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

DH PH
r
1
P0
DH PH P0
r

P0
P0

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

6
4
Number of Markets

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 RF

EXAMPLE:
FORWARD-LOOKING EQUITY RISK PREMIUM

Yield on treasury bonds

Yield on Treasury inflation-protected
securities

3.8%

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%

1.8%

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 RF

(1 0.02)(1 0.025)(1 0) 1.0 0.028 0.038

3.5%

ESTIMATING THE REQUIRED RETURN ON

AN EQUITY INVESTMENT
Multifactor Models
Capital Asset Pricing
Model

FamaFrench model
PastorStambaugh model
Macroeconomic models
Statistical models

Build-Up Method

CAPITAL ASSET PRICING MODEL

(CAPM)

E ( Ri ) RF i [ E ( RM ) RF ],
Where
- E(Ri) = Required return on equity for security i
- RF = Current expected risk-free return
- i = Beta of security i
- E(RM) = Expected return on the market portfolio
- E(RM) RF = Equity risk premium
Assumptions
- Investors are risk averse
- Investment is based on meanvariance optimization
- Relevant risk is systematic risk

BETA ESTIMATION ISSUES

Choice of Market
Index

S&P 500 and NYSE Composite are

common choices in the United States

Five years of monthly data is most

Length &
common choice
Frequency of Data

Adjusted Betas

Betas move towards 1.0 over time

Thinly Traded and

Adjust comparable betas for leverage
Private Firms

MULTIFACTOR MODELS:
FAMAFRENCH MODEL

Market
Risk
Premium
RiskFree
Return

Size
Premium

Required
Return
on
Equity

Value
Premium

FAMAFRENCH MODEL
ri RF imkt RMRF isizeSMB ivalue HML,
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
ri RF imkt RMRF isizeSMB ivalue HML iliq LIQ,
where
- LIQ = The return to illiquid stocks minus the return to liquid stocks
- liq = The sensitivity of security i to movements in illiquid stocks

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

ri RF

mkt
i

RMRF SMB
size
i

value
i

HML

3% 1.20(5%) 0.12(2.2%) 0.34(3.8%)

10.56%

BUILD-UP METHODS

Required Return
on Equity

For Private Firms

- Typical risk premiums
- size
- firm-specific risk
- Other risk premiums
- marketability
- control

Risk-Free
Rate

Equity
Risk
Premium

Other
Risk
Premiums

Other
Risk
Discounts

Bond Yield plus Risk

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

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

Equity

Tax Rate

Cost of Equity

Market Value
of Equity

WEIGHTED AVERAGE COST OF CAPITAL

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

EXAMPLE:
WEIGHTED AVERAGE COST OF CAPITAL
Risk-free rate

3.0%

Equity risk premium

5.0%

Beta

1.20

YTM of long-term bond

Long-term debt/Total capital at
market value

6.1%
40%

Tax rate

30%

EXAMPLE: WEIGHTED AVERAGE COST OF

CAPITAL
re RF i [ E ( Rm ) RF ]
re 3% 1.2(5%) 9.0%
MVD
MVCE
WACC
rd (1 Tax Rate)
re
MVD MVCE
MVD MVCE
0.40(6.1%)(1 0.30) 0.60(9.0%)
7.11%

CHOICE OF DISCOUNT RATE

Cash Flows WACC
to the Firm
Cash Flows Required return on equity
to Equity
Nominal Nominal discount rates
Cash Flows
Real Cash Real discount rates
Flows

SUMMARY
Return Concepts
Holding period return, realized return, expected return,
required return, discount rate, return from convergence of
price to intrinsic value, and IRR
Equity Risk Premium
= 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

SUMMARY
Models for the Required Return on Equity
Capital asset pricing model
Multifactor models
FamaFrench model
PastorStambaugh model
Macroeconomic models
Statistical models
Build-up method

Beta Estimation Issues

Choice of market index

Length and frequency of data
Adjusted betas
Thinly traded and private firms

SUMMARY
International Considerations for Required
Returns

Exchange rates
Emerging markets
Weighted Average Cost of Capital
Use market values, marginal tax rates, current bond YTM,
and equity required return
Choice of Discount Rate
Use WACC for firm cash flows
Use equity required return for equity cash flows
Use nominal rates for nominal cash flows