. Book-to-market: Average returns are higher for stocks with higher BTM ratio. BTM
can be interpreted as a proxy of relative distress. Poor prospect firms tend to have
higher BTM ratio & would faces higher cost of capital.
• Fama & French show that these factors explains better cross-section variation of
stock returns than simple CAPM.
• Ri = Rf + βi (Rm - Rf) + Si(SMB) + Hi(HML)
SMB = the difference between the average historical returns on a portfolio of small
stocks and portfolio of big stocks.
HML = the difference between the average historical returns on a portfolio of high
BTM stocks and portfolio of low BTM stocks.
Example:
Estimation of Growth Rate & Growth Period
• One of the major components of forecasting cash flows is to determine the
length of extraordinary growth period which depends on where the firm is
standing in his life cycle.
(i) It is not the question of whether but when firms hit the stable growth wall.
High growth makes the firm larger and size will eventually becomes a
barrier of future high growth.
(ii) In a competitive market high growth (excess return = ROIC > WACC)
eventually draw new competitors.
• Size: Should not only current market share but potential growth in the total
market for its product & services.
• Magnitude & sustainability of competitive advantage: Strength of entry
barrier.
Sustainable Growth Rate
•
Estimating Revenue growth for young firm
• Example: An online toy retailer with Rs.100 million current revenue. Assuming
the entire toy market is Rs.70 billion last year and expected to grow at 3% p.a.
for next 10 years. This retailer is expecting to grab 5% of the total market
share after 10 years.
• Calculate the compounded annual revenue growth rate?
• For higher revenue growth higher re-investment is also required.
• The traditional form of reinvestment is CAPEX.
• Non-traditional Form: Acquisition, investment in distribution and marketing
capabilities, R&D etc.
• Accounting Form: Operating Lease
• Generally we do not consider these while estimation of FCF (Adjusting CAPEX)