Fundamentals of Valuation

Chapter TWO: Return Concepts

1.Introduction
 The return on an investment is a fundamental element in evaluating an investment.
 • Investors evaluate an investment in terms of the return they expect to earn on it
compared to a level of return viewed as fair given everything they know about the
investment, including its risk.
 • Analysts need to specify the appropriate rate or rates with which to discount
expected future cash flows when using present value models of stock value.
2. Return Concepts
 2.1. Holding Period Return
 The holding period rate of return (for short, the holding period return) is the
return earned from investing in an asset over a specified time period.
 R = Dividend yield + Price appreciation return (capital gain yield)

𝐷𝐻 𝑝𝐻 − 𝑝0
 𝑟= +
𝑃0 𝑝0
 2.2. Realized and Expected (Holding Period)
Return
 In the expression for the holding period return, the selling price, PH, and in general,
the dividend, DH, are not known as of t = 0. For a holding period in the past, the
selling price and the dividend are known, and the return is called a realized holding
period return, or more simply, a realized return. For example, with a beginning price
of €50.00, an ending or selling price of €52.00 six months later, and a dividend equal
to €1.00 (all amounts referring to the past), the realized return is €1.00/€50.00 +
(€52.00 − €50.00)/€50.00 = 0.02 + 0.04 = 0.06 or 6 percent over 6 months.
 2.3. Required Return

 A required rate of return (for short, required return) is the minimum level of
expected return that an investor requires in order to invest in the asset over a
specified time period, given the asset’s riskiness. It represents the opportunity
cost for investing in the asset—the highest level of expected return available
elsewhere from investments of similar risk.
 For example, using the capital asset pricing model (discussed in more detail
later), the required return for an asset is equal to the risk-free rate of return
plus a premium (or discount) related to the asset’s sensitivity to market returns.
That sensitivity can be estimated based on returns for an observed market
portfolio and the asset. That is one example of a required return estimate
grounded in a formal model based on marketplace variables (rather than a single
investor’s return requirements). Market variables should contain information
about investors’ asset risk perceptions and their level of risk aversion, both of
which are important in determining fair compensation for risk.
2.4. Expected Return Estimates from Intrinsic
Value Estimates
 When an asset is mispriced, one of several outcomes is possible. Take
the case of an asset that an investor believes is 25 percent
undervalued in the marketplace. Over the investment time
horizon, the mispricing may:
 • increase (the asset may become more undervalued);
 • stay the same (the asset may remain 25 percent undervalued);
 • be partially corrected (e.g., the asset may become undervalued by
15 percent);
 • be corrected (price changes to exactly reflect value); or
 • reverse, or be overcorrected (the asset may become overvalued).
Example 1 An Analyst Case Study (1):
The Required Return on Microsoft Shares
 Thomas Weeramantry and Francoise Delacour are co-managers
of a US-based diversified global equity portfolio. They are
researching Microsoft Corporation (NASDAQ-GS: MSFT),5 the
largest US-headquartered technology sector company.
Weeramantry gathered
 a number of research reports on MSFT and began his analysis of
the company in May 2013, when the current price for MSFT was
$33.31. In one research report, the analyst offered the
following facts, opinions, and estimates concerning MSFT:
 • The most recent quarterly dividend was $0.23 per share. Over
the coming year, two more quarterly dividends of $0.23 are
expected, followed by two quarterly dividends of $0.25 per
share.
 • MSFT’s required return on equity is 7.0 percent.
 • A one-year target price for MSFT is $37.50.
Example 1 An Analyst Case Study (1):
The Required Return on Microsoft Shares
 An analyst’s target price is the price at which the analyst
believes the security should sell at a stated future point in
time. Based only on the information given, answer the
 following question concerning MSFT.
 1. What is the analyst’s one-year expected return?
Answer of MSFT case
 Solution: Over one year, the analyst expects MSFT to pay $0.23 +
$0.23 + $0.25 + $0.25 = $0.96 in dividends.
 Using the target price of $37.50 and dividends of $0.96, the analyst’s
expected return is ($0.96/$33.31) + ($37.50 − $33.31)/$33.31 = 0.029
+ 0.126 = 0.155 or 15.5 percent.
2.5. Discount Rate
 Discount rate is a general term for any rate used in finding the
present value of a future cash flow. A discount rate reflects the
compensation required by investors for delaying consumption—
generally assumed to equal the risk-free rate—and their required
compensation for the risk of the cash flow.
Generally, the discount rate used to determine intrinsic value depends on
the characteristics of the investment rather than on the characteristics
of the purchaser.
2.6. Internal Rate of Return

 The internal rate of return (IRR) on an investment is the discount rate that
equates the present value of the asset’s expected future cash flows to the
asset’s price—that is, the amount of money needed today to purchase a right
to those cash flows.
Year−ahead dividend
 Required rate estimate =
Market price + expected dividend growth rate
 The use of such an IRR as a required return estimate assumes not only market
efficiency, but also the correctness of the particular present value model (in
the above example, the stable growth rate assumption is critical) and the
estimated inputs to the selected model.
3. The Equity Risk Premium
 The equity risk premium is the incremental return (premium) that investors
require for holding equities rather than a risk-free asset. Thus, it is the
difference between the required return on equities and a specified expected
risk-free rate of return.
 equity risk premium is also commonly used to refer to the realized excess
return of stocks over a risk-free asset over a given past time period.
 Using the equity risk premium, the required return on the broad equity
market or an average-systematic-risk equity security is
 Required return on equity = Current expected risk-free return + Equity
risk premium

 required return on share i = Current expected risk-free return + ᵦ𝑖 (equity

risk premium)
Thank You